Convergence Sets BT Apart

With the closing of the EE acquisition,

The U.K. has trailed several other European countries in moving to converged services, but we think this acquisition will help jump-start that move. BT should benefit, as it controls the whole network, while others will need to wholesale at least some services from somewhere else.

BT’s best-performing division has been its consumer sector, and the addition of EE should help this business even more. The company’s investment in fibre should provide growth in the Openreach division. Fibre is now available to over 25 million premises in the U.K., and BT has 4.1 million retail subscribers and 1.8 million wholesale customers.

The company has also won 44 regional bids in the Broadband Delivery UK project. While this should provide some revenue growth, we project that it will be at lower margins than the Openreach division’s other revenue.

We are not as enthusiastic regarding BT’s other venture of taking on Sky SKYAY/SKY in television by launching its own sports channels. BT has spent or has contract commitments to spend about GBP 2 billion on content and launch costs. While BT won the exclusive rights to the UEFA Champions League and UEFA Europa League and now has more than 3 million direct customers (5 million including wholesale), Sky continues to add broadband customers. We are pleased that BT is beginning to charge its lower-tier broadband customers for access to its sports channels. We think BT needs to charge in order to have any hope of earning a decent return on the capital it has invested.

Elsewhere, BT’s global services division and the U.K. public sector are struggling, negating growth in the retail division, but in the longer term, we expect the global services division to return to revenue growth. However, the U.K. public sector and an accounting scandal in Italy are also pressuring margins. Additionally, the company’s low interest rates are increasing its pension deficit.

Scale Helps Dig a Narrow Economic Moat BT owns the only telephone network that reaches the entire population of the U.K. The other primary fixed-line network in the U.K. is owned by Liberty Global's LBTYA Virgin Media division and covers only about 60% of the population. (Liberty Global is in the process of infilling several holes in its network that it expects will take coverage to about 70%.) While the U.K. is one of the most competitive telephone markets in the world, with no other network competitor across 40% of the population, BT still has a lock on some revenue from a large part of the country. Local loop unbundling, where the largest competitors have put their own equipment in BT's exchanges, covers about 85% of the population. Even here, though, other operators still need BT for the "last mile." Sky has been the most aggressive when it comes to adding equipment to BT's exchanges and talks about potentially extending its network to 90% of BT's exchanges. Recently, the U.K. has offered to help fund laying fibre in rural areas, which threatens to undermine BT's exclusive network. However, BT has won every auction thus far. The few municipalities that have entered partnerships with a company other than BT are so far tiny. While margins on this rural broadband business will probably be lower than those of the company's traditional business, it prevents another operator from building a competing network. With the majority of the bids complete, we don't anticipate any significant new competitors.

Besides its core infrastructure, which makes complete avoidance of BT very difficult, the company also owns one of the world’s largest global enterprise businesses. While this business had issues during 2009 and 2010 because of the long-term nature of most contracts, there are significant costs associated with switching carriers.

Underfunded Pension, Competition Are Risks BT's financial risk profile decreased as its debt load and pension deficit were brought under control. However, the pension is so large that small changes to assumptions can have significant effects on asset and liability valuations. While the company's triennial agreement and previous up-front payments reduced the deficit, this didn't eliminate the volatility in the fund caused by its enormous size, as evidenced by the increased deficit since then. The weak U.K. economy and government-mandated austerity plans add operational risk. The effects of Brexit could push the economy into a recession and could cause people to reconsider the importance of top-of-the-line bundles of phone and Internet access services that BT has been pushing. Recent accounting issues in Italy show that the company can still be aggressive in accounting for its enterprise business contracts, and there could yet be more restatements needed.

On top of all that, the U.K. remains one of the most competitive markets in the world, with more than 100 companies offering telecom or Internet access services. Virgin Media now offers Internet access at speeds faster than anything BT can offer in scale. The company needs to invest in its next-generation network in order to compete. Also, the European telecom regulator could implement policy changes that could hurt the company. The company is further increasing spending of GBP 960 million for three more years of Premier League Football. It also spent GBP 12.5 billion for EE in 2016, though a significant portion was paid with its own shares rather than cash. EE will return BT to owning its own wireless network. While these deals make strategic sense, they increase execution risk and increase the company’s debt.

Management raised the dividend 10% for fiscal 2017, but announced that while it plans to retain a progressive dividend, future increases will be at a lower rate. This is a positive change compared with the dividend cuts at many other European telecom operators.