Stockwatch: Is BT a buy after rapid rebound?

by from interactive investor |

They're up over 13% in quick time, have outperformed the wider market and still offer a tempting 7% yield. Edmond Jackson gives his view on this contrarian play.

Does the blend of a 7% yield backed by strong cash flow, a forward price/earnings (PE) ratio sub-9 times and well-established industry positioning – albeit keen competition – now constitute an attractive risk/reward profile for this telecoms behemoth? 

BT Group is ditching its chief executive of 14 years due to shareholder pressure after the FTSE 100 listed stock fell from 500p at end-2015 to a low of 203p in early June. A fresh boss at the helm could inject “something new” in the narrative, raising expectations. 

But if you consider BT's current context: while the group may look overall flat financially it could well be over the most challenging hurdles, thus the board's commitment to at least maintain the dividend is leading investors to reckon they can get lucky. At the very least they can lock in a quality yield, with capital upside as the market steadily re-adjusts its sense of risk.

The stock's rise to about 230p, while markets have been jittery over trade tensions, implies sentiment is able to tilt positively on stock specifics alone.  Enough investors have likely awaited some kind of "bottom" to be defined than catch a falling knife; hence, as soon as a rally became apparent then more chased it. 

Chartists might question whether a bottom really is in place, and on fundamentals BT anyway has much to prove, but interest rates aren't going up anywhere near enough in the medium term to compromise the attraction of a sound 7% yield.

Low risk of a new boss 'kitchen sinking'

Turnaround stocks typically rise in response to a capable new CEO appointment, although risks also follow given a strategic review often leads to write-downs and restructuring costs. 

It's not impossible that a new BT boss finds more to do, if more likely finessing actions over the last year or so: e.g. 13,000 job cuts and moving headquarters out of central London; £530 million to clean up an accounting scandal in Italy; legally separating the Openreach network operator; a £200 million increase in capital expenditure to £3.7 billion in each of the next two years, rolling out "fibre to the premises" broadband and 5G mobile networks; and a new rights deal for Premier League football has been struck for BT Sport. 

Sales of non-core/underperforming assets e.g. in global services, are also being examined – which positive news would likely boost the stock further.

BT's dirty washing is, therefore, a known factor, the stock falling from about 238p in May after it was displayed at the prelim results.  At the very least, bad news should be relatively mitigated going forward, and investors have a sense that against a 7% yield this can be enough to help the stock rise.

Pension issues have been a particular black mark, now in a cleaning-up process with the final salary scheme closed and a 13-year plan established to reduce BT’s £11.3 billion pension deficit – with £2.1 billion payments over three years and a further £2 billion to be raised from a bond issue.

An incoming CEO should, therefore, have a relatively easier time and be able to associate with more positive news.  A residual long-term risk could be dumping sports TV to focus on advancing telecoms capabilities – what I'd prefer to see BT doing, as a customer – though it seems doubtful a CEO so minded would get hired by the board of directors anyway, given they have endorsed sports TV development. 

Promise to at least maintain the dividend payout

At the 10 May prelims, BT said it would maintain its dividend in respect of the latest financial year and the next two years adding that it remains committed to a long-term policy of dividend growth. 

Indeed, the group's cash flow profile shows good scope to grow dividends: while results for the year to end-March presented a static picture – adjusted pre-tax profit down 2% on revenue down 1%, Q4 did show signs of improvement and specifically regarding dividends, free cash flow (after capital expenditure) rose 7% near £3 billion and was over £1 billion in Q4. 

What the narrative doesn't say at this point is capital expenditure fell 15% anyway in Q4 "as we execute our strategy to be a more asset light business" and timing of supplier payments also helped.  Moreover, free cash flow is guided lower for the current year to a median £2.4 billion, although management does tend to target conservatively. 

Dividends can still be at least maintained in coming years given the cash flow statement shows them requiring £1.5 billion, hence £1.4 billion being spent also on cutting debt (£13.7 billion net at end-March, generating net annual finance costs of £2.6 billion, or 13% of operating profit). 

So, the board should steadily be able to cut debt further and grow the dividend, more noticeably if BT's overall financial trend improves.

Mind the variability in divisional performance

A chief uncertainty and why the stock remains priced for a near 7% yield, is BT's consumer businesses driving financial growth - especially free cash flow – while the commerce-oriented services lag. 

Global services, wholesale and business/public sector activities – a third of operating profit – are trending moderately negative with 7-8% falls in operating profit in the last financial year although global services are down 33%.  The operating review proclaims a simplifying the organisational structure during the year, strengthening management teams towards "a leaner, more agile and focused organisation", but obviously time will tell as to results.  At least the hinted disposals in global services should help. 

The last trading guidance, which is two months old, cited order intake up 1% to £3,391 million for business and public sector work, down 28% to £1,419 million for wholesale and ventures, also down 17% to £3,845 million for global services – "reflecting market conditions and our strategy to exit lower margin business."  Q1 results are due later this month, hence potential to further a stock re-rating if the bad news element reduces.

Speculative and investment grade aspects

Strictly speaking BT rates a 'speculative buy' in terms of its commercial profile, though optimists are sensing a chance to get lucky now the group is past "peak restructuring" and its cash flow/payout policy, imply an investment grade stock.  Whether to buy now or await more evidence boils down to your risk preference. 

For the stock to be priced for a more normal sense of yield for a mature cash-generative group – e.g. 5% representing a price over 300p – the commerce-related operations do need to prove better performance. 

Costs have been taken out and a more customer-oriented approach instilled, though time will tell.  Thus, in the short term the stock's rebound is liable to hit a ceiling if Q1 doesn't inspire, but, if BT is now on the right track strategically, then it is shaping up as a multi-year recovery play – with a chance now to lock in a highly attractive yield, relative to cash flow strengths. 

It's also not impossible despite BT's £23 billion size, that rival telecoms have their spreadsheets up for a takeover: passing "peak restructuring" and offering strong cash flow, are often key criteria in any industry.  Speculative buy.

BT Group - financial summary               Consensus estimates
year ended 31 Mar     2014 2015 2016 2017 2018 2019 2020
                   
Turnover (£ million)     18,287 17,968 19,012 24,062 23,723    
IFRS3 pre-tax profit (£m)     2,312 2,567 2,907 2,354 2,616    
Normalised pre-tax profit (£m)     2,592 2,923 3,255 3,034 3,296 2,912 3,297
Operating margin (%)     17.1 19.2 19.6 15.1 16.9    
IFRS3 earnings/share (p)     24.5 25.1 28.2 19.1 19.1    
Normalised earnings/share (p)     25.4 29.4 31.1 25.3 25.3 27.5 27.0
Price/earnings multiple (x)             9.1 8.4 8.5
Historic annual average P/E (x)     15.2 15.7 13.8 11.5 8.9    
Cash flow/share (p)     53.3 52.2 53.6 55.9 57.9    
Capex/share (p)     29.9 28.7 28.2 31.4 33.6    
Dividend per share (p)     9.9 11.4 12.9 14.4 14.4 15.6 15.7
Dividend yield (%)             6.3 6.8 6.8
Covered by earnings (x)     2.7 2.6 2.5 1.8 1.7 1.8 1.7
Net tangible assets per share (p)     -46.5 -29.7 -53.6 -67.2 -41.8    
Source: Company REFS                  

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

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