Description

It is probably very ambitious to cover BT (previously known as British Telecommunications Plc) in a write up on VIC. Its primary listing is in the UK – BT/A LN but it also has an ADR in the US. At the time of writing the last price for BT was 131 pence (USD 19.54 for the ADR - BT US)

I believe that BT is a short candidate with a potential reward of 20% or more.

I will be referring extensively to the 2008 annual report which also combines the 20-F. This is located at http://www.btplc.com/Report/Report08/pdf/AnnualReport2008.pdf  I will also refer to the quarterly KPIs (key performance indicators) for Q1 http://www.btplc.com/Sharesandperformance/Quarterlyresults/Financialpresentations/q108KPIs.pdf and Q2  http://www.btplc.com/Sharesandperformance/Quarterlyresults/Financialpresentations/q208KPIs.pdf In addition I will refer to the Q2 results release (at http://www.btplc.com/News/ResultsPDF/q208release.pdf ).

Summary
I believe that there are six key points which I believe will impact it into 2009.
    1.    Pension issues will haunt the balance sheet in 2009
    2.    Operating leases need to be capitalised
    3.    Global services is in a deeper hole than management realises
    4.    Competitive environment worsening – both wireless and wired
    5.    Fibre to the home or kerb does not have the same benefits as elsewhere in Europe
    6.    The iPlayer will uniquely distort the UK market in 2009 onwards

Superficially BT appears cheap versus its competitors but I believe that adjusting the balance sheet for off balance sheet liabilities leads to a different picture (details below).

I believe that 2009 eps will fall at least 10% versus consensus and that there will is risk of a dividend cut that will lead to sales by traditional UK long only and income fund investors.

I will address the above issues in greater detail shortly but I think it important to firstly give an overview of BT.

Please note that BT has a March year end.

Overview
BT is the incumbent telecoms operator in the UK. It has a market cap of GBP 10.2bn at a share price of GBP 1.31.

More detailed numbers are on page 2 of the Q1 and Q2 KPI documents referenced above.


Issues:
1. Balance sheet and pension issues
According to the 2008 annual report net debt at 31 March 2008 stood at GBP 9.460bn (reference note 10 page 109). In the Q2 (ie H1) results release the company reported net debt of GBP 11bn (see page 6).
It is the net debt as reported by the company that most analysts use.

However I believe that BT has specific pension liabilities that need to be brought onto balance sheet.

There are two specific elements to this - at the  Q2 results the company reported a pension surplus of GBP 0.6bn (this had fallen from GBP 2bn at 31 March 2008). However part of the reason for this was that under IAS 19 the company uses the AAA bond rate to discount its liabilities - and this rose from 6.85% to 7.25% from March 31 to Sep 31 (and a move of 5bps in inflation expectations). The pension liabilities fell as a result by GBP 1bn (from GBP 34.4bn in March 31 to GBP 33.4bn on 31 Sep). However I believe that this really reflects the current widening of corporate bond spreads - however if going into 2009 corporate bond spreads fall again I believe that the liabilities will rise. Given risk free interest rates have fallen as well I think it is reasonable to assume that a normalisation of bond markets will lead to a GBP 1bn impact on the liability side of the pension fund.

Secondly it is important to note the size of the pension fund. The BT Pension Scheme covers over 350k people (compared to 110k directly employed currently). The last actuarial review was carried out on 31 Dec 2005. This occurs every 3 years and the next review is due on 31 December 2008 - probably reported with the Q4 results after 31 March 2009. It is difficult to predict what the outcome of this will be but having met various analysts during the year who have looked at the whole UK pension regime the distinct impression that I have is that the pension regulator is seeking to get companies to make more conservative assumptions on life expectancy and also on future returns.

I believe the key reference is note 29 of the BT Annual report (page 125 onwards); in particular the sensitivity analysis which appears at the bottom of page 128. This shows that a 1 year increase in life expectancy at 31 March 2008 would have increased the pension liability by GBP1.4bn. The current life expectancy estimates appear midway through page 126. I think that the key point to note from the table is that though the company is assuming only 1 year of increased life expectancy every ten years in actual fact between 2007 and 2008 the expected life expectancy for men increased by 0.2 years (though admittedly for women only by 0.1 years).

It is hard to predict the exact outcome of the actuarial review but I think a guessestimate would be that there is an increase in the pension liability equivalent to 1-2 years of life expectancy ie GBP 1.4bn - 2.8bn - say GBP 2bn as a working estimate.

I also believe that there will need to be an adjustment at some point due to the assets, rather than generating the expected returns in 2008 having actually declined in value. At 31 Sep 2008 the pension assets were worth GBP34.4bn vs GBP37.3bn as of 31 March 2008. However only 35 percent of plan assets were in equities at that date  and I think the key issue will be if the return expectations have to be cut (I think that they probably will have to be).

Offsetting all the above at the Q2 results the company announced it had reached an agreement with the unions to alter the retirement age (to 65) and various other changes which would lead to an annual saving of GBP 100m per annum. Most analysts have looked at this and assumed that this provides relief for the company. I believe the opposite that - ie that the unions are acutely aware of the risks in the pension fund - and no one seems to be asking what quid quo pro has the company offered to unions in order to accept a reduction in the pension contribution from the company. (Remember that the unions are in a relatively strong position because there is an implicit government guarantee dating back to the days before privatisation). (I speculate that the unions and the company have probably split any additional pain 50:50 so if the unions are giving up GBP 100m per year in company contributions they probably also want the company to up its contributions by at least that much - but I must emphasise this is speculation).

So putting all the above together - at a best case the reduced pension contribution by the company roughly matches any increase in liability due to the pending actuarial review and any possible corporate AAA bond rate fall. In the worst case a combination of the actuarial review, a fall in AAA corporate bond rates, an adjustment of future return expectations on assets, a fall in the pension fund assets and a quid quo pro to the unions could lead to a significant impact on what pension liability the company has. I think a reasonable stab at the worst case is probably around GBP 2bn but it is hard to get a finger on the exact number currently. (Note that in a note of 25th Nov 2008 Merrill Lynch estimated that the pension deficit by May 2009 could be anywhere from GBP 2bn to GBP 6bn) - and at their midpoint of GBP4bn they suggest BT would have to make incremental annual payments of GBP 300m per year for 10 years.

As an aside, and it ought to be in most analyst models, it is worth noting that after the 2005 review the company found the fund to be GBP 3.4bn in deficit - to fill this the company agreed to pay GBP 280m per year for ten years. However in fact the company paid GBP 520m in 2007 and GBP 320m in 2008 to cover the first three installments (ie covering 2006, 2007 and 2008). In 2009 the company ought to pay GBP 280m in Dec - this ought to be in most analyst models. (The NPV of the seven years of payments remaining discounted at 7% is GBP 1.5bn and this is in addition to the GBP 2bn I suggest in the previous paragraph.).

It should be noted that following the profit warning of BT Global Services S&P and Moody put BT's credit rating on negative watch. If my hypothesis on the pension issues works through then I believe the credit rating will be cut leading to an increase cost of debt in 2009.

2. Operating leases
KPN is held up by many analysts as the model for a European telco operator of the future - in particular over the last couple of years KPN has built a fibre to the kerb (FTTK) or fibre to the cabinet (FTTC) network. In order to fund this it has sold off a lot of buildings - particularly those containing local exchanges (central offices in US telco parlance). This has provided a number of benefits - the capex has been significantly offset by the capital gains and secondly operating costs of the network are significantly cheaper (fibre requires less electricity consumption and no need to pay rates and maintenance on exchange buildings if they have been sold off). In addition it has improved KPN's competitive position in Holland.

BT has spent the last couple of years in vigourous discussions with Ofcom (the regulator) to discuss rolling out a similar network in the UK and whether it will have to open it up to competitors and at what price. I believe that this misses a key point - the majority of BT's buildings are leased and not owned following a sale and leaseback a few years ago.

The key table to review is on page 53 of the annual report which shows the gross up value of the contracted operating leases (which I believe mainly relate to real estate) to be GBP 8.742bn. To estimate an NPV I have simply taken the GBP 469m per year over 19 years (300m in the last year) and discounted it at 7% (the sale and leaseback was undertaken about 5 years ago and I think about 7% is a reasonable rate for property investors in the current environment). Undertaking this gives an NPV of GBP 4.8bn and I think it is reasonable to put this number onto the balance sheet when review BT's financials.

The key issue however is that as a result of leasing its buildings BT cannot (i) sell the buildings to fund the capex for a fibre rollout (ii) have an immediate reduction in operating costs because it still has to pay the lease.

Combining the above two sections it seems to me that as an investor one should take BT's 31 Sep reported debt of GBP and add GBP 4.8bn for capitalisation of operating leases; GBP 1.5bn for committed pension deficit payments and then possibly GBP 2bn for the impact of the pending actuarial pension review thus getting an adjusted net debt figure of GBP 19.328bn which is clearly significant for a company with a market cap of GBP 10.2bn

3. Global services
Global services is the IT and network outsourcing division of BT. It was an attempt to move into higher value services. Since the company is mainly covered by telecom analysts rather than IT services analysts the global services division is poorly covered. Hence it was a shock to the market when this unit warned earlier this year.

I think it is very important to appreciate the scale of this unit in the context of BT - as of the end of March 2008 Global Services employed 33.1k of BT's entire headcount of 111.9k ie 29.5% of the headcount (note 30 page 130 of the annual report). However I suspect the underlying total may have been higher as BT has a significant number (roughly 50k) indirect staff and I suspect a high percentage of them are dedicated to global services. In terms of revenues in 2008 Global Services provided GBP 7.889bn of the total group revenue of GBP 20.7bn (ie 38%) but only GBP 70m out of GBP 2.541bn of group operating profit (ie 2.75% ).

The CEO of  Global Services until 18 months ago was Andy Green who has recently taken over as CEO of Logica. Due to his new role I have undertaken some interviews with people who know him from BT and the general consensus appears to be that he was good at signing long term contracts but poor at delivering profitability. In fiscal Q2 BT warned due to profitability at Global Services and I think this is part of the Andy Green legacy. At Q2 Global Services announced an operating loss of GBP 53m versus a GBP 7m operating profit for the equivalent quarter a year ago.

Looking through BT's reports it also appears to me that Global Services management appears to have been focussed on revenue growth by a combination of organic growth and acquisitions and EBITDA rather than other measures. I have not had the time yet to try to separate out how much of Global Services growth has been due to acquisition. On a reported basis Global Services revenue grew 13.1% in Q1 and 14.6% in Q2. I think that these numbers are important because IT services companies typically have good margins when they are growing and deteriorating margins when they stop growing. If due to a global slowdown this unit's growth does slow down I would therefore anticipate that the margin deterioration will be much worse than management currently anticipates.

It is also important to note that the running of Global Services, post the warning, has been taken over by Hanif Lalani - who was previously the group CFO. As far as I am aware he has no background in IT services (please note that I have not been able to confirm this). My concern would be that especially in a downturn someone with more experience is required. To head the UK part of Global Services, more recently BT has appointed Royston Hoggarth (12 Aug 2008) who is a well known industry professional but my fear is he will be impeded in making changes from above and below.

The bottom line is that I am bearish of IT services in Europe in 2009 generally and particularly wary of BT's Global Services. I expect it to continue to be loss making in fiscal 2009 and fiscal 2010. I suspect that due to its heritage, and poor internal reporting (reflected by feedback I have received that group management was caught unaware of the deteriorating profit prospects) and the history of focus on revenues and not profitability (especially with long duration contracts poor profitability early in a contract can get even worse as the contract proceeds) I suspect that analysts are too bullish on this unit into 2009 and 2010.

I do not have enough insight into company plans on Global Services but I think that there will need to either be a significant restructuring charge for non-profitable contracts and readjustment of the staff pyramid or a sale of the business. Based on experience with other IT services companies I have covered in a downturn I think a 2% negative operating margin in the remainder of 2009 and in fiscal 2010 may be a very good outcome for the business. This would compute to roughly GBP 160m per year hit at the EBIT level or 1.5 pence at the eps level (taxed at 28%). (I believe some analysts and some company guidance has suggested a recovery in 2010 so the actual delta from expectations will be from say 3-4% margin in 2010 - but I need to confirm this number and a number of analysts do not appear to have fully adjusted their numbers for the out years following the various warnings and results).

If revenue growth in 2009 slows down significant; in particular if it become negative then the margin impact could be significantly worse than I suggest.

4. Competitive environment
Currently BT is the market leader in broadband to the home but I do not believe that it is no longer price competitive. I also believe that entering 2009 there will be aggressive competitive pressure from both wireline and wireless competitors. To give a comparison I will consider the basic broadband package from BT - after an introductory price for three months the cost is GBP 15.65 per month - this is for an allowance of 10GB per month (note that line rental is on top - this appears to be GBP 11.50 per month via BT). In comparison Tiscali (www.tiscali.co.uk) is currently offering unlimited service for GBP 14.99 (this includes line rental); Talktalk costs GBP 16.99 (again including line rental) with a 40GB limit; Sky is GBP 10 per month for existing customers (ie of the TVservice) witha 40GB download limit.

The above are not quite direct comparisons as BT's service also includes wifi minutes but I think that the above illustrates the point that BT is significantly more expensive than the competition.

In 2009 I expect that Sky in particular will be pushing its combined TV, phone and broadband offering; and CarPhone Warehouse will push its offerings as it tries to recover its financial position. There is also a quite aggressive marketing campaign from Virgin offering 24Mbps or more based on its cable network - BT cannot compete against this until it starts rolling out fibre.

At the same time I expect that wireless broadband will start taking offering for more mobile customers - for instance for GBP 15 per month Three (a UK mobile operator) is offering 5GB per month on its 3G network. It is noticeable visiting mobile phone shops over Christmas that more and more are bundling laptops with data access. I believe that this trend will grow in 2009 as more netbooks and notebooks have built in 3G cards.

I also believe that a worsening economic climate in 2009 will lead to more price sensitivity for consumers and businesses.

With the Q2 results the company reported that it had 27% market share of retail net adds versus an established broadband market share of 34% - I think this reflects my concern of the deteriorating market position for BT.

In fiscal Q2 (to Sep 2008) the revenue of the retail business grew by 1% yoy with EBITDA margin improving 9% and operating profit growing by 13%. I believe that going into calendar 2009 it is highly likely that the top line will go negative and though the company has done a good job in improve margins there will be a hit to the margins as a result. It is also important to note that the retail business is an important customer of the Openreach and Wholesale business so the total impact will be spread across the businesses. Currently I am modelling minus 2% growth in revenues for the retail business in fiscal 2010.
 
In 2008 BT Retail had external revenues of GBP 8.2bn and operating profit of GBP 1.050bn ie a margin of 12.8% - assuming that margins remain roughly flat (ie planned cost savings offset the decline in revenue) this will mean that this unit will provide roughly GBP1-1.1bn of revenue in 2009 and not the increase to 13.5-15% that some analysts are assuming.

5. Fibre does not provide the same benefits as elsewhere in Europe
I have already discussed the impact of the operating leases on BT's lack of benefit on switching to fibre. It is worth also considering the cost. Various estimates I have seen have suggested GBP 10bn or more (some as high as GBP 14bn) to pass 90% of the UK homes (eg see http://www.broadbanduk.org/content/view/236/7/ ). The key issues with this are (i) the price at which BT would need to provide access to competitors (ii) the cost to finance the debt that would be required to fund such a rollout (iii) cost overruns (in the UK infrastructure builds typically go significantly over budget).

I anticipate that by mid 2009 a fibre rollout will be on the agenda with Ofcom and the government both keen to push it. However due to a rising cost of capital due to a (i) a weak balance sheet (ii) the credit crunch (iii) downgrades by rating agencies (eg in November S&P put BT on a negative credit rating from stable) and due to falling ARPU expectations (due to the discussion above re the competitive environment) I do not believe that it is clear whether a fibre rollout will be significantly NPV accretive to shareholders and secondly I fear the company may need to either suspend dividends or raise additional equity to help finance it.

6. The impact of the iPlayer
The BBC is the major public service broadcaster - and this year began offering its programmes for upto 7 days after broadcast over the internet. Other broadcasters have followed. I believe usage is growing dramatically. The consequence is that BT Vision (which is BT's over the internet TV offering) has had limited uptake (a few hundred thousand users). I believe that going into 2009 the iPlayer and competitive offerings from other TV networks mean that BT will have difficulty increasing the ARPU it gains from each customer - and in fact puts the economics of fibre to the home in question (why would a consumer pay from a TV service from BT when it is possible to get high quality TV from the BBC for free).

Risks to my hypothesis
1. Ofcom review of ULL
Ofcom appears to have ruled favourably regarding unbundled local loop rates recently - however I believe that this is already in the price and as competitors gain scale they will still hurt BT.

2. Fibre ruling
I expect in H1 2009 Ofcom will rule on the price at which BT will have to provide fibre to its competitors - I believe it may be slightly better than the market is expecting but the real issue for me is how BT will finance it.


Conclusion
Consensus eps according to Bloomberg is 21.2p for fiscal 2009 and 20.865p for 2010. I think, because of the reasons discussed above, particular if there is a restructuring charge and further deterioration in Global Services the eps for 2009 could fall by 10% (ie 2p or more). But, in some ways more importantly, if there is also a slow down in the Retail business, an increase in pension contributions and an increase in interest costs then the 2010 eps could fall to 15-18p. The dividend in fiscal 2008 was 16 pence - consensus has this falling to 13p in 2009 and 12 p in 2010. I think this fall is highly likely, but if the company presses the green light on rolling out its fibre network I believe that this dividend may need to be suspended or a capital raise will be necessary given that the off balance sheet liabilities I have discussed mean that the true debt it almost twice the reported debt.

On a superficial basis BT appears cheap compared to its major European competitors with a PE of 6.27 and EV/EBITDA of 3.57 vs 10.12 and 4.93 (using as the peer group Western European competitors with a market cap of over GBP10bn). However if I adjust the multiples by 1.5 to allow for the offbalance sheet debt (ie GBP11bn of on balance sheet debt; GBP 8 bn of offbalance sheet debt and market cap of 10.2bn plus risk of further deterioration of balance sheet if a restructuring charge needed at Global Services) the PE becomes 9.4 and the EV/EBITDA becomes 5.355 so more in line with its major competitors.

If I project forward and my assumptions of operational deterioration are correct however then going into fiscal 2010 (ie from April 2009 onwards) eps cuts and the strategic issues discussed (plus the greater exposure of the UK consumer to a downturn vs his continental counterparts) means that on forward multiples I believe BT deserves to trade on significant discounts to its competitors. I therefore think that over the course of 2009 BT will underperform its competitors significantly. I would therefore suggest VIC members consider either an absolute short or a pair trade versus a basket of continental telcos (perhaps also including Vodafone in the UK).

Catalyst

1. Actuarial review of pension scheme in calendar Q1 2009
2. Economic slowdown in the UK
3. Competitive pressure
4. Fibre rollout leading to need for capital
5. Worsening position and restructuring costs in Global Services Unit
6. Downgrade in rating by credit agencies