BT Group, F2Q 2006 (Qtr End 9/30/2006) Earnings Call Transcript

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BT Group (NYSE:BT)

F2Q 2006 Earnings Call

November 9, 2006 5:00 am ET


Christopher Bland, Chairman of the Board

Ben Verwaayen, Chief Executive Officer

Hanif Lalani, Finance Director

Ian Livingston, Chief Executive Officer, BT Retail

Paul Reynolds, Chief Executive Officer, BT Wholesale

Steve Robertson, Chief Executive Officer, BT Openreach


Paul Howard – Cazenove

Nick Lyle – UBS

Chris Halliett(?) – ABN Amro

John Clarke – Brewin Dolphin

Steve Malcolm – Arete

Simon Weedon – Goldman Sachs

Laura Mills – Merrill Lynch

Jonathan Groocock – Oriel Securities

Christian Maher – Investec

Stephen Howard – HSBC

David Wright – JP Morgan

Mike Cansfield – Ovum Ltd


Ladies and gentlemen, welcome to the BT Center Auditorium. Can you please make sure that you have all your mobile phones and pagers switched off. There are no fire alarms planned for today, and, in the event of an alarm sounding, will you please leave the auditorium by the two fire exits at the front of the room.

Christopher Bland, Chairman of the Board

Good morning, and welcome to BT’s results presentation for our Q2 and half year. This morning, I’ll focus on the half-year results, Ben and Hanif will take you through Q2 in more detail. First, I must draw your attention to the cautionary statement which is also included in your pack. I must remind you that during this presentation, we will make various forward-looking statements, factors which could cause our actual results to differ materially from the results we currently expect or have identified in detail on the screen and in your presentation packs.

In the first six months of this financial year, the business delivered another set of strong financial results. We’ve continued to make transformational changes, whilst at the same time delivering for customers and for shareholders. Group turnover increased by 3% to £9.8 billion. New Wave now accounts for over one third of group revenue and will continue to be an increasing proportion of the total. EBITDA before specific items grew 2% YoverY to £2.7 billion. EPS before specific items rose 19% to £0.113 .

This was driven by revenue growth, cost efficiencies in traditional areas, lower interest and tax and our ongoing share buyback program. As a result, we’ll pay an interim dividend of £0.051 per share, which is 19% higher than last year. At £321 million, free cash flow was 15% lower than last year. This was driven primarily by increased capex as 21CN deployment gathers pace. In addition, the net outflow of working capital in the first half was slightly higher than last year. This is expected to reverse in the second half of the year.

The 3% rise in group turnover is bolstered by a near 20% increase in New Wave revenues in tandem with a traditional revenue decline of less than 4%. New wave revenue has grown twice as much as the fall in our traditional revenue. One of the most striking elements of BT’s transformation is our changing revenue mix. Back in September 2002, New Wave only accounted for 13% of total group revenue, while calls and lines represented 46%. This half year, New Wave is 34% of the total, with calls and lines less than one third. This transformation is now recognized by peers and industry commentators. This chart from a recent edition of The Economist clearly demonstrates how BT has become far less reliant on voice than other telcos.

BT is well positioned to take full advantage of the evolving opportunities which arise in an IT world. In the past five years, despite our voice revenues declining, we have continued to grow earnings and delivered increased shareholder returns. We have also transformed our balance sheet. Our net debt had reduced by £1.5 billion over the last 3.5 years. During that time, we have also paid out almost £3 billion in dividends and bought nearly £1 billion worth of shares. Over the same period, the pension deficit has fallen from £6.3 billion to £2 billion net of tax on an accounting basis.

By the end of December, we expect a final decision on the pension funding requirements for the next three years. EPS before specific items rose 19% to £0.113. We have now delivered 18 consecutive quarters of EPS growth. Another endorsement of our strategy, its execution, management’s strong financial discipline and BT’s focus on returns. Finally, the interim dividend we are paying is £0.051, a YoverY increase of 19%. This payment is in line with our progressive dividend policy. We continue to target a payout ratio of at least two thirds of earnings next financial year. Now I’ll hand you over to Hanif, to take you through the details of the quarterly numbers. Hanif?

Hanif Lalani - Finance Director

Thank you, Christopher. Good morning. Our Q2 results build on the momentum we have established in recent years and underpins the confidence we have in the outlook statement that we provided. Group revenue at £4.9 billion in Q2 rose 4%, with double digit growth in New Wave revenue more than offsetting the stable rate of decline in traditional revenue. EBITDA grew 2.4%, a third quarter of positive growth. The EBITDA performance in each line of business is in line with the outlook statement we provided at the start of the year.

EPS before leaver costs increased by 13% to £0.06, the eighteenth consecutive quarter of YoverY growth. Group revenue grew for the eleventh quarter, primarily driven by strong growth in New Wave revenues, at £1.7 billion, 21% up YoverY. The main drivers of growth in New Wave revenues are network IT services which grew 10% to £1 billion and broadband revenue, which increased by 39% to almost half a billion pounds.

As a Group, we serve a diverse range of customers from single households to multinational corporations. You can see that 75% of our revenue is achieved in a B2B environment, up from 69% a year ago with all three segments growing YoverY. Across all customer segments, New Wave as a proportion of total revenue continues to grow, particularly in Consumer this quarter. Revenue growth combined with a focus on cost reduction has once again resulted in EBITDA growing positively in the quarter extending our improving trend to seven quarters with the last three quarters returning positive growth.

Let’s review the Group P&L. Operating profit rose £22 million whilst margin remained unchanged at 14.5%. Lower finance costs due to refinancing of higher coupon debt resulted in a reducing average interest rate. This combined with an increase in pension credit meant profit before tax was £632 million, £73 million higher than last year. The effective tax rate reduced by 0.74 percentage points to 24.5%, taking profit after tax to £477 million, 13.6% or £57 million higher YoverY. All of these numbers exclude specific items.

Specific items this quarter were a £23 million charge relating to our property rationalization program and a £20 million profit on the part disposal of our stake at the IPO of Tech Mahindra in India during August. Our remaining equity in Tech Mahindra is currently worth around $1 billion.

Capex in the quarter amounted to £812 million, a 17% increase YoverY. We continue to reduce expenditure on legacy and transmission equipment, as 21CN preparation activity and deployment gathers pace. At the same time, we’re investing heavily in systems and network software to deliver 21CN and LLU capabilities for other service providers. Our annual expenditure on capital will remain at around £3.1 billion.

Let’s look at free cash flow. EBITDA post leavers rose £37 million. During the quarter we benefited by £48 million from lower interest and tax payments. However, increased investment in 21CN, as well as systems to support and deliver our commitments under the telecoms strategic review resulted in capex rising £123 million this quarter. Other inflows were offset by a higher working capital outflow due to the impact of timing differences. These timing differences will reverse out during the second half of the year. Free cash flow in the quarter was a net inflow of £338 million better and YoverY net debt was reduced by £54 million to just under £8.1 billion.

Let’s review the line of business performance. Global Services, revenue rose in Q2 by 3% to £2.2 billion. UK traditional revenue decreased by 8% with reductions with dial IP volumes. New Wave grew by 6% despite an adverse foreign exchange movement of £12 million. A combination of increased revenue and a proactive focus on supplier management resulted in gross profit improvement of £26 million at £638 million. EBITDA increased 4% YoverY to £229 million while the gross profit improvement was partially offset by higher SG&A costs.

Lower depreciation contributed to a 16% increase in operating profit of £72 million before leaver costs.

Moving on to BT Retail, traditional revenue declined by 9% whilst New Wave revenue grew by 34%, driven primarily by broadband. Although revenue fell by 3%, gross profit increased by 7% reflecting successful margin and supplier management both in the consumer and SME market. This results in gross profit margins improving by 2.5 percentage points with SG&A costs falling 2% driven by continued focus on delivering cost efficiencies. EBITDA rose 23% to £235 million. Operating profit before leaver costs improved 29% to £196 million.

BT Wholesale revenue of £1.9 billion increased by 4%, driven by external revenue growth of 7%. External revenue in Q2 of over £1 billion was boosted by strong growth in New Wave services. Internal revenue increased marginally to £855 million due to growth in internal broadband revenue, partly offset the impact of lower call volumes and lower regulatory prices. Gross variable profit improved by 1% although margins decreased to 49% due to the change in sales mix.

In spite of greater 21CN opex expenditure, network and SG&A costs decreased by 1%, as a result of efficiency savings. Overall, EBITDA before leaver costs increased by £14 million to £484 million. Higher depreciation due to shortening of the useful economic life of legacy transmission assets to be replaced by 21CN resulted in a 2% decline in operating profit at £193 million.

Finally, Openreach. Revenue in Q2 was 1% higher at £1.3 billion, despite price reductions amounting to £45 million YoverY. External revenue increased by £102 million predominantly due to the growth of WLR and LLU volumes. Internal revenue declined by 8% to just over £1.1 billion, reflecting the volume shift from internal to external channels and reductions in price in the prior periods.

Operating costs increased 4% as staffing levels and overtime was increased in help improve service levels and handle the significant increase in activity volumes. Consequently, EBITDA fell 5% to £460 million. As you can see, each line of business has specific strengths and unique capabilities which together have contributed to the positive momentum the group has established. Once again, we have demonstrated that we have the right strategy to continue to drive improving financial results across the group and have delivered our eighteenth consecutive quarter of EPS growth.

This supports our positive outlook for growth in revenues, EBITDA, EPS and dividends. Over to you, Ben.

Ben Verwaayen - CEO

Hanif, thank you very much. Good morning everybody. I thought I would like to surprise you with a slide. Let’s start with this slide. You didn’t see it last time and I got complaints about it. They said, we have seen it so many times, why did you leave it out. I thought it was a good idea not to leave it out, because it gives an opportunity not to rehearse the slide over and over again, but to show to you this version of it. This strategy is not a strategy on paper. It’s a strategy of things that are happening right now on all four elements. I think if you walk through this presentation, you will see that we are hitting all the four elements at the same time. We are delivering a very robust defense of our traditional business.

We are getting better at it.

You can see we have more of our revenues under contract and we are getting better at it. You will see that we are delivering 21CN and you can see more and more milestones being completed and at the same time, you will see that our New Wave is growing and is growing fast. If you look to those four elements of strategy they have a similarity with the four things we are delivering and we should deliver, our growth in revenue, our growth in EBITDA, our growth in EPS and our growth in dividends. Those four elements coincide with the fact that as a company, we have four units or four lines of business that form a every strong group.

The advantage of four different lines of business is focus. At the same time, the advantage of group is our capability to work together where it makes sense and be faster, better and cheaper than our competition. Each of those lines of business has their own task in life. Global Services allows companies to globalize. We are more and more successful in bringing that capability to the market space. Retail is selling more and more higher added value services on a nationwide basis. Wholesale is focusing more and more on a market of managed services. It’s great to compete in this market, with more and more customers – be it in the traditional mobile space or the traditional fixed space or in the converged space – want managed services, to form for themselves a platform for their go to market strategy.

Openreach, I think, is delivering an access strategy to the UK market that will allow that market to expand. If you start with Global Services, the most important question that people always ask is are you on track for further growth and how are you doing with your EBITDA margin of 15%. In September, Andy and team gave a presentation about where we are. To be on track is the right wording. Look to what we have done – in the Network IT Services space, we grew 10%. Just for the fun of it, look up what our competitors did. Look where we are. Most of them, you will find a minus before the number and in a very few you will find they have grown in this space in low single digits.

We are taking market share and I am going to prove that to you. We are taking market share. Our EBITDA margin rose 16bps and every single step here is important. At the same time, our operating profit rose 16%. I think we have strong financials. We also have a unique proposition, we serve 128 countries and territories around the globe and we add to that every single week. We have a capability that makes us unique, not just on a geographic territory, also on what we offer to the companies that are our customers. We have a service level capability that allows us to prioritize services that are crucial for our customers. Second to none, there are six layers of services that we can bring anywhere on the globe, that allows companies to do business in a totally different manner.

Last but not least, this is a market about value. Value that we bring and that other people bring. The scale of partnerships is an essential ingredient to bring value to our customer base. To know how to partner with others sounds very easy, but not too many people have mastered the skill. I think we are pretty good at it, and getting better and better every single day. To get recognition as a leader is important in the market. There are two things here: first of all, the industry analysts are unanimous about what capability Global Services has to offer. We add to that organically and inorganically.

The acquisition of Counterpane was not significant by the size of it but by the depth of it. It will give us a unique security services capability for a market that is going in that direction. Last but not least, if you look to the future, we are growing faster in our non-traditional markets. We have a cost saving capability and we executed on that and we will hit the 15% margin. If you look around the globe, I said last time it’s not just the spread in geography, it’s also in sectors and it is a focus to bring those services where our customers wanted to be. In this quarter, we have added 223 new accounts, household names, names like these, and if you look to where they are coming from, out of the 223 more than 10% is now Asia.

It is a phenomenal change over where we were, even a couple of years ago. We have the capability here to bring added services to a scale that we weren’t a couple of years ago. You have seen that Q3 started very well with two announcements that are strategically extremely important and size-wise very important. This chart was shown to you by Andy when he has his global services day. I wanted to repeat it. It’s the roadmap to 15%. It tells you that it’s not just better selling, it’s not just the mature thing of the contract or the ability as an organization to organize yourselves much more according to the new realities of the market and being in?depth on sector.

It’s the capability to execute the positive side of growth and the cost transformation that’s going to take place in Global Services. It gives us this road map and the feeling of confidence that this road map is a real road map that you can follow quarter after quarter.

Let’s talk about Retail. Hanif gave you a lot of numbers, but a 23% increase in EBITDA is a good number. It’s a fantastic number. It shows some of the discipline that we have today in Retail. Retail is a very, very diverse business. Yes, it’s Consumer, but EBITDA in Consumer is less than 50% of that of Retail. It’s business, and was talk about Consumer in business, but it’s also enterprises. It’s a business that’s very focused on segments of the market where they bring world-class solutions.

We’re doing terrific in Ireland. I believe our market share of broadband in Ireland is 35%. It is a very, very diverse business that’s delivering high value services to our customers. We do a lot of innovation. I don’t know how much time you have reserved in your calendar for the BT PodShow. You better reserve more in your calendar – we have one million hours available to you today. People are producing content for it, and if you do the calculations, it will only take you 11.5 years, 24x7, to watch the library we have here today. It’s growing and it’s available as of today.

We have other great numbers. You may have seen this one, it’s not to advertise this wonderful product to the Chairman, though he would love to have it. We sell 25,000 of these a week. This is broadband at its best with packages at is best and it’s Wi-Fi. We have talked about it many, many times. Where are the Wi-Fi phones? Here they are. This is one Wi-Fi phone. We’ll have three different Wi-Fi phones in January coming, so finally the market has decided that it is not just enough to have it in a form that people cannot use for too long, with a battery issue or a price issue. We’ll now have very attractive Wi-Fi phones. It can work with your hub because it’s Wi-Fi enabled, as you know, and it will help us on the fusion. There is a lot of innovation, that is the summary of this. There is a lot of innovation coming through.

I think that if you look to the retail performance, it is also those two elements – defending the traditional and growing the new. Defending the traditional, our renewed price plan is really appreciated by the public. You can see that here. Almost 400,000 options two and three were signed in the quarter. The flip side of that of course is that the number of active losses has not been so low for three years. We are really getting traction with our price plan. Let’s talk about our New Wave, our broadband. If you look to broadband, there are three things I would like you to focus on and pay some attention to.

First of all, our market share is 25% in quarter. Second, of what we sold, 60% is higher value packages. We said last time that the market would have two different corners. One corner is price, and in the UK you call that ‘free’. In the other corner is value. That is where we play. What you find is that in the value corner, people want the total value, as much as the can, all those wonderful new services that you get on top of your broadband line. 60% is signing option two and three. That is not bad for our margin. If you look at how attractive our offer is, look to the right hand side of this chart, which is the orders. We have signed 350,000 plus orders in the quarter.

As you can see, we have the largest install base – 3 million. If there is churn, we are unlikely to have churn when there is nothing. When you build from scratch you do not have churn, so churn is here. In total, we have grown double the size of our biggest competitor which is still cable in net adds. If you want to see that translated into two things, into what it does for our ARPU – our ARPU goes up. Per customer, our ARPU goes up. If you want to see this wonderful, colorful chart that we have shown many times, you see one thing.

There is always volatility in the quarter. It has been historically the case and boringly, BT is around 25%. That is where it is today on the total market. If you look to the total market, the success of some of the newcomers is at the expense of cable and not so much at the expense of BT.

Let’s talk about business. I am very proud to say that we are taking market share in the SME markets. I love to say that because for a very long time, I couldn’t say that. Why are we taking market share in the SME markets? Two reasons. We have a good price plan. Like BT together in the consumer market, the BT business plan is really attractive and it is even more attractive now that it is a converged plan. It takes in mobile as well. You can see, 60% of our voice is now under contract. It adds new services to our capability.

Second, if you look to broadband in the business market, we are clearly the number one ISP. 46% market share. By the way that is higher than our market share in lines. It is a point that we have argued all along – there is not a direct one-on-one connection between the lines and broadband. Do you remember that debate? Here it is happening in the SME markets. You can also see that 40% of our customers have signed long-term contracts on broadband. Two years is a long term contract for broadband.

The add-on service that they buy from us, more than 90% buys more than just the broadband. I can tell you, this is a good formula to grow this business in this segment. Talk about the other parts of retail, the enterprises. As I said, these are very focused businesses on a very diverse number of markets and they are in a very different stage. If you look to payphones, the name of the game is cost and cost control. We took 20% of cost out, that helps in that particular market.

On the other hand, look to BT Conferencing. We built a global platform and in and by itself, BT Conferencing is gaining customers around the globe. It is a very successful, very rapidly growing. You can see the growth here, it is over 29%. It is a very, very good number. At the same time, we are focusing on segments of the market if you see BT Expedite and the household names in the Retail market, it is a very good performance. I can talk about it, but why don’t we look at it.

[Video Presentation]

If you’re interested, there’s no reason why all football clubs cannot follow Arsenal. Even if it’s Celtic. You’ll get more about Retail if you join Ian and his team in December when they have a more specific day to talk about what Retail is going to do.

Let’s move on now to Wholesale. I think it’s an exciting story. The transformation in Wholesale is a transformation that is very profound. It is now capable of helping other people in the market have a different level of performance. That is because of the innovation that took place in Wholesale itself. It has great financials. This is the first time we have a quarter of external revenue over £1 billion. It grew 7%. EBITDA grew 3%. I think from this chart, the most important word to remember is ‘managed services’ – the capability to take the hassle for other players in the market and let them concentrate on what they do best.

It is a very attractive, proven performance that you can see is gaining momentum with other players. I think that if you see the next steps, it is all about improved services and improved capabilities. I know lots of people have said once LLU is growing, DSL can’t grow. LLU has reached the status of 1 million. You could say that is pretty grown up. At the same time, DSL is growing, just to note. If you look to 21CN, it is a world first. It is also reality, today. Here. It is not just Cardiff, we have prepared for 21C 100 cities now, 100 places. We had 75 million trial calls over the network and we’re rolling it out.

We’ll roll it out in a way that has advantages, not just for BT from a cost perspective, but more important it has new service capabilities and it gives to customers new, differentiating capabilities and new capabilities to be faster in new services. Whether it’s new Ethernet or IP services, 21CN will transform the way digital services can be brought to the country.

If you look to the speed in which this is happening, this is a chart that shows you that in four years time, there is no digital divide in the UK. This will be nationwide. We did it with broadband. Today, if you look to broadband, we have a 99.97% coverage and of the 5,582 exchanges, only 35 are not broadband enabled. This goes even further. This is a total network spread done in 2011.

Let’s talk about Openreach. It is very important because it’s so different. I think that the Chairman and myself have been invited to talk about why we started Openreach in the first place in many different places in Europe. Businesses have asked, operators have asked and other people have asked, what is this? The answer is it’s very good. That’s the answer. It’s very good for the market, I think it’s very good for BT and most importantly it’s very good for the end users. It has a very focused set of regulations that make the access market a real capability enabler for other players and other services.

It has regulated returns and therefore has an enormous focus and it has the capability to allow new developments to take place with a certainty on the access. Access is, as Andy can tell you, one of the most important cost factors for anyone who wants to go to the market. Yes, we have increased activities and I’ll show you that. We are delivering, and we are delivering something that is pretty unique. It is equivalent not just in output but also in input, and I think we are delivering a service assurance to customers that is very, very important. Let’s look to where we are. We had 263 undertakings.

Of those 263, 146 are ongoing obligations. Behavioral stuff that will never be finished because it is how you have to behave and what you have to do. There were 117 very concrete deliverables. Sometimes it sounds like people think we’re not delivering. Well, we have delivered, done and ticked the box on 87, most of them much faster than we anticipated. We are working today on the 30. I think we are delivering a very, very robust system. It is true that you have to go back in the most painful detail of your organization to make everything equivalent, and we have to invest a lot of money to make sure we have all those equivalent systems.

Sometimes we have to invest faster and more than we thought. Sometimes, we have to invest not just in stuff, but also in culture and people.

It takes two sides. If you see what it means from a service perspective, I want you to understand a little bit about the dynamics there. Two years ago, the activity in this part of BT could be measured by what we call jumpers – what that means basically is making connections in an exchange. We did 17 million of them two years ago. The workforce was there and we had our pattern and everything was okay. Today, we have to do not 17 million but 27 million activities. The complexity of the activities has gone up.

In 19% of cases now, we have four different activities under that one umbrella, because what we deliver is much more complex than we used to do. You still have to do it in the same physical surround. You just can’t pour in a truckload more people, so you now have to work 24x7 in order to get the work done. There’s a total shift in work patterns, skills and in volume. I think Steve and his team are coping with that pretty well.

We do it in a very transparent way with the industry. It is not us designing the process, it is us together with the industry designing the process and it is done in a way I would describe as good, open spirit and cooperation. This is the volume they have to deal with. One million lines, and we expect the LLU to hit 1.5 million. It’s very important for us, it will give us more space, as you know, on the pricing level. It’s 1.5 million before the end of our fiscal year. This will be on track and you’ll see what it does for the volumes.

Let me try to summarize. We have a continued momentum in BT. All our four lines of business are delivering. They are delivering on an individual basis, where they are focused on what they need to deliver, and they deliver it collectively where there is an opportunity to work together and gain speed and momentum. We bring it together in our strategy, which is focused on converging innovation. You know this chart, and it will be up for a long time. The numbers are a little changed. This is our eighteenth consecutive quarter on EPS and eleventh consecutive quarter of revenue growth, and the seventh consecutive quarter of our EBITDA improvement.

We know how to compete. We know how to compete in the traditional markets and in the new markets. We are on track to deliver, as we promised, both on the top line, on the bottom line, on earnings per share and on dividends. Thank you.

Christopher Bland

Questions? I’ll go to the right hand first. Hanif thinks you're split into bulls, don’t knows and bears, but if you would like to identify yourselves not under that category, please do.

Questions and Answers

Q - Paul Howard – Cazenove

Just on the broadband and markets, the last two quarters for the UK market as a whole, annual growth in net additions has slowed quite sharply. I’m just wondering whether you think that’s down to the provisioning issues some of your competitors have had, or whether you think there’s a slowdown in the rate of growth itself? Going forward, for your share, I think you’re saying you’re still targeting around the 25% share of net additions. Given the ramp up in net additions that Sky are talking about and perhaps Carphone are talking about, do you not think that’s going to fall in the next couple of quarters, perhaps, before things stabilize?

A - Ben Verwaayen

I think I’ll take the total market and maybe Ian, you’ll say something on retail market share. The total market, we have now 46% of households in the UK with broadband. As we said before, this is no longer just a service that has to do with your PC and getting the same services faster. It is rapidly expanding into a whole series of new services, like VoIP. We were nowhere in VoIP half a year ago. We have 650,000 people now. I think it is not true that there is a limitation to broadband as we saw it a couple of years ago. I think there is room for growth because of the new applications that will come in. It will be an integral part for example in the division and other services that we bring to the market.

A - Ian Livingston, Chief Executive Officer, BT Retail

I don’t think it’s got – I think the 627,000 extra broadband customers was a great number. It wasn’t that far below same quarter last year. Actually, broadband is still growing very strongly to be honest. If people are putting it down to problems with provisioning, I think probably they should look in their own business, not elsewhere.

Q - Paul Howard – Cazenove

I wasn’t blaming you.

A - Ian Livingston, Chief Executive Officer, BT Retail

Some others might have done. I’m delighted to say that we provide 95% of our customers within five days, not five weeks. We are looking to the highest possible share poll. It’s a tough market, unquestionably. There is lots and lots of competition. I think we’ll all see fluctuations in market share and in net adds. Of course we’ve got a big install base, we’ve got the market here, and you’re seeing a lot more churn. There’s no question about it, if you’ve got no install base, then it won’t affect you. We’ve dramatically increased our sales, so actually gross adds are up quite considerably. We’re going to add in BT Fusion, Wi-Fi version will be coming next quarter. We’re going to add in BT Vision, which will be before you ask launched next month. So there’s a lot of new services coming that I think we’ll help support, and the market as Ben said, will bifurcate between ‘I want a dumb pipe’ and those people who really want broadband to offer services that they can do.

Q – Nick Lyle – UBS

Could you update us on your thoughts on distributions and gearing, and give us an idea of timing as to when you might come back and explain your thoughts? Secondly, how long can the retail gross margin keep on improving? Could you maybe expand on the strong gross margin improvement you’ve seen again?

A – Christopher Bland

First of all, distributions – we’re on track to deliver two thirds next year in terms of dividends, and that is our declared intention and that’s where we’ll get. On gearing, the overall level of gearing is something that the board looks at regularly. We need to remind ourselves and indeed you that we’ve come a long way. Early on, we were obsessed quite rightly with reducing debt. We can still remember where it was £30,000,000,000. Now we have come a long way and plainly our mindset has changed. We continue to keep that under review. We’ve got a good record. Since March 2003, we paid out £3 billion in dividends, £0.9 billion in share buybacks, spent £1 billion on acquisitions and we’ve reduced debt by £1.5 billion. We’ve done pretty well. That’s not to say that our present structure is set in stone. It is worth reminding ourselves that the separate existence of Openreach, but within the structure of the BT Group, I should emphasize, may give us additional abilities in terms of our debt capacity and indeed the costs of debt. That, along with our total options, is something we continue to keep under review. That is a significant change compared with a year ago, when Openreach didn’t exist. The second part of the question was on Retail margins?

A - Ian Livingston

Yes, I think we’ve done very well on value added services. In our real focus, we’ve seen a big change in what people are buying in broadband for instance. We’ve seen them taking up items such as BT digital vault which protects all of your music and photographs as well as all of your data online. People really like these services. We think by focusing on these services, we can increase our margins. We’ll keep a very good eye on costs and particularly on bought-in costs of things, which have also helped. I think if you put the two of them together, plus be very aggressive in pricing. I mean, these margin improvements have been at a time where we’ve moved the price of option three down from £15 to currently in the market £7.95 for all of your calls, any time of the day, to any fixed line. It’s a real bargain. We can be very aggressive in the market as well as increasing our margins and that’s what we’ve done. I guess we surprised a number of you with the profit increase. I hope to carry on surprising you.

Q – Chris Halliett(?) – ABN Amro

A first quick question on Wholesale broadband pricing. I guess we’re about 10-11 weeks away from potentially reaching the 1.5 million lines. Can you give us an indication of how your thoughts are progressing on how that pricing might change and when you might looking or able to announce those prices? Secondly, just picking up again on the Retail margin, do you, in terms of subscriber acquisition costs, I guess you’re probably getting more 18-month contracts coming through. I wonder how you account for those? Does it have any impact on the improvement in gross margin?

A - Paul Reynolds, Chief Executive Officer, BT Wholesale

On the Wholesale pricing, we said we’d voluntarily hold prices until we reached 1.5 million and that’s clearly going to happen in the next few months. We’ve virtually agreed a position and we expect to announce the new Wholesale prices next week.

A – Ian Livingston

Our subscriber acquisition costs, unlike some other companies in the sector, are fully expensed so actually giving people free hubs like that actually hurts our margin, but we think helps our long term margins.

Q – John Clarke – Brewin Dolphin

Just a little bit of clarification on the dividends situation. Ian, obviously you’ve reiterated your guidance to 1.5 times cover next year. I note that reported EPS is to a quite considerable effect influenced by the vagaries of pension fund movements, net income from that, hedge funds and all sorts. It wouldn’t be unfair to suggest that reported EPS can swing by 5-10% around those figures and those are totally unpredictable to an outsider. Could you give us some guidance on whether the 1.5 times cover relates to what you might call profit if you like before vagaries of hedge funds, pension funds etc, or after?

A – Christopher Bland

I’ll ask Hanif to talk about the vagaries of pension funds and other. We won’t give you specific guidance on what the dividend will be next year, but I think we will take a fairly robust view of all the factors involved.

A – Hanif Lalani

What we’ve said is that we expect the payout ratio to increase to two-thirds by 2007/08. That’s against reported earnings. If you look at the pension accounting, the way the pension accounting works is in a very simple way. At the start of the year, through our actuaries and through our auditors, we agree the cost of servicing the liabilities and we agree on the return on investments we’re getting. That rate is consistent for each and every quarter thereafter, so the pension interest credit coming through, the interest line, quarter in quarter out it’s the same number. Within the reported earnings.

Q – John Clarke – Brewin Dolphin

Okay, but if one looks at the net interest payable, we’ll assume your debt is £8 billion for argument’s sake and we’ll assume that the gross interest you pay out is £480 million on it, 6% interest. This is back of the envelope stuff I know, but half of that would be £240 million in a half year so your actual charge for the half year I think was £100 million, so there’s about £100 million in there all the time…

A – Christopher Bland

I think we should take the detailed back of the envelope stuff off line with Hanif, if you wouldn’t mind. The central point of your question is, is that included or excluded, and it’s included.

Q – Steve Malcolm – Arete

Two questions – one is on ISP consolidation. I think previously you’ve been quite reticent, but obviously we’ve seen some moves in the sector in the last few months. Have your thoughts changed on that, and the ability to gain greater scale through acquisitions? The next one is on broadband and increasing the speed. You mentioned the presentation moving to 24Mb. Can you give us a little bit more color on your plans for rolling out Max, 2 plus and possibly VDSL on a two or three year timeframe, and where you see the average speed settling down in the next two to three years?

A – Ben Verwaayen

You will not be surprised if I say we are always looking, and you will not be surprised if I say that of course, not to any price, in that we’ll look to opportunities as they may arise and we’ll be prudent on that. We have I think a track record to make our decisions and to stick to them and then deliver. That should also be the case in this particular market. We’ll see. On the speed of broadband?

A - Ian Livingston

On broadband, firstly I would say that speed isn’t everything. We have a great 2mb service across the UK, we have Max which goes up to 8mb and service providers are progressively moving the customer bases where they take service from BT wholesale onto the Max service. Over 1 million are there already and it’s progressing quite rapidly. Service is based on ADSL 2 plus and up to 24mb. It’s going to be much more important with bandwidth hungry applications coming in – Vision and other services like that. We’re rolling that with 21C. We expect 24mb services in the marketplace from January 2008. We’ve already got our plans very well advanced and all of that. We’re looking right now at VDSL type services, but we’ll give no commitments on that because you know, we’ll fit it in when the customer demand is there to use it.

Q - Simon Weedon – Goldman Sachs

One question, really, relating to your comments about Openreach and the potential cost implications of what you’re having to do to upgrade the through-flow. You’ve talked about moving to 24-hour working and increasing the staffing and engineering. I wondered how much of that was present in the numbers we’ve just seen for the quarter just completed and what sort of cost impact you expect over the next six months or so? Also, if you could touch on whether that’s going to be capitalised or expensed, that would be helpful. Or both.

A - Steve Robertson, Chief Executive Officer, BT Openreach

Certainly part of it will be capitalized. A large part of it is expensed. You shouldn’t expect the night time work and 24 hour working to necessarily cost more, a lot of that is done on an agency basis and there are also significant efficiencies in working 24 hours as well. Rather than having people coming and going, they go into the exchange and actually get on with the work. We’re probably almost operating at the peak levels that we expect to be operating in. Probably a little bit more in terms of mass migration over the next few months, but it’s basically on target.

Q - Simon Weedon – Goldman Sachs

But we don’t know what your target is.

A - Steve Robertson, Chief Executive Officer, BT Openreach

That is what the target is – basically our results reflect exactly where we expected to be.

Q - Simon Weedon – Goldman Sachs

Would you expect to add costs to it?

A - Steve Robertson, Chief Executive Officer, BT Openreach

There’s going to be some incremental costs and also incremental revenues.

A - Christopher Bland

It’s not significant.

Q – Laura Mills – Merrill Lynch

I had a quick question on your EBITDA and one of the reasons why it came down last year was a pretty significant increase in research and development spending, I guess due to a lot of the products launched in retail. Can you comment on how R&D is trending so far this year if possible? Then one final clarification on the dividend – the two thirds of EPS is very clear, but should we conclude from your comments then that if the EPS gets inflated at the end of the year because of the pension again, you’re happy to pay out a dividend that’s higher than your free cash flow?

A – Hanif Lalani

R&D first. On R&D, last year, we spent on developing new products and services because I think when Ben spoke this year he talked about Vision, Wi-Fi handsets – if we look in the Global space there’s innovation going on there and in Openreach and in Wholesale. We continue to spend on R&D. I think for those who are observers of the 20-F and study the 20-F, you’ll note that YoverY our R&D costs have gone up. That’s more to do with the fact of how we capture the information and show it than in actual cash terms. We’ve continued to invest in R&D at the same rate. In terms of earnings, we’ve said that we’re going to pay dividends out on reported earnings.

A – Christopher Bland

We will be robust, but not foolish.

Q – Jonathan Groocock – Oriel Securities

A quick question on your 21CN, I notice it goes up to 2011. Does that mean the £3.1 billion capex envelope will now stretch out towards 2011 when some of us might have had it coming down post 2009?

A – Ben Verwaayen

I don’t think there’s any change in what we have given you before as a guidance. What it does is give you a good insight when to expect what. Some of the rollout is going, as you can see here, to the major areas and then you have to fill in the other parts. I would not expect any change in that.

Q – Christian Maher – Investec

Just on the debate around gearing, which is probably going to get more momentum I guess, the tri?annual pension fund review is going to be out by the end of the calendar year. Is there any more color you can give us on that in terms of how the process is going, you know, the possibility of what the Crown Guarantee may or may not mean as well?

A – Christopher Bland


Q – Christian Maher – Investec

That’s the problem with coming last.

A – Christopher Bland

I’ll give you a little more color, that was a bit of a mean answer.

Q – Christian Maher – Investec

I’m in the wrong seat with the highest priced target, so be nice.

A – Christopher Bland

The Crown Guarantee is not going to be of significance in its impact on the result. It’s a backstop, it’s very nice to know if you’re a member of the pension fund, and I think in broad terms all I would say is we expect to reach a conclusion certainly by the end of the calendar year. We also don’t expect it to have a material P&L impact.

Q – Stephen Howard – HSBC

A point I suppose of clarification. If you were to break out the one-off revenues, that are related to competition so I’m thinking there of things like ULL connection fees and so on, but there may be other items as well, what roughly do you suppose that that is contributing per quarter in terms of revenues at present and perhaps the outlook over the next couple of quarters? One quick supplementary – I gather it’s late Autumn and BT Vision launches next month. Can we have a bit more detail on how ambitious or aggressive a launch we might expect and look forward to? Thanks.

A – Hanif Lalani

On one-off fees, it’s a very simple thing. If you look at least year, we had WLR. The year before that we launched carrier pre?select. We launched lots of other products. They have a connection fee, a migration fee, a cessation fee, so every time you launch a product you’re going to get an uptake of that. You also look at the cost base and that also have one-off costs, opex and capex. We’ve launched new products in the past. We expect to launch new products in the future. I can’t see that as being a material issue. I think there will be new products and the fees will be whatever the fees are. If more customers want to buy LLU, there’ll be more connection fees. The more POPs we launch, the more connection fees. If they decide to cease, there’ll be cessation fees, so from my perspective it’s not significant in either direction.

A – Ian Livingston

We’re actually I think in mid-Autumn at the moment, not in late Autumn. I’ve become an expert on the seasons. We’ll give you the details next month. I would hate for you not to come. We’re going to be very ambitious and you’ll see some wonderful services. We’re obviously going to ramp things up and we’re not going to go and put our foot straight on the accelerator. We’ll build it up. You’re going to hear some very ambitious plans and some very exciting plans.

Q – Miguel Edurace(?), Pallay International

Two questions if I may, Ben. When the other operators and the regulator asks you about Openreach, what it does, whether it’s good, whether it’s bad, what do they ask and what do you answer? Do you persuade them it’s a good idea, or do you tell them do it as late as you can, or only if you have to!

A – Christopher Bland

What they ask is how did you do such a brilliant thing in the UK and how can we copy it.

A – Ben Verwaayen

Yes, sometimes. Most of the time they don’t talk about the copying. I think the model as such is in a way a model that you only can arrive at if you have a balance between better regulation, more precise and deregulation on the other side. In many markets, they struggle for both to be honest. It is probably that debate – how you trust and verify on one side, and you don’t because you can’t verify up front, and how do you deliver. That’s most of the debate. I think that over time, there will be a European model. It will probably not be the UK model, which will be a good thing in a way because then markets can adjust to a generic model, but it will be pretty close. It will take time.

Q – David Wright – JP Morgan

Just trying to understand one or two of the revenue trends. In the traditional business, I think rental and usage deteriorated quite significantly in Q2, but there was a sort of pop in private circuits which was up 5% and down 2% in Q1. Should we expect that to continue? Then secondly on the new wave, I think ‘other’ was significantly better, which I understand was some consolidation of DABS. If we could maybe understand what that contribution was and what the clean revenue was, ex consolidation affected growth?

A – Ian Livingston

DABS, first of all, DABS is going really well. It was a business that was doing a bit more than £100 million when we bought it but it’s growing very well. We’ve seen double digit growth which in the PC and related services market is pretty special. It’s very strong double digit growth, so it’s a success story. One of the reasons it’s a success story is we’re actually bringing together what we’re doing in particularly BT business, and increasingly in consumer, so giving a converged profit position. BT IT manager, provide the PC, provide the accessories from DABS, provide the services from BT and bring it all together for the customer. It’s growing both in its own right and also we’re growing converged services. It’s something over £100 million, £125, £130, something like that when we bought it for the year as a whole, but we’re actually growing it significantly since then.

A - Steve Robertson

On private circuits, what you’re seeing is a dynamic of different technologies for alt net, for mobile operators and everybody else. You can use radio technology to do a transmission, you can use private circuits. What you’re seeing is many of the alt nets deciding which technology they want to go with in terms of further rollout or change in resilience in their network. That helps us and in terms of rental, it’s all about special offers in the marketplace. I think that’s a temporary affect that will reverse out later in the year.

Q – Mike Cansfield – Ovum Ltd

It’s quite some time since you’ve given us any feedback on how well Fusion is doing in terms of customer numbers. Can you give us any guidance at all on that?

A - Ian Livingston

It’s slowed down a bit, as you’d expect, because we’re waiting for the handsets. We’re running at about 40,000 customers now. We said last quarter we’d hold back on the marketing, waiting for the Wi-Fi phones and I’m delighted to say they are just around the corner. Wi-Fi phones and some very nice personal organizer devices that some time I’ll show you and you can even buy. When these come, we’ve got a range of products and I think that’s when we start putting our foot down again on the marketing and that’s in business, we’ll do that next month, and in consumer it’ll be Q4.

A – Ben Verwaayen

It might be nice to say that we have signed our first contract for corporate Fusion. We launched it pretty recently. Leeds City Council and Mediaset in Italy will be the first to sign the contracts, so it is gaining traction.

Christopher Bland

Thank you all very much.

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