If you wanted to invest in a safe and stable company with the aim of receiving a reliable dividend today, plus good prospects for dividend growth tomorrow, an obvious choice would be BT (LON:BT.A). From a dividend investor’s point of view, what’s not to like? The company has paid a dividend every year since 1985 and operates in an extremely defensive sector (people don’t typically stop making phone calls just because there’s a recession). Having started life as a state-run monopoly with 100% market share, BT is still the UK’s market leader in fixed line voice and fixed line broadband services. And now, following its recent £12.5 billion acquisition of EE, BT is also the UK’s market leader in mobile.
Perhaps best of all, BT shares are now available with a near-8% dividend yield. Potentially, that’s an almost 8% cash return on your investment from day one. This combination of a defensive company and a very high yield are compelling, so let’s have a closer look at whether BT is likely to be a dream investment, or a nightmare. I’ll use four simple questions:
Q1: Is BT growing faster than inflation?
The first thing I look for in a company is growth, because the last thing most dividend investors want is capital losses and a declining dividend. For me, growth is something to be measured over the long-term, so I always look at a company’s ten-year record of growth, measured across revenues, earnings and dividends.
Thanks to the wonders of inflation, companies must grow by about 2% per year for their dividends to at least retain their real-world purchasing power. Anything less than that and the company is effectively shrinking. So how does BT measure up to that standard? Not very well, unfortunately.
Over my usual ten-year measurement period things look pretty good, with BT’s average growth across revenues, earnings and dividends coming in at 7.4% per year. However, most of that growth has simply been a recovery from the damage done by the global financial crisis. If you look beyond the last ten years, BT’s growth story falls apart.
For example, according to ShareScope, BT’s 1998, 2008 and 2018 revenues were £15.6 billion, £20.7 billion and £23.7 billion, respectively. So, BT’s revenues have been increasing, but more slowly than the 2% needed to keep up with inflation. In terms of earnings per share, BT’s adjusted figures for 1998, 2008 and 2018 are 23.8p, 23.3p and 25p, which means that BT’s earnings have basically been flat for 20 years. Finally, and perhaps most importantly, BT’s dividends in 1998, 2008 and 2018 were 14.7p, 15.8p and 15.4p, so BT has also failed to grow its dividend for the past 20 years.
This is not exactly a confidence-inspiring start. However, BT has managed to “grow” by more than 7% per year over the last decade (even if that growth was more of a recovery from a fall than a rise to new heights), so I might be willing to overlook its weak growth record if its other key factors are suitably impressive.
Q2: Is BT sufficiently profitable?
After growth, the next thing I look at is profitability. My preferred measure is returns on capital employed (ROCE), which basically measures the amount of profit generated from a company’s long-term fixed capital (e.g. factories, machinery) and short-term working capital (e.g. inventory or cash in the bank). A simplistic example (and ignoring working capital) would be a £1 million widget factory generating profits of £200k per year. That would be a return on capital employed of 20%. A £1 million dongle factory generating profits of £50k per year would be producing a return on capital employed of 5%. All else being equal, a 20% return from a factory is better than a 5% return.
Profitability is important for a couple of reasons. First, it makes expansion and growth easier because the money for the next factory, for example, can be saved up more quickly when ROCE is higher. Second, return on capital employed is a reasonable indicator of competitive strength. If a company has no competitive advantages then it will be forced to sell its products cheaply, or it won’t sell them at all. If a company has a high ROCE then it is probably selling its products at a premium price, and there must be some reason why customers are willing to pay top-dollar for that company’s products. If ROCE is consistently high then the company may have a durable advantage over competitors, and that could help the company to sustain a decent growth rate for many years into the future.
On average, dividend-paying companies earn a return on capital employed of about 10%, and I won’t invest in any company where ROCE is consistently below 7%. So where does BT fit into this profitability spectrum?
The answer is that BT’s profitability is decidedly average, which isn’t necessarily a disaster. Compared to an average ROCE of 10% from UK dividend-payers, BT’s ten-year average ROCE is 9.2%, which is below average, but only just.
This isn’t a complete surprise because BT is a relatively capital-intensive business. In other words, it must build a lot of physical telecommunications infrastructure before it can earn a penny of revenue or profit. For example, over the last decade, BT spent almost £22 billion on long-term fixed capital assets, which is more than it made in profits.
But, as I said, slightly low profitability isn’t a disaster; it just isn’t particularly impressive either, especially for a company with a dominant market position and a universally well-known brand.
Even with relatively low long-term growth and low levels of profitability, I might still invest in BT if it can answer my next two questions in a suitably impressive manner.
Q3: Is BT’s balance sheet strong enough to withstand an unexpected disaster?
Even a fast growing, highly profitable company can find itself bankrupt if its debts are too high. That’s because interest payments and the obligation to repay the debt are relatively fixed, while the profits used to pay back those debts are most definitely not fixed. And that’s true even for a defensive company like BT. A year or two of weak profits for an overleveraged company can leave it in administration or liquidation, so one thing I always try to avoid is companies with an excessive amount of debt.
As a general rule, I’ll only invest in a defensive sector company like BT if its borrowings are less than five-times its five-year average profit. Over the years I’ve found that to be a reasonable maximum, beyond which the odds of debt-related problems increase dramatically.
Today, BT’s debt ratio is slightly above that limit. With borrowings of £14.3 billion and average profits of £2.5 billion, BT’s debt-to-profit ratio is 5.7. Even for a company as defensive as BT, I think that’s an imprudent amount of debt. However, thanks to BT’s enormous pension fund, the picture is much worse than that.
In recent years, investors have grown used to hearing about pension funds and how a seemingly healthy company was brought down by a massive pension fund deficit (Carillion being a recent poster-child for this trend). The problem is that a pension deficit is much like any other form of debt in that the company has a legal obligation to repay it. That’s why I treat any pension deficit as a form of debt and add it to the company’s borrowings to calculate a debt plus deficit ratio to profits.
In BT’s case, it has a pension deficit of £11.3 billion. If you classify that as debt, then BT has total debts of some £25.6 billion. That sounds like a lot, and it is. It is in fact more than ten-times the company’s recent average profits, or more than double my five-times profits debt rule.
In other words, as far as I’m concerned, BT is dangerously overleveraged, regardless of how defensive it may or may not be (and looking at its low-growth history and dividend cuts in 2001 and 2009, I don’t think it’s as defensive as many people think).
Q4: Is BT’s share price attractive, given its growth, profitability and balance sheet strength?
Looking at growth, profitability and leverage is a quick way to separate good companies from bad and ugly companies. However, the price you pay to buy a share of a company is just as important as the quality of that company. If you pay too much then your investment could produce weak or negative returns, even if the underlying company produces consistent and highly profitable dividend growth.
This is exactly what happened to investors who bought shares in Coca-Cola in 1998 when the dividend yield was less than 1%. Over the past 20 years, Coca-Cola has increased its dividend almost five-fold, which is a very solid performance. However, the share price has remained stuck at or below its 1998 level for most of the past 20 years, so those investors have seen zero capital gains, despite the underlying company’s continued growth. The moral of the story is that you can turn a great company into a bad investment by paying too much in the first place.
There are various ways to think about what is and isn’t an attractive valuation, with most investors using the PE ratio and dividend yield. I like dividend yield, but I use PE10 (price to ten-year average earnings) instead of the standard PE ratio because the standard PE ratio can be thrown off when a company’s latest earnings are abnormally high or low.
So how does BT compare to the average for UK dividend-paying stocks by those measures? Somewhat obviously, BT’s dividend yield is far above average. With a yield of almost 8%, it’s well into most dividend investors’ “red-flag” territory, where the yield is so high it seems unlikely it will ever actually be paid (in other words, a dividend cut is probably imminent).
Personally, I fall into this red-flag camp. BT’s debt and pension obligations must be keeping the CEO awake at night. And if they’re not, they should be. To me, it seems like madness for a company to be paying cash out to investors while at the same time it has debts and a pension deficit which are huge multiples of its earnings. The newly agreed pension deficit reduction plan has BT obliged to pay almost £1 billion into the pension scheme each year until 2030. And this from a company whose annual post-tax profits have never consistently been above £2 billion.
For me then, BT is not a serious investment candidate. I’m not a turnaround investor and I don’t like to invest in high risk situations if I can help it. And to me, BT looks like a high-risk turnaround, with its recent strategy update announcing management’s commitment to “transforming BT’s operating model” via a “three-year reduction of c.13,000 mainly back office and middle management roles”, plus “[c]ost reductions to help offset near term cost and revenue pressures” while “[h]iring c.6,000 new employees to support network deployment and customer service”. The strategy update also says that “BT is uniquely positioned to be a leader”, but this has been true for decades and it hasn’t led to any sort of decent performance, so I have zero faith in BT suddenly turning into a high growth tech giant (or even just maintaining its dividend).
If a potentially distracting transformation project on top of BT’s massive debt and pension obligations isn’t enough to put you off, then you might also want to know that BT’s PE10 ratio is 8.2. That’s well-below the UK dividend-payers’ average of 24, which is partly why BT is the 21st highest-ranked stock on my stock screen. So if you can handle the potential risks, then I would say that BT is attractively valued, but I certainly won’t be investing in this particular high yielder.