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

24th Jan '17 by Edward Croft

32 comments 26807 reads

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.

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.

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…

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AnonymousUser37607

24th Jan '17

Thanks Ed

Absolutely no surprise in the statement:

"It’s worth noting though, that the majority of analysts covering the stock still retained ‘buy’ or ‘strong buy’ recommendations on it before today."

Very insightful article last week in the WSJ on research analysts & the role that the vast majority really play in the securities industry:

http://www.wsj.com/articles/new-wall-street-conflict-analysts-say-buy-to-win-special-access-for-their-clients-1484840659

lightningtiger

I am shocked, I really have a job to comprehend that this has actually happened to BT. This was my first job after leaving school, working as a technician, wiring up all the telephone exchanges, joining up new subscribers, fixing all the faults etc. It was a good secure job and a good company to work for., and a good pension too..
Now reading your report Ed, it is not at all surprising.
With so many flags showing on Stockopedia and a consistent down trend for about a year and the breaking news today,this will take British Telecom a ling time to recover.

Julian Rowe

GUILTY AS CHARGED.
Took my eye off this ball, then stared denial in the face. A belend of hopism, always bad, mixed with an unhealthy ostrich philosophy (a blind eye to Pension deficit, Earnings manip and ).

The Italian arm is 1% of BT's business.
It's main business customers like Govt are cutting back, and competition is looming. BT Sport looks over bought.

I'm back to where I was 2 years ago, having lost GBP1250 today alone. Have we hit bottom? Not at all sure, & holding the BT stock is now a big risk....plus bearing in mind what Stockopedia has shown us is the typical trajectory of a stock 'post profit warning' in the next 200 days is flat and prospect of nothing if not a further fall of 10%.

Nick Ray

Just to play devil's advocate on what the data was telling us about £BT.A I note that it also passes the "James O'Shaugnessy's Cornerstone Value Strategy" screen and the "Buffettology-esque Sustainable Growth" screen. So you can cherry-pick whether the data says that it was about to collapse further or turn the corner.

Cisk

25th Jan '17

The writing was on the wall when they overpaid for champions league, £900 million down the drain. And they can't even roll out fiber properly. My previous local exchange in central London was delayed perpetually, in fact I think it still hasn't happened.

Just shows it takes more than a smooth-talking young CEO to turn a company around. It's obvious they just don't know what to do. Throwing cash at a television business is probably a bad idea. Far better to run the existing business as efficiently as possible and run the 'wires' business as a standalone company. That doesn't seem to have hurt National Grid (LON:NG.) that much? Throw in a decent dividiend policy for the wires business and it would appeal to investors. Ring fence the pension liabilities.

Now BT if you read this you don't need to pay those overpriced management consultant monkies millions to fix your problems. It's all common sense.

Edward Croft

So you can cherry-pick whether the data says that it was about to collapse further or turn the corner.

Indeed this is true. Fundamental data can be in conflict at times. But that's why it pays to read between the lines. One point I didn't mention above was the StockRanks were highlighting BT as a potential Value Trap. The Value Rank was in the high 60s, while the Quality Rank and Momentum Rank were low. This is the classic fingerprint of a Value Trap in the StockRank styles taxonomy - it's worth reading the guide on the subject here or my webinar here.

BT's has behaved almost archetypally from the factor-investing point of view. It's risen when the QVM factors were strong (doubling as a 90+ ranked share) but then fallen dramatically as the quality and momentum ranks sagged.

BT was in my original 2015 NAPS portfolio rising from 401p to 471p - a 17% rise over the year. It was then ditched at the year end as the ranks had fallen and it no longer qualified. Rebalancing is a crucial aspect to earning the value & momentum premiums available in the market.

I hope there aren't too many bruised holders out there. My intention with this piece is certainly not to rub salt in any wounds - I just wanted to highlight some of the red flags that might have helped people make good decisions on the stock. A single flag for poor momentum or quality is not necessarily a cause for concern, but when there are many red flags it's definitely worth taking note. Leverage and Earnings Quality Risks in combination can pack quite a punch. Those insights might be useful when reviewing other portfolio holdings.

Bonitabeach

Ed,

I would add a seventh:

Appalling Customer Service & Poor Value For Money

I write as an ex-BT customer both in the commercial and domestic environment. Far too many competitors offering much better service & prices. It also made me sell my modest holding!

No position.

JohnEustace

This should hurt BT badly. It's really only the Openreach monopoly and the reassurance of the familiar brand name that gets them customers. Having in the past had to deal with significant business billing disputes with them and been given the runaround for years I have a strong feeling of schadenfreude tempered by sympathy for the good employees who will be impacted. Customers who leave them generally breathe a sigh of relief and don't return.
That experience kept me away from their shares.

tacoman

Casting my eye over the Stockopedia page once I heard about BT I can honestly say that I would not have been anywhere near BT and a lot of this has to do with the great clarity of information presentation we get on Stockopedia. The Stockopedia UX team is top-notch. The signs were all there and I consider myself a Stockopedia novice! Well done Ed

Campbell Crockatt

Great Article Ed,

I appreciate (most of) the many subtleties of what you are saying. E.g. "Buyer Beware!"

My suggestion - that this BT situation - could form a useful (real world example) and Appendix - to your Webinar on Profit Warning.

Kind Regards

Campbell

brucepackard

Ed, very good post.
I just thought I'd point people towards this note by the stockopedia contributor http://www.stockopedia.com/contributors/uk-value-investor/

Perhaps these are a bit more qualitative than a Benesh M score, and the stock ranks...but he did publish the article in July 2016!
https://www.ukvalueinvestor.com/2016/07/bt-shares-could-be-risky.html/

dealtn

BT's Italian business makes up a very small, even insignificant, part of the business. Whilst it certainly reflects badly on senior management, the reality is that yesterday's fall was (much) more to do with earnings guidance going forward, and little to do with quantifying a known accounting fraud.

Indeed whilst some comments above flag poor customer service issues, frankly if you have a large enough company with literally millions of customers, it would be remarkable were it not possible to find dissatisfied individuals.

The big news was in the commercial (business not personal) division.

Whilst there is no doubt some truth in each of the points raised in the article, and accusations of cherry picking are valid to some extent (and to be fair accepted by the author) it is too easy to say in hindsight this was avoidable.

Investor sentiment, and momentum, have clearly gone against the company right now, but in the longer term I am not so negative as most it would appear. The BT sports roll out, and EE access to an increased personal customer base are positive, and demonstrations of management able to change a business strategy (not easy I would imagine with a goliath). I also feel that the "pension" hangover will turn out to be good thing, rather than a "ball and chain", as the discounting rate used for the liabilities will (eventually) adjust to where long term yields will get to. I accept I am very much in the minority with respect to this view though, although extremely comfortable being a contrarian.

Getting the timing right on investing here will be the difficult part of the investment case for me.

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

1 - A High Earnings Manipulation Risk

2 - A Falling StockRank

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Edward Croft

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