BT Group (LSE: BT-A) is the kind of big cap income stock I like to buy following bad news. The stock has already risen by 10% since the end of January, when BT warned investors to expect a £530m loss as a result of accounting mis-statements in its Italian business.
It’s probably fair to assume that this is a one-off issue, so BT’s forecast P/E of 12 and prospective yield of 4.5% could be a buying opportunity.
Good news x2
BT impressed the market last week with two pieces of good news.
The first was that the group has agreed a deal with regulator Ofcom regarding Openreach. BT will be allowed to retain control of Openreach in exchange for making the broadband division “a legally separate company”.
The second piece of good news was the appointment of Jan du Plessis as the group’s next chairman. Mr du Plessis is a respected City heavyweight who has successfully guided Rio Tinto through a difficult period over the last eight years. He was also chairman of SABMiller when the group was sold to AB InBev in the third-largest takeover of all time.
I’m positive about the outlook for BT under Mr du Plessis’s chairmanship, and I’m a (reasonably) satisfied customer of the firm. But I’ve still not bought any shares. Here’s why.
Read the small print
The press coverage of BT’s share price crash in January focused on the group’s headline Italian problems. But the company also put out a profit warning that day.
BT cautioned investors that the outlook for “UK public sector and international corporate markets has deteriorated”. The firm now expects underlying revenue to be flat during 2016/17 and 2017/18.
If a company’s sales are flat but inflation is rising, then profit growth becomes very difficult as costs tend to rise. BT’s forecasts bear this out. The group expects earnings before interest, tax, depreciation and amortisation (EBITDA) to be broadly flat in 2017/18.
Despite this, BT remains committed to a policy of increasing its dividend by 10% each year. The group justifies this with reference to its free cash flow, which is expected to be £2.5bn in 2016/17 and £3.0-£3.2bn in 2017/18. But this is an adjusted figure. It excludes deficit reduction payments on BT’s £11bn pension deficit and some other exceptional costs.
Bad news to come?
The net cost of BT’s pension deficit payment last year was £677m. I’ve assumed a similar cost this year. I’ve also added in the £200m BT has spent on share buybacks to cancel out the dilution caused by employee share options. This leaves the group with free cash flow of about £1.6bn. That should be just enough to cover this year’s dividend, which I estimate will cost about £1,530m.
My concern is that the outlook for next year may worsen. The group’s current chief executive Gavin Patterson will want to minimize bad news in the hope that trading will improve. But when Mr du Plessis arrives in November, he’s likely to want to get bad news out of the way fast.
I think it’s too soon to buy BT. In my view, there’s a real chance of another profit warning and perhaps a dividend cut. For now, this one’s going onto my watch list.
Roland Head owns shares of Rio Tinto. The Motley Fool UK owns shares of and has recommended Anheuser-Busch InBev NV. The Motley Fool UK has recommended Rio Tinto. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.