Stockwatch: can we trust BT’s new dividend promise?

Telecoms giant should benefit from the pandemic need for broadband upgrades, but profits need to rise.

Last March I drew attention to BT (LSE:BT.A) as a strategic ‘buy’, with unfortunate timing: the stock had jumped from 109p to 134p as markets surged in response to global monetary stimulus.

It failed, however, to sustain this rise, fell back and bumped along in a circa 100p to 110p range.

I did stress that much depends on how free cash flow – i.e. capital available from operations, after investment etc – pans out, and I believe the stock’s risk/reward profile remains attractive long term, with the price currently 102p. 

The market is wrestling between one sense of BT as an ex-state monopoly still enjoying a wide customer base in broadband and telephony, with EE integrated as a leader in mobile, versus the others sense of a history of failed promises. 

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Once again, and in response to last Thursday’s interim results, the stock jumped from around 100p to test 110p, but started this week briefly below 100p. Most likely the trigger was an objective to resume dividend payments in the next financial year to March 2022, chiefly a progressive policy commencing with 7.7p per share.

Stock will re-rate if risks surrounding the dividend ease 

If such a payout is realistic it represents an opportunity now to lock in a circa 7.5% yield, with the price able to benefit initially from demand for an attractive dividend payer.

It could also rise over time as this dividend de-risks. 

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If the image of BT improves to being a quality defensive utility stock then a yield nearer 5% would be more appropriate. On dividend valuation alone the payout would need to progress only to 8p for 150p to be an initial share price target, although buyers now would have locked in a 7.5% yield then enjoy 50% capital growth. Such is the bull case.

Digesting the interim release and considering what might be in the board’s mind – to be so confident on a 7.7p payout next year despite falling interim 2020 revenue/profit – it would appear a profits re-rating due to cost-cutting and reaping benefits of technology investment.

Yet this depends on a scenario where 2020 proves to be the UK’s recessionary trough and 2021 heralds an extent of economic recovery. Do you trust Boris’s claim of a sunny springtime?

I am steeled for disruption lasting years, and it concerns me that a progressive dividend policy starting from 7.7p may not equate with Covid-19 disruption compounded with a hard Brexit potentially.

Not surprisingly, the stock see-saws.

Financial nitty gritty behind the board’s confidence

BT’s potential defensive quality is shown by a doubling in fibre-to-the-premises (FTTP) orders during its first half year to end-September, a trend likely to continue. FTTP makes a lot of sense for families watching online TV/films, having a variety of devices linked to the internet and at least one person working from home.  

As a BT customer I am plenty satisfied with their competitive mobile offering to broadband consumers, as well as swift attention to billing and technical/service issues. 

Many will be like me: in 24-month contracts and likely to end up wearing BT’s annual price increases. From 1 April 2021 they will be 3.9% plus the CPI inflation rate. While BT says these increases will let it invest in its business, implicitly this supports free cash flow and therefore dividend prospects. 

A modernisation programme has delivered £352 million of cost savings during the first half of the year. It is expected to rise to £1 billion a year by March 2023 and £2 billion by March 2025, with a £1.3 billion one-off cost over five years.  

That BT may now be turning a financial corner is shown by it raising the lower end of its adjusted outlook of earnings before interest, tax, depreciation and amortisation from a range of £7.2-7.5 billion to £7.3-7.5 billion.  

At least £7.9 billion is targeted for the year to March 2023 “with sustainable growth from this level going forward”. That does however assume economic recovery from Covid-19, better product sales and savings from modernisation and cost cutting.

As yet, the first half year numbers do not inspire

Profit/earnings per share measures are down a terse 20% and pre-tax profit of £1.06 billion compares with a 5% rise in capital expenditure to £1.9 billion. The capex hill is yet to be surmounted.

An overall 6% revenue decline is expected for the current year to March 2021.

You would think this should be a halcyon year for people and businesses upgrading broadband. Clearly it is not enough to offset lower demand amid Covid-19. 

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A declining historic revenue trend has yet to improve and was jolted up 28% in 2017 only due to integrating EE.  

There has been a 6% fall in overall interim consumer revenue and a 9% drop on the enterprise (business customer) side. Consumer represents nearly half of group revenues, then enterprise and Openreach are quite similar, with a fourth global segment in the teens’ percentage returns area.

Consumer has felt “the continued impact of Covid-19 with sport, including pubs and clubs, and roaming revenue significantly down, and loss of retail store sales in the first quarter”. Declining landline voice-only sales and a late iPhone product launch made things worse.

Covid-19 challenges are similar on the enterprise side

It is also worrying how mobile revenue (cited as ‘retail’ despite being counted on this side of group operations) is down 13% “reflecting ongoing intense mobile competition” besides Covid-19 reducing both domestic and international call volumes. 

Inherent high competitiveness in telecoms may eventually stymie annual price rises BT can get away with for now, having contracted customers typically for 24 months.  

The business said:

“We expect to see further impacts from business insolvencies, particularly among our small and medium-sized customers, although the size of the impact will depend on the level and length of government support.” 

Normalised interim free cash has plunged 30% to £422 million, however there are temporary factors such as increases in stock to cope with the end of the Brexit transition period, and the final purchases of vital Huawei 5G kit and spares before the government’s ban.

As an indication how it needs to improve, the cost of a 7.7p dividend would be around £764 million versus £1.5 billion for the 15.4p payout of past years.  

Balance sheet lends less support than at first sight 

A 102p share price appears more than supported by 122p net assets per share, as of last September. Yet 13.7 billion intangibles constitute 113% of £12.1 billion net assets. 

There is £16.5 billion long-term debt and £2.7 billion short-term, relative to £6.5 billion cash/investments and £5.4 billion of leases. Such liabilities at least provide some context for the pension fund deficit jumping from £1.1 billion to £4.9 billion (chiefly due to low bond yields).  

The liabilities’ profile means BT’s balance sheet is hardly optimal to weather extended disruption from Covid-19. Interim net finance costs took 24% of operating profit. 

Trade payables are virtually twice trade receivables, raising the perennial question (with such imbalance) if the group is borrowing near-term also from trade creditors. 

It puts all the reckoning on whether profit and cash flow can ramp up sufficiently and sustainably to achieve a 7.7p payout. 

Off-chance of a strike by Communication Workers Union 

Be aware of rumblings that re-surfaced a month ago of possible strike action after details emerged of a plan to halve redundancy payments. 

They affect 106,000 staff amid office re-locations and existing site closures. The union held a national day of action in support of BT workers and has threatened an industrial ballot, however I suspect lockdown may compromise genuine action. Nevertheless it should be borne in mind. 

Risk of an unclear US presidential election outcome 

If neither Trump nor Biden concedes defeat and it goes to court, markets are liable to turn jittery. In 2000 it took until 12 December for the Supreme Court to rule in favour of George W Bush, during which time the US stock market fell more than 7%. 

This time around, political differences are entrenched deeper and civil disorder may follow. While Biden has led in the polls, so did Clinton in 2016 and Trump is likely to benefit once again from his coy supporters in swing states. The question is: how much?

Nevertheless I think the risk/reward profile on BT equity tips broadly to upside hence I reiterate: ‘Buy’.

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