Fair Value Estimate: 129.00p | Uncertainty Rating: High | Economic Moat: Narrow
Thesis (Last updated on 20/10/10)
After two years of problems at BT's global services division, the company appears to have turned the corner. However, the pension overhang is not going away anytime soon.
In the early to mid-2000s, BT (BT.A) made a major push to expand its presence in the ICT (information, communications, and technology) market, especially outside of the United Kingdom. The firm aggressively bid for many large contracts to handle all of a company's telecommunications needs. These often were in conjunction with others that also included taking control of many of their computer needs as well. These would be multiyear contracts, usually lasting 5-10 years, with significant up-front costs but with large returns later on. However, as some of these contracts ran out, the large returns did not materialise, as costs hadn't been contained or estimated returns were too aggressive. These poor returns required BT to take over 1 billion pounds in write-offs over the past two years. The EBITDA in the global services division dropped from a high of £304 million, or 14% EBITDA margin for the fourth quarter of fiscal 2008, to just £7 million during the third quarter of fiscal 2009. The fiscal first quarter of 2011, which ended last June, had recovered to £130 million, a 6.5% EBITDA margin. This was a faster recovery than we expected. We think it signals that the worst is over, and the division should be able to continue to improve. However, we don’t ever expect to see a 14% EBITDA margin from this division again.
With the Asian markets recovering faster than the rest of the world, BT is increasing its focus on this region. Currently it has about £350 million in revenues from Asia and thinks it can grow this by about 6% annually. One concern we have here is that BT will be too aggressive in pricing to enable growth, as it was when it made a push in the US about five years ago; that move later came back to haunt BT.
Unfortunately, offsetting the improvement in global services is continuing bad news on the pension front. BT is one of the world's oldest phone companies and has one of the largest pension liabilities in the UK. As of March 2010 its pension assets were £35.4 billion, which is about 30% larger than BT’s enterprise value. While this value popped with the market during fiscal 2010, given the current low interest rate environment, the future expected returns on the portfolio have been lowered, offsetting much of the rebound. The funding shortfall is now £ 5.7 billion.
The traditional UK telephone business is actually holding up quite well. BT is the largest provider of broadband in the country, and it is the only firm with a network that covers the entire population. The UK is one of the most competitive phone markets in the world, with many resellers, but most still rely at least partially on BT's network. BT is increasing the pace at which it rolls out fibre to enable it to offer broadband speeds up to 40 Mb/second in order to compete against Virgin Media (VMED), which is offering up to 50 Mb/second now, with 100 Mb/second expected by the end of the year. BT is also seeing more of a push in the small- and medium-sized business market from both Virgin Media and Cable & Wireless Worldwide (CWC), but we think BT can hold its own against both. We don't see these other firms' increased focus as compromising BT's strong positioning.
Valuation
We are maintaining our fair value estimate for BT at 129p per share. Despite the global services division recovering faster than we expected, its significantly weaker margins are not strong enough to prompt us to raise our fair value estimate. We continue to expect revenues to decline through fiscal 2012, before a recovery in the top line. As part of the restructuring of the global services division, BT is being careful about new large contracts. We have already seen new contracts drop from over £8 billion annually for fiscal years 2005-09 to about £6.6 billion in fiscal 2010. The lower revenues from this division will offset some growth in the other segments. However, the newer contracts should help raise margins in the division. We now expect EBITDA margins to reach about 30% by fiscal 2015 up from the atrocious 17.5% in fiscal 2009.
Risk
BT's risk profile has increased with the debt it has taken on and the weak UK economy. The firm levered up its balance sheet to buy back stock as well as make acquisitions to beef up its global services division. The UK, like the United States, is suffering from a housing market bust, which is rippling through the economy, and could cause people to reconsider the importance of the top-of-the-line bundles of phone and Internet access services that BT has been pushing. In addition, the pension fund has rapidly swung from a surplus to a deficit. On top of all that, the UK remains one of the most competitive markets in the world, with around 200 firms offering telecom or Internet access services. Virgin Media now offers Internet access at speeds significantly faster than anything BT can offer. The firm has slashed its dividend in order to protect cash, but it still needs to invest in its next-generation network in order to compete. Also, the European telecom regulator could implement policy changes that could hurt the firm.
Management & Stewardship
Michael Rake was named chairman in September 2007. He was previously chairman of KPMG and brings significant experience in international business, strategy, and accounting. Ian Livingston became CEO in June 2008. Previously he ran BT's retail division, and before that he was CFO. Tony Chanmugam was named CFO in December 2008; he was previously CFO of BT's retail division. In January, 2010, Jeff Kelly joined BT as CEO of the struggling global services division. He has 25 years of IT services experience, most recently as head of the Americas division of EDS. The board has more independent directors than executive directors. The nonexecutive directors bring a good diversity of backgrounds. One nice thing about many of BT's incentive programmes is that a significant portion vests only if BT's total return is in the top fourth of returns compared with a group of European telecom operators. We also appreciate that the firm is paying more of its incentive-based compensation in the form of shares as well as requiring senior executives to build a substantial personal shareholding.
Overview
Financial Health: BT has used its free cash flow to pay down debt. Net debt has declined to £8.9 billion from £28 billion in 2001, despite acquisitions, stock buybacks, and dividends. However, its underfunded pension fund puts its balance sheet at significant risk.
Profile: BT Group, formerly known as British Telecom, is the incumbent phone operator and largest supplier of fixed-line phone services in Britain with about 59% market share. BT's external sales are split 41% global services, 37% retail, 16% wholesale, and 6% from Openreach and other. BT is the largest supplier of high-speed Internet lines, including lines it wholesales.
Bulls Say:
-- In January 2006, Ofcom, the UK telecom regulator, approved BT's plan to operate its wholesale division separately from its retail division without breaking it up. Recently, Ofcom has decreased the regulation on BT's consumer business. This reduces the risk to the company's strategy, revenue, and earnings.
-- BT continues to acquire small companies, adding further capabilities to its managed-services and consulting offerings.
-- The global services division has shown strong signs of a turnaround with EBITDA of £130 million in the first quarter of fiscal 2011, up from £7 million during the third quarter of fiscal 2009.
Bears Say:
-- The British telecom market is very competitive. For example, more than 200 companies offer DSL service. Virgin Media is the first company able to offer a quadruple play in the UK, and it has rolled out Internet access service that is significantly faster than anything BT can offer on a large scale.
-- Fixed-line sales are shrinking, and new growth areas are becoming more competitive. This prompted the firm to cut its annual dividend payout by about 60% in fiscal 2010.
-- BT's global services division currently isn't earning anything close to its cost of capital, and is consuming valuable management time.
-- The European telecom regulator is threatening to change telecom regulations across Europe, which could hurt BT's results.
-- BT has an underfunded pension of £5.7 billion, which will cause the firm to pay at least £525 million annually to the fund.
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