BT (NYSE:BT) is a company which is known to virtually everyone in the UK and its shares are a favourite among investors seeking low risks and reliable dividends.
After all, what could be safer than a company which used to be a state-owned monopoly, and which today is far and away the leader in the UK's fixed and mobile telecoms markets?
In reality, the situation is very different and, despite some recent successes, BT could be much riskier than many investors think. Here are five reasons why:
Reason 1: BT has produced virtually no revenue growth for a decade
Many investors choose BT because it is so well known and because it has a progressive dividend policy. It just feels like the sort of company which should be able to increase its dividend every year. For that to happen, BT would also need to increase its profits both consistently and sustainably, and that in turn would require revenue growth.
The problem is that BT has failed to grow its revenues for over a decade.
In recent years BT's revenues have gone nowhere
As the chart shows, BT's profits and dividends have been growing at a rapid pace. However, most of this is simply a recovery of profitability after the company's surprisingly bad performance during the financial crisis (BT's dividend was cut by 60% and its shares fell by 80% between 2007 and 2009, which doesn't sound like a very low risk investment to me).
Since the crisis, BT's focus has been on efficiency and cost cutting which has resulted in widening profit margins and improving returns on capital employed, but that can only go so far. At some point, revenues must go up if the company is to continue growing.
Although this lack of revenue growth does not represent an acute risk to shareholders, it is a serious risk to the possibility of decent returns over the next five or ten years. It also undermines BT's ability to meet one of my key investment rules of thumb:
- Only invest in a company if its ten-year growth rate is above 2%.
Although BT has grown by around 2.8% a year when measured across revenues, earnings and dividends, its revenue growth has in fact been negative, which does not bode well for the future.
Reason 2: BT has a massive debt pile
Debt can be thought of as rocket fuel for corporate performance, but rocket fuel is dangerous stuff, especially if there's a lot of it concentrated in one place. In BT's case, it has borrowings of more than £14 billion. That's a huge amount, even for a company of its size.
For example, over the past five years, its average post-tax profits were just over £2 billion, so its borrowings are about seven times its recent average profits.
This breaks another one of my rules of thumb:
- Only invest in a defensive sector company if the ratio between its borrowings and average post-tax profits is less than five.
Companies that have more debt than that are, in my opinion, somewhat like a ticking time-bomb.
As long as everything is going well and enough cash is generated to cover those massive interest payments (BT pays more than £500m in interest each year), then everything is fine. But if the company stumbles, even slightly, it can quickly become impossible to run the company, pay dividends and make those interest payments all at the same time. And, of course, it is much easier to cut the dividend than it is to refuse to make interest payments.
Note: You could argue that BT's most recent post-tax profits are higher than that £2 billion average, but its £14 billion debt pile is still more than five times its most recent profits, and so even with excessive generosity, it still fails to pass that rule of thumb.
Reason 3: BT has a massive pension deficit
As if having massive amounts of borrowed money to pay back wasn't enough, BT also owes the BT Pension Scheme more than £6 billion (and there are some estimates that it is as high as £10 billion).
As Philip Green is finding out, pension deficits are a real debt that cannot simply be ignored.
Fortunately, BT is not ignoring its pension problems. Like any good corporate citizen, it is trying to make good on its obligations to pensioners by paying large amounts of cash into the scheme in order to shrink the deficit. Over the past couple of years, BT has paid almost £1 billion a year into the scheme and is set to pay another £3 billion over the next five years. This is very commendable, but it is an additional fixed financial obligation which, like interest payments to banks, the company must put ahead of payments to shareholders.
Again, as long as everything works out well, there should be nothing to worry about, but if there are any bumps in the road this additional burden could send BT spinning off into the weeds (or somewhat less metaphorically, could easily result in another massive cut to its dividend).
Underlying this vast £6.4 billion pension deficit is a veritable mountain of pension liabilities totalling £44 billion, which easily breaks yet another rule of thumb:
- Only invest in a company if its pension liabilities are less than ten times its average profits.
BT's £44 billion pension liabilities are more than 21 times greater than its average profits of barely more than £2 billion, so this rule of thumb is broken by a country mile (and that is still the case even if a more generous figure of £3 billion is used to reflect higher recent profits).
Reason 4: BT has to spend billions on infrastructure every year just to stand still
Building and maintaining the infrastructure for our modern high-bandwidth world is an expensive business.
Over the past ten years, BT has spent an average of £2.7 billion a year on capital assets as it continually upgrades exchanges, lays fibre optic cables and develops new and better services. Unfortunately, this money is not being spent as part of a massive push to grow the company, but is instead required just to replace the existing infrastructure as it becomes old and outdated.
One way to think about the ongoing replacement cost of existing capital assets (i.e. BT's network infrastructure) is to look at how much depreciation a company records each year. For example, if you bought a car today for £10,000 and expected it to be worthless and in need of replacement ten years from now, you might say that the car was depreciating in value by £1,000 per year. This is effectively how much money you'd need to save each year in order to replace the car at the end of its useful life.
In BT's case, it has depreciated the value of its existing capital assets by some £2.8 billion a year over the last decade, which is very slightly more than it spent on new capital assets (also known as capital expenses or capex).
So despite spending almost £3 billion a year on capital assets, BT has not significantly increased the size of its asset base and therefore has not significantly increased the earnings capacity of its capital assets.
This is perhaps one reason why revenues have been reluctant to grow.
This requirement for massive capital investment sets off a warning light from another rule of thumb, which is part of my value trap analysis:
- Be wary of investing in companies where capex is consistently greater than profits
BT's capex has consistently been about 140% of profits, so it is clearly a company that requires large and consistent capital investments; much more so than most companies.
The risk here is twofold:
- Downside risks are greater when times are tough - The requirement for capital investment is relatively fixed and therefore somewhat akin to interest payments on borrowed money. This makes the company (even) more sensitive to difficult economic environments. Capex can be cut if income declines in a recession, but that just stores up problems for the future as capital assets decay and are not replaced or upgraded.
- Growth is more difficult when times are good - Even if things go well BT has to pump enormous amounts of money into expanding its capital asset base before it can begin to generate revenues, profits and cash from those assets. This upfront expenditure is often paid for with borrowed money, but for me BT already has too much debt.
Reason 5: BT just spent £12.5bn acquiring EE
Although acquisitions are not necessarily a bad thing, they can be problematic if either a) the acquired company operates in a completely different industry to the acquirer or b) the acquisition is very big.
BT's acquisition of EE (the UK's largest mobile network) falls into the latter category, with a price tag of £12.5 billion. Most of that price was paid with newly issued shares, but a significant £3.5 billion was paid in cash, which is one reason why BT's debts increased from around £10 billion to £14 billion over the last year. That £12.5 billion price tag is more than four times BT's average profits of £2 billion, which sets off yet another of my warning light in one of my value trap rules of thumb:
- Be wary of companies that have made an acquisition which cost more than the company's average profits
Even assuming that BT's profits will be higher going forwards thanks to this acquisition, say £3 billion a year, the acquisition triggers this warning.
The problem is that large acquisitions are typically integrated into the acquirer's business rather than left as standalone companies in order to generate synergies, cost savings and other profit-seeking improvements.
But integrations take time and effort, and the bigger the acquisition, the more time and effort they typically take. This can distract the acquirer from its own core business, creating an additional risk.
Now, in all likelihood, this acquisition will work out well and EE will add value to BT, but it very probably does increase BT's riskiness in the short term and would be a negative mark against BT in my value trap analysis.
Five is more than enough reasons for me to avoid BT
As you might have guessed, I am not looking to buy shares in BT. In my opinion, it's a low growth, highly indebted company which has a large pension deficit to fill, an insatiable need to make huge capital investments, and an enormous new acquisition to integrate.
Of course, things may work out fine and, in a benign economic environment, BT may be able to thread the needle and balance all of these negative factors to produce a positive result.
But personally, I think the future is unlikely to be so kind to BT or its shareholders.