British Telecommunications as a Company in Transition - Assignment Example

British Telecommunications, which once enjoyed freedom from competition as a government monopoly, is now facing unprecedented challenges from communications providers in every part of the world in which it operates. Over the next several years, BT will continue to confront price pressures in its broadband unit, declining residential phone service sales and a need to keep pace with the rapid technological development occurring in its various industries (BT Group 2006). BT will be forced to make strategic capital investments if it hopes to successfully meet its competitive challenges and invest in potential growth markets. This will require serious decisions by BT management about how to organise BT's capital structure. BT will need to determine an optimal capital structure that will allow it to operate competitively while also maximising the company's value and shareholder value. Fortunately, BT's past and current operations provide the following clear lessons that should serve as guidelines as BT management plans its capital structure for the future: 1) A capital structure based on bank debt, while providing some advantages, creates apprehension among BT investors, which is damaging to share value. 2) BT's current focus on cost savings and retained earnings to fund operations has created heightened investor confidence and has made the company leaner, which will help it compete effectively in markets facing price pressures (Engebretson 2003). 3) As BT makes capital structure decisions going forward, it should adhere to the 'pecking order' philosophy of capital structure, which states that a firm's first choice for financing should be internal funding, followed by debt and then the issuance of equity (Liesz 2001). By remembering the lessons of its past as it plans for a challenging future, BT management can develop a capital structure that will allow it to operate effectively while creating value. Debt: A difficult lesson from the past Like many firms throughout the world, BT became caught up in an acquisition frenzy during the late 1990s and at the turn of the century. In the process, BT relied on a capital structure that was very dependent on bank debt to finance its activities. Richard Fairchild points out that BT management consistently increased the company's level of debt from 1998-2001 and, in the process, investor confidence eroded (Fairchild 2003). Perhaps BT, as a former government monopoly, does not attract investors looking to assume a high level of risk. At any rate, investors took notice of BT's mounting debt and BT's stock price suffered. From 1998-2001, BT's debt increased from 4.8bn to 31bn, mostly from acquisition activities, particularly the licensing rights for 3G (third generation) in the United Kingdom and Germany (Fairchild 2003). Fairchild points out that, during this period, BT's stock price decreased by approximately 65%, eventually leading the company to use a rights issue in 2002, to decrease its debt to 18.4bn (Fairchild 2003). It is hard to blame BT management for increasing the company's bank debt during this period, as this path was followed by several other European telecommunications companies. BT competitors France Telecom, Deutsche Telekom and KPN all have sold or spun-off divisions in the past five years to protect their credit ratings after acquiring high levels of debt (Asset sales to provide new challenge for telco 2006). Analysts described the problem faced by telecommunications providers as a "damned if they do, and damned if they don't" scenario (Asset sales to provide new challenge for telco 2006). In BT's situation, the market clearly was nervous about management's decision to base its capital structure around bank debt. Fairchild points out that when BT increased its level of debt to 31bn, Standard and Poors downgraded BT's credit rating from AA+ to A, which is a reduction of four levels (Fairchild 2003). One could argue that the market was ignoring the various positive aspects of debt in a company's capital structure. As Fairchild indicates, capital structure theorists believe that, in some cases, debt can provide a healthy signal from a company (Fairchild 2003). Management's willingness to take on bank debt can demonstrate management confidence in the firm's prospects and also can increase management's commitment to the company (Fairchild, 2003). One could argue that these positive attributes were behind BT's high levels of debt, because the firm was using the debt for aggressive growth initiatives. However, as Brigham, et. al. indicate, debt financing increases the risk to earnings before taxes, and can lead to uncertain profit levels (Brigham, et. al. 1998). Indeed, BT's profits did decrease during this period and the company even posted a loss in 2001 (Fairchild 2003). This uncertainty over profits may explain why investors reacted so negatively to BT's growing debt. As Fairchild points out, when BT was profitable, it had always maintained a low debt-to-equity ratio, and investors seemed comforted by this (Fairchild 2003). BT was taking its investors out of their comfort zone. Fairchild argues that BT maximised its value when it hit 11bn in debt (still more than twice its 1998 levels), just before the 2001 3G deal (Fairchild 2003). Investors were willing to go along with a certain level of debt in BT's capital structure, but as debt continued to grow they clearly became nervous. The end result was a massive restructuring of BT's capital structure - starting with the rights issue in 2002 - that began a commitment by BT to rely less on bank debt. BT learned that excessive bank debt was damaging to its credit rating and to investor confidence, and these lessons must be kept in mind as BT plans for the present and the future. Present activities: Confidence restored The problems BT had earning investor confidence from 1998-2002 now seem to be in the past. As of August 2006, BT's stock is enjoying an annual high on the London Stock Exchange. During the past 10 months alone, BT's stock price has increased nearly 20%, from 205 to 245. Why this sudden surge in investor confidence It is not because BT's credit rating has improved - in fact, it has not. In July 2006, Standard and Poor's again lowered BT's credit rating, this time to a BBB+, citing, among other factors, "the persistent and aggressive competitive challenges faced by BT" (BT long-term credit ratings cut to BBB+ vs. A-; outlook stable - S&P 2006). But, really, Standard and Poor's pessimism has more to do with competitive concerns about the telecommunications market in general as people move away from residential phone service and some European companies begin offering low-priced - or even free - broadband Internet service (D'Arcy 2006). It is a tough market, but BT seems to have positioned itself well. In 2003, more than a year after BT began its financial restructuring, industry publication America's Network ranked BT the fourth-best-positioned telecommunications provider in the world to meet future challenges (Engebretson 2003). America's Network cited BT's ability to make difficult decisions, its willingness to scrap unprofitable ventures and the fact that "its balance sheet now looks credible," because it had reduced its debt (Engebretson 2003). BT's financial credibility extended throughout fiscal-year 2006 and into the first fiscal quarter of 2007. Revenue for FY 2006 grew to 19.51bn from 18.4bn in 2005, while profits increased to 2.34bn from 2.22bn (BT Group 2006). According to BT's annual report, this growth occurred despite challenges that included a shrinking residential phone market, price pressure in the broadband industry, under-performing investments, and escalating costs for its worker pension program (BT Group 2006). How, in this climate, did BT increase sales and profits, and invest 727 million in research and development to continue to develop 'new wave' markets -- such as networked IT services, broadband and mobile communications -- which now account for 32% of BT's revenues (BT Group 2006) The answer is BT's new capital structure, which is much less focused on bank debt. It is, in fact, hard to imagine BT achieving this level of success while paying principal and interest on 31bn in debt and dealing with sagging investor confidence. However, BT over the past five years has focused on cost cutting and efficiency improvements to free funds for growth initiatives, while continuing to decrease company debt. According to the 2006 annual report, BT saved 400 million in 2006 through programmes that were designed to improve efficiency and streamline customer communications, such as electronic billing (BT Group 2006). Much of that money, according to the report, was reinvested in growing 'new wave' markets (BT Group 2006). "We remain focused on financial discipline and on delivering efficiency programmes that will generate sustainable cost savings," BT management said in the report, adding that the company was committed to saving 400 million in each of the next three years (BT Group 2006). BT seems to be making good on its promise. For the first quarter of the 2007 fiscal year, BT posted a 19% increase in profit, despite just a 3% increase in sales, largely through the company's continued focus on cost savings and efficiency (ComputerWire Staff 2006). BT's new capital structure, which focuses on efficiency, cost savings and internal equity, as opposed to bank debt, clearly has been beneficial for the company. This new capital structure has increased investor confidence and positioned BT well in a changing and competitive market. In fact, BT's new-found financial health has led some industry experts to speculate that it might make a strong target for acquisition by private equity firms who seem to be looking closely at the telecommunications industry (Rosenbush 2006). BT's financial discipline, cost control and profitability seem to demonstrate that its problems of five years ago are behind it. By creating a capital structure that focuses first on internal financing, the company has won back investors and put itself in a strong competitive position. However, BT's capital structure decisions over the next several years, as it deals with emerging challenges, will have the most significant impact on the company's long-term success. Capital structure: Looking forward BT's 2006 annual report clearly demonstrates that BT management is aware that the company, and the markets it serves, are experiencing serious changes. Residential phone service, once the core of BT's operations, is no longer a vibrant market. BT reported that call minutes and market share were both down as customers turn to other communications technologies, such as mobile phones, e-mail and instant messaging (BT Group 2006). BT went on to say in its report that call minutes are no longer a particularly effective measure, because customers now mostly buy communications packages - a situation that would have been inconceivable in the United Kingdom 10 years ago (BT Group 2006). But as the residential phone market was stagnant, emerging technology markets continued to grow significantly for BT. As was previously mentioned, BT reported that 32% of its revenue now comes from new wave activities, such as networked IT services, broadband and mobile communications (BT Group 2006). The lesson here is that the future lies in emerging technologies, but this can be a frightening prospect as well. Competing in emerging markets is expensive, as BT learned when it acquired 3G licensing for the United Kingdom and Germany and significantly increased its debt. In fact, succeeding in emerging markets depends on developing - or gaining access to - the latest technologies before one's competitors. This requires a significant investment in research and development and quite likely the need to acquire companies or licensing rights to access new technologies. BT must continue spending to stay successful, as was evidenced by its significant research-and development investment of 727 million in 2006 (BT Group 2006). BT has certainly been on the acquisition path as well. In April, for example, BT purchased Dabs.com as a means of improving BT's ability to handle large-scale e-commerce orders from businesses and consumers (BT buys Dabs.com 2006). As another example, in 2005 BT bought Ireland-based Cara Group to help BT establish a leading networked IT service business in Ireland and increase BT position in LAN and wireless networking markets (Richardson 2005). As we can see, research and development is only one part of the answer as BT looks for growth opportunities in emerging markets. When BT sees successful companies operating in markets it wants to access, it will need the funds to acquire those companies. This could place strain on BT's capital structure, luring it back to the easy money of bank debt. As BT looks for strategic growth opportunities, it is important that it bear in mind the lessons of the past, that investors and market analysts are wary of the company operating with too much debt. Because BT's credit rating is already suffering due to the competitive nature of the markets it operates in, using large amounts of bank debt makes even less sense. The lessons of BT's past - and the successes of its current operations - show us that BT is best served by adhering to the 'pecking order' philosophy of capital structure. Myers and Maljuf suggest that managers are predisposed to a pecking order of methods for raising funds, with the first choice being retained earnings, the second choice being bank debt and, as a third choice, issuing equity (Cited in Fairchild 2003). Obviously, in the late 1990s, BT strayed from this model and depended more heavily on bank debt. Going forward, the pecking order model makes sense for BT management for a number of reasons. Using retained earnings, as BT has done over the past few years, has forced the company to look for cost savings and to improve efficiency, and this has built confidence among investors and analysts. Also, using retained earnings instead of bank debt will be better for BT's credit rating, which could use a boost. Despite BT's dubious experience with bank debt, it still remains a plausible second option for needs, such as acquisitions, that exceed the capabilities of retained earnings. It is, after all, too simplistic to say that BT investors dislike bank debt. Remember, Fairchild argues that BT had actually maximised its value when it increased its debt from 4.8bn to 11bn from 1998-2000 (Fairchild 2003). BT's investors are willing to go along with a certain level of debt in BT's capital structure, as long as the debt does not become excessive. At this point, issuing equity is a distant third choice for BT as it looks for financing options within its capital structure. As Thomas Liesz points out, issuing equity causes an "inevitable negative market reaction" (Liesz 2001). Investors usually assume bad news is coming when a company issues equity to raise money, and it would make little sense for BT to do anything that would convey such a negative message. BT has made strides to improve its balance sheet over the past five years, but it continues to operate in competitive markets, which has hurt its credit ratings, if not its stock price. However, the negative ripples that would likely be caused by issuing equity could lead investors to question whether they have been over-confident in BT's prospects. Issuing equity could undermine much of the progress BT has made, which is why it would only make sense as a last resort. Pecking order is only a theory, but it is interesting to consider how applicable it is to BT's capital structure. When BT deviated from the pecking order, preferring bank debt starting in the late 1990s, it met with a negative market reaction. As it reverted to a capital structure that focused first on retained earnings, its prospects improved. These lessons need to be kept in mind as BT continues to compete aggressively in its changing markets. Conclusion BT is a company in transition. Its core market, residential phone service, is stagnant and its future lies in emerging communications markets. Competing in those markets means overcoming price pressures and having access to key markets and technology. These are expensive tasks that will require a capital structure that is considered sound by the investment community while also making sure the company has access to the funds it needs to compete. Since 1998, BT has learned important lessons about its capital structure and how capital structure decisions are perceived by the market. BT investors - and BT's credit rating - will not tolerate excessive bank debt. By contrast, using retained earnings to fund its activities has improved BT's balance sheet and allowed it to find costs savings that will help it survive in competitive markets. Pecking order theory provides BT with a model for its capital structure going forward. Pecking order forces company management to look internally first for financing, which allows management to maintain a focus on profitability and cost control (Liesz 2001). Bank debt, as a second option, makes sense because it does have certain advantages and is preferable to the negative reaction companies tend to face when they issue equity. Pecking order offers a disciplined methodology BT can follow as it makes capital structure decisions. Further, it allows BT to learn from its past missteps while building a capital structure that gives the company an opportunity to thrive in the future. Works Cited "Asset sales to provide new challenge for telco bondholders" (2006), Risk Publications, 21 July, Retrieved 17 August 2006 from http://www.riskpublications.com/credit/feb01/news/crednews1.htm. "BT buys Dabs.com" (2006), Channel Register, 28 April, Retrieved 18 August 2006 from http://www.channelregister.co.uk/2006/04/28/bt_dabs. BT Group (2006), Annual Report 2006. 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Rosenbush, Steve (2006), "Fresh barbarians at the gates" Business Week Europe, 14 June, Retrieved 18 Aug. 2006 from http://uk.biz.yahoo.com/14062006/244/fresh-barbarians-gates.html. Read More