One of the biggest stories to hit the FTSE index for a while surrounds BT Group, who have uncovered an alarming discrepancy during an audit of their Italian businesses. In the main, this seems to have revolved around the incorrect allocation of sales, and also complicated factoring, purchasing and leasing transactions. Because of the accounting treatments of the latter, we can easily see how this can affect profit and hence how we value companies.
Scandals are nothing new – after all, we’ve seen the Tesco scandal erupt in past years (which its share price is still paying for) which ran along similar lines. A slight difference here is that the BT issue seems to have occurred over several years. Which seems to imply that these irregularities have survived many audits, both internal and external which raises further questions.
As we can see, the share price took a fairly hefty hit:
At one stage, the share price did threaten to go under 300p, but recovered a little. So the questions are, can this be a good recovery play? This will always be a tough question, because as we can see, there is plenty of insider information unknown to us and many things can be disguised so that they are not as they seem.
Why did this occur?
It seems to me that the causes of scandals like this are something structurally inherent within a company. Some of the chief causes are:
- Managers performance appraisal being tied to profits
- Managers remuneration also being tied to profits or the share price
- Pressure to present good figures to the stock market, for a ‘smooth’ effect
- Lack of controls from the head office, who may accept assurances from others
- Poor audit facilities, or not enough depth into transactions
- Too close a relationship with the auditor, who may not raise the alarm for fear of rocking the boat
Any of these reasons can be correct, although the scale of which it has happened suggests that management at the very top had to be aware of the gaming of the figures going on. You’d have to expect some pretty high profile heads to roll.
What’s the damage?
On paper, the damage is huge: around £530m of the value of the business has to be written off. Earnings have been overstated in previous years thanks to these accounting practices, and now this position has to be unwound to reflect that.
In the context of the company itself, the damage is not so big. BT Group still has a market capitalisation of around £30bn even at todays low share price, so we can see that £530m is a very small percentage of that.
What might be more meaningful is potential reputation damage that has been caused. Customer-wise, I feel this is less damaging than another event such as a database hack. The service standard to most people would have been unaffected, and most people could accept an explanation that the company was trying to bend the rules for financial reasons only. The bigger question may be around ethics and integrity – if its happened here, could this be part of a wider-scale problem at BT? If it is, the pain could be felt further.
Is there an investment case?
Looking at the figures from Youinvest, there still seems to be a compelling case to invest in BT. A former monopoly, they still retain a large swathe of the market. It’s unlikely that fixed telephone lines will go away any time soon (although an improvement in internet technology may reverse that), and BT are the largest provider of these in the country. For my money, they have also diversified very well; their internet and TV provisions are certainly up there with the markets best. This is reflected in the figures:
The company are consistently profitable, and have a very stable turnover. Most impressively over the last 5 years, EPS has risen tremendously, outstripping the rise in profits. Dividend per share has also risen year-on-year for the past few years and the yield is projected to be around 5% for this year. One rather large fly in the ointment is the debt levels here, which at a high, but manageable level. This level of long-term debt has been increasing over the years. Coupled with a pension deficit and large investments in football, there are a few risks here to think about.
As we can see, taking the hit now would almost certainly put a stop to these trends and account for a significant part of profits. But as long as this issue was isolated, there is no reason why the trend may not resume in future years.
Do we buy?
Despite the few problems we have I don’t really have a problem with BT – I think it’s a well-run company. This type of thing I feel would be a classic Buffett play. He wasn’t a fan of debt, although my view is that debt is cheaper to the company than equity.
Maybe I’m being greedy, but my own price targets are a little less than this so I won’t be getting involved just yet. I certainly think it’s good value at the current price, but to allow for some extra upside I am willing to wait a while and see if this can be picked up at sub 300p or even sub-290p. We’ve had a recovery of sorts today but as the fallout from this continues there may well be more volatility in the price of the shares.