BT: a cheap stock with a secure dividend

Is BT in terminal decline or will its broadband business put it on the path to prosperity? Today’s results give support to both arguments but here’s why we’d still buy the shares?

Sales down, profits up

BT’s results for the three months to December saw the continuation of a familiar trend. Sales declined by 5% but underlying costs were cut by 6% leading to operating profits and earnings per share respectively increasing by 8% and 13%.

The major concern is BT’s pension fund. The deficit has increased by £1.6bn to £4.1bn. One of the most unfortunate consequences of the UK’s policy of printing money to buy government debt is that it has pushed bond yields down (by pushing bond prices up). This makes it more difficult for pension funds to generate the necessary investment income to pay their pensioners, which in turn, means they have to put more money into the fund.

Broadband continues to do well

Whilst BT is still losing customers in its traditional telephone business and its IT services division has yet to return to profit, broadband remains its star performer. BT’s 56% market share of new broadband customers reflects the quality of its broadband product whilst take-up of its high-speed broadband is increasing.

BT’s investment in high-speed broadband is arguably its key attraction to investors. Today’s announcement that it is increasing download speeds and the number of households that can receive this service is good news. The projected growth of internet TV and film streaming services such as LoveFilm and Netflix will need the speed and capacity of BT’s broadband network if they are to be successful. BT could be a great way to play this theme.

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BT generates lots of cash

BT is basically a utility but it does not have the financial characteristics of regulated water and electricity companies. These are seen as safe havens by investors for their secure cash flows and generous dividend payments. However, they also have to invest most of their cash flows back into their assets and consequently do not have much left after they have done this. In other words, they have little or no free cash flow and have arguably been borrowing money to pay their dividends.

This is not the case with BT. Surplus or free cash flow increased by 11% during the last three months to £634 million as the company kept a tight rein on costs and investment expenditure. Management is now stating that it expects to generate £2.4 billion of free cash flow for its 2012 financial year and this is very good news for investors for a number of reasons.

The key measure for investors

One of the ways that investors can value companies is to calculate what is known as the free cash flow yield. This is done by dividing the free cash flow of the company by its market value. At 209p, BT has a market value of £16.25bn and a free cash flow yield of 14.8% (2.4/16.25). This looks very attractive indeed. In fact, BT’s free cash flow could decline by almost a third and it would still have a 10% free cash flow yield.

Another way to use free cash flow is to check on a company’s ability to pay dividends. Based on Bloomberg forecasts, BT has a prospective dividend yield of 4%. With a free cash flow yield of 14.8%, BT’s dividend is covered nearly four times by cash flow which is very reassuring. (See my colleague Tim Bennett’s video: The number company directors don’t want you to know.)

Last but not least, BT’s free cash flow may allow it to put more money into its pension fund, addressing a key risk to shareholders. In fact, CEO, Ian Livingston suggested this morning that BT might well do this.

We’re not denying that BT faces challenges, but you can’t ignore its cash flow and that’s why you should probably buy the shares.