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Why I’m avoiding BT Group plc despite 20%+ upside potential by 2019

Photo: Albert Bridge. Cropped. Licence: http://creativecommons.org/licenses/by-sa/2.0/

BT‘s (LSE: BT.A) share price has slumped by 22% in the last month. The news that its Italian division will be investigated, as well as downgrades to future profitability, have not been well-received by the market. Clearly, it could make a comeback and deliver upwards of 20% in capital gains over the next couple of years. However, the reality is that the company remains relatively high risk and could be worth avoiding at the present time.

An upbeat future?

In the current financial year, BT is forecast to record a fall in earnings of 16%. Much of this is due to the impact of the performance of the Italian division. Looking ahead, it is expected to have a further negative impact over the medium term. However, the company is expected to return to positive earnings growth in the next financial year.

For example, in 2018 its bottom line is forecast to rise by 3%, and in 2019 its net profit is due to move 5% higher. While neither of these figures are particularly impressive, they show that BT may be more resilient than many investors realise. In fact, if the stock was to trade on its five-year average price-to-earnings (P/E) ratio of 12.2 and meet its forecasts to 2019, its shares could move over 20% higher in the next two years.

Risky outlook

While there may be upside potential on offer, there is also considerable risk. The full extent of the problems within the Italian division may not yet be known and until the investigation is fully completed, the company’s share price could remain under pressure. Furthermore, how it will impact the performance of the business in future is a known unknown. As such, the forecasts for 3% and 5% growth in the next two years may prove to be overly optimistic.

Sector growth potential

Certainly, there is now reduced choice for investors within the quad-play sector. The acquisition of Sky (LSE: SKY) by 21st Century Fox means there is one less option for investors looking for long-term growth. However, the sector seems to be a relatively sound place in which to invest. The offering of quad-play services by the likes of Sky and BT means they could benefit from cross-selling opportunities. This could boost their bottom lines and lead to higher share prices over the medium term.

Of course, when compared to Sky’s P/E ratio of 17.6, BT’s rating of 10.9 indicates it is a buy. However, Sky has a bid premium included within its current valuation, so the gap is probably not as wide as it first appears. In addition, Sky lacks the uncertainty of a major investigation into one of its business units, which could harm BT’s profit yet further. As such, despite its obvious capital gain potential, the overall risk/reward ratio for BT seems to be relatively unfavourable.

A top growth stock

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Peter Stephens has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.