Shareholders in BT, the UK’s leading fixed-line and mobile telecommunications
group, have had a woeful time over the last two years. BT's shares have fallen close
to 50%, shedding over £22bln in market cap over the period.
Some of BT’s problems have no doubt been sector specific – with the telecom sector across Europe hit by intense competition, regulation and adverse macroeconomic trends. But BT’s woes have been compounded by specific issues affecting it alone – in particular its ballooning pension’s deficit, uncertainty around its capex programme, and specific regulatory issues surrounding its Openreach division. This has meant that BT has been the worst performing stock in one of the worst performing sectors. This is evidenced by the significant discount at which BT trades vs its peers (see table below).
With a 6.6% dividend yield, 8.4% equity free cash flow yield and trading at 5.2x EV/EBITDA, BT trades at about 30% discount to peers. At current price, the shares offer a potential for ~40% - 50% upside.
The BT
investment case in detail
My investment case for BT rests on two parts: first, that BT’s operational
performance will be stable and its dividend maintained; and second, that specific
concerns surrounding BT (in particular concerns around its pension’s deficit
and its Openreach division’s capex and returns) will surprise on the upside.
Operational
performance
BT’s consumer and EE divisions are its growth engines. Both
divisions are expected to drive revenue and EBITDA growth going forward. In addition,
BT is going to combine the two divisions together, which is expected to
generate ~£250m of annual cost savings and additional revenue opportunities
from cross-selling across platforms. Together, consumer and EE generate >40%
of group revenue and ~30% of EBITDA and I expect their share to go up toward
50% of revenue and ~35%-40% of group EBITDA in the long-run.
BT’s public sector and global services divisions face challenges
and I expect both of these divisions to take revenue and EBITDA hit. They both face
headwinds, although the public sector division seems to be stabilising
somewhat.
BT’s Opeanreach
division, which provides wholesale copper and fibre
connections between BT’s exchanges and UK homes & businesses and services 590
Communications Providers as customers, has been doing well. Opeanreach
should benefit considerably from the ongoing shift from basic broadband to
super-fast broadband. However, Opeanreach has significant incremental capex (~£4bln) needs
over the next 8 years owing to its regulatory commitment to deliver Fibre-to-the-Premise
(FTTM) to 10m homes by mid-2020s. Ofcom regulates >90% of Openreach revenue
with ~75% being subject to price control. Market has been concerned about Opeanreach’s
ability to generate a return on its capex spend owing to regulatory pressure from Ofcom. But recent discussions and
announcement from Ofcom have been positive, with an acknowledgement by the
regulator of the need for BT to be able to generate a fair return on its
expenditure. I project Openreach to be able to generate a ~10% return on its
asset base in the long-run, at which point there is a good chance of Openreach being valued in the
same way as a regulated utility, trading at a premium to its asset base.
A
factor which should not be missed is the considerable moat provided by
Opeanreach to BT, with no other player likely to come close to its scale and
reach in terms of network infrastructure in the UK. With demand for data and speed soaring, this augurs well for Openreach in the long-run.
In
summary, whilst consumer and EE will drive growth in revenue and EBITDA, the
drag from public sector and global services divisions, and the near term
uncertainty surrounding Opeanreach mean my forecast assumes flat to little revenue
and EBITDA growth for the group. This could surprise on the upside.
Pensions
BT’s
pension scheme, which has c300k members in defined benefit, had an accounting
(IAS 19) deficit of £9bln as at December 2017. Net of tax, the accounting
deficit stands at ~£8bln. The deficit has increased considerably owing to the continued
low discount rate environment.
Every
three years, as part of its triennial valuation, BT has to agree cash deficit payments with its pension’s trustee
and meet agreed cash payments to cure the deficit. The triennial valuation is determined based on the
actuarial (not the IAS19) valuation of the deficit. Consensus forecast for the theoretical actuarial deficit is ~£11bln. If the actuarial
deficit comes at this level, BT could be required to make >£1bln of annual
cash payments into its pensions trust, resulting in a material hit to its cash
flows and a possible cut to dividend.
BT
is currently in negotiation with its pension trustee as part of its June 2017 triennial
valuation to agree deficit repair payments for the following three years. The
negotiations are expected to conclude by mid-2018. The market currently appears to be pricing in a worst case scenario. However, I
think market’s concern is overdone and the outcome is likely to surprise on the
upside for the following reasons:
1. Recent outcome of negotiations
with the pension’s trustee in the case of both BAE and Tesco surprised on the upside on the actuarial valuation due to more pragmatic assumptions.
2. Analyst at UBS note that changes
to mortality assumptions alone should reduce BT’s actuarial deficit by £3bln. This is supported by data from the Continuous Mortality
Investigation of the Institute and Faculty of Actuaries showing life expectancy
in the UK falling for 65 and 45 year olds, which should reduce the
pension liabilities and therefore the deficit.
3. Following consultation, BT has now
closed the defined benefit scheme for its existing managers and discussions
continue with team members and their union to close the defined benefit scheme
for the wider population. Whilst this will not reduce the actuarial
deficit, this should reduce cash payments to the pension scheme by ~£80m per annum.
4. Although BT recently lost the
court case to convert the indexation from RPI to CPI for ~80k members in its
pension scheme whose benefit is linked to RPI (with RPI consistently
overshooting CPI), BT has said that it will appeal the lower court’s ruling. BT
has previous implemented this change of indexation from RPI to CPI for other members in its scheme back in 2010, which helps support its argument to make the change now. If successful, this is
expected to reduce the pensions deficit by £1.7bln.
5. In addition, BT has said that it
is considering alternatives to paying cash into scheme (e.g. providing a claim
over its network and infrastructure assets). Whilst this will not reduce the
pensions deficit, this should have a positive impact on cash flow and taxes.
I expect the negotiated actuarial deficit
to be in the region of ~£8bln, with the net deficit after taxes coming at
~£6.6bln. On the cash flow side, this should result in net cash contribution, net
of taxes, of ~£650m per annum vs the market’s current expectation of >£800m of
cash contribution per annum. My assumption recognises the benefit of the benefit from changes to mortality assumptions alone and to the extent BT is successful in any of its other initiatives listed above, the deficit could be further reduced.
Openreach
& FTTH capex
The
rollout of FTTH to 10m homes under BT’s commitment with Ofcom is expect to take
8 years with ~£300 - £600 of cost to connect per home. I forecast total incremental
capex to be ~£4bln (£500m per annum).
The current share price appears to factor in significant capex increase for Opeanreach with no return. However, Opeanreach should be able to generate ~10% return on its asset base in the medium to long term owing to two factors:
- With the rollout of FTTH,
Opeanreach should be able to shut down its legacy copper network, which is projected to result in opex savings of ~£300m per annum; and,
- Opeanreach should be able to
charge a premium for FTTH (FTTH has significantly lower maintenance and opex requirements compared to copper, which should mean that CPs are prepared to pay a premium). Even a modest premium of £3.5 per month, assuming a
25% take up of FTTH (i.e., 2.5m of the 10m homes connect to FTTH), should result
in incremental EBITDA of £100m per annum. Analysts expect Opeanreach to be able
to charge a premium of £5 - £7 per month and there to be a 30% take up.
The
combined opex savings of £300m and incremental EBITDA of £100m should give Openreach a 10%
return on the £4bln of incremental capex in the long-run. As the capex stabilises and Opeanreach's returns become certain, it could be
valued as a utility at a premium over its asset base. This could generate a
significant uplift in BT’s valuation (in fact, BT could even consider a spin-off
of Openreach once its returns have stabilised and if/when the pension deficit is
resolved).
Dividend
should be secure
My
forecast equity free cash flow in 2018 and 2020 falls short of cash required to
fund dividend due to one-off payments - restructuring costs in
FY18 owing to EE integration; a one-time catch up cash tax payments in FY20
owing to change to UK tax rules governing quarterly instalment payments; and, the
spectrum auction expected in FY20. However, I expect BT to retain its dividend
in both years on the basis that management already know of these one-offs
and have yet stated the desire to retain the dividend and BT has sufficient headroom
to increase its net debt.
Valuation
Putting
all of my above assumptions together, I value BT at £3.52 a share using a
discounted cash flow model. This is an upside of ~45% to the current share price.
If Opeanreach achieves certainty on its FTTH rollout and returns and the
market values Opeanreach on a premium to its asset base, I estimate per share
value to be £3.70 per share, a 52% upside to current share price.
Summary
As
a worst performing stock in one of the worst performing sectors, BT’s current
share price is significantly (>30%) cheaper to peers. The headwinds facing
the telecom sector appear to be easing owing to lighter touch regulation, significant
demand driven by need for data and speed and some easing of the competitive
environment with participants recognising the need to make a return
after years of increased capex and competition. BT’s own issues surrounding its
pension deficit and Openreach’s FTTH rollout have been overblown. The outcome
of the triennial review with the pension trustee towards the middle of 2018
should be a catalyst. The recent announcement by Ofcom, where they appear to be
acknowledging Openreach’s need to be able to make a decent return
on investment has already kicked off a mini rally in BT’s shares.
