BT Group (LSE: BT-A) (NYSE: BT.US) leaped ahead of the wider market last year, delivering a stunning 64% gain for investors, compared to the 14% price gain delivered by the FTSE 100.
The good news seems to keep on coming, too — last week, BT reported an 8% increase in pre-tax profits and record numbers of new fibre broadband customers.
So what’s the problem?
BT’s gigantic pension deficit is no secret, but last week’s news that the firm’s pension shortfall rose by almost 9% to £7.3bn during the final quarter of 2013 came as a surprise.
To put this into context, £7.3bn is nearly double BT’s £7.6bn net debt. What’s more, BT’s pension deficit is beginning to look out of control, as it has tripled in less than three years, from £2.4bn in June 2011, to its current value of £7.3bn.
Why is it getting worse?
BT blamed the rise on ‘an increase in market inflation expectations’, which will mean that index-linked pension payments will rise faster, increasing the fund’s liabilities.
However, this news might surprise to investors, who have seen gilt yields rising and current inflation levels falling — a combination that was expected to lead to a reduction in pension deficits for companies such as BT.
For private investors, the technicalities of pension deficit calculations are less relevant: the big question is how is BT going to dig itself out of this hole, and will it lead to falling profits, or even a dividend cut?
What will happen next?
The next triennial valuation of BT’s pension scheme is due later this year. Following the last review, in 2011, BT agreed to make nine annual additional payments of £325m, from 2013 until 2021, a reduction from the £525m annual payments it was making until 2012.
Given the rapid rise in BT’s pension deficit, the scheme’s administrators may decide that more decisive action is necessary, and might try to reverse this year’s payment reduction.
If this, or something similar, happens, then BT’s dividend could be threatened, as its debt levels would be likely to rise, meaning that more of its cash flow would be required to fund interest payments.
BT shares already yield a below-average 2.8% — any threat to the firm’s expected dividend growth could result in a rapid re-rating of BT’s share price.
