BT shares: where next for the telecom giant?

BT Group remains on course to meet expectations this year and its dividend looks safe. However, the future beyond that looks increasingly tough for the UK’s largest telecoms company as the high cost of investment in the latest technologies, such as full-fibre ultrafast broadband and 5G, looks set to squeeze cashflow and place shareholder payouts at risk.

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Revenue has been in decline for three consecutive years and its latest annual pre-tax profit was the lowest on record for five years. The immediate outlook paints a bleak picture and suggests this trend will continue. Investment in new technology is growing, the regulatory and political scene is causing uncertainty around BT’s plans, and competition is intensifying.

BT won’t see a return on its investment in the likes of full-fibre broadband for years - if not decades - and may have to cut its payouts to shareholders to fund its ambitions in the meantime. This has seen the investment case for BT turn to the long term, while traders may find opportunities as the company navigates the tough few years ahead.

BT shares have almost halved over the last five years, but does this mean the company is falling out of favour with investors or being significantly undervalued by the market? We have a look at the company, its prospects, and the opportunity on offer.

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BT Group’s full-fibre plans

The current Conservative government believes improving the country’s access to faster internet speeds is a priority. This is vital as the amount of data we use continues to skyrocket and more people adopt new Internet-reliant technologies such as smart home devices. Accelerating the UK’s investment in full-fibre broadband was one of the first pledges made by Boris Johnson when he became UK prime minister, promising ultrafast broadband for the entire country by 2025 after describing the previous target of 2033 ‘laughably unambitious’.

This is a huge task for the telecoms industry, which are responsible for upgrading the UK’s current system. BT has raised its investment in full-fibre broadband, having connected over 1.8 million homes by the end of September 2019. However, that figure is small in the grand scheme of things, and just 8% of the UK population currently has access to ultrafast broadband.

What is full-fibre broadband?

Full-fibre allows people to access what is known as ultrafast broadband. This represents a step up from superfast broadband, which almost 96% of the country has access to. The government has said ultrafast broadband will be 30 times faster than superfast broadband.

There are two primary components to any internet connection. The first is the connection to the area, usually to a central cabinet that serves all the surrounding homes and businesses. The second is the connection between the cabinet and each individual premise. There are currently three types of internet connections:

1. The first uses copper cables to connect to both the cabinet and to the building.
2. The second uses a faster fibre-optic cable to connect to the cabinet but a copper one to connect to buildings.
3. The third uses fibre-optic cable to connect to both the cabinet and the building.

Ultimately, as the name suggests, ultrafast broadband relies on full-fibre optic connections that allow data to be transferred at a much faster rate than the traditional copper wiring system that has been used for decades.

Full-fibre broadband is not cheap

There is very little resistance to upgrading to ultrafast broadband and governments around the world recognise the benefits it will bring, but there is a fierce debate over how it is done and who foots the bill. Governments want it as soon as possible, but those that actually have to do the work, like BT, want reassurances that they will get a decent return on their hefty investment and guarantees that the industry will have the resources it needs to tackle such a huge task. Updating all the connections to street level to fibre-optic from copper is one thing, but replacing the individual connection to each and every building in the country is another.

BT has firm plans in place to connect four million premises to full-fibre broadband by March 2021, but it is unwilling to commit beyond that until it has received more clarity from the government. It has said it is willing to raise that target to 15 million homes by 2025, but only if the government clarifies critical unknowns, such as the return it will get and how it will secure the 30,000 extra workers that BT predicts will be needed to achieve the roll out.

Ultimately, connecting 15 million premises within the next six years is a mammoth task – and that is less than a half of the 32 million premises that would need to be hooked up in order for the UK to have nationwide coverage.

A government report released in 2018, when the UK’s target was based on the year 2033, suggested the total cost of investment would be 'in the region of £30 billion' – a figure that BT has echoed. The same report said that private investment by the likes of BT and its peers should cover 90% of all the costs of the full-fibre upgrade with just 10% covered by public finances.

BT’s chief executive Philip Jansen recently said the company would have to spend an extra £400 million to £600 million per year to connect 15 million homes by 2025.

Does the election pose a threat to BT?

There are concerns about BT’s full-fibre plans because of the election. Any talks or negotiations that have been held with the Conservative government so far – underpinned by Johnson’s pledge – could be for nothing if the Conservatives fail to win in December. There is no guaranteeing how a new government – whether its Labour or some form of coalition – will prioritise the matter or handle negotiations. At the very least, it is prolonging discussions at a key time for the company.

BT has said it is confident its full-fibre plans will be welcomed and embraced by whatever government the UK has on December 13th. It has spoken to all political parties and has said the questions are about how best to do it rather than whether it should be done at all. One of the main reasons the election has been considered a problem for BT is Labour’s plans to renationalise several listed companies spanning everything from transport to utilities, and BT has been regarded as a potential contender. However, BT is adamant that the company is not on Labour’s hit list, although Openreach could be an entirely different matter.

The election means there is unlikely to be any major progress on BT’s all-important full-fibre plans for a while. If the Conservatives get re-elected, then this should be beneficial to BT and allow it to continue with the talks it has already had. A new government could press the rest button.

How will BT fund this huge investment?

Well, this is the all-important question that investors want the answer to.

Firstly, BT Group is undertaking a huge restructuring aimed at saving costs, including culling 13,000 jobs. This ‘transformation programme’ was launched in the middle of 2018 by BT’s former chief executive Gavin Patterson, which Jansen inherited when he took over at the start of February 2019. When BT released its interim results for the six months to the end of September, it said pre-tax profit remained broadly flat year-on-year (YoY) at £1.3 billion despite reporting a 2% drop in revenue and an 18% increase in investment in its network because it offset these by cutting costs. BT has cut around 2,200 jobs since the start of the year and 6,200 over the last 18 months. So far, it has yielded annual savings of £1.1 billion at a one-off cost of £487 million. All-in-all, it is hoping to book annual savings of £1.5 billion at a total cost of £800 million over a three-year period. BT primarily rolled out full-fibre and became the first mobile operator (having bought EE in 2017) to have launched a 5G service in the UK.

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Secondly, BT has said it will cut spending in other areas so more can be allocated to its full-fibre plans, and said it is willing to load up on debt too.

Thirdly, there are also divestments that could help supply the funds needed – although progress on this front has been frustratingly slow for investors. For example, it said in April it was looking to sell its Irish business as part of its larger plan to downsize its operations outside of the UK to focus on fewer but bigger international corporate customers. There has been very little news on this front since and it is still looking for a buyer, although there have been reports that it is in talks with Mayfair Equity Partners about a €300 million sale. Drumming up interest has been even harder for other units such as its Italian arm that was at the centre of the accounting scandal in 2017 that prompted BT to trim down its international exposure in the first place. The fact no progress was reported on either sale in its recent interim results disappointed investors, who want to see BT raising the cash it needs.

The concern is that all three of these measures won’t be enough and that BT will have to act on the fourth option: cutting the dividend. When it released its last set of annual results in July, BT kept its dividend flat at 15.4p per share for the third straight year. It said it was confident it could match that payout in the current financial year to the end of March 2020. It maintained its interim payout last month at 4.62p and the final dividend looks safe.

But the dividend situation looks highly precarious beyond this year. BT’s chairman Jan du Plessis said at the company’s last annual general meeting that BT would consider cutting the dividend a ‘year or two in the future’.

BT Group could be latest telecoms firm to slash its dividend

BT Group would not be the first major telecoms company to sacrifice payouts so they can meet their investment needs.

Vodafone announced it would cut its dividend for the first time ever back in May when its new chief executive, Nick Read (who was promoted from chief financial officer), said the business needed to free up funds to invest in new technologies and reduce its large debt burden. Its full-year dividend was slashed 40% to just 9 cents – much deeper than the 14.55 cents predicted by analysts at the time. The cut was needed to fund higher than expected costs of rolling out 5G in Germany and to provide headroom after loading up on debt to acquire assets in Germany and other eastern European countries from Liberty Global. Perhaps you could write a sentence here about Vodafone's first half (H1) results to keep the article up to date.

Vodafone bounced back somewhat in the six months to the end of September, although still suffered heavy losses. Revenue rose 0.4% to €21.9 billion but it still booked a large €1.9 billion loss because of a court case that didn’t go its way in India. The dividend was 4.5 cents per share, which represented 50% of the annual payout made in the last financial year but still down from the 4.84 cents paid in the H1 of the previous year.

Deutsche Telekom did the same just last week, stating it will cut the dividend this year to 60 cents from the 70 cents paid last year. This is primarily to facilitate the proposed merger of the company’s T-Mobile division in the US with Sprint – a deal that has been held up by regulatory scrutiny. However, the cut has also been seen as a precautionary step as spending rises, especially as the firm is performing strongly at present. Deutsche Telekom said it booked over €20 billion in revenue in a single quarter for the first time ever and its adjusted earnings had risen 5%. Deutsche Telekom also raised its full year guidance – and yet it still felt the need to make a hefty trim to shareholder payouts. Chief executive Tim Hottges said: ‘Earnings increased in all areas of the group in the first nine months of this year — with some of that growth in the double digits. At the same time, we are investing record amounts.’ Notably, Deutsche Telekom is the largest single investor in BT Group with a 12.1% stake.

Competition in telecoms is intensifying

BT has always held an edge over its competitors in the UK because of its ownership of Openreach, which manages the fibres, wires and cables connecting the country. This means BT acts as a wholesaler to nearly every other broadband and phone-line provider in the country. Vodafone, Sky, TalkTalk and Plusnet are among the companies that buy wholesale services from BT – in fact, only Virgin Media, owned by Liberty Global, doesn’t rely on Openreach to provide services to their customers. Ultimately, Openreach still handles over 80% of the country’s internet traffic and the unit remains one of the most profitable parts of BT.

This has given BT a monopoly, although it has weakened. BT still owns Openreach, but regulators forced BT to separate it from the rest of the business in 2016. Plus, BT’s market share has deteriorated: it’s still by far the largest provider of broadband and telephony, but its share has fallen to 41% from 58.5% in 2008, according to data from Ofcom.

There have been a number of mergers and acquisitions within the European telecoms sector in recent years, including BT’s purchase of EE. This combined the country’s largest fixed-line telecoms provider with the largest mobile service provider. Similarly, Vodafone and Liberty Global have combined forces through a joint venture in the Netherlands. Although, not all deals have been welcomed, with a proposed merger between Telefonica's O2 and Hutchinson 3G’s Three being blocked by UK regulators in 2017.

There are several drivers of this growing consolidation. The need to raise investment has encouraged firms to scale up and improve profitability, and they are also keen to converge their services (whereby they sell multiple services to their customers, like Internet, mobile and TV) to increase customer loyalty and profitability.

Consolidation could threaten BT’s position. For example, Virgin recently announced it will stop piggy backing off BT’s mobile network when the contract expires in 2021 and switch its three million customers to Vodafone’s network, which will also assist in launching Virgin’s 5G service. This means Virgin won’t be using BT to offer broadband or mobile services in few years, and it brings Vodafone and Liberty Global closer together. Vodafone bought Liberty Global’s operations in Germany and Eastern Europe for €18.4 billion earlier this year – although, this left it with the hefty debt burden that helped induce the dividend cut. A merger of Vodafone and Liberty Global’s UK operations has been touted for some time – and Virgin’s decision to switch to Vodafone has only reignited the rumour mill. That could be detrimental to BT’s position as it would combine its one real rival in broadband with its second biggest competitor in mobile services (behind O2).

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Other deals have been suggested too. Liberty Global, as one of the more financially fit players in the market, is seen as a potential buyer of other BT rivals, including O2 or Three. There has also been reports that Sky is to invest in Virgin’s UK broadband network. Liberty Global’s chief executive Mike Fries said earlier this year that merging with a mobile provider could deliver annual synergies of €700 million – but said this wasn’t enough to drive a deal yet and that the focus was on organic growth.

BT Group outlook: what to expect

BT has said the 15.4p dividend will be safe and that it will deliver its guidance this year. It has said it is expecting a 2% decline in adjusted revenue and adjusted Ebitda of £7.9 billion to £8.0 billion. Capital expenditure will rise to within a budget of £3.7 billion to £3.9 billion while normalised free cashflow is to fall to a range of £1.9 billion to £2.1 billion.

BT Group consensus expectations

However, the market is expecting a tougher period after March 2020. Full-fibre plans are expected to see spending rise further while revenue and cashflow continue to deteriorate, suggesting a dividend cut is unavoidable. Its cost-cutting efforts are expected to help offset these somewhat, with static earnings over the next three financial years:

_{(Source: BT-compiled consensus of analysts. Correct as of November 11, 2019)}

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BT shares: broker recommendations

BT Group currently has a long-term broker recommendation of Buy and an average target price of 249.58p, according to data from Reuters. That target price is 32% higher than BT’s current share price, implying there is considerable upside. However, it is worth noting that BT shares have traded significantly below the average target price and considered undervalued for several years, suggesting either the market has failed to appreciate BT’s value or that brokers have incorrectly judged the firm’s valuation.

_{(Source: Reuters. Correct as of November 8, 2019)}