Over the past two years, shares in BT (LSE: BT-A) have taken a hammering as investors have turned their backs on the company. Since mid-2015, shares in the telecoms giant have slumped by 33% excluding dividends.
It does not look as if there’s any respite on the horizon either. BT is under attack from all sides. Regulators want the company broken up, customers are looking elsewhere for better deals, and its pension problems are not going to go away any time soon. The biggest issues, however, are the company’s ballooning debt and pension obligations.
Pension problems
BT has an estimated £14bn pension deficit which is causing a massive headache for the company and its management. It needs to get this obligation under control, but the options are limited. There’s been talk of industrial action if management tries to curb the benefits or close the scheme, which would cripple the business. There’s also been chatter that regulators may force it (and others like it) to curb its dividend payouts to investors to contribute more to the fund.
This is an enormous risk in my view. The £14bn deficit is not just a threat to investors’ profits, but it’s also a risk to the firm’s long-term growth potential. If it is forced to sacrifice capital spending to increase contributions to the pension scheme, it’s going to be difficult for management to compete with peers that are encroaching on its turf. Companies such as Vodafone, Sky and Talktalk are all chipping away at BT’s dominance, and they don’t have the same regulatory and financial issues, giving them more money to spend on customer acquisition.
With this being the case, even though shares in BT currently support a highly attractive dividend yield of 4.9%, I would not buy the company for its dividend potential. Instead, I like the look of Rio Tinto (LSE: RIO) which has a much more flexible financial profile and is not facing pressure from regulators or pension trustees.
Cash cow
Over the past few years, Rio has undergone an impressive transformation. The company has refocused its business on cash generation, cutting costs as low as possible and mothballing expensive capital projects.
The results have been nothing short of outstanding, and Rio is now a cash cow. The company paid down $2bn in debt during the six months to June 30, taking net debt to $7.6bn, almost half the level reported at the end of fiscal 2015. Pre-tax profit for the period jumped 57% to nearly $5bn.
With debt falling and profits flowing, management has decided to reward shareholders with a record interim dividend payout of $1.10 (83p per share at current exchange rates), equivalent to $2bn. The miner is also planning to double its current $500m share buyback scheme. These record payouts come just a few years after Rio slashed its dividend following a downturn in the mining industry. And while management was initially scolded by investors for taking this action, it seems it has paid off with debt down significantly, giving management more flexibility for cash returns.
City analysts had been expecting the company to pay out 192p per share for 2017, giving a dividend yield of 5.7%. So overall, as an income play, Rio looks to be a much better buy than BT.
