Are these telecoms stocks heading for a fall?

Updated: 
BT logo on building

Shares in telecoms firms BT Group (LSE: BT.A) and TalkTalk Telecom Group (LSE: TALK) have lagged the FTSE 100 this year. While the index has gained 11% in 2016, BT has fallen by 20% and TalkTalk has slipped 7% lower.

This downward trend seems firmly established: BT shares fell by 3% after the group's interim results were published this morning, despite a 20% rise in adjusted pre-tax profit.

What's the problem?

BT's reported revenue rose by 34% to £11,872m during the first half of the year, while reported pre-tax profit rose by 9% to £1,388m. These figures reflect the contribution from mobile operator EE, which BT acquired in January.

However, the new shares issued as part of the EE acquisition means that despite the increase in profits, reported earnings per share for the first half fell by 6% to 11.6p. Against this backdrop, BT increased the interim dividend by 10p to 4.85p. This should be comfortably covered by free cash flow, so seems safe enough.

BT's operational performance also seems quite good. The group added 280,000 pay-monthly mobile customers and gained 65% of all new broadband sign-ups during the first half.

The elephant in the room is BT's pension deficit. This rose by £3.3bn to £9.5bn during the second quarter, mainly due to lower interest rate assumptions. BT spent £900m on deficit reduction payments last year. If this larger deficit persists, then these payments could rise in the future, putting pressure on dividend growth.

Analysts' earnings forecasts for BT have fallen by 10% over the last 12 months. The current consensus figure is for earnings of 29.2p per share and a dividend of 15.4p. This puts BT shares on a forecast P/E of 12.9 with a prospective yield of 4.1%. In my view, that's enough for now, given the risks associated with the firm's jumbo pension deficit.

Can this 7% yield be saved?

According to new figures from market research firm Kantar, TalkTalk has lost 14% of its customers since its network was hacked last year. The firm's share of new customer acquisitions has dropped from 13.4% to 9.4% since last September.

While TalkTalk's operational performance does appear to be stabilising, I'm not sure this will happen quickly enough to address my financial concerns about the business.

TalkTalk's last-reported net debt of £679m gives a net debt/EBITDA ratio -- a key banking measure -- of 2.6 times. That's very high. Even if the group hits its target of tow times by the end of this year, debt will still be high.

Debt looks high based on other measures too. TalkTalk's net debt is greater than its net fixed asset value of £447m, and represents a multiple of five times 2017 forecast net profits. I believe there's a good chance that a dividend cut will be necessary at some point to help reduce the group's debt.

Notwithstanding this, TalkTalk's adjusted earnings per share are expected to rise from 8.4p to 14.1p per share this year. This puts the shares on a forecast P/E of 14.5, with a prospective yield of 7.7%.

The size of this forecast yield tells me the market is concerned about a dividend cut. I agree, and continue to rate TalkTalk as a sell.

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Roland Head has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.


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