BT goes from basket case to bull case

BT (BT.A) has faced a plethora of challenges in recent years, underpinning the IC’s sell tip in February 2018. At the time, we didn’t think the telecom giant’s difficulties were “anywhere near over”.

This was before before the ousting of chief executive Gavin Patterson in June 2018, following shareholder pressure. New of the departure, which will be effective from the start of February, came just weeks after the announcement of BT’s three-year, £1.5bn cost-cutting programme. Ostensibly, investors weren’t convinced that he was the right person to clean up the sprawling company.

This dispiriting prologue begs the question: why switch stance on BT now? The answer does have caveats. The road ahead is far from obstacle-free, and investors should be mindful that this is a contrarian play. But the market has started to price in a possible recovery for BT over the past four months, encouraged by a reassuring set of half-year results, and the prospect of a new leader at the helm with strong expertise in transforming complicated businesses. And not only may the timing be right to bet on a recovery at BT, but worries about the economic outlook means the timing may be right to bet on the defensive telecoms sector.

For the six months to September, BT's revenues slipped just 2 per cent to £11.6bn, after growth within the consumer business helped to temper regulated price reductions in Openreach (BT’s wholesale subsidiary) and declines in the enterprise division. Adjusted cash profits (Ebitda) climbed 2 per cent to £3.7bn, buoyed by restructuring-related cost savings. And, encouragingly, management said it expects full-year cash profits in the upper half of its £7.3-£7.4bn range.

But beyond the income statement, cash flows – and by association, the dividend – are integral to the debate about what BT’s future holds. Incoming boss Philip Jansen, who was most recently co-CEO at digital payments behemoth Worldpay (NYSE:WP; LSE:WPY), will face pressure to address this – particularly given reports that Greenlight Capital, the investment firm of high-profile activist David Einhorn, has taken a stake.

Still, as things stand, BT’s investment plans and other cash-flow requirements make planned dividend payouts look something of a stretch for the next few years. Investment in mobile infrastructure and fibre-to-the-premises is set to rise to an annual £3.7bn for two years, while the triennial review of the pension deficit has earmarked big top-up payments until 2020, including a £1.25bn contribution scheduled for June. In the first half alone, network investment climbed 15 per cent to £988m, lifting total capital expenditure by 8 per cent to £1.8bn and the pension deficit consumed £2bn.

Yet management has proposed dividends of 15.4p, or £1.5bn annually, for the next two years. This would be covered by so-called 'normalised' free cash flows, but that excludes pension top-ups and fifth-generation (5G) spectrum-purchase-costs – essential to BT’s EE mobile division remaining competitive. House broker JPMorgan expects reported free cash flow not to cover the dividend until the financial year to the end of March 2021. Year-end net debt is forecast to peak at £11.9bn (1.6 times forecast cash profits) at the end of March 2020 compared with £9.6bn at the end of the last financial year.

But forecasting for BT's cash generation looks more grounded than it has for some time following last year's completion of the triennial pension review, some relatively favourable regulatory decisions and a general thawing of relations between BT and the regulator/government. What's more, if interest rates and bond yields continue to rise, BT’s pension liabilities could reduce.

But it’s easy to see why Mr Jansen might seek to free up cash in any case, especially given he wants to “pursue the right technology investments to help grow the business”. Mr Patterson did earmark some assets for disposal, but Mr Jansen could find more. Reduced content spending for BT Sport could be another option, especially in light of a wholesale deal with Sky that starts in 2019. And there’s the question of whether the group will sell part, or all, of Openreach – a business already legally separate from BT – particularly while the likes of Virgin Media are building competitive infrastructure. But management has resisted so far. And according to broker Numis, selling Openreach “is likely to be regressive, complicated and cost inefficient”.

Many will hope that Mr Jansen improves BT’s relationship with regulators. To that point, Citizens Advice issued a super-complaint in September, asking the CMA to investigate whether loyal customers are being penalised. Still, the government said in July’s Future Telecoms Infrastructure Review that “promoting investment should be prioritised over interventions to further reduce retail prices in the near term”. Ofcom has also recently launched a review into broadband pricing.