Morningstar is initiating credit coverage of BT Group with a BBB- rating. The British telecom giant scores best on our Business Risk pillar, owing to its large size and solid competitive position in many of the markets it serves. BT is the largest Internet access provider in the UK and it is the only firm with a network that covers the entire population. The firm faces no direct fixed-line competition across about 40% of the nation. On the surface, the UK is one of the most competitive phone markets in the world, but many rivals merely resell capacity on BT's network, leaving the firm's cash flow largely intact even if it loses a retail customer. Beyond its traditional local fixed-line business, BT has pushed aggressively into international telecom and information technology markets over the past several years, with poor results. This business, which the firm calls Global Services, now account for about 40% of revenue, but a much smaller portion of profits. The group won several long-term services contracts that have failed to deliver promised profitability, and restructuring efforts have depressed firmwide margins. BT has made strides to improve this business over the past year, but its presence weighs on our view of the firm. Overall, though, we expect BT will generate steady cash flow for the foreseeable future as the core telecom business continues to hum along.
Our view of BT's current financial position is much less rosy. The firm's debt load expanded rapidly during fiscal 2008 and 2009 (ended March), as it bought back stock, funded a large dividend, and made acquisitions to enhance the Global Services business. The firm's debt load stands at more than £10 billion, net of cash and the value of currency hedges, up from less than £8 billion at the end of fiscal 2007. At first glance, this debt load appears reasonable, equal to about 1.8 times operating income, excluding depreciation and amortisation. BT also faces a major deficit in its pension plan, though, and adding in this unfunded obligation roughly doubles BT's leverage. About half of the firm's debt load comes due over the next five fiscal years, and it is currently debating with regulators concerning required pension contributions. We assume BT front-loads pension contributions, setting aside £775 million annually through fiscal 2012 and £250 million thereafter. This assumption pegs BT's cash contractual obligations at nearly £15 billion over the next five years. Even with our expectation of steady cash flows, we don't believe the firm will generate enough cash to fully meet these obligations, and will thus be forced to tap the credit markets to fill the gap.
Fortunately for debt holders, BT has recognised the relatively difficult financial position it is now in, and has taken steps to remedy the situation. The firm cut its dividend by more than half at the start of fiscal 2010, and has been using cash to repay debt. We've seen this story with BT before, though. The firm racked up huge debts during the telecom bubble of the late 1990s, and then spent several years working to repair its finances. Our fear is that as BT's financial position improves, it will again return to its free-spending ways.
