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Is BT Group plc a falling knife to catch after dropping 15% today?

Shares of BT Group (LSE: BT-A) fell by 18% during the first hour of trading this morning after the group issued a profit warning and warned that the cost of an Italian accounting scandal could mean a hit of £530m.

Italian scandal

In October, BT announced that an internal investigation of accounting practices in its Italian business had identified “certain historical accounting errors”. These were expected to result in a writedown of £145m.

BT has since commissioned an independent review of the problem by accountants KPMG. It found that “the extent and complexity of inappropriate behaviour were far greater than previously identified”.  The total cost of this accounting scandal is now expected to be that worrying £530m.

This won’t just be a historical restatement of accounts. BT expects normalised free cash flow to fall by £500m this year due to the cash costs involved in unwinding these inappropriate transactions.

Problems at home

BT’s Italian problems are bad enough. But the group has also issued a full-scale profit warning this morning.

Lower levels of spending by UK public sector and international corporate customers mean that full-year adjusted earnings before interest, tax, depreciation and amortisation (EBITDA) should now be about £7.6bn, down from previous guidance of £7.9bn. Normalised free cash flow is expected to be about £2.5bn, down from £3.1bn-£3.2bn previously.

BT’s guidance has also been cut for 2017/18. The firm now expects revenue, adjusted EBITDA and free cash flow to remain broadly flat next year.

The only potential bright spot is that BT says dividend payments will still increase by 10% in both 2016/17 and 2017/18.

Is BT a recovery buy?

BT shares have now fallen by 36% to just 310p over the last year. The shares haven’t traded at this level since 2013. So is this a contrarian buying opportunity?

I’m not sure. Today’s news has surprised the market. Some of the group’s major customers must have made quite severe cuts to spending.

However, BT has been struggling to generate sales growth for years. The group’s revenue fell from £20.1bn in 2011 to £18.9bn in 2016. Although the acquisition of mobile operator EE has added about £5bn to annual sales, it doesn’t seem to be contributing much organic growth.

Based on today’s guidance, I estimate that BT shares are now trading on a P/E of about 11, with a prospective yield of about 4.9%.

These figures may seem cheap, but I’m concerned that the pressure on BT’s finances will worsen over the next year. Free cash flow is now expected to be lower than expected, but demands on the group’s cash will remain high.

Today’s dividend guidance suggests the group will pay out about £1.5bn to shareholders over the next year. BT also faces a triennial pension valuation in June. The group’s pension deficit had ballooned to £9.5bn at the end of September 2016, so it could face additional deficit reduction payments following this summer’s valuation.

Overall, I think there’s a good chance that things will get worse before they improve. Earnings and dividend guidance may be cut again. I won’t be buying after today’s news.

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Roland Head 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.