BT(LSE: BT.A) currently looks to be one of the most undervalued stocks in the UK's leading index, and indeed the UK market as a whole.
The stock is trading at a forward P/E of 8.4 and an enterprise value-to-earnings before interest tax depreciation and amortisation (EV/EBITDA) ratio of 5.4. The market median P/E is 14.1 and EV/EBITDA is 11.5, so BT is trading at a discount of around 50% to the broader market.
In theory, BT's depressed valuation should make the stock a no-brainer investment. As the largest telecommunications company in the UK, with a virtual monopoly over a large part of the UK's telecoms infrastructure, BT has a tremendous competitive advantage.
Unfortunately, the government and regulators are not happy with the company's position in the market, especially considering it has been dragging its feet upgrading critical broadband infrastructure across the country. And the group has also been accused of "excess profits, chronic under-investment, poor service levels, and patchy coverage" at its Openreach division by three partners Sky, TalkTalk and Vodafone who use the Openreach network to offer services to their customers.
To offset these concerns, Openreach has been hived off into a separate legal entity and BT has committed to spending £3bn upgrading its network across the country.
However, this significant capital outlay might not be enough. Other companies, fed up with BT's slow service, have started to edge in on the its monopoly. Earlier this year, TalkTalk announced plans to connect three million homes with its fibre network in partnership with investment firm Infracapital. Meanwhile, Vodafone has partnered with Neil Woodford backed CityFibre to deliver full fibre connectivity in 12 cities and reaching one million homes across the UK by 2021. Peterborough, Milton Keynes and Aberdeen are all on the list to be hooked up this year.
Put simply, BT can no longer rely on its size to guarantee sales. Every day consumers are being offered more options, and they are no longer limited to just one telecoms supplier. It's not just the broadband market where BT is suffering. Virgin Media and Sky are attacking its pay-TV offering and services like Netflix and Amazon, which do not require a lengthy and costly subscription, are only becoming more attractive to consumers.
In my view, to stay ahead of the game, BT is going to have to spend more on its infrastructure and customer offering, which is going to be difficult considering the company's pensions and debt obligations. In fact, credit rating agency Moody's recently downgraded BT's credit rating citing "a deterioration in its underlying operating performance trends, a significant capital spending risk, and the sustained large pension deficit."
To free up cash, I believe the company is going to have to cut its dividend at some point, which might not be a bad thing if it gives the group financial flexibility to pay down debt and invest more in winning over customers.
So overall, the BT share price looks cheap, but it is cheap for a reason. That being said, there is plenty of bad news already reflected in the current valuation and if the company manages to beat expectations, the shares could suddenly re-rate higher.
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Rupert Hargreaves owns no share mentioned. John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. The Motley Fool UK owns shares of and has recommended Amazon and Netflix. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.