Personally, I’ve always avoided BT (LSE: BT.A) as an investment because, while the company does have some desirable traits, it also has plenty of other negative qualities.
The most significant sticking point for me has always been its debt. I try to avoid companies with high levels of debt because they lack financial flexibility. At the last count, the group reported a net debt figure of £9.6bn, and that’s excluding the pension deficit of £11.3bn.
Taking action
The good news is, the company is taking action to reduce it’s retirement obligations. Last month BT agreed to a 13-year recovery plan with the trustees of the pension scheme. Under the terms of the deal, the group will make payments of £2.1bn by March 2020 with a further £900m a year due after this initial balloon payment for 10 years. Management has also offered to raise an additional £2bn for the fund by issuing more bonds.
This is a bitter pill to swallow for investors as it will reduce the amount of cash available for distribution. But by cleaning up part of its balance sheet, the company is heading in the right direction.
At the same time, over the next few years, BT is planning to undertake a massive restructuring of its business. As part of this, the firm is planning to move from its London headquarters site and cut 13,000 back office and middle management jobs.
Unfortunately for staff who will lose their jobs, this appears to be the right course of action. Compared to international peers, BT looks like a bloated corporate beast. The company’s operating margin has steadily declined over the past five years from 15.5% to 13.3%. For comparison, US peer Verizon Communications reported an operating margin of 21% for its last financial year. Telecom Italia margin is 16%, and Swisscom AG sits in the middle with 18%.
The root of the problems
I believe the bulk of BT’s issues can be traced to the decisions of its former CEO Gavin Patterson. Since he took charge in 2013, the group’s revenue has increased from £18.3bn to £23.7bn, but higher operational spending has kept net profit flat.
Mr Patterson’s empire building has done the company no favours. His decision to spend more than £5bn on sports rights and then £12.5bn buying mobile provider EE starved the group of cash, leading to higher debt and underinvestment in its core telecoms business. And as I noted above, there’s little to show for this spending. Revenue is higher but so are costs. Meanwhile, net debt has jumped by more than £2bn, or 24%, and the number of shares in issue has risen by a fifth, diluting existing holders.
Return on capital employed, a measure of how much profit a company is generating for every £1 invested in the business, has declined from 16.9% in 2014 to 9.7% for 2018.
All of the above leads me to conclude that Mr Patterson has done nothing but destroy shareholder value over the past five years.
In my opinion, BT would be in a much better position today if the company had stuck to its core focus, and rather than investing billions in trying to break into new markets, reinvested the cash into its existing network.
When Mr Patterson took over, BT was the UK’s largest telecommunications provider by far with a dominant and unrivalled position in the market. Competitive advantages only last if a company invests in keeping competitors at bay, which it has failed to do.
Not only is the company now facing attacks on all fronts from multiple competitors, it has also attracted the ire of regulators who believe the business has let down customers by chasing after new markets. Sharon White, head of Ofcom, recently speculated that BT was in danger of going the same way as Kodak and Polaroid unless it stepped up investment in fibre.
Changing of the guard
It finally looks as if the company has got the message. BT is now planning to devote £3.7bn a year to upgrading its mobile and fibre networks. Part of the funding for this will come from cost savings of £1.5bn projected to be achieved from job losses.
What’s more, it’s beginning to look as if it is contemplating winding down its pay-TV operation now Mr Patterson is no longer in charge.
It is believed that the former CEO was forced to step down due to a loss of investor confidence. The Financial Times reported the same set of investors think the firm’s foray into pay-TV, notably the high-priced sports rights binge was a mistake the company should seek to reverse.
All in all, it looks to me as if BT is going to reverse course over the next few years and double down on what it knows best, telecommunications.
By investing in its core network and slowing spending on other expensive ventures, the business should also be able to start substantially reducing its tremendous debt pile — even after taking into account the excess pension payments.
Time to buy?
With this being the case, it looks to me as if the BT share price could be an attractive buy at current levels.
As the group’s problems have built up, its share price has plunged to a low not seen since 2011, dragging the valuation down with it. At the time of writing, the stock trades at a forward P/E of just 7.8, supports a dividend yield of 7.4% and trades at an enterprise value to earnings before interest tax depreciation and amortisation ratio (EV/EBITDA) of 4.7, around half of the telecommunications industry median.
There’s plenty of bad news already baked into this stock price, and in reality, I don’t see much further downside if BT continues to struggle. However, if the group’s turnaround plan starts to yield results, the stock could more than double (based on the EV/EBITDA ratio) as investors return.
