At first glance, the BT (LSE: BT.A) share price looks highly attractive. Indeed, shares in the telecommunications giant are trading at a price-to-earnings ratio (P/E) of just 6. That suggests they offer a margin of safety at current levels.
Further, the stock supports a dividend yield of 10.8%, at the time of writing. That looks extremely attractive in the current interest rate environment. It’s also more than double the FTSE 100 average of 4.7%.
However, it doesn’t look as if this dividend is sustainable. What’s more, BT’s management has warned several times over the past 12 months it could cut the distribution to fund capital spending. So, can investors depend on this double-digit dividend yield, or is it worth looking elsewhere for income?
The dividend question
It looks as if the market has already priced in a dividend cut at the company. The problem is, BT is just trying to do too much with too little.
It’s having to spend billions upgrading the UK’s internet infrastructure. At the same time, the company is also investing billions in 5G networks. Spending on sports content rights for its pay-TV channel, as well as marketing efforts, are also consuming big chunks of cash. Then there’s the firm’s colossal pension deficit to consider.
Boris Johnson’s decision to limit Chinese tech company Huawei’s exposure to the UK telecoms infrastructure is also expected to cost the business £500m.
When you take all of the above together, it becomes clear just how hard up the company really is. Its fiscal third-quarter results showed a 42% decline in free cash flow to £1bn, due to increased capital spending and sports rights payments.
Net debt increased by £1.1bn between 31 March-31 December last year. According to its results release, the increase in borrowing was “driven by £1.3bn of contributions to the BT Pension Scheme, £1.1bn dividend payment, £2.9bn net capital expenditure, £0.6bn lease payments, and £0.5bn interest payments.”
These outflows, totalling £6.4bn, were offset by cash flow from operations of £5.2bn. In other words, it seems as if BT’s dividend was paid with borrowed money. That’s a big red flag.
The pressures the company is facing aren’t going to dissipate any time soon. It will take several years to continue the rollout of the fibre broadband across the country, and BT will always have substantial capital spending commitments.
It can only borrow so much money before creditors start asking tough questions. As such, it doesn’t look as if the dividend is sustainable at current levels. BT cannot continue to borrow money to return cash to its investors, at current levels, indefinitely.
A dividend cut would improve dividend sustainability and help the group shore up its balance sheet. That might hurt income investors in the short term, but it would safeguard the company’s balance sheet for the long run.
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Rupert Hargreaves has no position in any of the shares mentioned. The Motley Fool UK has no 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.