Shares digital

In terms of share performance, the Fixed Line Telecommunications sector has proved to be anything but a haven in the recent economic turmoil. This traditionally predictable performer has underperformed the FTSE All-Share by more than 15% since the start of the year.

The giant that is BT Group (BT.A) dominates this relatively small sector, followed by the only other FTSE 100 player Cable & Wireless (CW.), and Colt (COLT) from the FTSE 250. While remaining a sector with defensive qualities, the effects of the credit crunch on end markets mean the seams have started to rip even here. Questions are being asked about the sustainability of dividends, rising pension costs, and the relentless competition from media stocks.

Look to the dividend

Dominated by mature companies with limited scope for growth, dividend is a key attraction for telecoms companies. Traditionally boasting solid dividend growth, BT has not shaken off speculation the dividend payout will be reduced for the full year. While BT has stated a high dividend will remain a priority, 31 October’s profit warning for its global services unit encouraged under already strong speculation a reduction is in store.

Analysts now forecast a consensus yield of 9.4% (a total payout of 10.6p a share) for 2009. This is a 31.5% cut from the year before. At the interims last Thursday (13 November) BT’s board confirmed it will pay an interim dividend of 5.4p, the same as last year. However, the reluctance to commit to the full-year figure means the issue remains contentious.

Dividend concerns also surround £67 million cap KCOM (KCOM). The shares have collapsed 53% since a disappointing first-quarter trading update on 26 September. Earnings are suffering due to operating losses in the IT Services division and a 22% yield indicates the market expects dividends to be cut. James Crawshaw, analyst at Singer Capital Markets, says KCOM’s high net debt and the potential need for a pension fund top-up makes a review of the dividend policy seem likely. Crawshaw says: ‘The current yield suggests the stock market is already pricing in a cut to KCOM’s dividend. This may not happen at the half-year stage (25 November is the date interims will be published) but seems likely for the full year.’ Singer forecasts a full-year dividend of 1.5p, below the current consensus of 2.6p.

The problem with pensions

Pension deficits continue to hound the sector’s mature companies, and the recent market volatility has done little to alleviate this issue. Singing a song that will be familiar for many companies, BT warned at the start of the year its pension surplus had been wiped out by market moves, meaning any further deterioration would require a top-up payment. Increased life expectancy is another headache as companies are forced to adjust their longevity assumptions. For BT, which currently has pension liabilities of £33.4 billion, each additional year would mean an extra 4% in liabilities.

However, BT last week reported plans to make changes to its pension scheme which, if completed, should reduce the ongoing cost by around £100 million a year. In addition to increased contributions, the retirement age would be raised to 65 and the final salary link will be changed to a career average. Changes would take effect from next April and only affect future benefit accruals.

Pension assets cover all but £9 million of KCOM’s £177 million pension liabilities, the funding of which is due for a review in April 2010. The likely decline in pension asset values suggests a top-up may be in line also for the Hull-based group.

Ofcom holds the cards

Hefty competition means companies in the sector face strong pricing pressures. While BT remains the market leader, the mammoth is facing increasingly aggressive competition from media companies such as BSkyB (BSY).

Broadband is the inroad for the media companies, whose television, internet and phone packages represent a serious threat. Broadband has for many years been the key driver for BT, but as this market is maturing the group has to look elsewhere as it seeks new growth drivers. BT Vision is the department that sells related television services, and it currently has 340,000 customers. Division head Gavin Patterson has stated the goal is to have more than two million customers by 2011. However, progress is hampered by the stiff competition from BSkyB. In addition to airing blockbuster films, the media group owns the rights to the big live football matches, the key selling point for pay television.

As BT has failed to reach an agreement with BSkyB on football, its ambitions to grow in the pay television market have looked uncertain. Some relief came when industry regulator Ofcom released a report in September, which proposed BSkyB sells premium content to BT and Virgin Media at regulated rates. They would then be able to sell it on at a profit. Ofcom has acknowledged BSkyB’s reluctance to supply premium content at affordable rates has led to reduced competition in pay-television.

Another key broadband competitor is cable television operator Virgin Media, which owns its own network offering high download speeds. Technology advances are key as BT and Virgin battle to offer the highest speeds. However, these are costly to implement. BT stated in June it will only build its £1.5 billion high-speed fibre network if the regulator allows it to make an appropriate return. This will be partly determined by the prices the regulator allows BT to charge its rivals to access the network.

Hungry for further growth, BSkyB is in talks with Tiscali about buying the Italian group’s 1.8 million-user broadband business. BSkyB has until now been happy to sell broadband only to its television customers but this deal would open the door to the possibility of cross-selling its television package to Tiscali’s subscribers. If successful, BSkyB would leapfrog Carphone Warehouse (CPW) to be the third-largest internet provider in the country, behind BT and Virgin.

Consolidation hopes

BT is still the king of the home phone, but has a number of competitors in the business market. Cable & Wireless (C&W) is the other key provider, with KCOM and Colt also laying claims to slices of the pie.

C&W has outperformed the sector since the summer, mostly due to the hope the international operations would be demerged from the Europe, Asia and US operations. Last week’s interims (10 November) confirmed speculation the economic turmoil has delayed plans to restructure the company. The board stated it remains ‘firmly committed to value realisation’ and is satisfied the ‘necessary work can be rapidly completed once markets are stable’.

With no timetable in place, however, the market is focusing on the underlying issues. C&W showed some good improvements at the interims, with better growth, margin progression and increased dividend. The group has raised full-year earnings before interest, tax, depreciation and amortisation (EBITDA) guidance from £720 million-£725 million to ‘at least’ £780 million, £23 million of which reflects consolidation from the recently acquired competitor Thus.

C&W reported its EAU division turned trading cash-positive in the first half, but pre-interest cashflow is still negative. Jonathan Groocock, analyst at Investec Securities, says: ‘C&W points to a £10 million trading cash inflow, but this includes £7 million of finance income as well as £4 million of non-cash pension credit in the EBITDA figure.’ The group trades on a price earnings ratio (PE) of 10.7, versus the 7.2 sector average, a level deemed unsustainable by Groocock.

Takeover speculation has driven Colt shares to outperform this year, a trend that lasted until October when the market realised an approach is probably some way off. Despite the shares being down 11.6% since the 23 October third-quarter results, the company still trades at a sector premium PE of 9.7 without dividend support. Investec upgraded its earnings per share (EPS) expectations at the interims, but noted this was based on below-the-line rather than operational performance. Analysts’ consensus for full-year EPS now stands at 6.8p, slightly over Investec’s 6.5p estimate.

The rise of wireless

The UK business telecom services market grew to £13.2 billion in 2007, according to Ofcom. This includes a 16% rise in mobile phone revenues and a 2% decline in fixed services, as lower costs prompt some users to migrate toward mobiles and email.

While this is a negative trend for BT, the landline giant was given reason to be hopeful in August, when Ofcom initiated a full-scale inquiry into the mobile phone industry. The contentious issue of mobile termination rates is now under the microscope, as around 20% of operators’ revenues stem from these charges to access each other’s networks. BT pays about £1 billion a year for calls from landlines to mobiles, and has argued this practice is obsolete. Despite the rising use of mobile phones, neither businesses nor consumers are likely to start relying solely on mobiles any time soon – especially as wireless broadband is not yet a competing force to wireline broadband.

One company making concerted efforts to change this, however, is Uxbridge-based Freedom4 (FFG:AIM). After selling off its broadband and network divisions last year, the Aim-listed £20 million cap has turned its focus to the development of fourth-generation (4G) fixed wireless broadband services. While also providing the shorter-range WiFi and 3G services, the first WiMax services have now been rolled out, offering technology that means high-speed broadband can be accessed while on the move. Although debt-free, Freedom4 chief executive Mike Reid told Shares the company will not become profitable for at least a year. However, Intel is putting in the money required to run the company for now, as the maker of WiMax computer receiver chips stands to benefit from this infrastructure being established in the UK. ‘We think WiMax will be everywhere in two to three years,’ says Reid.

Defying the sector’s downward curve is Telecom Plus (TEP), where the shares have maintained their level while others have fallen this year. The London-based group, which has a market cap of £219 million, provides competitive packages of utility and phone services through a network of direct sellers. The company is debt-free, has a good reputation for customer satisfaction and seems to have turned a corner following its supply issues a few years back. The cash-rich group is trading at a premium PE of 12.3, and paid a 10p dividend last year. This is expected to rise to 17.8p, which translates into a yield of 5.4%.

The shares of Aim-listed Alternative Networks (AN.:AIM), a reseller of communication services, have also held up well this year. With a market cap £65.3 million, the UK-based group is expected to pay a dividend of 4.6p when it reports full-year results on 2 December. In October’s trading statement, the group said ‘trading and cash generation for the year have remained robust’.

Slow and steady

With the recession having caused problems to float to the surface, several of the sector’s companies have started presenting plans for how they will improve the situation. For many of them there is reason to believe most of the issues have been priced into the shares at this point, but with the current uncertainties dominating the market it is hard to tell if the bottom has been reached.

Regardless, the deep-rooted problems facing the companies will take some time to mend. In the meantime, however, they should continue to provide more or less reliable dividend income, even if the payouts are reduced.

Shareholders should keep in mind in this mature sector it is the tortoise, not the hare, that will win the race. It may not be as exciting, but it should provide some security in these uncertain times.

COMPANIES FOR SECTOR REPORT

BT Group (BT.A) 122.5p

Beyond trouble on the line

With concrete plans for how it will deal with its problems now in place, the bad news that has besieged BT’s share price of late, including fears about the cut to the dividend, should be priced in. BT’s shares have fallen by nearly half since the beginning of the year, and now trade on a PE of only 5.5. The day of the interims (13 November) saw the stock rally as much as 12%, before closing up 8.9%, at 122.5p.

The interims saw the announcement of plans to cut staff numbers by 10,000, as well as intentions to reduce retirement liabilities. BT is now set to base pension payouts on a career average salary, as well as increase member contributions and raise the retirement age to 65.

One key issue still remaining is the dividend, which is a key selling point for the group’s shares. Analysts estimate the dividend to fall by 41% this year, to a consensus of 9.1p (down from 15.4p in 2008). That dividend translates into a 7.5% yield which, at exactly 1.5 times the coupon on ten-year gilts (currently 5%) indicates the market is just about comfortable with the revised forecasts.

Cable & Wireless (CW.) 141.7p

Call waiting

C&W’s demerger plans may not have a time stamp on them, but the board seems determined its touted ‘value realisation’ will happen – eventually. While the share price fell as the market realised it was in for a wait, it could be argued it makes sense to keep the two divisions under one roof for now, as eggs in different baskets is a positive element for any company under the current conditions.

The stock has started to recover after the market’s disappointment, as 10 November’s first half results came in ahead of expectations. Some concern has been raised over the group’s cashflow but on the whole revenues rose 5%, gross margin was up 8% and operating costs down 3%. Capex was below guidance, and the acquisition of Thus is looking like a good strategic and financial move.

C&W is now trading on a 10.7 PE, which is a premium to the 7.2 sector average without any immediate catalyst in the pipeline. However, the board increased the interim dividend by 13% to 2.8p and the forecast payout for the full-year equates to a 6% yield (8.5p).

Colt (COLT) 66.75p

Inflated after takeover

hopes fade

Trading without the support of a dividend, a PE of 9.7 in a sector averaging 7.2 makes Colt look expensive compared with its peers. Hopes of a takeover of the specialist in fibre-optic networks for European business customers had sustained the stock until September, when the economic conditions made speculations of an approach from a suitor seem increasingly unlikely. Third-quarter results on 23 October did little to remedy the trend, with the shares, having fallen 11.6% since the announcement, now at 66.8p, or 59.4% below the level seen a year ago.

The third-quarter results showed operations in line for Colt. However, its ?78 million capex for the period was higher than forecast. The group expects the figure for full-year capex to be ?300 million, up from last year’s ?259.7 million level. Without the prospect of a takeover there is little to justify the company’s premium rating and investors should avoid the shares.