BT: spend, spend, spend

Is it all just a little bit of history repeating for BT (BT.A)? Its dividend had steadily increased in the 15 years after the telecoms company’s privatisation in 1984, until it hit two sizeable roadblocks. 

The group’s pension fund had swung from surplus to deficit, its assets having fallen with the world’s equity markets below the current value of its future pension payments, meaning trustees had come cap in hand for £525m per year for three years. This paled in comparison to the problems at its global services division, where managers had been unrealistic about the costs and other assumptions - and thus the profitability - of major contracts. This led to total charges of £1.6bn for the 2009 financial year.

Six years on, the pension deficit and the global services division pose another significant threat to the payout. Already, the group has had to water down its payout guidance for FY2018, after a profit warning owing to an accounting scandal at the Italian division of its global services business. This time, it was improper accounting that understated costs: these irregularities left it with a £245m bill at the 2017 full-year results. Coupled with charges for Openreach and weakness in its public sector sales, this left basic earnings per share a third lower at 19.2p.

Then there is the matter of the triennial valuation of the pension scheme. Falling gilt yields since the last valuation should mean the deficit is a good deal wider: analysts expect it to have grown by at least half to £11bn. The trustees, empowered by the regulator, may call for a good deal more cash over a shorter timeframe to close the gap.

There are many drains on BT's cash flow

Add to this the pressure for investment: for Openreach, to improve the nation’s broadband infrastructure and provide greater coverage of fibre-to-the-cabinet connections; and for BT Sport, with a new £394m-a-season deal for Champions League rights. In FY2017, capital expenditure as a proportion of revenue was 14 per cent; it would be nearer 16 per cent with this factored in, and that is before extra costs for buying spectrum rights for the mobile business.

BT, like peer Vodafone (VOD), strips out spectrum payments from its ‘normalised’ free cash flow; the former also exempts pension deficit payments and any tax benefits gained from them. Analysts at Jefferies add the pension payments and restructuring costs back in, along with the cost of share buybacks. For FY2018, this leaves dividend-free cash at £1.59bn, below the £1.61bn expected dividend (see graph). Even this doesn’t include spectrum payments, where how much BT is allowed to spend will be within the gift of regulators.

Which is all to say there are a lot of costs coming down the tracks that could make BT’s progressive dividend policy difficult to maintain. The company has said that future growth in the payout will rely on a number of factors, including investment and other cash commitments and, of course, earnings growth. The outlook isn’t great there: Bloomberg consensus estimates project a compound annual growth rate of just 3 per cent to FY2021.

But the unpredictable nature of pension discussions makes this a potential bull as well as a potential bear point. The company could give trustees what is termed a ‘contingent asset’ in lieu of cash right now - such as a claim over the broadband network - or agree deficit payments that are stretched out longer than the market expected, or back-end loaded. Clearing this problem could restore confidence to the payout and see the shares re-rate. There is also the possibility of closing the scheme to future accrual, to put a lid on liabilities.