Interactive Investor

Stockwatch: BT and a sector bucking the market trend

25th January 2022 12:17

Edmond Jackson from interactive investor

Our companies analyst assesses the strengths of this industry from a personal perspective, and concludes it’s a good bet in a troubled world. 

Telecoms were an interesting standout versus Mondays market slide, with BT (LSE:BT.A) up 3p to 192p until Wall Street took a big dive, and Vodafone (LSE:VOD) up 7p to 125p, significantly on merger speculation in Sundays press.  

Both stocks have been in a strong bull trend since early November, up 38% and 15%, respectively. To what extent might this reflect a general shift towards ‘defensive’ stocks with assumed yield strength? How resilient are they to inflation, and also to market turbulence now the Ukraine crisis looks set to fester? 

Markets finally wake up to Putins brinkmanship 

Following my piece on East European hostilities last Friday, there is no genuine diplomacy under way and both sidespositions are hardening: Russia seeks a return to the 1990s balance of power in Eastern Europe, while Natos red line is to maintain – indeed reinforce – its defences in Bulgaria and Romania.  

Possibly, a way out of conflict over Ukraine would be to declare autonomy in the Donbas eastern region of the country; but hawks in the West would dismiss that as classic appeasement, rewarding Putins tactics and raising the odds that they will continue. 

The prospect of war and sanctions likely to harm the West as well as Russia are coming just when central banks need to tighten monetary policy to contain inflation. A flight to safety is justifiably under way in equities, but do telecoms constitute more than a current wonder?  

Companies genuinely able to pass on price rises 

My bullishness on telecoms derives initially from scepticism about Ofcom – which I do not regard as sufficiently strong in consumer interests. Price rises will not be challenged by a regulator that has swallowed the corporate line – that they are justified by necessary investment to upgrade infrastructure. 

BTs managing director for consumer customer services tweeted five days ago about a 9.3% total price rise from 31 March – constituting CPI inflation of 5.4% plus BTs policy of 3.9%. As far as I can see across the industry (having just lately searched for a relative wanting to switch provider), rivals are broadly herding around this rate of increase; I would say they are taking their cue from what the big beast in British telecoms has got away with on pricing policy.  

Ofcom will doubtless not object to BTs citing an exceptional factor: the dramatic increase” in data usage over recent years. Broadband use has risen 90% since 2018 and mobile data usage is up by 79%. BT’s relentless spamming of customers to take up BT Sport subscriptions over recent years is unrelated. 

Another reason (within its marketing agenda) is unlimited” use plans requiring network investment to handle the big increase in demand. Simultaneously, the pandemic has boosted working from home, online education and TV streaming. 

Ofcom has already allowed BT to write 3.9% plus inflation” into its terms and conditions, so it will be interesting to see if in due course rivals use this benchmark to price more keenly. But for the time being, Vodafone and others are in line. 

Aside from merger speculation with Three, which would potentially re-rate Vodafones UK reach, the extent of price rises looked a key reason for BT sharesstrength Monday morning, as investors digested over the weekend how those price rises could reinforce cash flow and thereby payout prospects. 

BT offers relatively more secure dividend profile 

A key reason why I drew attention to BT as a buy” from 102p in November 2020 was its firm objective to restore a 7.7p progressive dividend policy. It presented a chance to lock in a circa 7.5% yield, with the stock also set to benefit both from investor demand and as the dividend de-risks. We now see a confident approach to consumer price rises as partly reinforcing this. 

Comparison of financial summary tables also shows BT with a relatively more robust profile than Vodafone, despite criticism of a lengthy restructuring that led to a change of CEO. Both groups show revenue and profit declines broadly since 2018, yet BT sustained earnings cover for its dividend of 1.2x to 2.0x and, according to forecasts, should enjoy around 2.5x in respect of 2022 and 2023.  

Vodafone, however, has seen much tighter earnings cover – albeit robust cash flow – with consensus for 1.1x and 1.2x going forward. Yes, dividends are paid out of cash flow, but the stock market is going to question the disparity with earnings. This, in a nutshell, is why Vodafone is priced for a 6.2% prospective yield at 124p currently, versus 4.2% for BT at 190p.  

Both companies have substantial liabilities: Vodafone is geared at around 100% net and BT at 155% net, while in terms of overall risk of serious financial distress within the next two years, Vodafone edges into a distress” rating on the Altman Z2 score, compared with BT at the upper end of cautious”.  

To Vodafone holders, I would say these credit ratings do tend to be historical in perspective and the market is right to sense potentially greater strength from merger prospects going forward. Quite whether that adds up to a buy” case is unclear; it would be speculative, for sure. 

BT Group - financial summary
Year end 31 Mar

  2016 2017 2018 2019 2020 2021
Revenue (£ million) 18,879 24,082 23,746 23,459 22,824 21,370
Operating margin (%) 17.9 12.3 13.3 14.0 13.8 12.0
Operating profit (£m) 3,384 2,957 3,163 3,282 3,143 2,569
Net profit (£m) 2,466 1,908 2,032 2,159 1,734 1,472
Reported EPS (p) 28.3 19.1 20.4 21.6 17.4 14.6
Normalised EPS (p) 35.3 33.1 29.6 28.4 21.3 20.5
Operating cashflow/share (p) 59.1 61.8 49.5 42.7 62.9 59.2
Capital expenditure/share (p) 28.0 31.5 33.8 36.9 41.2 48.7
Free cashflow/share (p) 31.1 30.3 15.7 5.8 21.7 10.5
Dividend/share (p) 14.0 15.4 15.4 15.4 4.6 0.0
Earnings cover (x) 2.0 1.2 1.3 1.4 3.8 0.0
Return on equity (%) 45.2 20.7 22.3 21.5 13.9 11.1
Cash (£m) 3,914 2,048 3,550 4,880 6,641 4,652
Net debt (£m) 10,847 10,665 10,725 11,996 19,253 18,185
Net asset value (£m) 10,112 8,335 9,911 10,167 14,763 11,679
Net asset value/share (p) 102 84 100 102 149 118

Source: historic company REFS and company accounts

Vodafone - financial summary
Year end 31 Mar

  2016 2017 2018 2019 2020 2021
Revenue (€ million) 49,810 47,631 46,571 43,666 44,974 43,809
Operating margin (%) 2.7 7.8 9.2 -2.2 9.1 11.6
Operating profit (€m) 1,320 3,725 4,299 -951 4,099 112
Net profit (€m) -5,405 -6,297 2,439 -8,020 -920 112
Reported EPS (euro cents) -20.3 -7.8 15.8 -16.2 -3.1 0.4
Normalised EPS (cents) -18.0 -9.8 16.3 -6.7 -7.9 1.2
Ops cashflow/share (cents) 53.7 50.8 48.8 47.0 59.1 58.0
Capex/share (cents) 52.0 31.7 29.3 29.5 25.8 29.1
Free cashflow/share (cents) 1.7 19.2 19.5 17.5 33.2 28.9
Dividend/share (cents) 14.4 14.8 15.1 9.2 8.9 9.2
Earnings cover (x) -1.4 -0.5 1.1 -1.8 -0.4 0.0
Return on capital (%) 1.0 3.3 4.0 -0.8 3.0 4.0
Cash (€m) 18,259 14,955 13,469 26,649 20,646 14,980
Net debt (€m) 38,793 31,314 29,512 26,306 54,279 52,780
Net asset value (€m) 83,325 72,200 67,640 62,218 61,410 55,804
Net asset value/share (cents) 314 271 254 228 229 198

Source: historic company REFS and company accounts

Lengthening service contracts mitigate balance sheet risk 

I recall, as a BT customer, that some years ago contract length rose from 12 to 18 months; and just recently I was pitched with a renewal offer it would seemingly be foolish to decline, to enter a 24-month contract for broadband. 

The pricing was very keen, although it amounted to somewhat false reassurance as BTs terms and conditions allow for change. I believe even the 3.9% plus inflation” is not set in stone. 

Tying customers into longer-term contracts builds earnings quality and reduces dividend risk, despite appearing less competitive. If the telecoms industry was genuinely competitive, then 12-month contracts would operate as they do in insurance.

Doubtless Ofcom accepts an industry view of how it promotes investment, rather than enabling consumers to switch (without penalties) on an annual basis, thereby limiting price rises. 

Vodafone similarly now declares 24-month contracts. I find myself unlikely to switch from BT, given its mobile SIM card offer appears keenly priced, and with double data as a broadband customer and access to various BT hotspots. Owning EE helps the transition to 5G services. Despite post-Brexit criticism about likely raised charges, I recently got through to a friend – as a free call, on an unlimited” SIM package – on the Continent. Free Norton protection for my devices is another plus. 

There must be millions of other BT customers like me who are likely to acquiesce in such an arrangement and are comfortable at entering a 24-month contract. BT will probably continue to sneak in price rises but is Ofcom going to act – or indeed will I, to change provider in two yearstime? 

Convergence of policy terms and pricing has an oligopoly feel  

Unless Vodafone acquires Three to re-rate its UK presence, I view BT as having an increasing grip on UK telecoms that will help it steadily to de-risk its balance sheet besides investing in capability. 

Both stocksmomentum looks likely to consolidate, similarly to the way tobacco is benefiting from portfolio re-allocation into defensive” sectors. On a three-month view, you might get better buying prices than today, if things go from bad to worse over Eastern Europe. Yet they constitute a firm hold” through political uncertainty, able to pass on inflation and other costs without regulatory check.   

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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