Warning bells ring at BT: The telecoms giant has problems, say Mary Fagan and Richard Thomson

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The Independent Online
THE third British Telecom share sale is the kind of deal the City loves. Almost everyone in the Square Mile, it seems, is in on the action - and there is plenty of it. This time, almost certainly, the whole of the remaining 22 per cent stake held by the Government is on the block, which will net the Treasury more than pounds 5bn.

As usual with such large share offerings, impartial opinions about the issue are scarce. Investors are left to do their own analysis of the issue or to rely on a mere handful of stockbrokers not involved in selling the shares. Not surprisingly, it is highly unusual to hear a bad word about BT in the Square Mile just now.

As with most large share sales, there is likely to be a fairly large discount in the issue price. Around two-thirds of the issue, moreover, is likely to go to private investors, as in the previous BT share sale, leaving institutions bidding for the stock in the after-market. Normally, these factors would ensure that the shares rise to an attractive premium after the sale.

But a few dissenting voices are warning investors that the shares may not be as attractive as they are cracked up to be by the general swell of City optimism. 'The assumption that the price will rise sharply could be wrong this time,' said John Tysoe, analyst at SocGen Strauss Turnbull. 'After the issue, the performance will be lacklustre.'

James Dodd, of Kleinwort Benson, agreed. 'If the market believes BT's earnings are about to fall, the price won't bounce up,' he said, adding: 'The shares could well become a yield stock like the water or electricity companies.'

Last week, Kleinwort published a hard-hitting attack on the conventional view that BT is a safe bet because of its recent cost-cutting measures and drastic manpower reductions.

The consensus in the City is that BT will announce on Thursday pre-tax profits of around pounds 2.5bn for the year to 31 March 1993, compared with pounds 3.1bn in 1992, but picking up again strongly in the current financial year. Provisions for redundancies are likely to be blamed for much of the drop in profits, as BT is currently shedding 15,000 people a year.

But Kleinwort is predicting flat or declining earnings from 1995. BT, it believes, is about to be pole-axed by sudden competition from cable companies in Britain and by its inability to expand into equally profitable businesses overseas.

BT's policy, under chairman Iain Vallance, of jacking up domestic telephone rates has made the market ripe for competitors. Cable companies, mainly from the US, have recently discovered an insatiable demand among British phone users for an alternative to BT, with thousands each month signing up for the alternative services. 'This is serious because BT's local calls are the most expensive in Europe,' said Mr Dodd. It is a crucial source of earnings for BT but one that is very vulnerable to attack. The cable companies could be raking in revenues of up to pounds 1bn within five years, largely at the expense of BT.

This, coupled with BT's tough new price control formula, due to take effect in August, could bite from 1993/4. The Kleinwort report concludes: 'With such an earnings outlook, it is most unlikely that BT will be able to offer sustained outperformance relative to a market where corporate earnings are recovering sharply.'

BT admits that healthy future earnings growth requires expansion outside the UK, but this is fraught with problems. 'Acquisitions are one of the highest-risk corporate activities there is,' warned Mr Dodd. 'BT will be losing some of its UK earnings - where profit margins are around 30 per cent - and trying to replace them with lower-yield, riskier overseas investments.'

BT has already been frustrated in its attempts on US markets by withdrawing from both McCaw and Electronic Data Systems, because it could not win full control of either.

To succeed abroad, moreover, BT must also leap the regulatory hurdles of telecommunications in other countries. The company is waiting for the outcome of an application to the Federal Communications Commission to be allowed to offer international services from the US. It is being hotly opposed by AT&T on the grounds that the UK market is insufficiently open to foreign companies.

The very public debate between BT and AT&T, however, may do no harm to the BT share sale. Investors in the US have traditionally taken a positive view of telecommunications and no doubt realise that BT, with its experience in the UK, is well-placed to take advantage of liberalisation and competition in other countries.

If liberalisation takes years to come about, however, BT will be hard-pressed to find a way of investing its growing cash pile and replacing UK earnings. It could eventually be forced simply to use its cash to pay higher dividends, but there is no sign as yet that the company's management has any intention of doing so.

'This will remain a recurring problem for BT,' said Mr Tysoe.

Even the bears concede that there are two crucial points in BT's favour. One is that, for once, the regulators will not unsettle the share issue.

Donald Cruickshank, who took up the post of director general at Oftel last month, seems determined to stay silent while the sale goes ahead. The view in the City is that Mr Cruickshank will not interfere with the new pricing regime agreed between BT and Sir Bryan Carsberg, who left Oftel for the Office of Fair Trading last summer. That formula will keep annual price increases on BT's 'basket' of basic services to inflation minus 7.5 percentage points when it takes effect in August. The current formula is 'RPI minus 6.25' and the change is considered a challenge for BT.

The other favourable factor is cost-cutting. BT can still make huge savings by reducing its staffing levels. Thousands of jobs are still to go, and these cuts will, Kleinwort agrees, eventually save billions.

In the medium term, however, the company seems likely to suffer. It may take years for the cost-cutting benefits to come through, while BT faces pressure from competition already. Heavy redundancy costs will push profits even lower.

Whatever the bulls of the BT share issue may say, investors are likely to treat the company with considerable caution. BT will not have the future all its own way.

(Photograph omitted)