BT Group (LSE: BT-A) shares look pretty cheap at the moment. Trading on about nine times forecast earnings and with a 6.5% dividend yield, they’re a tempting target for income-seeking investors.
Despite this, the market wiped 5% off the group’s share price on Friday morning, when third-quarter figures showed a 3% drop in both revenue and adjusted earnings during the three months to 31 December.
BT said the fall was mainly due to tough trading in its Global Services division, which works with corporate customers. But I think it’s also worth noting that average monthly revenue from mobile users on contracts fell by 2% to £26.20. Despite network upgrades, tough competition appears to be keeping a lid on prices.
Here’s what worries me
BT has been on my watch list for some time, but I’ve been struggling to decide whether to invest.
My main concern is that high levels of spending haven’t generated much growth. Excluding around £5bn of annual revenue from the 2016 acquisition of EE, the group’s revenue is broadly unchanged from 2012.
A second concern is that profitability has fallen sharply in recent years. BT’s return on capital employed — a useful measure of profitability — has fallen from an impressive 19% in 2012 to just 9.4% last year.
Finally, BT’s monster £7.9bn pension deficit and net debt of £8.9bn could limit the group’s ability to invest in growth.
The outlook may be improving
I believe all of the risks facing the group should be manageable.
For example, there are signs that spending on television sports rights could soon fall. Chief executive Gavin Patterson said recently that he’d be happy to be a “strong number two” behind Sky. A recent content-sharing deal with Sky seems to support the view that both companies will co-operate to offer their customers a broader range of content.
It’s also worth remembering that the wider telecoms sector has also experienced tough trading over the last few years. BT’s market-leading scale could make it a good choice as a contrarian buy. And the recent arrival of highly-regarded chairman Jan du Plessis could also be a catalyst for a turnaround.
Cash + dividend attraction
One reason to like BT is that the business still generates a lot of cash. Today’s figures show that normalised free cash flow for the nine months to 31 December was £1,947m, broadly unchanged from the same period in 2016.
Although this normalised figure excludes the cash impact of various one-off costs, net debt was broadly unchanged at the end of 2017, despite £2.5bn of capital expenditure.
Income investors will be hoping this stable performance will support the dividend. The payout is expected to rise by 2.7% to 15.8p per share this year, giving a prospective yield of 6.5%.
I estimate the cash cost of this payout would be about £1.55bn. The company’s guidance is for normalised free cash flow of £2.7bn-£2.9bn this year. Given the other demands on BT’s cash — especially pension deficit payments — I think the dividend is at the top end of what’s affordable. A cut might be necessary .
Despite this risk, I’m tempted to put a long-term buy rating on BT. I believe there’s a lot of room for improvement and expect this value to be realised, sooner or later.
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