Perhaps the main effect of Brexit thus far has been a weakening of sterling. This is set to cause a rise in inflation as imports become increasingly expensive. Although the Bank of England remains dovish, a tighter monetary policy stance may become necessary as the price level rises at a faster pace and weaker sterling provides a boost to the economy.
In such a scenario, BT (LON:BT.A) could be a major beneficiary. Its large pension liability should be aided by the potential for higher interest rates over the medium term. This could allow for greater reinvestment and/or dividends in place of additional contributions to the pension fund.
Further, BT’s share price has fallen by 15% since the referendum. It now offers good value for money in my view and its strategy could deliver growth, especially through cross-selling.
The potential for higher interest rates
While negotiations on the terms of the UK leaving the EU have not yet commenced, the impact of Brexit on sterling has been clear. It has weakened by around 17% versus the US dollar since 23 June, and in my view there is scope for further depreciation.
Uncertainty surrounding Brexit is likely to increase next year once Article 50 is invoked. A hawkish Federal Reserve also means that the dollar will appreciate while the pound does the opposite.
The effect of a weaker pound on inflation is just starting to be felt. Inflation hit 1.2% in November, but fast forward a year and it could be much higher.
According to the Bank of England, it will be just under 3% in 2017 and this could lead to an expectation that higher interest rates will be required further down the line in order to cool inflationary pressures.
This prospect is made more likely because initial forecasts for a large rise in unemployment and a slowdown in GDP growth in the UK may not come to fruition. Therefore, an ultra-low interest rate may not be needed, particularly with weak sterling providing a boost to the economy.
The effect on pension liabilities
BT has a pension liability of £6.4 billion. This originates from its days as a nationalised business and in my view it continues to be a drain on its performance and investment appeal. It means reduced reinvestment, as well as higher risks.
Therefore, I believe that the company has been hurt by its large pension liability in recent years, since low interest rates have caused gilt yields to compress. In turn, this has meant the net present value of pension liabilities has risen.
…the company has been hurt by its large pension liability in recent years, since low interest rates have caused gilt yields to compress.
However, if there is an increased chance of interest rate rises over the medium term, then, other things being equal, gilt yields should also increase. The effect of this on defined benefit pension liabilities across the board should be positive and improve funding levels. It could mean that there is extra cash available to reinvest for future growth, pay down debt or to even offer a higher dividend.
I also believe that it will cause a reduction in the risk profiles of companies with large pension liabilities. This could cause investors to switch from highly indebted companies to ones with large pension liabilities. Therefore, the latter’s valuation could rise.
BT’s investment case is improved by a strategy which in my view will deliver improving profitability in the long run. Its acquisition of EE has positioned the company for growth within the quad play space, with it now being the dominant player in the market. The integration of EE has been successful so far and planned synergies are being delivered as expected.
The revised corporate structure which has been put in place since the EE acquisition is a logical move and should provide improved efficiencies. This is alongside cost cutting measures which do not seem to be negatively impacting on service levels or customer satisfaction. This is evidenced by a sustained low churn rate in mobile in particular.
The business has been able to add significant numbers of new customers to its broadband offering in particular, with it having a 65% retail share of total broadband net additions at 76,000 in Q2. This provides the company with cross-selling opportunities further down the line.
Continued reinvestment in 4G and superfast services, alongside products such as free BT Sport for broadband customers, mean that BT continues to offer a degree of product differentiation versus rivals.
Valuation and income potential
Since the referendum, BT’s shares have underperformed the wider market by 27%. This may be partly due to uncertainty surrounding costs for the inappropriate management behaviour at BT Italia. A non-cash specific item charge of £145 million was recorded in Q2 as a result of the investigation.
The company’s shares now trade on a P/E of 12.1. I believe this is fair value given the 6% EPS growth forecast for 2017, as well as its long term growth potential from the cross-selling of services.
If interest rates rise over the medium term and the pension liability falls, there may be more cash available with which to pay higher dividends.
A yield of 4.2% should also appeal in a higher inflation environment. Dividends per share represent 50% of EPS, so should rise by at least as much as earnings. If interest rates rise over the medium term and the pension liability falls, there may be more cash available with which to pay higher dividends.
However, this would have to be balanced alongside a potential reduction in the £14.3 billion debt pile as well as a reinvestment in the product offering. Therefore, dividend growth may be generous, but not sky-high over the medium term.
In my view, BT will benefit from Brexit.
The weakening of sterling is set to cause inflation to spike which could mean that there is pressure on the Bank of England to raise interest rates. This could cause gilt yields to do likewise and mean that BT’s pension liability is reduced in size. A freeing up of cash for dividends, paying down debt or reinvestment may result, which could improve the company’s prospects as well as market sentiment.
Additionally, I feel that BT’s strategy is sound and its dominant position within the quad play market could lead to substantial cross-selling opportunities. A fair valuation and above average income prospects enhance the company’s appeal. Therefore, I’m bullish on its potential over the medium term.