BT Looks to Home Comforts Amid Italian Crisis

The impact of BT's accounting scandal in Italy became more apparent on Friday as the UK telco reported a sharp fall in profit and had its outlook cut by ratings agency Moody's. (See BT's Patterson Feels Italian Heat, Eurobites: BT's Italian Bother Claims Sciolla's Scalp and Dodgy Italian Job Savages BT Earnings, Share Price Tanks.)

Headline figures for the last three months of 2016 -- BT's fiscal third quarter -- were buoyed by the takeover of mobile operator EE last year, but underlying revenues shrank by 1.5%, said BT, revealing pressure at all of its non-consumer businesses.

Thanks to the inclusion of revenues from EE, third-quarter sales rose 32%, to about £6.1 billion ($7.7 billion), compared with the year-earlier period. But BT's profit before tax fell 37%, to £526 million ($659 million), because of costs incurred as a result of accounting irregularities in Italy that have turned out to be more serious than was thought in October, when they first came to light.

After BT Group plc (NYSE: BT; London: BTA) revised down its outlook earlier this week, guiding for no sales growth this fiscal year and next, the company's share price lost about a fifth of its value on the London Stock Exchange and has since failed to recover. The share price was trading up almost 2% at the time of publication, at 308 pence, remaining well below its level at the start of the week (384 pence).

Concern has grown about a number of challenges facing BT besides the impact of the accounting scandal in Italy, where the UK telco offers Ethernet, cloud, VPN and other products through its global services division. Conditions in the UK public sector and international corporate markets are deteriorating, said BT, and analysts are worried about growing debts and a large pension deficit.

In a statement released late on Thursday, Moody's said it had revised its outlook on BT to "negative" from "stable" following the operator's own adjustments.

While the Italian business accounts for a tiny fraction of BT's revenues, its overstatement of results has forced BT to make huge balance-sheet write downs and signals "less than adequate operational controls at BT Group level," according to Moody's.

Due to a recent hike in the pension deficit, BT's leverage ratios also exceed the threshold normally tolerated for its Baa1 rating, says Moody's, with adjusted debt currently equal to about 3.5 times annual earnings (before interest, tax, depreciation and amortization).

"So far, we tolerated a higher pension deficit because it was balanced against our expectation of BT's improving operating performance," said Laura Pérez, lead analyst for BT at Moody's. "However, the profit warning will further delay the deleveraging that we had anticipated in a context of relatively high leverage ratios for the current Baa1 rating."

Besides predicting that sales will not rise this year and next, BT is forecasting adjusted EBITDA of about £7.6 billion ($9.5 billion), some £300 million ($376 million) less than it was previously expecting. EBITDA is expected to remain "flat" in the 2017/18 fiscal year.

During an earnings call with analysts, BT's under-pressure executives insisted the operator had the situation in Italy under control and that new measures would guard against similar abuses in future.

"We have moved swiftly to strengthen the finance organization and taken steps to make key changes to processes and controls where we identified weaknesses," said Simon Lowth, BT's chief financial officer.

BT is targeting a return to profitability in Italy in the 2018/19 fiscal year and CEO Gavin Patterson would not rule out a divestment of the asset should the operator miss this objective.

Despite expressing confidence in the product portfolio of the overall global services division, he also hinted that BT might look into selling parts of the business if improvements are not forthcoming.

"Expectations around the pipeline are not as strong as expected… and there are too many bespoke contracts which adds unnecessary cost," he told analysts. "There is a lot we can do and if we can't in a particular subsidiary we will look to see if it is more valuable to someone else -- we are looking seriously into the future of global services."

Foreign exchange movements combined with the acquisition of EE led to an 8% year-on-year increase in revenues at global services in the third quarter, to about £1.4 billion ($1.8 billion), but underlying sales were down 7%. Excluding revenues from the Italian business, they would have fallen by 2%, said BT.

Similar pressure was evident at the telco's business and public sector unit, where several contracts are expiring and BT has failed to land new deals. Once again, the takeover of EE boosted headline sales by 15%, to about £1.2 billion ($1.5 billion), but underlying revenues dropped 6%.

As regards the business sector in BT's domestic market, Lowth was keen to downplay analyst anxiety about the uncertainty facing banking-sector customers in the wake of the UK's decision to leave the European Union. "I think when it comes to financial services we feel quite confident about our relationships but it's true that the sector faces challenges in terms of regulation and some uncertainties," he said. (See What Hard Brexit Means for Vodafone, BT.)

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