Sunday, 6 May 2018

Azul: Get aboard!

Hunting for attractively priced cyclically exposed securities in an economy emerging from a deep recession can be beneficial to one’s wealth. Azul, the Brazilian airline founded by David Neeleman (ex boss of JetBlue in US), is just such a security.

Brazil is recovering from its worst recession in modern history. After contractions of 3.5% in each of the 2015 and 2016, Brazil’s GDP increased 1% in 2017. OECD forecasts GDP growth of 2.2% and 2.4% in 2018 and 2019 respectively. Domestic air passenger numbers grew by double digits last year and is set to grow at a similar clip over the next few years as the economy expands.

Azul’s stock offers one of the best opportunities to tap into Brazil’s recovery with a potential ~60% upside over a 2 year investment horizon and an attractive risk-reward profile.

Azul’s investment case

Brazil’s best positioned airline
Azul is the fastest-growing, most profitable and best positioned airline in Brazil. It serves 100 destinations in Brazil and is the only carrier in 71% of its routes, making it an indisputable leader in most of the routes it serves. Limited number of local passengers in these key routes provides strong barriers to entry for competition. In addition, Azul’s high frequency of flights per day on its key routes makes it the preferred carrier for business travelers - the customer segment that should grow the most as the economy recovers.

All of the above means that top line should growth at a healthy ~18% - ~20% CAGR over the next three - four years as the economy expands.

Fleet upgrade to propel margin expansion
Azul is currently upgrading its fleet by replacing the older generation E-195 aircraft with new generation E2 and A320neo aircraft. The E2 and A320neo reduce Cost per Average Seat Kilometer (CASK) by ~28% compared to the E-195s. By 2020 Azul expects 47% of its Average Seat Kilometer (ASK) to be served by these new generation aircrafts which should help lift its EBIT margins to 15% by 2019 and close to ~18% by 2020. The new generation aircrafts, being larger in size, should also support further growth in Azul’s cargo segment.

Management are excited about the margin expansion which is going to come from the fleet upgrade. Here are just couple of quotes from management on the fleet update.

John Peter Rodgerson - Azul S.A. - CEO & Member of Board of Executive Officers
“We're very excited about the next couple of years. As David mentioned earlier, we're going through a significant fleet transformation process as we replace older generation aircraft with next-generation aircraft, namely the A320neos and the Embraer E2. In addition to being extremely fuel-efficient, these aircraft have more seats than the older-generation aircraft they will be replacing, contributing to a significant increase in margins going forward. Our A320s have the lowest CASK in Brazil and are currently flying, on average, 14 hours a day. The neos have a 29% CASK advantage over our current E-Jet and are expected to represent 27% of our total ASK in 2018, and that will go up to 41% in 2020.”

Abhi Manoj Shah - Azul S.A. - Chief Revenue Officer & Member of Board of Executive Officers
“We have the A320s that we're just beginning the process. To give you an idea, the A320s are currently in only 32 of our nonstop routes, and Azul has almost 250 nonstop routes. So still very much a long way to go in putting in the 320s, and that's just going to be really exciting as we go forward.”

Other revenues set to grow healthily
Ancillary revenues, mainly from checked baggage fee, grew 22% in the fourth quarter 2017 and represent 14% of total revenue. Azul expects ancillary revenues to continue to increase thanks to a new law allowing checked baggage fee.
Azul’s cargo revenue increased an impressive 60% in the fourth quarter, mostly driven by the larger cargo compartments of the A320neos and the growth in international capacity. Further, in December 2017, Azul and Correios, the Brazilian Postal Service, signed an MOU for the creation of a private integrated logistics company. Once approved by Brazilian authorities, this new company will further strengthen Azul’s cargo business. None of the upside from this venture is in my forecast.

TudoAzul, Azul’s high-growth, high-margin loyalty program
Azul’s loyalty program, TudoAzul has maintained a strong growth. Management believe TudoAzul to be the fastest growing loyalty program in Brazil. It has more than 9 million members at the end of 2017, with 2 million members were added in the last 12 months alone. TudoAzul now has 16% gross billing share across airline loyalty program’s in Brazil, up from 13%, but management believe that the pie in the entire industry is growing and Azul is still well below what management believe is its fair market share in this business. Further, it is worth noting that two of the major carriers in Brazil – LATAM and Gol – both have their loyalty program separately listed with R$3.5 billion-plus valuations. Azul owns 100% of TudoAzul and given it doesn’t provide detailed breakdown of this business, the true independent value of TudoAzul is unlikely to be reflected in the current share price. A future listing of TudoAzul is a free option with great upside potential.

Azul’s 41.25% interest in TAP 
In early 2016, as part of a consortium, Azul invested €90m in the then bankrupt Portuguese airline, TAP Portugal. The investment was structured as a convertible bond giving Azul 41.25% of the equity value of TAP. HNA, the distressed Chinese investor has a call option to buy 1/3rd of the bond from Azul at the end of 2017 but did not exercise (given the situation HNA are in, this is not surprising). Azul now own the 41.25% exclusively. Based on recent communications, management appear extremely excited of the value this investment could unlock. According to management, TAP is going really well right now. Given the leadership at TAP today is former Azul members, management have a very good sense of the direction the business is taking. This again is a fantastic option (potentially worth 2x – 3x the current book value of R$836m if the turnaround is successful) which is not reflected in the current share price and my forecast.

US – Brazil open skies agreement provides Azul an opportunity to add to profitable international routes
The US – Brazil open skies agreement, which was approved in March this year, offers Azul an opportunity to add to its international routes (international revenues currently account for ~10% of Azul’s total revenues). Azul has already entered talks with United to establish a JV and expect to accelerate this process.

Strong balance sheet and operational resilience
Azul has a strong balance sheet, with cash and equivalents of R$ 3.6 billion against total debt of R$ 3.5 billion. Capitalising all of Azul’s leases at 7x rents takes Azul’s adjusted net debt to just over R$ 9.1 billion. Adjusted net debt is 3.9x EBITDA at the end of 2017, from 5.7x in 2016. This should continue to fall.
Operationally, Azul is exposed to depreciation in the Brazilian Real and oil price increases. However, the company was able to successfully pass on recent oil price increase to consumers via ticket price increases. And its strong balance sheet, in particular high cash balance equating to ~50% LTM revenue, gives a strong base to withstand adverse FX moves.

Based on the current share price of R$ 33.48, Azul trades at 6.7x forecast 2018 EBITDAR and 5.3x forecast 2019 EBITDAR. In comparison, Copa Airlines, the leading Latin American carrier, trades at 8.2x forecast 2018 EBITDAR. Azul, given its strong EBITDAR growth combined with a dominant market position with little to no competition in its main routes and barriers to entry, merits a similar multiple to Copa. However, even assuming a 7x multiple to forecast 2019 EBITDAR gives a per share value of R$ 53 for a 59% upside to the current share price. A 7.5x multiple, which in my opinion is perfectly reasonable, equates to a per share value of R$ 59 for a 76% upside. See appendix at the end for my summary financial forecast. 

My valuation doesn’t take account of the multiple free options available to a shareholder. These include the upside to Azul’s cargo business from the JV with Brazilian Postal Service, potential value unlock from a future listing of TudoAzul royalty program, the significant potential upside from the 41.25% stake in TAP Portugal, and the increase in international revenues from the US-Brazil open skies agreement.

Appendix: Financial forecast

Friday, 6 April 2018

The AA Plc: on the road to recovery

AA is UK’s largest road side breakdown recovery provider (it rescues a broken down motorist every 9 seconds). The company also provides insurance brokerage (mainly motor & home insurance) and driving lessons (~84k driving school students across the UK at FY18). The company IPO’d in 2014, after being held in private equity hands for 10 years. AA’s share price has fallen ~80% from its post IPO peak and by ~65% from the IPO price. I believe that the shares today offer good odds for a potential ~50% - ~70% return over a 2-3 year hold.

AA investment case in detail
Most of AA’s share price fall (~65%) has come in the last year (particularly since August 2017). The main reasons for the fall have been repeated profit warnings, increased capex outlay on a major IT project to revamp the legacy CRM system, and the more recent strategy presentation on 22 Feb 2018 where the new management set out the company’s new strategy (throwing in ~£145m of additional capex into the mix along with a dividend cut and substantially reduced profit forecasts for FY19). I will start off by listing what I believe are market’s chief concerns with AA, and then go on to set out my view and investment thesis.

Market’s concerns with AA
1.     The road side recovery business has been steadily losing paid personal members (B2C). From 3.58m B2C members in FY14, the business today has ~3.29m. B2C members are the lifeblood of the road side recovery business, contributing ~72% of the road side divisions EBITDA and ~56% of group EBITDA. There has also been downward pressure on the B2B / corporate membership base lately (weak new car sales in the UK is generally seen as a negative for this business). Competition from upstarts like Greenflag has disrupted the duopolistic nature of the business - whilst AA and RAC continue to be the two main operators in the UK road side recovery market, Greenflag, with its aggressive pricing strategy, has been claiming members. The market’s view appears to be that AA will continue to leak members (unknowns like the impact of electric vehicles and autonomous vehicles on the business doesn’t help either).
2.     Net debt / EBITDA stands at >7x, with my forecast net debt to EBITDA for FY19 at >7.6x. Whilst the AA is not at any immediate risk of breaching debt covenants and the maturity profile of its debt is sufficiently staggered with a weighted average maturity of just over 5 years, market will be concerned of the impact down the line if the core business continues to suffer – e.g. dilutive equity offer in future or a debt for equity swap, debt costs on future refinancing if AA’s bonds get de-rated to non-investment grade…
3.     AA’s new strategy announced on 22nd February 2018 brings with it significant capex spend (~£280m of capex over the next 3 years, of which ~£140m more than previous forecasts). In addition to the ~£35m of additional spend on the new CRM system, management wants to invest substantial amounts in new technology, marketing and its insurance offerings (e.g. Car Genie – AA’s new telematics system to predict faults before they occur, app and digital initiatives, additional capital for the insurance business). While management view the new strategy as paving the way for long-term growth, market will be concerned if this is the company trying to throw the kitchen sink at an unwinnable problem (i.e., the slow dying roadside recovery business). 
4.     In addition to the above concerns, market appears to give no credit to AA for the growth prospects it has in its insurance offerings (e.g. only 9% of AA’s personal members hold AA motor insurance, AA has recently kick started its own underwriting business).

My view and investment thesis
Road side recovery business
In my opinion, the road side recovery division is an extremely attractive business. It consistently generates ~49%-50% EBITDA margins and high ROIC of ~17% - 20%. In spite of increased competition the division has demonstrated pricing power over long periods. AA’s scale and quality of service helps in this regard- it has the biggest patrol network at >~2900 patrols across the UK and based on my research, it provides the best quality service compared to competition.
The economics of the road side recovery business is extremely attractive. Looking at the last six year numbers, the business generates average revenue per user (ARPU) of ~£54 per annum. This is across both B2C & B2B membership base, with B2C members generating ARPU of ~£158 per annum, almost 8x the ARPU of B2B members. The average cost per member per annum is ~£26, giving the business a juicy ~£49%-50% operating margin. The main attraction of the business is that whilst all member pay a yearly membership fee, the number of breakdowns attended per annum works out to ~27% of the membership base (people pay for the peace of mind).

For example, in FY17 the AA attended to 3.6m breakdowns, which works out to ~27% of its membership base in the year of 13.52m members. ARPU per member in FY17 was £55 and average operating cost per member was £27 [average cost per breakdown of £105 * 27% of the membership base]. These economics have been consistent over the last six years (see table below).  

Based on the above economics, if the AA can show stability in the number of members and ARPU per member, there is no justification to market’s concerns in my opinion.
On membership, it is a fact that AA has been leaking personal member. Since the IPO it has lost a total of ~650k personal members. But it is worth noting that the majority of lost members (~360k) was suffered due to discontinuance in December 2015 of free roadside membership for AA’s insurance customers. This closed the pipeline of AA insurance customers who were getting free membership, with a view to later converting them to paid members (but discontinuance also helped improve ARPU). Ignoring the free membership base and looking at paid membership base alone, the CAGR since IPO has been -2.1%, with recent years actually showing stability in the paid membership base (the paid members ship base showed a modest growth of 0.3% in FY17). 

In addition, the AA has been adding an average of >500k new paid members each year since the IPO, and improved membership retention rate from 79% in FY14 to 82% now.  

My forecast for membership base going forward

In forecasting the B2C membership base, I take account of AA’s retention rate (82% over last 2 years) and new member additions since FY14 which has averaged more than 0.5m over the last 4 years. Management strongly asserted in the Feb strategy day that the retention rate has held strong at that level. Assuming the retention rate holds stable and new members continue to be added at current levels, I forecast the membership base stabilising by FY22, and returning to a modest growth thereafter.

On B2C membership base, I take a fairly conservative view. AA currently has close to 10m B2C members with a 65% market share in the UK B2B roadside recovery market. It has very strong retention rates (100% in the last 3 years). However, B2C revenues are correlated with new car sales and I discount for the negative trend in UK new car sales in my estimate. I forecast B2C membership falling steadily over the next 5 years and stabilising at just over 9.3m mark. This is a fairly conservative estimate in my opinion and I expect the company to exceed this level.

Forecast for membership base (FY18-23)

There are plenty of factors which should help AA meet (and probably exceed) my membership base forecast above:
-        the new AA app has good features compared to competition and has shown uptick in usage rates amongst members;
-        the  Car Genie telematics product is to be rolled out across the membership base and is able to predict ~1/3rd of breakdowns; more importantly, it differentiates AA’s offering against competition;
-        the increased patrols (addition of 65 patrols takes AA’s total patrol numbers close to 3000) and call centre staff should help AA meet its service delivery targets of arriving within 45mins of a call and targeting call answer time of 20secs. Better service = higher retention rates + better reviews + growth in new members;
-        the new CRM system should help the AA improve membership retention and increase cross selling (e.g. better cross selling across its insurance, driving services and road side membership platforms). For a company that is 110 years old, it is amazing that before the new CRM system it had no way of knowing much about its customer base across its business lines and target its offerings (the monopolistic nature of the business in the past meant the company could get away with this).

The operating cost side of the roadside recovery business
As discussed earlier, the economics of the roadside recovery business is very attractive. The business is helped by the fact that most of its operating costs are fixed (e.g. majority of the break downs are attended to by AA’s own patrols and it has its own call center staff). Breakdowns attended in a year have ranged between 24% - 27% of the membership base, meaning that the business consistently makes 49%-50% operating margin given ARPU of ~£55 and average cost per breakdown of ~£102.
However, there are times when the business has to use independent garages - e.g. at the time of peak demand due to weather conditions. This erodes the businesses operating margins. If you study the margins over the years, it is clear that the number of break downs during the year and operating margins show a negative correlation. Management recognises this and is working to reduce reliance on independent garages by improving patrol/resource allocation by targeting peak times and areas (e.g. the company is working on forecasting patrol needs by postcode based on past data and is targeting patrol allocation accordingly).

The other factors which should help margins going forward are:
-        app usage has steadily been increasing since introduction in 2015, with ~35% of the members now registered via app and ~45% of the breakdowns now tracked on the web and app. 20% of the member breakdowns do not involve a call and management has a target of reducing calls to call centres by 20% by FY21. The app has good features with members being able to access all membership benefits in one place, plan journeys, get live traffic updates, report and track breakdowns etc. Average app session of >3mins for an app of this nature is impressive. As more members use the app for recovery assistance, the reliance on call center should reduce, improving operating margins
-        Car Genie should help AA patrols better manage calls (e.g. by knowing more about a call in advance, a patrol should be able to spend less time and better prepare for each call; some calls could also be solved remotely)
-        the new CRM system should make it easier to track and renew members helping increase efficiency

However, I don’t give any credit for the above upsides and my forecast assumes that the margins in the roadside recovery business drop from the current 49% - 50% to 45%.

Marrying all of the above, my forecast for the roadside business is below:

A word on EVs and autonomous cars
There is some speculation on the impact electric cars and autonomous vehicles will have on a business like the AA. It is difficult to predict car reliability for EVs and autonomous vehicles with any certainty. Moreover, penetration of EVs currently is <3% and forecast to rise to ~10% by 2021. AA predicts that ‘self induced’ faults (e.g. tyres, locked out) will remain unchanged. Moreover, there could be new types of faults these vehicles suffer from (e.g. battery faults, technology malfunction etc). There is nothing to suggest that EVs won't breakdown. AA has already got trained patrols who can handle EV breakdowns. As for autonomous vehicles, they are some way away; and again there is nothing to suggest that autonomous vehicles will not need break down cover.

Management has laid out a new 5 year growth plan for the insurance business under which it targets 2m+ motor and home policies by FY23 from the current ~600k. It plans to grow EBITDA by 9% - 14% in its insurance business between FY19 – 23. I believe managements target is achievable for the following reasons:
·       of the AAs 3.3m B2C members, only 9% have AA motor insurance. There is a large captive customer base ready to be tapped. The new CRM system should help in this regard. New management brings real focus in this regard and initial growth figures are noteworthy (motor insurance policies have returned to growth and now stand at over 600k, and the in-house underwriter has now written over 400k policies across home and motor insurance, a growth of 4x in the last year)  
·       AA has now rolled out insurance hosted pricing (IHP) in its brokerage business. IHP allows live price feeds to the underwriting panel and greater speed to market for its insurance brokerage. This is already having a positive impact on policy growth in the brokerage business.  
·       AA is putting in place plans to use its proprietary data to enrich its in-house underwriter (e.g. anonymised data from Car Genie and its B2C membership base to better quote and write policies)
·       The new CRM system should enable better targeting and cross selling opportunities
·       Over 87% of the quote requests to AA come from non AA members. AA currently doesn’t offer quotes to non-members, but this is set to change. This offers a sizeable opportunity for the AA, not only to broaden its underwriting footprint but a new customer base to be targeted for its roadside recovery business.

I forecast CAGR EBITDA growth of 6% over FY19-23, 300bps below management’s lower end forecast. I believe the AA has more than a decent chance of beating this.

Driving services
The driving lessons business comprises of the AA Driving School and BSM. It is a steady business with ~84k students at FY18 generating EBITDA margins of ~29%. Management considers this business to be core and expect to cross-sell insurance and roadside breakdown cover to this student base.

I keep my forecast for the driving services business steady at current levels.

Debt structure
A net debt/EBITDA ratio of >7.6x would be a no-go for most equity investors, but in my opinion the key risks for equity owing to high debt are remote in AA’s case for two key reasons: 1) given the debt’s maturity profile there is a very low risk of a dilutive equity offering; and 2) AA has significant headroom above its financial covenants given its strong cash generation and risk of a default is remote.

The blended cost of AA’s debt is 4.52%.
The spread out maturity profile gives the company headroom to refinance itself on a continuing basis; the strong credit (the A notes have an investment grade rating) attracts institutional investors. AA’s bonds trade at good levels - the shortest maturity A3 note and the longest maturity A2 note both trade above par and have nearly always done so. The remaining notes (A6, A5 and B2) with maturities around 2022-23 saw sharp declines in value at the time of the strategy update, but have since recovered.

The AA has a covenant light structure. There is only one maintenance Debt Service Coverage Ratio (DSCR) covenant associated with the Class A Notes.  This covenant, which effectively is an interest coverage ratio, is set at 1.35x. With c.£100m of annual interest cost for the Class A Notes (fixed in nature), Class A Free Cash Flow would need to more than halve before any breach could potentially occur. At FY17 the ratio was 3.3x and even at the FY19 low, I predict a ratio of 2.7x. As such, the risk of default is very low.

The high net debt/EBITDA leverage does not have a covenant impact as the AA does not have any leverage-based maintenance covenants.

While I don’t see any risk of a dilutive equity issue, there are a couple of points worth noting re the debt structure from an equity investor’s point of view:
1.     The next refinancing date for AA is on its 4.25% £500m A3 notes in July 2020. All of AA’s A notes currently have an investment grade rating from the S&P. However, if S&P were to review AA’s investment grade rating (e.g. due to increased capex, execution risk on under the new strategy, reduced profitability forecast for FY19) and downgrade AA, this could have a bearing on the interest rate AA has to pay when it comes to roll-over the A3 notes in July 2020. For example, AA’s B2 notes currently have a B+ rating with a coupon of 5.5%; a similar rating and coupon would increase the cash interest costs by £6.25m per annum, reducing eFCF. That said, I expect interest costs to steadily decline post-July 2020 due to the following reasons:
a.       given free cash flows, AA could simply chose to repay a substantial portion of the principal at maturity. For example, AA should easily be able to repay £100m of the A3 notes, requiring only £400m to be refinanced, in which case its cash interest hardly increases even assuming a 5.5% coupon on the new notes.
b.       When S&P last downgraded AA’s B2 notes back in July 2016, a key factor was the IFRS pensions deficit which stood at £622m; this has now fallen to ~£390m in FY17, reducing the risk of a downgrade.

2.     The other point worth noting re AA’s debt structure for an equity investor is the opportunity it provides for significant transfer of value from debt to equity over time. Whilst AA cannot repay it’s A and B notes at present due to onerous make whole prepayment penalties, it is able to start repaying its 5.5% £570m B2 notes from August 2020 without any prepayment penalties. Moreover, it has ~£2.2bln of its ~£2.7bln total debt coming to maturity around 2020/23. Given its free cash flows, AA has an opportunity to: a) repay a fair chunk of the notes, reducing the debt and future interest costs, and b) reduce its blended average interest cost from the current 4.52%. As an example, if AA uses ~70% of its eFCF to start repaying its £570m B2 notes starting August 2020 when the prepayment penalty falls away, it adds ~£8m to eFCF in FY21 and ~£16m to eFCF in FY22. There are a number of options available to AA to reduce its cash interest costs as its notes come to maturity.
In my calculations I have not modelled any upside to cash interest before FY23, which is conservative in my opinion. From FY23, I model a reduction to cash interest of £15m from the current ~£115m – this is easily achieved either by reducing the blended average interest costs on the notes by 60bps from the current 4.25% to 3.6%, or by reducing the total debt by ~£380m using AA’s FCF, or a combination of the two.

In summary, I believe the risk of a dilution for equity holders is remote, and in the longer term there is good prospect of transfer of significant value from the debt to equity holders.

Free cash flow
In what should be the trough year for profitability and cash flow, eFCF is forecast to hit a low of £20m in FY19. But this is largely as a result of ~63m of exceptional (see below). I forecast eFCF to recover to £80m in FY20 and average over £100m thereafter.

As can been seen from managements presentation above, they forecast normalised FY19 eFCF post adjustments at £107m. The bridge between the forecast FY19 eFCF of £20m and normalised eFCF of £107m is - £55m of transformational capex, £12m of punitive swap costs which terminate in FY19 and £20m of exceptional owing to disposals and one-off working capital adjustments. I agree with all but one of management’s number – on capex, I would only given credit for the ~£31m of capex spend in FY19 on the CRM system, which is genuinely one-off; the rest of the capex initiatives could be a regular occurrence. My normalised FY19 eFCF comes at ~£80m. However, from FY20 onwards, I expect eFCF to average above £100m. Based on the current share price of £0.94, this works out to a eFCF yield of ~15%. 

In my cash flow forecast, I budget capex post FY21 of ~75m. Management’s forecast for normalised capex post the implementation of the new strategy is £55m per annum, but I expect some of the expenditure to have to continue (e.g. IT spend is likely to be at elevated levels owing to the need to constantly innovate the digital offerings and market spend is likely to stay high owing to competition).

My DCF value for AA comes to £1.65 per share, which is a ~75% upside to the current share price.

EV/EBITDA multiple
Using normalised EV/EBITDA multiple, I value AA at ~£1.49 per share, which is a ~58% upside to the current share price. I use a multiple of 10.5x EV/EBITDA on normalised EBITDA of £370m. The 10.5x multiple is backed up by the following variables back up by my forecasts: a cash tax rate on EBITDA of 7%, reinvestment rate of ~31% on EBITDA, WACC of 8% and EBITDA growth rate of ~1.9%.
EV/EBITDA of 10.5x = [(1- 7% tax rate)*(1- 31% reinvestment rate)] ÷ (8% WACC – 1.9% growth rate)

It is worth noting that AA has traded at an EV/EBITDA of 10.5x on average since its IPO in FY14.
Note, my CAGR EBITDA growth rate over FY19-23 is well below managements forecast range of 3% - 6%. If management hit their forecast, there is additional upside to my valuation.

Catalyst and support
1.      Stability in road side membership
2.      Growth in insurance business
3.      Execution of the new strategy - CRM rollout, Car Genie, cross selling, app usage, better reducing reliance of independent garages
4.      Transfer of value from debt to equity over 2020 – 2023 period by reducing blended interest costs and debt
5.      Potential takeover bid – I think there is less prospect of a bid in the near term given the substantial pre-payment penalty on the B2 notes on a change of control. However, the A notes have no change of control payment trigger, which could be attractive for a bidder and the B2 prepayment penalty reduces substantially in FY19 and completely falls away in July 2020.

Sunday, 25 February 2018

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.

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.

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.


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.