BT Group: Dividend At Risk – BT Group plc (NYSE:BT)

BT Group’s (BT) dividend yield above 7.5% seems attractive for dividend-oriented investors. Recently, management maintained the dividend and mentioned a possible increase in the future.

But I don’t share management’s optimism. Considering pension contributions and one-time expenses, the free cash flow doesn’t cover the dividend. Also, taking into account the competitive landscape and the regulatory hurdles, I don’t expect the situation to improve over the next few years.

Besides, based on the multiple of my free cash flow estimates, the valuation doesn’t provide any margin of safety.

Image source: Visor69 via Pixabay

The real free cash flow potential doesn’t cover the dividend

From a high-level perspective, the situation looks simple. The company reported a fiscal 2018/2019 normalized free cash flow of £2.44 billion. And management forecasted fiscal 2019/2020 normalized free cash flow to be in the range of £1.9 billion to £2.1 billion due to the ramp-up of investments.

As the dividend represents a cash outflow of approximately £1.5 billion, the normalized free cash flow more than covers the dividend. But the situation isn’t so simple. Management excludes significant cash outflows like pension contributions and one-time items from its free cash flow calculation.

About pensions, the fiscal 2018/2019 year was exceptional as the company had agreed to contribute £2.1 billion. This extra cash outflow and the dividend justify the increase of the net debt from £9.6 billion to above £11 billion despite the normalized free cash flow of £2.44 billion.

BT Group: Net debt

Source: Presentation May 2019

But the company will still have to contribute to the pension scheme with annual payments of at least £900 million till 2030 included.

BT Group: pension contributions

Source: Annual Report Fiscal 2018/2019

Thus, taking into account the pension contributions over the next decade, BT Group needs to realize a normalized free cash flow of at least £1.5 billion + £0.9 billion = £2.4 billion to cover the dividend.

With a higher pension contribution of £1.25 billion during fiscal 2019/2020, the midpoint of the expected free cash flow will actually be £2 billion – £1.25 billion = £750 million.

But the company also excluded hundreds of million of costs every year from its normalized free cash flow calculation. For instance, management considered legal and restructuring costs as specific items not to be included in the normalized free cash flow calculation.

BT Group: specific items

Source: Annual Report Fiscal 2018/2019

Considering the history of specific costs and the ongoing transformation, it’s fair to assume specific items will represent an annual cash outflow of several hundred million pounds over the next years. For instance, the company announced it would take part in the next 5G spectrum auction later this year.

With these specific items, free cash flow will not exceed £500 million this year. Even with lower pension contributions and lower specific items during the next years, the £1.5 billion dividend isn’t likely to be covered.

Operational challenges

Over the last several years, the normalized free cash flow has been decreasing.BT Group: historical normalized free cash flow

Source: Presentation May 2019

The trend will continue this year as management expects normalized free cash flow between £1.9 billion and £2.1 billion. And I don’t see any improvement in the medium term.

As per the charts below, broadband and mobile traffic has been growing over the last several years in the UK, and the growth is expected to continue.

BT Group: bandwidth consumption in the UK

Source: Presentation May 2019

But revenue in the UK Telecom industry didn’t match the volume growth.

UK Telecoms industry revenue

Source: Presentation May 2019

In the medium term, I expect this discrepancy between consumption and revenue to continue. One month after BT Group announced the availability of 5G in 6 cities, Vodafone (VOD) communicated about aggressive 5G pricing in the UK.

The situation is the same with fiber. The chart below shows the lower retail prices from BT Group’s competitors over the last 12 months.

BT Group

Source: Presentation May 2019

Also, the recent decision from the UK regulator Ofcom will favor competition in some protected markets. The regulator decided to extend access to some of Openreach’s infrastructure. The goal is to facilitate the deployment of fiber for broadband and mobile networks.

Besides the challenges with revenue growth, management announced the possibility of accelerating fiber deployment to connect 15 million homes (instead of 10 million as initially planned) by the mid-2020s. This plan still has to be confirmed but, if approved, will require extra capital. During the last earnings call, management discussed the options to finance this initiative:

I would not go straight to dividend because we’d look at every option that we have, and you’d have, you could increase lending, there may be more transformation benefits, you might reprioritize capital. And then, as part of that, you look at the dividend, of course you have, but it’s way too early to speculate on that at this stage.” – Source: earnings call fiscal Q4 2019

In parallel, management expressed the goal of reaching a BBB+ credit rating. As the current rating stands at BBB, I don’t see how an increase of the net debt would trigger a better credit rating. Also, reducing investments in the context of network transformation with 5G, fiber, and all-IP against aggressive competitors doesn’t seem a viable option.

Thus, if management decides to implement the accelerated plan to connect homes to fiber, a dividend cut would be the most likely option.

In any case, even without this extra investment, the dividend is still not covered anyway by the free cash flow after pension contributions and specific items.

No margin of safety

As management maintained the dividend, the drop in the share price brought the dividend yield above 7.5%. It’s the highest dividend yield for the company over the last several years.

ChartData by YCharts

At £2.002 per share ($12.85 per ADS), the market capitalization is close to £20 billion ($24.68 billion). With the midpoint of the forecasted normalized free cash flow range at £2 billion, the market values the company at 10x the normalized free cash flow. This valuation is reasonable considering flat revenues.

But we saw normalized free cash flow excludes £900+ million of annual pension contributions till 2030 and specific costs. Even if we assume specific costs of £100 million only, free cash flow will drop below £1 billion. And the valuation becomes demanding at more than 20x the estimated £1 billion of free cash flow.

Thus, the stock price doesn’t offer any margin of safety. Also, despite the attractive dividend yield, this investment isn’t adequate for dividend-oriented investors. When taking into account all expenses, the free cash flow doesn’t cover the dividend.

Conclusion

The dividend yield above 7.5% seems attractive for dividend-oriented investors. The normalized free cash flow management calculates exceeds the cash outflow the dividend represents.

But taking into account pension contributions and specific items, free cash flow drops below £1 billion. Also, with the competitive landscape and the regulatory challenges, the situation isn’t likely to improve in the medium term.

Thus, at 20x my free cash flow estimate, the valuation doesn’t provide any margin of safety considering the lack of revenue growth. And dividend-oriented investors run the risk of a dividend cut.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.