BT: The time is right

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

I expect the current dividend to be secure. BT’s management has stated that it expects a flat to growing dividend and my forecast equity free cash flow supports BT’s ability to pay the dividend.

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.

Character Group PLC: What’s not to like?

If I had to list five things I like about the Character Group PLC, the London AIM listed small cap, they would be:

• simple unchanging business;
• business with a strong competitive advantage, demonstrated by consistently high returns earned on invested capital;
• highly cash generative;
• strong balance sheet supported by healthy cash balance and real estate; and,
• a management team with significant skin in the game and a solid track record.

Add to the above the 4.2% dividend yield and 12% free cash flow yield implied by the current share price, and you have a stock with significant value. I believe that the recent fall in share price - ~14% fall over a year – owing mainly to fall in international sales resulting from Toys R US’s bankruptcy is a temporary blip and offers a good opportunity to buy.

The business

CCT is the largest independent toy company in the UK. It designs and manufactures toys and games, mostly under licence and based on popular television, film and digital characters. It also partners on an exclusive basis with other overseas based toy producers to market and distribute their product in the UK. Its customers include the major UK toy retailers, UK Independent toy stores and a wide selection of overseas distributers.

With an impressive portfolio of tried and tested winners in Peppa Pig, Little Live Pets, Stretch, Mashems and Teletubbies and an eye catching list of new comers which include the Pokémon products to be launched in summer 2018 and two new award winning toys in Stretch Armstrong and Laser X, CCT’s immediate customers should have no difficulty in grabbing the attention of their immediate customer base: the Pre-school child. There is no doubting the fact that the contents of many a parent’s wallet will continue to flow smoothly, ultimately to CCT (most parents with pre-school kids will attest to the fact that Peppa Pig is the dictator who rules childhood).

CCT’s management appear extremely enthused with their product line, calling it the best ever in the company’s history. I believe their optimism is justified; the second half of 2018 and onwards augurs well for sales growth, profitability and free cash flow.

Consistently high returns on average equity

For a business with no long-term debt or liability, return on equity is a good measure of quality of operations. One can do all kinds of qualitative analysis to gauge a business’s competitive advantage, but numbers speak lounder than words. If a business has consistently earned high returns on capital, it has an edge. CCT’s competitive advantage becomes apparent when you look at the consistently high return on average equity the business has generated.

Bar a couple of bad years, the business has consistently generated superior return on average capital, generating an average spread over my expected cost of capital of 41% over the past 11 years. This is no mean feat and would not be possible without an edge in my opinion.

Highly cash generative

A businesses cash generating capacity is the single most important yardstick in judging its value. The returns on equity and earnings matter very little if there is no free cash flow backing it. Earnings are a matter of opinion, but cash is a matter of fact, and CCT definitely packs a punch by this measure. It is a business that is highly cash generative, including in down years for earnings. Add to the free cash flow CCT’s track record of consistently buying back shares and paying a dividend, and you have winning combination.

Strong balance sheet

The cash generative nature of the business combined with no long-term liabilities and owned real estate assets means that CCT has a strong balance sheet. CCT’s net cash balance of ~£12m and £5.2m book value of owned real estate equates to £0.82 a share or ~19% of the current share price. Based on current share price of £4.75, this implies a per share value for the operating business of £3.75 equating to a free cash flow yield of 14%.  

Management with skin the game and a solid track record

CCT’s directors own ~22.6% of the company, with its two joint managing directors alone holding 16.6% of the shares. These are individuals with a long track record with the business, with the two joint managing directors having been with the business since inception. The board is by far the biggest shareholder in the company and has significant skin in the game. These are individuals who know the business very well, have deep relationships in the industry and have consistently generated shareholder value.

CCT has generated a total return of 333% over 10 years and an annual return of 13% over the same period. This compares to the total return during the same period of 1.18% for the AIM as a whole. During this period, it has reduced its share count by ~47% through buybacks, using a total of £38m of its free cash flow to buy back its shares. This has had a positive net effect on the earnings and cash flow yield for its shareholders. There is no reason to suggest this track record cannot continue.                                                                                                                                                           

A company generating 13% per annum over 10 years for its shareholders is doing well.

Valuation

At a cash flow yield of 12% (14% FCF yield accounting for net cash and real estate on balance sheet), a price to earnings ratio of 9x and a dividend yield of 4.2%, CCT is a compelling value opportunity. The recent share price dip due to overseas sales fall, owing mainly to the Toys R US bankruptcy, offers a great buying opportunity. Add to this the best ever portfolio of toys in the company’s history, management’s optimism for future trading and solid track record over a very long period, the odds should be in favour for a long-term buy and hold strategy.  

 

CenturyLink: Bond with an equity kicker

Keith Meister of Corvex Management presented his thesis on CenturyLink at the Sohn Investment Conference back in May 2017. The essence of his thesis was that CenturyLink (CTL), with a dividend yield then of 9.2%, was a credit investment with equity upside. What has changed since then? The market now offers the stock at an even better yield of 11.35%, and the equity kicker still exists. It is even more of a buy than it was back in May.

The bears will rightly point out that the high yield is a reflection of the credit risk and the dividend may not be secure. But I disagree. The clincher is the merger between CTL and Level3 which is set to complete by the end of October 2017 and will be truly transformative for the combined group. Once things settle down post-merger, the market’s focus should turn to the substantial benefits this merger offers for the combined new group.  

Below is a list of my investment pros and cons for CTL. My free cash flow forecast and valuation analysis is included below.

Pros	Cons
11.35% dividend yield Based on forecast free cash flows (provided below), I believe that the dividend is secure and management have made their intention of retaining the dividend clear. The current yield is ~930bps above the 10 year treasury and also significantly above peers.	Competition and revenue pressure intensifies Competition in intense and it has been showing in the declining revenues at CTL. While Level3 offers a better revenue mix and growth, it will be key for the combined group to arrest revenue decline and stabilise. Any sign of integration risk could make enterprise customer nervous.
Transformative merger with Level3 But for the merger with Level3, I wouldn’t be recommending CTL. The merger offers the following benefits: -          scale to compete effectively (CTL+L3 will be the second largest domestic communications provider serving enterprise customers with significant network); and with demand for data set to explode, the combined group should be well set to capitalise. -          Post-merger, the group should be well positioned in the growing enterprise services market, with enterprise revenues constituting a growing percentage of sales. This should help offset the declining legacy segment.   -          Significant synergies on offer: to the tune of $850m of operating synergies and $125m of capex synergies, giving further boost to free cash flows. -          Level3’s ~$10 billion of NOLs should substantially reduce cash taxes for the combined group, again a positive for free cash flows. All of the above means an improved EBITDA margin, better free cash flows, and most importantly, an improved dividend coverage securing the current yield.	Integration risk The investment case for CTL is predicated on a successful merger and integration with Level3. It will be important that the group achieves revenue stabilisation, projected synergies and cash tax benefits indicated by the merger. That said, I note that most analyst expect managements projected synergies to be on the conservative side and achievable.   It is worth noting here that the market seems to be linking CTL with what’s happened to Frontier Communications Inc. Frontier was another high yielding stock which was all set to take-off after its acquisition of Verizon’s nonwireless services in 2016. But a disastrous integration resulted in massive loss of customers. The stock tanked and dividend was cut. CTL’s current share price is a reflection of market’s nervousness owing to this recent event with Frontiers. The advantage for CTL and Level3 is a management team who have rolled up and successfully implemented several acquisitions in the past with success.
Cheap to peers; should rerate down the line CTL trades well below peers: peers trade at 7.3x FY18(E) EV/EBITDA whereas CTL+L3 is at ~6.5x; and peers trade at ~14x FY18(E) Price/FCF whereas CTL+L3 is at ~7.6x. In addition, CTL's dividend yield of 11.3% is a spread of ~9.3% over ten year treasury. Once the merger with Level3 is cemented, market’s focus should return to the positives for the combined group and the stock should rerate.	Legacy business declines at a faster pace The emergence of wireless has been detrimental to CTL’s fixed-line business. The number of fixed-lines CTL offers has been declining steadily over the years and there is no doubt that fixed-line and all the revenue streams attached to it will slowly wither and die. If the decline is dramatic, it will impact free cash flows. The key is the shift to enterprise and strategic revenue mix offered by L3, it will be important and the decline in legacy revenues is offset by enterprise.

Valuation analysis

Using a combination of peer multiple, dividend yield, and discounted cash flow analysis, I get a per share value for CTL of $28.6 per share, equating to a return of ~50% based on the current share price of $19.03.

CTL+L3 proforma forecast

Ladbrokes Coral Group: Lame duck or a smart bet?

Lame duck, in literal sense, refers to a duck unable to keep up with its flock. Market sure thinks that the Ladbrokes Coral Group (LCL) - the second largest gambling operator globally in terms of net revenue - is a lame duck. LCL lags its peers by a big margin - trading at 7.4x FY18 consensus EPS (peers trade at 13x), under 6x FY18 forecast EBITDA (peers are at 9x), and at 11.12% FY18 forecast free cash flow yield (peers are at 8.5%). If LCL were to match its peers, its shares should be around ~£2, which at the current share price of £1.2 implies a discount to peer multiple of ~40%. For the second largest operator in the sector, LCL sure looks cheap (see key stats below).

But, there is a reason for market’s concern. The UK’s Department for Culture, Media and Sport (DCMS) is carrying out a review of the perceived harm caused by fixed-odds betting terminals (FOBTs or B2 machines in technical jargon) – these are gaming machines within betting shops which offer games like roulette and have acquired an infamous reputation as the “crack cocaine” of gambling. FOBTs currently allow a bet of up to £100 per game every 20 seconds, although in practice the average bet tends to be a lot lower and there already is strict self-regulation where bets over £50 are heavily policed. However, FOBTs have a bad name and the DCMS is set to publish its Triennial review in October 2017 where it will likely recommend restrictions on them, including a cut to the maximum stake per bet. Rumours are that the review will contain four options for FOBTs: status quo, max stake cut to £30 per bet, max stake cut to £20 per bet and max stake cut to £2 per bet. In all likelihood, the eventual outcome, after a period of consultation, will be a cut to the maximum stake per bet of a material number. Analysts predict that a cut to FOBTs max stake to £2 per bet could result in LCL’s revenues falling by £450m per annum, and a cut of £20 or £30 lead to LCL’s revenues falling by ~£90m.  The market clearly is concerned and appears to be pricing in a bad outcome.

However, based on the price targets of 17 analysts who cover LCL, the market appears to be pricing in too much of a discount.

If the median estimate of the 17 analysts offering a target price for LCL is to be believed, the current share price offers a ~33% upside over the next 12 month period. This is worth looking into in a bit more detail.

Breaking down LCL

In addition to its UK retail estate which is in the eye of the regulator, LCL has a fairly decent European retail estate and a strong growing Digital platform. Both European retail and Digital divisions combined delivered ~37% of the group’s revenue in FY16; this is set to grow with Digital continuing to perform very well operationally. None of these divisions are impacted by any changes to the FOBT regulations.

Applying peer multiple of 7x EBITDA to the European retail division and 12x EBITDA to the Digital division’s forecast FY18 numbers, the UK retail estate trades at a paltry 1.3x forecast FY17 EBITDA (see table below). This implies that the market expects a disastrous outcome for the UK retail estate revenue and profitability going forward. 

UK Retail estate and FOBTs

LCL’s UK retail estate generates revenues from both over the counter (OTC) bets on sporting events and from machines (both FOBTs and B3 machines). Both OTC and B3 machine revenues are not the subject of the regulatory review. Based on available historic results for the combined group, LCL derives ~35% of its total revenues from gaming machines in its UK retail estate; based on management’s recent presentation, approximately 67% of machine revenue comes from FOBTs (B2 machines) which are subject of the review; the rest of LCL’s machine revenue come from B3 gaming machines where the max stake is currently at £2 per game and is not subject to the regulatory review. Therefore, ~25% of LCL’s revenue is at risk [35% machine revenues x ~70% B2 revenue] from the impending regulation on FOBTs (this can’t be strictly true as there will be a number of shops where the machine revenue partly subsidises the OTC business without which the shops will be loss making and need to shut resulting in a reduction of a part of OTC revenues, but for the purposes of our analysis I am solely focusing on the direct FOBT revenues which is at risk from the regulation).

25% of LCL’s revenue equates to ~£530m based on an average of last two year’ results. How much of the £530m is at risk if the maximum stake falls to £2 or £20 or £30? Management do not give this information or provide sufficient background information for us to be able to estimate this precisely. However analysts have forecast a fall in LCL’s revenues of £450m if the FOBT max stake is cut to £2 and a fall in LCL’s revenues of ~£87m if the FOBT max stake is cut to £20/£30.

I think the analyst forecast makes sense in both scenarios.

Data from the UK’s Gambling Commission shows that a B3 machine, which has a max £2 stake per bet, yields roughly 30% what a B2 (FOBT) machine does. Therefore, if the FOBT stake is cut to £2 and all of LCL’ machines (regulation restricts 4 machines per shop equating to 14.6k machines in total across LCLs 3,660 shops) lose 70% of their yield, the revenues would drop by ~£380m; add a trimming to the shop estate of ~5-10%, the total revenues would drop by ~£450m under a £2 FOBT scenario.

As for the analyst forecast of ~£87m drop in revenues if the max FOBT stake is cut to between £20/£30, this one is more difficult to reconcile. Detailed information on the gross yield per machine per stake bet is not available. The best stat I could find was from a report published by Responsible Gambling Trust in 2016 that uncovered data on FOBTs. The report found that the average bet on a FOBT was £8.17 across a total of 9.2 million bets sampled (which is a fairly large sample size). The report found that the average max stake bet lost 50% more per bet (£15.39 per gambling session) compared to a non-max stake bet, which lost £10 per gambling session. Using these stats, and assuming just over 30% of the losses are incurred by players betting max stake bets, one can work out a loss in revenue of ~£85m for a cut in max stake to £20/£30. Another study by RGT which surveyed 4001 loyalty cardholders found that ~16% players placed max stake bets, therefore assuming 30% of losses are incurred by max stake bets appears more than prudent (that said, not sure if a max stake player would necessarily respond to a survey in the affirmative). Broadly, the prediction of revenues falling by ~£87m for a £20/£30 FOBT scenario also appears reasonable.

Applying peer multiple to the FY18 EBITDA forecast for both my worst case (max stake cut to £2) scenario and my base case (max stake cut to £20) results in a per share value of £1.47 and £1.62 respectively. This represents an upside to current share price of 22-35% (see table below).  

FCF forecast and DCF valuation for base case and worst case

Below, I present my DCF valuation for LCL using a WACC of 8.8% and nil terminal growth rate.

Valuation summary

Risks

-          European retail and Digital don’t perform as expected

-          Revenue and margin fall due to FOBT regulation are more severe than forecast

Additional potential upside

-          GVC, the online gambling group, has previously shown interest in LCL and rumours of GVC’s continued interest in LCL have been doing rounds lately. GVC will likely wait for the outcome of the FOBT review before making a move, but its interest provides downside protection and potentially an upside if the FOBT review outcome ends up in the base case scenario.

-         My forecast above assumes that any reduction in FOBT stakes will take effect from FY18 onwards; it is highly likely that the period of consultation will mean that the effect of a stake reduction is likely to kick in later or from FY19, which should be an upside to my forecast. This will also allow the company sufficient time to cut overheads and shops (with an average lease length of ~3.5 years and well negotiated terms for lease breaks according to management, the company has good flexibility).