There is never just one cockroach in the kitchen, runs an old investment dictum. But for BT Group, the problem is more that the kitchen might also be home to more troublesome pests.
On Tuesday, the company said accounting irregularities in its Italian operation would result in a hit to profits larger than originally estimated. Its shares fell more than 20 per cent, far more than the Italian issue alone should warrant.
At the time of its half-year results in October, the issue in Italy was a mere detail, with BT expecting a £145m balance sheet adjustment as a result. A subsequent investigation has revealed that executives in Italy inflated profits over a number of years by artificially depressing the cost base. They entered into sale-and-leaseback agreements and borrowed against receivables. The result is that earnings before interest, tax, depreciation and amortisation will be reduced by about £175m this year and next. Unwinding all the unauthorised transactions will reduce free cash flow by about £500m.
True, Italy represents just 1 per cent of BT’s ebitda and the reduction in cash flow is not big enough to imperil the dividend, set to grow 10 per cent this year and next. The group is confident that any nefarious goings-on are confined to Italy. Nevertheless, it reflects poorly on BT that this could have gone on so long without detection (a whistleblower, rather than any internal audit process, revealed the practices). It may have been privatised more than three decades ago but, to a degree, BT still flies the flag for UK plc. It could also do without questions about probity at a time when it has a relatively new finance director and is in delicate negotiations with regulators and pension trustees.
To see why, look at the impact on free cash flow. Analysts had put this at £3.8bn for the year to March 2018, but the company has guided that down to £3bn-£3.2bn. A review of pension funding could require a cash top-up, knocking perhaps another £300m or so off that latter figure. That would put the dividend at 62 per cent of free cash flow, leaving less wriggle room in the event of more nasty surprises.
These may come. Alongside the Italian revelations, BT reported a slowdown in the group’s public sector and global services businesses, which are more material contributors to profit. BT was particularly downbeat on the UK, predicting that 2017-18 will bring a squeeze on budgets in both the corporate and public sectors.
So far, those profit reductions are also smaller than the hit to the share price implies. But shareholders are increasingly worried about the rats, not just the roaches.
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