Stockwatch: How safe is BT’s tempting dividend?

by Edmond Jackson from interactive investor |

With lots of dividends cancelled, our companies analyst tells you what he thinks of BT’s payout.

Amid see-saw volatility of perceived “defensive” stocks rebounding from market-battered lows, versus oil and estate agents snatching the leaders’ baton yesterday, FTSE 100-listed BT Group (LSE:BT.A) stands out as a possibility for a consistent rally.

Moreover, it is up from a 103p low on Monday 16 March to about 137p in early dealings today, despite some big market downdraft days along the way.

I don’t normally pay attention to short-term volatility, but I think this informs us about BT’s credentials both to weather this storm and capitalise on it.

Source: TradingView Past performance is not a guide to future performance

Food retailers and utilities may well continue to edge up, given 12 weeks is a long time for many adults and children to be housebound. It is also entirely possible that governments don’t want to panic people or lose support for proposals, saying social isolation could be needed for a year or more, on and off.

China and South Korea’s strong measures appear to have been effective in stamping out the spread of Covid-19, however it is impossible to say what might happen as restrictions ease.  Given a massive substitution of food and drink previously consumed outside, now taken in the home, food retailers will benefit, and home energy consumption remain elevated.

But a point will come, especially if these stocks become very fully valued, despite a cut-throat industry, when hot money shifts out, which could start as soon as viral cases peak, replaced by a swing back into hard-hit risk assets. Such a pattern plays out time and again in historic market crises. 

Risk/reward profile looks to be tilting positively

Meanwhile, broadband services are positioned for medium to long-term gain, given the Johnson government’s call for more people working from home, and its objective for enhanced fibre connectivity. Longer-term the lifestyle change will stick to some degree with technology enhanced at home, and you can bank on BT to expand its sales of mobile connectivity – with special deals for broadband customers.

BT’s acquisition of EE puts it in pole position to capture benefits from 5G, which EE has already launched, with networks merging in 2022.

Yes, Open Reach is required by Ofcom, effectively to undermine its parent BT by enhancing the telecoms network for rival providers, and there are negatives in BT’s financial equation.

Last September’s balance sheet had £18.3 billion adjusted net debt and a (reducing) £6.1 billion pension deficit, versus net assets of £10.3 billion, of which £14.1 billion represented intangibles. All that contributes to a bankruptcy risk indicator of 1.4 on the Altman scale, meaning BT is not entirely safe from financial distress, so caution should be taken.

The first half-year interest charge was, however, covered by operating profit (before adjustments) of 6.6x and it’s not as if interest rates are going up soon.

And yes, the prospect of economic crisis led to markets initially ditching stocks with bloated balance sheets. But governments’ exceptional fiscal responses to the crisis mean this is liable to stoke inflation down the road, which will to some extent “inflate debts away” as will be authorities’ (including central banks) game-plan for survival.

It’s hardly as if interest rates will rise again, maybe for an extended period. So, without endorsing indebted companies, I think there looks to be scope for an aspect of bad sentiment reversing – exemplified currently by BT shares rising, given its 8%-plus prospective dividend yield is viewed as possibly less risky.  

Such a yield is based on consensus forecasts for a trimming of the total dividend from 15.4p to 15.1p in respect of the current year to end-March, then a cut to 10.8p in the coming year to 2021, covered twice by earnings per share (EPS) of around 23.4p.

In strict earnings terms that implies a forward price/earnings (PE) ratio of 5.7x, but only if expectations for the coming year are fair. If anything, you would think the sudden lifestyle changes ahead, imply upside.

What really counts for dividends, however, is free cashflow, where expectations have altered towards BT undertaking more investment - hence final results (published on 9 May last year) will be significant as to what guidance emerges.

There wasn't any pre-close period update last year, so it may be that we have to wait until then, unless management decides to issue something this time given the circumstances.  

The 31 October interims had cited £1.9 billon capital expenditure during the first half year “up £225 million…driven by increased network investment,” which likely explains the trim in dividend expectations for 2020/2021.  

In BT's third quarter to end-January, free cashflow eased 11% due to investment. The 4.62p interim dividend was 30% of last year’s full-year 15.4p dividend, although interim payouts are often skewed so as to give boards leeway when it comes to deciding the final payout - i.e. not necessarily same extent of cut to the total payout.

So, it looks like the market is also re-appraising BT’s dividend yield, especially relative to so many companies that will have to cut savagely to preserve cash. Yes, BT is in an investing phase that will last years, but the government has indicated intention to help leverage broadband – and the Tories will support private business rather than nationalise it (barring rail companies, perhaps).

The stock’s current rise is, therefore, logical in terms of a 9% yield having been too generous (i.e. the share price was too low). 

BT - financial summary            
year end 31 Mar 2014 2015 2016 2017 2018 2019
             
Revenue (£ million) 18,287 17,851 18,879 24,082 23,746 23,459
Operating margin (%) 15.9 17.8 17.9 12.3 13.3 14.0
Operating profit (£m) 2,910 3,181 3,384 2,957 3,163 3,282
Net profit (£m) 2,018 2,135 2,466 1,908 2,032 2,159
Reported EPS (p) 24.5 26.1 28.3 19.1 20.4 21.6
Normalised EPS (p) 26.9 34.0 35.3 33.1 29.6 28.4
Operating cashflow/share (p) 58.3 58.6 59.1 61.8 49.5 42.7
Capital expenditure/share (p) 28.6 29.5 28.0 31.5 33.8 36.9
Free cashflow/share (p) 29.6 29.0 31.1 30.3 15.7 5.8
Dividend/share (p) 10.9 12.4 14.0 15.4 15.4 15.4
Earnings cover (x) 2.3 2.1 2.0 1.2 1.3 1.4
Return on equity (%)     45.2 20.7 22.3 21.5
Cash (£m) 2,469 3,957 3,914 2,048 3,550 4,880
Net debt (£m) 7,345 5,811 10,847 10,665 10,725 11,996
Net asset value (£m) -592 808 10,112 8,335 9,911 10,167
Net asset value/share (p) -7.5 9.7 102 84 100 103
             
Source: historic Company REFS and company accounts            

Be steeled for any reports of network overload 

Now markets have become febrile according to news, the chief setback for this net-positive scenario would be: examples emerging of a still predominately copper-based network becoming unable to cope with potential demand ramping up. 

This week it has gone from people working online from home – to video conferencing, then whatever education may be provided to schoolchildren at home, although it seems inevitable, capacity-hungry gaming and Netflix addiction will soar.  

BT claims its network will not buckle under the extra strain: “We have more than enough capacity in our UK broadband network to handle mass-scale home-working in response to Covid-19” it says, because video calls and e-mail represent a fraction of peak evening demands on capacity from video streaming and game downloads.  

Yet Spanish telecoms operators – Telefonica (XMAD:TEF), Orange EURONEXT:ORA) and Vodafone (XETRA:VODJ) - have cautioned that 40% more data is being used during the day, while mobile data usage is up 50%. While part of the bull case for owning telecoms stocks - as people upgrade their packages – customers have been asked to reduce internet usage during peak hours so people working from home are not disrupted.

This has come despite 75% of Spanish homes having fibre-to-the-premises versus only 8% in the UK.

BT insists the chances of deterioration in performance are low. Yet it remains to be seen how school closures combined with children being significantly indoors until summer – probably online – affects networks.  

Mid-teens % operating margins and 20% return on equity

BT has tended to get most attention for its debt and £1.5 billion cost-cutting drive, although margin and ROE numbers (see table) are consistently respectable. They follow, I believe, significantly from a strong core of customers either lethargic to switch - or like me, pretty pleased with BT’s improvements in recent years.

Three years or so ago I changed broadband supplier to BT’s superfast Infinity package and am also poised to switch my mobile contract to BT. Dealing with BT’s call centres once used to drive enough BT customers to their wits end, but things have improved significantly.  

I also like the guarantee of a 4G connection device immediately supplied, should my landline broadband fail; BT’s e-mail being a dependable back-up to my regular Outlook e-mail; the national extent of BT wi-fi hotspots, also capability often to log onto BT wifi with fon (where subscribers make available a portion of broadband capacity, thus expanding the network).

I am increasingly unlikely to change provider at all, especially as mobile/broadband deals consolidate for the best prices and the BT/EE combination looking formidable for 5G. I suspect there are plenty others like me, and it constitutes an extent of economic moat.  

For sure, it’s a mixed investment case – BT having replaced its CEO from January 2019 to address plenty of issues, Ofcom liable to snap at its heels to promote competition, and an uncomfortable balance sheet. 

But this Covid-19 crisis adds to government’s “full fibre” objectives, as potential to grow contracts and a loyal customer base. With adept management this can filter through to bolster earnings and the dividend, in due course. Strategically BT rates: Buy.

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

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