Interactive Investor

Stockwatch: time to buy this FTSE 100 income stock with a near 6% yield?

23rd September 2022 12:00

by Edmond Jackson from interactive investor

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With lots of moving parts, does companies analyst Edmond Jackson view this firm as a cheap opportunity or an investor’s chance to cut and run?

Question mark with investor 600

Does a 32% fall in BT Group (LSE:BT.A) over the last two months, to offer a near 6% yield, present a buying opportunity or a sign of worse to come? 

It also begs the question whether this FTSE 100 stock is subject to momentum trading.  

In October 2020, I drew attention to it as a “buy” at 102p given BT’s declared objective for 7.7p a share, a progressive dividend policy – implying the stock would rise because a near 8% yield was over-generous. 

I had some concern, as an implied £770 million payout might inflame the Communication Workers Union (CWU); it also depended on BT’s free cash flow profile after investment needs. 

The stock doubled to 205p by mid-June 2021 then slumped to 137p by that October. Such volatility was quite surprising after BT’s inflation-linked contract price rises. 

I switched to “hold” this year – lastly at 187p in April - as industrial relations’ issues have smouldered on. From 197p last July, the stock has slumped with two-day strike action at the end of August. Strikes have now been declared for 6, 10, 20 and 24 October by the CWU.

Otherwise, there has been little adverse news beyond “ongoing challenges to our enterprise businesses” (i.e. commercial-facing) cited in the group’s first-quarter results to end-June. 

BT’s services should be less cyclical in a downturn than many others linked to consumer discretionary spending – or exposed to higher energy costs,  yet well-paid directors have yet to buy into the drop, beyond token share purchases linked to an incentive scheme. 

Cheap on one measure, less so on another

Around 135p currently, the stock trades on 6.5x consensus for normalised earnings per share (EPS) of 20.9p in the current financial year to 31 March, representing 22% earnings growth. With net profit targeted to fall from £2.0 billion below £1.9 billion for March 2024, the price-to-earnings ratio (P/E) edges up to 7.0x. 

The historic free cash flow multiple is also a modest 10.4x, but according to projections by Berenberg it is “expensive” at 16x

This is relevant to the dividend, where if BT pays out (consensus for) 7.8p in respect of the March 2023 year, edging up to 7.9p for March 2024, you are looking at near 6% yield.  

Earnings cover would be around 2.5x but mind, dividends are paid out of cash flow. A 7.8p dividend would cost £775 million, not exactly backed by end-March cash reserves of £777 million, which BT may need also to apply elsewhere. 

It shows partly why BT management is dug in versus the CWU, for if wages jump – also if BT revenues get compromised to any extent by recession, while investment for 5G, etc, continues – then, yes, the dividend policy looks ambitious.  

Pressure on BT’s business-facing units appears a concern 

Berenberg has downgraded for this reason from “buy” to “hold”, if only trimming its target from 220p to 190p. 

These analysts question if BT’s average revenue per user growth might slow, in line with rivals, as contracts come to an end. 

First-quarter results showed 5% like-for-like revenue growth on the consumer side to £2.5 billion, while enterprise eased 7% to £1.2 billion. Global was flat, around £775 million and Openreach edged up 5% over £1.4 billion. 

I would not reckon the enterprise side gets hit by recession; it might well be affected though. 

Berenberg also questions if BT’s guidance for capital expenditure is realistic, despite a 17% first-quarter fall below £1.3 billion. There was no guidance in the statement, however, it just said the drop related to prior-year investment. 

Furthermore, Openreach has (separately) cited a decline in its broadband base, despite record growth in fibre-to-the-premises. 

Berenberg : “Is this the first evidence of alternative networks starting to impact? Will Virgin Media 02 succeed in the wholesale market or acquire TalkTalk TALK, putting Openreach’s revenues at long-term risk? By the time BT may resolve all such issues, the next general election will be approaching, at which point, pricing and Openreach debates will increasingly take over.”

I cite this as context, why doubts appear to have risen over BT.

Balance sheet remains a mixed bag 

At end-March it had £15.3 billion net assets equivalent to 155p a share, although 90% constitute intangibles.  

There was also £16.2 billion debt, chiefly long-term, hence a £821 million net interest charge for that financial year – covered 3.9x by operating profit. 

Such interest cover is not great when it is tricky to project the interest charge now rates - even on long-term debt - are going to rise by some extent. Quite for how long higher rates might last, whether a short sharp recession sees them ease again or there is longer-term stagflation. 

It is therefore debatable whether the modest P/E and material yield fully price in such risk. 

Yet a positive upshot of higher interest rates is reducing up-front pension contributions to meet long-term obligations.  

It comes on top of BT’s pension fund deficit falling a remarkable £4.0 billion to £1.1 billion in its last financial year. This was said due to positive asset returns (but how historic and might now be reversing?), an increase in deficit contributions and a change in demographic assumptions including a slight reduction in members.  

The scheme is still not expected to be fully funded until mid-2030; but crucially for stock sentiment, is no longer a millstone around BT’s neck. 

BT Group - financial summary
Year end 31 Mar

2016201720182019202020212022
Revenue (£ million)18,87924,08223,74623,45922,82421,37020,845
Operating margin (%)17.912.313.314.013.812.013.4
Operating profit (£m)3,3842,9573,1633,2823,1432,5692,784
Net profit (£m)2,4661,9082,0322,1591,7341,4721,274
Reported EPS (p)28.319.120.421.617.414.612.6
Normalised EPS (p)35.333.129.628.421.320.517.2
Operating cashflow/share (p)59.161.849.542.762.959.258.3
Capital expenditure/share (p)28.031.533.836.941.248.745.5
Free cashflow/share (p)31.130.315.75.821.710.512.9
Dividend/share (p)14.015.415.415.44.60.07.7
Earnings cover (x)2.01.21.31.43.80.01.6
Return on equity (%)45.220.722.321.513.911.19.5
Cash (£m)3,9142,0483,5504,8806,6414,6523,456
Net debt (£m)10,84710,66510,72511,99619,25318,18518,489
Net asset value (£m)10,1128,3359,91110,16714,76311,67915,296
Net asset value/share (p)10284100102149118154

Source: historic company REFS and company accounts

Is Openreach a bulwark for the dividend, or at long-term risk? 

It accounted for 45% of first-quarter, group EBITDA and on an ultra-long-term view is exposed to decline if there is continued shift towards mobile telephony – with rival networks getting a foot in.  

But having just experienced a slower 4G connection (as back-up for works on my BT line) versus super-fast broadband, I doubt people accustomed to fibre-to-the-premises, top speeds, would accept 4G. The 5G roll-out appears slow-going. 

Openreach therefore looks to have a broadly sound future, supporting the UK network for multiple telecom companies; there will be doubts at times though. It could become seen as a mature business after the current boost from full fibre connections.  

As a BT customer, I find myself wasting time, for example, because UK telephone-based customer service (beyond faults and billing) has been dropped in favour of online chat to India. It then takes a week to hear back from BT in the UK. A few years ago, BT proclaimed that it stopped using Indian call centres. Poor service could prompt account-switching to rivals when cut-price offers are made. 

Chief appeal as an income stock 

Vodafone Group (LSE:VOD) is down only 17% since mid-July, I believe reflecting its greater international revenues – versus BT essentially as a domestic UK utility. 

BT’s 32% de-rating looks to involve classic re-pricing around yield, as growth prospects come into question. Moreover, strikes undermine confidence that shareholder returns are secure: either the business gets disrupted or higher pay compromises payouts.   

Volatility may also relate to speculation over a takeover by French tycoon Patrick Drahi who owns 18% of BT. Yet despite a new right-wing libertarian government, Labour would whip up opposition at a time of wider dissatisfaction with private ownership of utilities. That raises risk for such a bid despite no formal regulation against foreign control. 

Potentially, a buying opportunity may arise if sentiment festers around October’s strikes and if some kind of resolution can be found. If not and the stock continues to fall, it could add pressure for a break-up. There are plenty of moving pieces here, but I overall I maintain: Hold.    

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

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