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Six red flags that could have saved you from the BT Profit Warning

This article was contributed by Stockopedia

Nearly £7 billion of value was wiped out today in BT, formerly British Telecom, after the phone giant revealed that an accounting scandal at its Italian subsidiary was much bigger than first thought. For around 1 million individual shareholders, this sort of massive collapse at a FTSE 100 blue chip is very rare, and very bad news.

We’ve taken a look at the Stockopedia StockReport, a page that’s packed full of algorithmic insights into the company’s finances - to see if these problems could have been anticipated.

This one page online summary of the company gives every investor the insights they need to avoid these kinds of large cap catastrophes.  Let’s take a closer look and learn to read some of the signs:

1 - A High Earnings Manipulation Risk

While BT’s shares have been tumbling for some time, today’s enormous 20% mark down was triggered by the escalation of an accounting scandal at their Italian subsidiary. Auditors KPMG uncovered a serious overstatement of earnings in its Italian subsidiary over a number of years.

"These investigations have revealed that the extent and complexity of inappropriate behaviour in the Italian business were far greater than previously identified and have revealed improper accounting practices and a complex set of improper sales, purchase, factoring and leasing transactions."

Can these kind of accounting scandals really be predicted?  Well yes, they often can.  The Stockopedia StockReport contains a neat metric called the Earnings Manipulation Risk. This indicator has been flagging as “High Risk” for BT for some time.

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Based on the work of Professor Messod Beneish, this forensic algorithm for finding accounting frauds has spotted a ream of high profile issues in the last two decades including Enron and Worldcom. By clicking the link on the indicator a set of risk factors is highlighted for BT including:

  • A disproportionate increase in receivables suggesting that the company may have been inflating sales figures by booking sales earlier or extending better credit terms to customers.
  • Unstable asset quality - which Beneish explains is a possible sign of improper capitalization of expenses and cost deferral.  Another common accounting fudge.
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    These sorts of accounting insights are just one click away on the Stockopedia StockReport.

    2 - A Falling StockRank

    BT had been one of the large cap stars in the UK market recovery from the global financial crisis.  From a low of 73.5p in 2009, the shares rocketed to peak above 460p at the start of 2016.  During this rise the Stockopedia StockRank had been consistently above 90 - putting it among the top 10% of ranked shares on the London Stock Exchange for a blend of fundamental and technical leading indicators.  

    But the shares dipped below a StockRank of 80 in June 2015 and have been consistently falling in the 18 months since.  Low StockRank shares have significantly underperformed the market in the last 4 years, and BT’s rank reached a new low of 46 just before today’s profit warning.

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    You can investigate the StockRank performance history of the market at this link.

    3 - A Growing Debt Pile

    Following the recent £12.5 billion acquisition of EE, the liabilities on BT's balance sheet have risen to over £30 billion.  The acquisition did bring BT's balance sheet comfortably back into positive (from negative) equity, but a closer analysis of the numbers reveals a few insights.

    The company received a cautionary flag on our Bankruptcy Risk Meter - based on the Altman Z-Score - which indicates a moderate risk of ensuing financial difficulty.  

    In particular, across the Altman Z-Score risk factors, BT fails on two questions -  ‘Are liquid assets a significant proportion of assets?’ and ‘Does firm value compare favourably to its liabilities?’  The first suggests that the company is highly illiquid and the second that the company’s liabilities are very large relative to the company’s market capitalisation.

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    The increasing leverage and liquidity risks had put the stock on the watchlist of bear raiders looking for fundamental reasons to short the stock.

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    4 - A Huge Pension Deficit

    BT’s enormous pension deficit is no secret, it has been the subject of much debate in recent times with speculation that the deficit could threaten dividend payments.  A recent report by MSCI found that BT had the second worst funded pension plan on the planet !

    At the end of September 2016, the deficit stood at around £11.5 bn while the trailing twelve month (TTM) Net Profit stood at £2.7bn.  This suggests that the deficit will continue to soak up a significant proportion of shareholder’s funds annually for the foreseeable future.

    Taking a look at the StockReport, we can see the pension adjusted gearing figures at the right of the "Leverage" box. 

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    Once you factor in the deficit it turns out BT is very highly geared indeed.  Highly geared companies can perform well while profits are growing and stable, but create dramatic risk when they are not.  Unfortunately, BT has followed this pattern today with the announcement of the write-down.

    If you want to learn how to read the pension deficit data on Stockopedia StockReports, please watch Stockopedia Financial Analyst Tom Firth’s introductory video here.

    5 - Flagging 1 Year Relative Price Strength

    Shares in BT have been under consistent pressure since the start of 2016. There was a sudden reversal in the group’s 5-year price trend at that point, signalling that the market was, at best, uneasy about the outlook.

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    As a result, 1-year relative strength against the market was a woeful -35.0% before the profit warning. At the close yesterday, the shares were already down 18.8% over 1-year, with particularly heavy selling volume in the second half of 2016.

    Momentum is one of the strongest leading indicators of future price trends and makes up a big part of the Stockopedia StockRank.  BT’s poor momentum was a strong indicator that institutional holders were concerned about the stock and that continued downward pressure was likely.

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    6 - Broker Downgrades & Estimate Cuts

    Analyst earnings forecasts have been falling at BT for 12 months - down from from 31.4p per share to 29.6p. On the surface, that’s a relatively small adjustment, but it does signal that the consensus of BT’s analysts were cooling their expectations.  Really this factor on its own was not enough to predict the announcement, but combined with the other factors should have magnified the concern.

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    It’s worth noting though, that the majority of analysts covering the stock still retained ‘buy’ or ‘strong buy’ recommendations on it before today. That reinforces the surprising element of the announcement, and the fact that analysts appear to have been unable to detect the true extent of the problems ahead of time.

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    For an analysis of how poor broker buy recommendations are as a predictive factor in stock markets  - please do read this piece "Can you beat the market using broker buy recommendations?"

    What Next?

    British Telecom was privatised in 1984 and it’s one of the biggest household names in the country. Millions of us are exposed to its performance through direct holdings, pensions and funds. So for an accounting scandal to wipe out a fifth of its value in a single day is horrifying - even though there were signs that this was an investment facing trouble.

    Profit warnings like this are an investor’s worst nightmare, often leaving them with no idea how to respond. However, research by our team at Stockopedia shows that, on average, when faced with a profit warning the wisest course of action is often to promptly sell.

    Our research shows that the average profit warning is preceded by at least six months of price pressure, followed by a 20% collapse on the day. This is exactly what we’ve seen from BT. The bad news is that the share prices of profit warning stocks often fall further over the next two to three months. They can then take up to a year before showing any signs of recovery.

    If you’d like to learn more about the insights into what to do when faced with a profit warning - click here to download the Profit Warning Survival Guide.




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