BT Group Stock: Still Seeing Little Love From The Market (OTCMKTS:BTGOF)

Incumbent U.K. telecom operator BT Group (OTCPK:OTCPK:BTGOF) has continued to frustrate, with the shares delivering a modest mid-single-digit loss since my last piece on the company in September. With BT already one of the cheapest names in its peer group, underperformance versus other European telecoms in that time is particularly disappointing.

While frustrating, results at the business level do not appear to be driving this, with the firm largely performing in line with expectations thanks to decent results in the Consumer and Openreach segments.

Those that follow BT know that the company has considerable calls on its cash flow. The ongoing national rollout of fiber-to-the-premises (“FTTP”), leading to elevated medium-term CapEX spending, is one, as are top-up payments required to plug the gap in its pension scheme. These are depressing free cash flow (“FCF”), with expectations of growth later in the decade basically doing all of the heavy lifting in terms of the value case here. That said, I don’t see much risk here given the nature of BT’s FCF growth drivers, and at a steep discount to peers and well below my fair value estimate the stock remains attractive for patient investors.

Operational Performance Remains Fine

Offsetting its struggling Business division with growth in Consumer and Openreach was a key theme last time out, and that has remained the case throughout the company’s fiscal 2023/2024 (N.B. BT’s financial year runs from April). To recap, the latter two customer-facing units have some nice growth drivers, largely in the form of the aforementioned fiber rollout. The Consumer segment largely speaks for itself, encompassing lines of business such as residential broadband and mobile. Openreach is the U.K.’s largest fixed-line network, essentially offering fully national coverage. It sells access to other providers like Comcast-owned Sky (CMCSA) and Vodafone (VOD), since Virgin Media O2’s (“VMO2”) cable network, which is the only other fixed network with near-national coverage, is closed to other service providers.

BT’s Business segment continues to struggle, facing both cost inflation and the ongoing structural decline of legacy high margin businesses like fixed voice. Business EBITDA fell 13% year-on-year in 9M23/24 to £1.2b, with an ugly 17% year-on-year decline recorded in Q3.

Consumer and Openreach continue to perform much better. As these represent around ~33% and ~45% of group EBITDA, respectively, they are also driving modestly positive group-wide growth.

In Consumer, 9M EBITDA was up 4% year-on-year to £2b, with Q3 EBITDA up the same amount. Contractual inflation-linked price hikes and the ongoing rollout of FTTP are helping, with Consumer broadband average revenue per user (“ARPU”) up 5% year-on-year. Take-up continues to advance, with the retail FTTP base up around 45% year-on-year and around 10% sequentially in Q3 2023/24. Because recent price hikes are largely inflation driven (and as such competitors are also raising prices by similar amounts), BT has seen stable rates of churn, with the broadband rate of 1.1% flat on the first half of the year.

The benefits of increased FTTP take-up are twofold. Firstly, fiber connections generate higher ARPU given their much faster internet speeds versus products based on legacy copper connections. In addition, cost requirements are much lower, as fiber requires much less maintenance compared to copper (e.g. fewer engineer callouts to fix line faults). As a result, BT is targeting between 25% and 40% headcount reduction over the next five years, which will provide support to EBITDA and FCF generation.

Openreach EBITDA increased 11% year-on-year in both Q3 (to £967m) and 9M23 (to £2.9b). Like Consumer, the Openreach division also continues to benefit from increased FTTP take up. Net adds came in at circa 430k in Q3, with the overall FTTP take-up rate inching up another 1ppt sequentially to 34%. Alongside price increases, this drove a 10% year-on-year increase in Openreach ARPU. With solid growth in Consumer and Openreach, overall group EBITDA was up 1% in Q3 (to £2.03b) and 3% for 9M23/24 (to £6.12b).

Valuation Remains Deeply Depressed

At the start of its fiscal 2023/2024 year, BT guided for pro-forma EBITDA growth, CapEx of £5b-£5.1 billion and normalized FCF of £1b-£1.2b. EBITDA has indeed landed modestly positive as per above, while CapEx and FCF are likewise seen at ~£5b and the top-end of £1b-£1.2b guidance. All told, BT is basically performing as expected at previous coverage.

Normalized FCF looks like it will land around £100m higher than what I expected, but this doesn’t really move the needle in terms of my DCF-derived fair value estimate. As such, I maintain that at £2.10 per share (~$2.60), with that based on a 9% cost of equity and normalized FCF rising by at least £1.5b by 2030/31. As this is driven by normalizing levels of CapEx post peak-FTTP investment, plus cost reductions emanating from decommissioning copper connections, I continue to see relatively little risk in achieving this.

While implied upside of around 100% looks eye-opening for a mature developed market telecom, I would point out how depressed BT’s valuation is compared to European peers. On annualized EBITDA of ~£8b, a market-cap of £10.5b, and net debt of £19.7b (including lease liabilities), BT trades on an EV/EBITDA of less than 4x. That is a full turn below French and Spanish peers Orange (ORAN) and Telefonica (TEF), which both trade for just under 5x forward EBITDA as per Seeking Alpha. Compared to best-in-class European operators like KPN and Swisscom (OTCPK:SCMWY)(OTCPK:SWZCF), which both trade in excess of 7x forward EBITDA, the discount is even starker.

At my £2.10 per share fair value estimate, BT would trade on EV/EBITDA of around 5x, roughly in line with Orange and Telefonica as per above. As such, I don’t consider this to be excessive. With the shares offering a 7%-plus dividend yield in the meantime (and free from withholding taxes for non-U.K. investors), BT continues to look attractive despite its hitherto disappointing performance, and I keep my ‘Strong Buy’ rating in place.

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