BT is a company which is known to virtually everyone in the UK and its shares are a favourite among investors seeking low risks and reliable dividends.
After all, what could be safer than a company which used to be a state-owned monopoly, and which today is far and away the leader in the the UK’s fixed and mobile telecoms markets?
In reality the situation is very different and, despite some recent successes, BT could be much riskier than many investors think. Here are five reasons why:
Reason 1: BT has produced virtually no revenue growth for a decade
Many investors choose BT because it is so well-known and because it has a progressive dividend policy. It just feels like the sort of company which should be able to increase its dividend every year.
For that to happen BT would also need to increase its profits both consistently and sustainably, and that in turn would require revenue growth.
The problem is that BT has failed to grow its revenues for over a decade.
As the chart shows, BT’s profits and dividends have been growing at a rapid pace. However, most of this is simply a recovery of profitability after the company’s surprisingly bad performance during the financial crisis (BT’s dividend was cut by 60% and its shares fell by 80% between 2007 and 2009, which doesn’t sound like a very low risk investment to me).
Since the crisis BT’s focus has been on efficiency and cost cutting which has resulted in widening profit margins and improving returns on capital employed, but that can only go so far. At some point revenues must go up if the company is to continue growing.
Although this lack of revenue growth does not represent an acute risk to shareholders, it is a serious risk to the possibility of decent returns over the next five or ten years. It also undermines BT’s ability to meet one of my key investment rules of thumb:
- Only invest in a company if its ten-year growth rate is above 2%
Although BT has grown by around 2.8% a year when measured across revenues, earnings and dividends, its revenue growth has in fact been negative, which does not bode well for the future.
Reason 2: BT has a massive debt pile
Debt can be thought of as rocket fuel for corporate performance, but rocket fuel is dangerous stuff, especially if there’s a lot of it concentrated in one place.
In BT’s case it has borrowings of more than £14 billion. That’s a huge amount, even for a company of BT’s size.
For example, over the past five years its average post-tax profits were just over £2 billion, so its borrowings are about seven times its recent average profits.
This breaks another one of my rules of thumb:
- Only invest in a defensive sector company if the ratio between its borrowings and average post-tax profits is less than five
Companies that have more debt than that are, in my opinion, somewhat like a ticking time-bomb.
As long as everything is going well and enough cash is generated to cover those massive interest payments (BT pays more than £500m in interest each year) then everything is fine.
But if the company stumbles, even slightly, it can quickly become impossible to run the company, pay dividends and make those interest payments all at the same time. And of course it is much easier to cut the dividend than it is to refuse to make interest payments.
Note: You could argue that BT’s most recent post-tax profits are higher than that £2 billion average, but its £14 billion debt pile is still more than five times its most recent profits, and so even with excessive generosity it still fails to pass that rule of thumb.
Reason 3: BT has a massive pension deficit
As if having massive amounts of borrowed money to pay back wasn’t enough, BT also owes the BT Pension Scheme more than £6 billion (and there are some estimates that it is as high as £10 billion).
As Philip Green is finding out, pension deficits are a real debt that cannot simply be ignored.
Fortunately BT is not ignoring its pension problems. Like any good corporate citizen, it is trying to make good on its obligations to pensioners by paying large amounts of cash into the scheme in order to shrink the deficit.
Over the past couple of years BT has paid almost £1 billion a year into the scheme and is set to pay another £3 billion over the next five years.
This is very commendable, but it is an additional fixed financial obligation which, like interest payments to banks, the company must put ahead of payments to shareholders.
Again, as long as everything works out well there should be nothing to worry about, but if there are any bumps in the road this additional burden could send BT spinning off into the weeds (or somewhat less metaphorically, could easily result in another massive cut to its dividend).
Underlying this vast £6.4 billion pension deficit is a veritable mountain of pension liabilities totalling £44 billion, which easily breaks yet another rule of thumb:
- Only invest in a company if its pension liabilities are less than ten times its average profits
BT’s £44 billion pension liabilities are more than 21-times greater than its average profits of barely more than £2 billion, so this rule of thumb is broken by a country mile (and that is still the case even if a more generous figure of £3 billion is used to reflect higher recent profits).
Reason 4: BT has to spend billions on infrastructure every year just to stand still
Building and maintaining the infrastructure for our modern high-bandwidth world is an expensive business.
Over the past ten years BT has spent an average of £2.7 billion a year on capital assets as it continually upgrades exchanges, lays fibre optic cables and develops new and better services.
Unfortunately this money is not being spent as part of a massive push to grow the company but is instead required just to replace the existing infrastructure as it becomes old and outdated.
One way to think about the ongoing replacement cost of existing capital assets (i.e. BT’s network infrastructure) is to look at how much depreciation a company records each year.
For example, if you bought a car today for £10,000 and expected it to be worthless and in need of replacement ten years from now you might say that the car was depreciating in value by £1,000 per year. This is effectively how much money you’d need to save each year in order to replace the car at the end of its useful life.
In BT’s case it has depreciated the value of its existing capital assets by some £2.8 billion a year over the last decade, which is very slightly more than it spent on new capital assets (also known as capital expenses or capex).
So despite spending almost £3 billion a year on capital assets BT has not significantly increased the size of its asset base and therefore has not significantly increased the earnings capacity of its capital assets.
This is perhaps one reason why revenues have been reluctant to grow.
This requirement for massive capital investment sets off a warning light from another rule of thumb, which is part of my value trap analysis:
- Be wary of investing in companies where capex is consistently greater than profits
BT’s capex has consistently been about 140% of profits, so it is clearly a company that requires large and consistent capital investments; much more so than most companies.
The risk here is twofold:
- Downside risks are greater when times are tough – The requirement for capital investment is relatively fixed and therefore somewhat akin to interest payments on borrowed money. This makes the company (even) more sensitive to difficult economic environments. Capex can be cut if income declines in a recession, but that just stores up problems for the future as capital assets decay and are not replaced or upgraded.
- Growth is more difficult when times are good – Even if things go well BT has to pump enormous amounts of money into expanding its capital asset base before it can begin to generate revenues, profits and cash from those assets. This upfront expenditure is often paid for with borrowed money, but for me BT already has too much debt.
Reason 5: BT just spent £12.5bn acquiring EE
Although acquisitions are not necessarily a bad thing they can be problematic if either a) the acquired company operates in a completely different industry to the acquirer or b) the acquisition is very big.
BT’s acquisition of EE (the UK’s largest mobile network) falls into the latter category, with a price tag of £12.5 billion.
Most of that price was paid with newly issued shares, but a significant £3.5 billion was paid in cash, which is one reason why BT’s debts increased from around £10 billion to £14 billion over the last year.
That £12.5 billion price tag is more than four times BT’s average profits of £2 billion, which sets off yet another of my warning light in one of my value trap rules of thumb:
- Be wary of companies that have made an acquisition which cost more than the company’s average profits
Even assuming that BT’s profits will be higher going forwards thanks to this acquisition, say £3 billion a year, the acquisition is triggers this warning.
The problem is that large acquisition are typically integrated into the acquirer’s business rather than left as standalone companies in order to generate synergies, cost savings and other profit seeking improvements.
But integrations take time and effort, and the bigger the acquisition the more time and effort they typically take. This can distract the acquirer from its own core business, creating an additional risk.
Now, in all likelihood this acquisition will work out well and EE will add value to BT, but it very probably does increase BT’s riskiness in the short-term and would be a negative mark against BT in my value trap analysis.
Five is more than enough reasons for me to avoid BT
As you might have guessed, I am not looking to buy shares in BT. In my opinion it’s a low growth, highly indebted company which has a large pension deficit to fill, an insatiable need to make huge capital investments and an enormous new acquisition to integrate.
Of course things may work out fine and, in a benign economic environment, BT may be able to thread the needle and balance all of these negative factors to produce a positive result.
But personally I think the future is unlikely to be so kind to BT or its shareholders.
Chris Evans says
Your analysis is indisputable and fair. I had been considering selling BT on any price strength and the recent favourable Ofcom judgment and quarterly results have resulted in enough (probably unwarranted) price improvement for an ideal sell opportunity. Your article has provided me with the impetus to act and I have sold my holding. Thanks!
John Kingham says
Hi Chris, don’t thank me yet. Wait five or ten years to see how things pan out with BT and then you’ll know whether it was a good idea or not!
John, I was very lucky taking a risk and buying after the financial crisis, BT at about £1.50 and adding to £1.80 and £2.15 –. Sold all in Feb 2015 (at £4.5) and for all the reasons you have highlighted I won’t be going back.
Still a win is a win as they say.
There is another reason why BT might have problems, in that much of the buried infrastructure that BT has could become obsolete, when 5G wireless which could offer far superior broadband than BT’s fibre to the cabinet. This fibre to the cabinet is what they call “Superfast Broadband” and in reality it’s anything but, since the last part is compromised by the copper cable, not FTH – Fibre to the home, that many other countries enjoy.
Granted, BT made a move to buy EE which will support 5G, but it comes at the huge cost you highlighted and this is going to be very very competitive.
John Kingham says
Yes, one of the problems with high capex companies is that the capital assets are expected to produce a certain return, but that’s all in the future and there are many reasons why assets underperform, with technological disruption being a major one.
To be honest I’m a bit of a technology Luddite and there’s a demand limit to all this bandwidth (we don’t all sit about drinking gallons of water everyday just because it’s cheap!).
For me a 10 Mb/sec is plenty enough to stream films, and 100 Mb/sec will easily stream multiple high def films.
Not sure what most people would do with 1 Gig/sec, but I’m sure if there’s money to be made people will be nudged into thinking they need that much.
Capital Intensive — yes that’s now one of my themes, together with onerous pensions, amplified in my mind by your good self. Just sold RR for the third time now in short succession after they issued bad results and the stock jumped 18% — again I got lucky, but again probably won’t be going back. The proceeds went into my capital light Burberry which I know is a favourite of yours and Nick Train’s. Burberry now up to 3.5% of my wad.
Speaking of Nick Train, Rathbone Brothers looks interesting, have you had the chance to pick through the bones of this one?
John Kingham says
No I haven’t had a look at Rathbone. At first glance it seems okay, ranks at 97 out of 240 on my stock screen, so okay but not obviously a bargain (again, at first glance). Other than that there’s not much I can say.
Hi John – great article. I have been working with the guys at the UK based Maturity Institute over the last couple of weeks doing a financial risk assessment of AT&T. It was interesting reading your piece on BT that you have arrived at very similar conclusions to ours on AT&T! Legacy organization; trying to make a strategic shift; capital intensive; and trying to absorb an acquisition – all parallels. I really do think that you concepts of value thinking and investing have a number of parallels to the work we are doing in investment advice which addresses underlying risks in the “mobilization of human capital” especially as organizations try to shift to a knowledge economy. Thanks
John Kingham says
Hi Nick, good to hear from you again. I see the guys at the Maturity Institute have put up some videos so I’ll have a look at those at some point (I read a lot, so any opportunity to consume information via another medium is very welcome!).
And regarding AT&T, I’m not surprise there are many similarities. What will be really interesting is how they cope with the de-wiring of the telecoms sector once we can get high speed internet through the air (BT phones are all moving to VOIP at some point anyway, after which there will be little or no need for “phone lines” anyway).
Hi John & all
Can’t argue with any of the above, also the current ratio is poor, and the Beneish M-Score is poor too. I confess I’ve still got some of these in my portfolio as I’ve not got round to dealing with them yet (as fortunately I’ve been distracted by life). Selling them has been on my to do list since my last portfolio health check
However to share some scuttlebutt, I’ve noticed an increase in the number of people I know switching to BT (all from Talk Talk). Not a move I’d make myself, as better deals are available elsewhere. neither does it do enough to balance the investment case in my opinion.
Thanks for all the good work.
John Kingham says
Hi Ric, don’t know much about TalkTalk, other than my TalkTalk phone line has been dead since Friday morning! Although that could end up being a BT fault anyway.
These physical infrastructure-based Telcos all be dead as a Dodo anyway if we all move to 4G (or 5G etc) and have high speed broadband to a wireless hub, or even use mobile phones as the main connection to the internet, to which the TV/games console/etc all connect.
At least that would mean no more digging up of roads to lay cable…
I am a bit contrarian here, although I only have 0.4% of BT in my portfolio as I took profits twice. I believe fiber optic is here to stay as the cheapest way to move GB of data around. Very few people may realise that 4G data is carried by fiber optic around the country, before it is radioed to your mobile.
I also believe that BT management is good and made some interesting steps which were profitable for the company.
BT is making a switch from being a provider for the copper line to your house to being a media provider. A few years ago I used to pay them £16/ month for the line rental + broadband and now I cannot find a bill under £60/ month, bur quite a few were £100, because my wife and son went over the top spending too many GB. That increase of the bill for me is pretty amazing stuff.
It is true they were landed some help from the OFTCOM too. I was a big user of 0844 numbers to call overseas at 1p to 3p per minute, until I found that OFTCOM gave them the right to charge me up to 11p per minute too, which they did! That was a gift from the Government or probably the result of some good loby with them.
You can see the effect of BT Sports, 11p per minute, lots of new sign-ups to BT services etc in the last quarter figures: revenue is actually 35% up on similar 2015 quarter.
Some of your points are valid, but I believe the risks are outweighed to some extent by the possible gains. Obviously the posibility of a recession has increased because of Brexit. BT is cyclical, although people may believe otherwise.
There is another issue: when building a portfolio, you need to have a sectorial balance and I would not run a portfolio with 0% in the comunication sector. I do not like Vodafone, neither the French Orange, I kept my Verizon shares and the closer I am in communications is that I own Facebook and Microsoft shares (Skype owner).
John Kingham says
Thanks for the additional info Eugen, although I think I would have a heart attack if my BT bill was over £100!
As for sectoral balance in a portfolio, personally I’m not fussed if I have zero percent in any given sector, as long as I don’t have too much (more than about 10%) in any one sector.
Having said that, I do currently hold a couple of telecoms companies.
I am not fussed either by having 0% in banks (sold the last US bank) or 0% in mining as I will have soon, once the new Alcoa is spoon off the value added Arconic (older Alcoa) I will only keep Arconic and sell the miner & smelter.
However Communications and Media is a different kettle of fish and I cannot afford to be 0% exposed. Sometimes you make the choice from what is on offer.
I also think that BT could spoon off some parts as well, Openreach is first to my mind. This will release value for BT shareholders and allow a better move to added value services.
(The £100+ bills were also the result of the sneaky introduction from July’15 of the 11p per minute charge for 0844 numbers. I found out about this 7 months later)