BT Group’s (LSE: BT.A) much-discussed £530m write-off related to fraud from Italian operations rightly came as a shock to investors of all stripes. However, while this is a large sum of money, I see much greater problems looming on the horizon for the massive telco than a single profit warning.
Openreach
The most worrying issue for me is continued wrangling with regulator Ofcom over the future of Openreach, BT’s subsidiary that owns the vast majority of the UK’s broadband and fixed line telephone infrastructure. Competitors accuse BT of stifling investment in Openreach which, alongside complaints from the public and politicians over the UK’s slow broadband speeds, has led regulators to consider forcing BT to formally divest it.
Although Ofcom’s latest review only mandated a legal separation, granting Openreach an independent board of directors and control over its own budget, BT and regulators continue to tussle over just how independent it should be. This is a dangerous situation for BT as Openreach is the group’s most profitable division and in Q3 provided 36% of group EBITDA and a whopping 60% of free cash flow. Losing this cash cow would understandably put BT in a very poor situation.
Risky business
Potentially saying goodbye to Openreach’s stunning cash generation couldn’t come at a worse time for BT as it’s attempting to reinvent itself as a consumer-oriented business offering quad-play packages of fixed line telephone, broadband, pay-TV and mobile services.
The investments needed to offer these services are expensive and it has in recent years spent £12.5bn acquiring mobile provider EE and billions more on sports rights to entice customers to sign up for its pay-TV options. These investments pushed net debt at the end of Q3 up to £8.9bn, or roughly 3.5 times forecast full-year free cash flow.
This business model may pay off as retail customer numbers are rising and quad-play packages do reduce churn and can kick off significant cash flow. That said, BT is joining an already crowded marketplace with major competitors such as Sky and Vodafone already targeting these same high-spending customers. If consumers don’t switch to its offerings, the company could be left with a load of debt and not much to show for it.
High debt
At 3.5 times full year free cash flow, net debt isn’t by itself a major problem just yet. However, the combination of high debt service payments, continued investments in the business, hefty dividends and much-needed pension contributions were greater than the cash generated by the business last year. This means that unless the big bet on the consumer-facing business pays off, BT will be forced to make the tough decision of whether to cut dividends or investments in growing the company.
In total all of these problems leave me viewing the group as a suspect investment at best. Growth and income investors alike will find there are plenty of safer options out there. Perhaps value investors may find BT worth a punt at 13 times trailing earnings, but I’ll certainly be looking elsewhere for the time being.
