Source: BT Group

The Global Services Division has been a shining star for BT so revelations that the tide has turned were not received well by investors.

Encouragingly sales at the division were strong up 15 percent to £2.2 billion. The unit secured contracts of £1.8 billion in the second quarter, making £8.4 billion achieved over the last 12 months. BMW figured among the wins.

The issue for the Global Services was one of profitability, margins were hurt by ‘slower than anticipated delivery of efficiency savings’ and a decline in higher margin UK Business. Given our view that corporate capex commitments are likely to continue contracting, particularly in the UK, management are right to swing into action.

Paying the price is division CEO François Barrault. His replacement Hanif Lalani has been assigned the code red task of reducing the cost base, whilst keeping sales growth going. He has moved sharply, having already identified £40 million in instant efficiencies.
 
We are confident that the division will get back on track. And the sooner the better. A margin contraction to between 7 and 8 percent at the division (BT had a target of 15 percent by 2009/10) is the primary culprit behind the group’s full year profits warning with group EBITDA set to show a ‘small decline’.

BT’s other divisions meanwhile look set to perform solidly, despite a weakening economic picture, particularly given management’s pre-emptive measures

The retail division continues to offset declines in traditional voice revenues with stellar growth in other higher margin ‘new wave’ areas such as broadband and network IT services. Turnover held up at £2.2 billion. BT remains the number one broadband supplier in the country with 4.6 million customers and revenue growth of 12 percent year on year. Whilst the market is maturing, BT has unsurprisingly shown a clear ability to grab those that are on offer. Superior customer service of course never goes to amiss, and in a belt tightening, buyer’s market. BT should continue to have the edge.

BT Wholesale meanwhile continues to make headway with the decline in revenues and profitability continuing to abate. The source of the wholesale division's declining growth goes back to 2006, when on the back of regulatory pressure BT's local network was opened up to competition. BT has combated the effect through growth in managed network solutions. During the quarter BT did a deal with T Mobile and 3 UK.

A further boost to the division will come as BT’s high speed 21st Century Network is rolled out. The £10 billion IP based network is now set to reach 10 million homes and businesses by 2009. BT has signed long term Ethernet service contracts with four of the five main mobile operators.

On the flipside BT’s Openreach division continues to benefit from “local loop unbundling”, the process which allows companies to install their own hardware in local telephone exchanges, thereby reducing network access costs and BT Wholesale's revenue.

Although remedial action has been taken at the Global Services division, and the outlook is positive at the other divisions, management are realists. Given the clear headwinds facing the global economy we are heartened by management’s pre-emptive strike to shore up profitability.

BT is cutting 10,000 jobs from its 160,000 strong workforce. The focus will be on voluntary leaver. Indeed 4,000 of the posts have already gone, with excess layers of management stripped out. Management as a result are confident of delivering £700 - £800 million in cost savings this year. Stripping out the fat is no bad thing, and indeed a healthy and necessary move that many companies will need to make as part of the economic downturn.

The company’s financial footing has also been boosted by a landmark agreement with unions over the company’s pension. Raising the retirement age to 65, increasing member contributions and changing from a final-salary link to average earnings will reduce liabilities and lead to £100 million in cost savings a year. Encouragingly, the pension has already moved from a deficit in the first quarter to a £600 million surplus.

So all in all the outlook for BT appears positive, despite the dramatic sell off in the share price. We believe that the measures put in place will underpin long term gains in profitability, and we do not see the massive earnings contraction which the current valuation implies.

As for the dividend, it is quite possible that BT will be able maintain the current payout, which would make a nonsense of the current yield. Even a trimming of the dividend will still justify cause for a re-rating.

Accordingly, BT group will remain held in the Fat Prophets Portfolio.