BT(LSE: BT-A) shocked the market earlier this week when it reported that it would take a larger than expected write-down on its Italian operations, following the discovery of fraud at the unit earlier this year. In an attempt to get all the bad news out at once, BT also published a profits warning alongside the news of its £530m write-off.
Investors reacted to BT's deluge of bad news by dumping shares in the company. When the dust had settled, BT was down 20% on the day.
The one good thing that came out of Tuesday's carnage is that BT's dividend yield shot up to a highly attractive 5.6%. Management has promised to increase the payout by an inflation-busting 10% per annum going forward.
However, while BT's 5.6% yield may look attractive in the current interest rate environment, investors need to carefully consider if it is worth the risk.
At first glance, BT's dividend payout looks safe. City analysts have pencilled in a dividend payout of 16.95p for the company's fiscal year ending 31 March 2018, which should be covered twice by earnings per share.
Nonetheless, when it comes to cash, BT is running out of options. For the fiscal year ending 31 March 2016, BT generated £5.2bn in cash. Of this the group spent £5.2bn on capital spending and other costs. Total cash dividends paid were £1.1bn. The gap between spending and income was funded with debt.
Looking ahead, the situation looks better, but not by much. City analysts believe the company will generate free cash flow of £2.1bn for the year to March 2018 after deducting pension payments and restructuring costs. The dividend is expected to consume £1.7bn, leaving headroom of £400m.
£400m in spare cash might seem like a lot, but compared to BT's £9bn pension deficit and £9bn debt mountain built acquiring mobile operator EE, £400m is almost nothing.
The problems keep coming
As well as an Italian accounting scandal, rising pension deficit and lack of growth at its international arm, BT dealing with regulatory concerns regarding its domination of the UK's Openreach network. And the company is having to pay more for the viewing rights for sports, which it is trying to pass on to customers.
From August, BT's 1.7m BT TV subscribers will have to pay £3.50 a month to access sports channels showing live Premier League and Champions League matches. On top of this price hike, BT has levied a separate £1.50 increase for BT broadband subscribers who access its television services, following the introduction of a £6 monthly charge for the broadband TV service last July. The question is, as the company hikes prices, how long will it be before consumers start to desert? If BT's offering becomes too expensive, the number of alternative replacement services is growing by the day.
Unfortunately, BT is stuck between a rock and a hard place. The company needs to hike prices to be able to afford its dividend, debt and pension costs, but the company cannot afford to lose too many customers. If customers do start to desert, management will have no choice but to axe the dividend.
Overall then, BT's 5.6% dividend yield is not as safe as it looks. There are better options out there.
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Rupert Hargreaves 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.