Telecoms regulator Ofcom fired a warning shot across the bows of BT Group (LSE: BT-A) (NYSE: BT.US) this morning.
The regulator said that spinning off BT’s lucrative Openreach infrastructure division “could deliver competition or wider benefits for end users”.
Openreach is the BT division responsible for providing the broadband infrastructure used by both BT and resellers such as Sky (LSE: SKY) (NASDAQOTH: BSYBY.US) and TalkTalk Telecom Group, which buy broadband capacity and services wholesale from Openreach.
The risk has always been is that BT has an obvious incentive to operate Openreach in such a way as to provide a less efficient service for these competitors.
There’s also a twin temptation for BT to use some of the profits from Openreach to subsidise its other businesses — most obviously its television venture.
BT denies these accusations, but this morning’s Ofcom statement made it clear that the regulator still has concerns:
“[separating Openreach] would remove BT’s underlying incentive to discriminate against competitors.”
To be fair, Ofcom did admit that separating Openreach wouldn’t necessarily be a magic solution, commenting that it might not address concerns relating to service quality and the timing and level of investment decisions.
BT investors — don’t panic!
It seems pretty clear that being forced to spin-off Openreach would be bad news for BT. However, any decision is a long way in the future, and Ofcom is considering other options such as strengthening the existing rules relating to BT’s wholesale services.
BT is strongly opposed to a split and has fended off previous attempts with the help of intensive lobbying. I think a forced spin-off is unlikely.
However, if a split did happen, it could provide an interesting investment opportunity for dividend investors. An independent Openreach would almost certainly end up as a FTSE 100 listed utility, which could be an attractive income buy.
What about Sky?
There are probably few things Sky’s management would like more than a chance to level the playing field in broadband, where BT enjoys many of the advantages of a monopoly.
Sky has no choice but to buy its broadband services wholesale from BT, despite the telecoms firm fast becoming Sky’s biggest competitor for television sports rights in the UK. BT’s aggressive bidding has almost certainly pushed up the costs paid by Sky for its football rights.
It must be frustrating for Sky to be funding the profits of one of its main competitors.
Should you buy Sky or BT today?
Both BT and Sky look quite fully valued at the moment. BT trades on a 2016 forecast P/E of 15.2, while Sky looks dearer on an equivalent P/E of 17.7.
Both offer a prospective yield of about 3.1% and generate enough free cash flow to comfortably cover these payouts, despite high levels of debt.
Where they differ is in profitability. BT’s operating margin has risen from 10.3% in 2010 to 17.8% last year That’s impressive.
Over the same period, Sky’s operating margin has fallen from 19.5% to 13.5%. The firm’s bold expansion into Europe aims to address this decline, but it’s worth monitoring.
I think both companies are a cautious buy today, although personally I shall be waiting for a cheaper opportunity.
