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Why are telecoms feeling the pain?

We evaluate the prospects of the UK’s big two telcoms

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

There are only two big UK-listed telecom companies, but they’re a major slice of the UK market.

The sector has had a tough time of late, with both Vodafone and BT underperforming the wider market.

Here we take a look at why, and evaluate their future prospects

BT and Vodafone total return vs FTSE 100 in the last 5 years

Past performance is not a guide to the future. Source: Lipper IM to 31/07/2019

Spending to stand still

Of course, there’ve been stock-specific issues holding back both companies. But there are a few factors impacting the whole sector.

The first is a large capital spend. Capital expenditure is what companies spend on fixed assets and property. And not many companies have to spend so much on their asset bases as the telcoms do.

Over the last 5 years BT and Vodafone have, on average, spent about 15% of revenues on capital expenditure. The average for the FTSE 350, excluding REITs and investment trusts, is around 7-8%.

A large capital expenditure bill isn’t always a bad thing. How else can companies broaden their asset bases? The problem with the telcoms’ spending is that they’re only really topping up their asset base. Both BT and Vodafone have seen their depreciation and amortisation expense outstrip their capital spend. This means they’re spending heavily just to stand still.

And spending doesn’t stop there.

Mobile providers have to buy frequencies to transmit mobile data. But these don’t count as capital expenditure. Governments around the world quickly cottoned on to that and, by structuring the auctions in a certain way, they created a cash cow.

Companies don’t have to add to their spectrum every year, but the costs can be significant. Vodafone has spent €15bn in the last 5 years, while EE splashed out £5bn before being bought by BT in 2015.

The second issue is the ever-growing competition in the mobile market.

Mobile coverage is strong across the board, especially in heavily populated urban areas. That means there’s little to choose between the mobile networks, other than the price they charge. That’s created intense price competition, and not just in the UK. Vodafone has felt the heat in countries from Spain to India.

When you have to cut prices to retain customers, it’s hard to grow margins.

See the Vodafone share price, our latest view, and the latest charts

See the BT share price, our latest view, and the latest charts

Debt becoming a burden?

It’s not unusual for telecoms to have a fair amount of debt. Revenues have tended to be reliable and in the good times the interest cost is easily affordable. But these debts have to be paid no matter what, and when profits evaporate the interest burden gets heavier.

Vodafone is hopeful of reducing leverage by selling or independently listing its towers assets. While this will help reduce debts, the group will lose the steady revenue and profit they generate.

BT has another monkey on its back – the final salary pension deficit. While this isn’t classified as debt, BT could be facing a multi-billion pound funding gap. As a result BT’s having to throw significant amounts of cash at the problem. A new funding package was agreed last year, which will see BT plough over £2bn into the pension scheme by 2021. Again, this soaks up cash.

The combination of squeezed margins and the significant demands on cash flows have jeopardised the dividend paying-prospects of both companies. Vodafone has cut its dividend from €0.15 per share to €0.09, which means a prospective yield of 5.9%. It should be remembered yields are variable and not a reliable indicator of what you’ll receive in the future.

And while BT hasn’t cut its dividend, it has scrapped plans to grow it, in the short-term at least. The prospective yield there is 8.4%.

So what’s next?

Investors should concentrate on the future, not the past. Think about driving a car – a glance in the rear view mirror is required every now and again, but you need to keep your eyes forward most of the time.

And with the share prices of Vodafone and BT driven down over the last couple of years, it’s worth evaluating the case for a recovery.

Both groups have a new chief executive at the helm, and are working on tying together their consumer TV, mobile and internet bundles.

However, that’s where the similarities end.

BT remains largely UK focused, but, after stepping back from India and completing the €18.4bn acquisition of Liberty Global’s cable and fixed line assets, Vodafone has tied its colours to the European mast. While growth across the continent has been sluggish recently, the group is confident trends will improve and expects service revenues to gradually recover from here. It’s certainly encouraging to hear a more upbeat forecast, but investors will need to see it materialise in the coming months.

See the Vodafone share price, our latest view, and the latest charts

Sign up to Vodafone research

BT’s strategy leans on cost-cutting, and the group has also announced plans to expand the roll-out of fibre broadband. The government is keen for BT to help facilitate the UK’s transformation into a fibre nation, so it’s possible a favourable deal could be reached with Openreach on funding and allowed returns.

Still, investors should be wary of the consequences if it doesn’t. The new CEO was clear that the dividend might get a trim if more cash is needed to go into the fibre build. That means we think income-seeking investors should proceed with a healthy degree of caution.

See the BT share price, our latest view, and the latest charts

Sign up to BT research

Unless otherwise stated estimates are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Past performance is not a guide to the future. Investments and income rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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