Dividend yields can be tricky things. On one hand, a high yield can be a signal that a company is being undervalued relative to its income-generating ability. On the other, it can be a sign of distress, and of the possibility of a coming dividend cut.
BT (LSE: BT) shares have a yield of 7.5% currently, significantly higher than the FTSE 100 average of around 4.5%. So which category do they fall into? Personally, I think it’s the latter. Here’s why.
Dividend unchanged for now
BT recently reported that it would leave its full-year dividend unchanged at 15.4/share, to the surprise of some observers and analysts. It had been reported that new CEO Philip Jansen was keen to slash the payout, but had been resisted by the board. While this may be welcome news to income investors in the near-term, it does raise some questions over how much capital management will be able to deploy if they are to turn the company around.
BT shares are currently trading at around 205p/share, which is right near fiveyear lows. Shareholders have been hoping that this new regime might be able to right the ship by investing aggressively in expanding its fibre optics network. (Indeed, that is why some see the current share price as a good entry point.) That may be a good way for BT to go forward. But how can it do that and maintain the dividend at its current level?
The total year-end dividend payout will come out to around £1.5 billion, while free cash flow for the year is expected to be somewhere between £1.9 billion and £2.1 billion. With mounting pension obligations and a growing debt load – all on top of these vaunted expansion plans – where is the money coming from, exactly? To make matters worse, normalised cash flow is expected to decline by almost 20% in 2019, putting further strain on the corporate treasury.
It is my belief that investors should consider the long-term prospects of a company, rather than just chasing high yields. I think that the current dividend is unsustainable in the long run, regardless of the recent announcement, meaning that the current high dividend yield is not an instance of free money, and that shareholders should not be surprised if it comes down.
That isn’t to say that Jansen and company cannot pull off the turnaround, provided they are given room to work. But if the board relents and does allow him to cut the dividend later this year, or even in early 2020, you can bet that the share price will not respond well. For this reason, I am wary of committing any capital.
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Neither Stepan nor The Motley Fool UK hold a position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.