It's time to take profits in BT
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Associate Editor
David Stevenson Jul 31, 2009
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How often does a company announce a 45% drop in profits – then see its shares spurt up almost 15% in a day?
No, I don't know either. But I don't imagine it happens very often. Yet it happened yesterday with struggling telecoms group BT.
A couple of months ago, when the share price had fallen to around 85p, we reckoned the shares were worth buying (BT - a buy for the bold). But now that they've risen 50%, they don't look so attractive. It's time to take profits – here's why...
BT's doing better than the City forecast
BT, Britain's largest fixed-line phone firm, has just 'fessed up to a 44% drop in its first-quarter net profits to £214m. On the surface that doesn't look great. But the stock market's expectations had fallen so far, it turned out to be much better than the City had forecast.
Analysts had been betting on a near 70% plunge, according to Bloomberg, so they were pleasantly surprised. What's more, group sales, which had been expected to dip by 3%, actually rose by 1% (although this was boosted by currency moves and acquisitions).
News on cash flow wasn't bad either. The company's still spending money faster than it's collecting it, but the cash outflow was stemmed by more than 80% compared with last year. Two of the group's four divisions have done OK, while BT Retail, which does stuff like BT Vision, BT Talk Together and BT Broadband, did well, ringing up a 30% operating profit gain. Once again, it was the troubled Global Services IT Division, which provides communication networks for multinational companies, which did the damage with a £124m operating loss.
Yet even here, chief executive Ian Livingston claimed that restructuring is making progress "although there is still much to do", while "the rest of the group continues to perform well".
So far, so good. But is any of it reason enough to hold on to the shares?
But its balance sheet doesn't look good
Mr Livingston says the company is on course to cut operating costs and capital expenditure by "well over £1bn, and to generate group free cash flow of over £1bn this year". That's exactly the sort of message you want to see if you're a shareholder.
But you'd be forgiven for having a feeling of déjà vu. This is exactly what the BT boss said in mid-May at the time of the full-year results. In short, there's no new news here. In addition, despite the last quarter's better-than-expected sales numbers, he's no more optimistic about the firm's future revenues. He still sees a 4% to 5% drop in sales over the current financial year. And we don't know what further horrors the recession could yet bring.
The issue now facing shareholders is that since May, when we described BT as a "brave, but potentially very profitable, buy", the shares have racked up a very healthy 50% gain. So they're nothing like as cheap as they were, as we'll explain in a minute.
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What's more, the risks haven't gone away. In fact, some have got larger, like the pension fund problem. The shortfall is now £5.8bn, which is double the deficit of just three months ago. To put that into context, the company's entire stock market value is less than £10bn.
The company says that this is caused by accounting changes and that it will pump an extra £525m annually into the fund over the next three years. But worse, BT is currently carrying out its triennial pension fund review. That might prove to be depressing reading for shareholders. "Analysts are concerned that the 360,000-member scheme could reveal a deficit of up to £11bn", says Rupert Neate in The Telegraph.
Ouch! Sorting out soaring pension fund deficits can prove to be a major headache. BT would have to find the money from somewhere, somehow. And one way would be to follow the example of other firms with similar problems, and cut back the dividend further. That would be very bad news for the share price.
What's more, the pension fund shortfall has dug a big hole in BT's balance sheet. At the end of June, its net liabilities exceeded its net assets to the tune of £3.2bn. So technically, the company is worth a long way less than nothing, although of course its ongoing money-making businesses are worth more than their book value.
But even so, the BBC's Robert Peston says "I can't remember the last time that a putative blue chip" – i.e. top-notch company – "like BT, a semi-utility that's supposed to generate buckets of cash, had a net deficit on its balance sheet".
Why it's time to cash in on BT
We were keen on BT in May because we reckoned the management team was doing what it needed to. It had issued three profit warnings over the past year and had just slashed the dividend. Most commentators were downbeat about the company's prospects at the time – which is often a good time to buy - the share price was under the cosh, and the yield, even after the payout cut, was still a decent 7%.
But right now, on similar profit forecasts to before, on a p/e of nearly 11x and a yield of just over 5%, BT isn't looking anywhere near as cheap as it was three months ago. Clearly it could well rally further in the current frothy stock market atmosphere. Yet that could also evaporate just as fast as it has appeared.
On balance, with the shares having soared and the risks greater than they were, my instinct would be cash in on the latest market moves, and to take at least some, if not all, of your BT profits.
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