Source: www.breakingviews.com is Europe’s leading financial commentary service.
BT has come a long way. Two years after its £6 billion (€9.6 billion) rescue rights issue, the UK telecom is throwing off cash again.
BT should generate about £1.8 billion of equity-free cashflow – the cash after interest and tax that is available for dividends or paying down debt – this year. And that makes a £16 billion market value look rather mean. After all, the cashflow yield of 11.2% compares with a telecoms sector average of 10%.
Investors seem concerned that BT’s sales will fall and erode this. However, these concerns are starting to look overblown. BT’s growth outlook, while dull, does not qualify as a disaster. What’s more, there are levers that can be pulled to protect cashflow from sluggish revenues. Equity-free cashflow could easily grow over the next few years.
Core business under attack This year will be tough for BT. The regulator has made it easier for resellers to compete for local calls. And this has attracted such companies as Carphone Warehouse and Tesco into the market. The deregulation of directory enquiries has also been a blow. All this will exacerbate the decline of BT’s core business.
But BT is fighting back. Its “new wave” revenues – aimed at offsetting the fall in core revenues – are approaching critical mass, largely thanks to its broadband roll-out success. Its IT services business also has a bulging order book. It would now take a really big setback in the core business for revenues to fall more than marginally at the group level.
BT also has a decent opportunity to cut costs. It is investing an additional £300 million this year modernizing its network – above and beyond its normal capital expenditure of about £2.3 billion.
The payback could be chunky. BT will be able to configure much of its upgraded network remotely. And that could help it cut jobs or redeploy resources.
BT has mentioned cumulative cash cost-savings from the network upgrade of £1 billion by 2008. But it hasn’t specified where the savings will come from.
What’s more, once the modernization programme is over, BT should be able to reduce capital spending. Even if only half the additional capex is removed, that could add up to £150 million a year to equity free cashflow from 2006.
Then there are interest savings. BT has an extremely inefficient balance sheet. It has £16 billion of gross debt paying high interest rates. On the other hand, it has a £7 billion cash pile earning low returns. But this won’t last for ever. Over the next three years, £7 billion of the expensive debt – costing it 7% in interest – will mature. Assuming BT repays that with cash currently earning, say, 3%, the group would save £280 million a year, or £200 million after tax.
If cashflow is adjusted to account for a more normal level of capex and interest, equity-free cashflow could be £2.1 billion to £2.2 billion. The yield would be a pretty tempting 13% to 14%.
One reason why investors may be reluctant to give BT the benefit of the doubt is because management has taken a cautious view on cashflow. Senior executives have resisted calls to explain what BT’s dividend policy will be next year and beyond. Moreover, this year’s dividend, paying out about 45% of earnings, isn’t terribly generous for a company with poor growth prospects.
But the management seems to be opening to the idea of returning more cash to shareholders. Here is a thought for the bosses: if they aren’t yet ready to commit to a progressive dividend policy, they could always buy back shares.
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