Just as in early 2003 when the market last took a severe nosedive, worries have resurfaced about British Telecom’s dividend and whether it will be cut after the next triennial review of the Pension Scheme which falls due on 31 Dec 2008.  The concern is that extra cash will need to be paid into the Pension Scheme and that the only way this cash will be found is by reducing the dividend (which costs £1,223 mln per annum at the current rate of 15.8 pence/share).

The last review of the Pension Scheme in Dec 2005 resulted in BT agreeing to pay £280 mln top-up payments annually for 10 years.  BT paid £840 mln by April 2007 and the next top-up payment will fall due in Dec 2009.  However the trustees of the Scheme have since sold down the equity exposure to 35% of the fund’s assets (it was 60% at 31 Dec 2005).  Wide credit spreads help to reduce the liability side of the Scheme with the result that it was actually in surplus by £600 mln as of 30 Sep 2008 (when the FTSE was at 4,902).

However BT has not been letting the grass grow under its feet and is currently in negotiations with its Scheme members to move to career average rather than final salaries, increase member contribution rates, raise the pension age to 65, lower the accrual rates, etc.  All this helps to reduce the risks of running the Pension Scheme from BT’s perspective by lowering mortality risk and inflation risk.  According to BT’s latest results, the cost of running the Scheme will be reduced by £100 mln annually.

Cutting 10,000 jobs (4,000 BT employees and 6,000 contractors) will also save in the region of £300 mln annually (using UK annual average earnings of £24,900 and adding in the employer NI and pension contributions that will no longer be paid by BT).

Another favourite cost-cutting trick used by telecom companies in tough times is to reduce capex.  In its July 2008 announcement about Super-Fast Broadband, BT forecast capex of £3.2 bln in 2008/9 and £3.1 bln in 2009/10.  This follows capex of £3.3 bln in 2007/8.  However, I am not assuming BT will cut capex to maintain their dividend.

The problems disclosed by BT in its Global Services business unit, resulted in Q2 ebitda falling from £186 mln in 2007 to £119 mln in 2008.  This is below the quarterly D&A charge of £172 mln, resulting in an operating loss of £53 mln.  There must be doubts over whether the £8.4 bln of contract wins (over the last 12 months) have been won at high enough margins to generate a profit.  Using the mid-point of the new 7%-8% ebitda margin guidance on full year revenues of £8.8 bln, BT Global Services’ ebitda will fall by £200 mln in 2008/9 from £861 mln last year.  The reason the market was so upset was that margins in this division were around 11% last year and BT was trying to lift them towards the 15% level.

If we follow the money, last year BT Group’s pre-tax profits were £2,506 mln.  Subtract the £200 mln shortfall from the Global Services division and assume the cost of redundancies is equal to the £300 mln annual savings, this reduces pre-tax profits to £2 bln.  Apply the 24.5% tax charge that BT usually seems to attract and this equates to distributable earnings of £1,510 mln. 

Hence maintaining the £1,223 mln annual dividend will be a close call as it essentially all boils down to what contributions BT agrees with the trustees of its Pension Fund.  However Pension Scheme equity exposure of 35% is not excessive and the changes to the Scheme BT is proposing to its employees will help to avoid the cost of the Scheme spiralling higher.  A 2006-sized top-up payment of £520 mln would trigger a dividend cut.  However interest rate cuts do benefit BT with its £11 bln net debt and earnings will rebound once the one-off cost of redundancies falls away, so if the dividend is cut then it is likely to be trimmed rather than slashed.  On a different valuation metric BT shares at 135p are hardly expensive on an EV/Ebitda of 3.7x whether the company reduces the dividend or not.  Worth buying a few and waiting until next year to see what BT agrees with the Scheme’s trustees.

Should you be taking up your entitlements to extra bank shares?  We will use RBS as an example here but the same logic applies to LLOY and HBOS.  An important advantage a private investor has over institutions is that they can take a multi-year view as opposed to worrying about how their performance will look at the next quarter-end.  This analysis is very broad-brush and simplifies much, but then who said investing had to be overly complex.  To rehash a Warren Buffet quote – “If it takes more than elementary maths to understand then don’t bother investing”.  The UK Government decided recently that in order to boost confidence in all UK banks, they should have much higher Core Tier 1 capital ratios than the prevailing 6%-ish levels and that in order for the banks to raise the necessary capital in a hurry the Government would provide the extra capital, if necessary. 

There were approximately 16.5 bln RBS shares outstanding before the UK Government agreed to underwrite a £20 bln capital raising.

£15 bln will be raised by issuing roughly 22.9 bln new shares at 65.50 pence.  The other £5 bln comes from preference shares issued to the UK Government.  Assume that in the next few years, once RBS has made its write-offs and the dust has settled, it gets back to making the £10 bln p.a. that it made in 2006/7 (higher net interest margins will help this profits rebound).  Assume further that it makes a 10% pre-tax return on the £20 bln of new capital it has just raised.  Tax those £12 bln of earnings at 28% and subtract preference dividends of £600 mln (12% on £5bln).  You end up with EPS of 20 pence on 39.4 bln shares.  Bank shares on prospective P/E ratios of approximately 3x are worth tucking in the bottom drawer…take up your entitlements (or buy the shares in the market if they are trading below the subscription price).

Is this the start of a year-end rally?  On 13 Nov 2008 the S&P tested its prior 10 Oct 839.80 low and rallied 11% from an intra-day 818.69 low to close at 911.29.  Volume was high too, with Dow volume of 476 mln being the highest volume printed since the 10 Oct volume of 674 mln.  This marks a potential change in direction and with divergences in place too (such as MACD and a lower high on the Vix), the stage is set for a rally in the indices.  Who knows how high we will go if this rally takes hold; lets just see what Mr Market gives us.  One hurdle is the 14 Oct 1,044 intra-day high…

Note that the FTSE had already posted a secondary low on 27 Oct and held well above its 10 Oct 3,874 low whilst the S&P was busy flushing out the weak longs yesterday.  Clearly this expectation of a rally will be wrong if the S&P closes below yesterday’s 818.69 low but for now the odds are in favour of a rally.

All this worrying about how high 3-month Sterling Libor rates are is missing the point.  In the last 12 months or so, 3-month Libor standing at a significant premium to the Bank Rate undeniably put the sword into Northern Rock and Bradford & Bingley (and the same sword prodded Alliance & Leicester into the arms of Banco Santander).  However, this is now (painful) history and elevated Libor levels are now part of the solution and no longer the problem for the remaining UK banks.

Once they have received their recapitalisation money (£7 bln for BARC, £11.5 bln for HBOS, £5.5 bln for LLOY and £20 bln for RBS), this cash will no longer need to be borrowed from the wholesale markets.  In general as the banks manage their loan-to-deposit ratios back down towards 100%, they will raise fewer funds via the 3-month interbank market.  Note that HSBC has an 88% loan-to-deposit ratio.  However the 3-month Libor rate is still important as the banks’ borrowers generally pay a spread over Libor (and for those borrowers that pay a spread over the Base Rate, please note that not all banks are lowering their Base Rates in lock-step with the rapidly declining Bank of England’s Bank Rate). 

In short, do not expect the banks to be falling over each other in their rush to offer down the 3-month Libor rate towards the Bank Rate.  Mr Darling can rant & rave all he likes, but the reason Libor stands at a 150 bp premium to the current 3% Bank Rate is that there is a general net borrowing requirement in the UK wholesale money markets and HSBC cannot fill the demand all by itself.  International investors are not exactly keen to hold a falling currency and this also reduces the supply of Sterling in the wholesale money markets.

Do not blame the banks either, as charging a fat spread between what they pay depositors and what they charge borrowers is a key part of good old-fashioned banking.  Remember the days when banks used to make money and pay cash dividends…

This describes the situation whereby a share price gets attracted towards at a particular level at which there are lots of options struck which are shortly due to expire.

A good example is RBS in its current capital raising which is set at 65.50 pence (the “Strike price”).  The UK Government has agreed to buy any shares that are not bought by other investors.  Shareholders are entitled to buy shares at the strike price (their “entitlement”) and have to pay for them on 25 Nov 2008 (the “pay date”).  This creates a situation where an investor who fully intends to subscribe for their entitlement can buy those shares in the market before the pay date if the share price falls below the strike price (RBS shares have often dipped below 65.50 pence since their capital raising was announced on 13 Oct 2008).  If RBS shares then rally above the strike price, the investor can sell the shares they bought lower down, safe in the knowledge that they can take up their entitlement and replace them at the strike price.  This process can be performed ad infinitum until the option expires on the pay date.

In reality what happens is that RBS shares trade very close to (get “pinned to”) the strike price, especially as we get the nearer the pay date, so as to prevent these ‘risk-free’ profits being extracted from the market by investors who fully intend to take up their entitlements.  The pinning situation disappears after pay date and a support/resistance level is left at the strike price in its place.  Pinning happens less often in traditional rights issues because many big market participants are already on the hook to purchase stock having already underwritten the rights issue.  In the current RBS example this is not the case because the Government has underwritten the stock placement.

The UK Government’s objective is not to acquire significant stakes in LLOY, HBOS and RBS.  Their objective is to restore market confidence in UK banks by addressing three inter-related areas which have come under the harsh spotlight of the market’s scrutiny.  These areas are :

1.  Do the banks have enough physical cash (or access to such cash) so as to be able to carry on conducting business?

2.  Will the banks be able to refinance their debts when they fall due?

3.  Do the banks have enough capital to be able to withstand likely losses and still remain in business?

The expansion of the Special Liquidity Scheme and the establishment of a Discount window at the Bank of England fully addresses point 1.  The provision of a Government guarantee for their debts provides confidence in a positive answer to point 2.  Point 3 is addressed by the Government underwriting the capital-raising issues announced on 13 October 2008.  There is clearly a hope that given that the banks now have a future, investors will step up to the plate and subscribe for most of the ordinary shares to be issued which will leave the Government with small stakes in the banks which will be sold off in the future (perhaps they will even be bought back by the banks themselves as they will likely be flush with capital in a few years time).  RBS and the enlarged-LLOY are both planning to buy back the Preference shares during 2009 so as to be able to resume paying cash dividends.

A lack of investor confidence that the banks will survive has been the focus of attention.  With this week’s 150bp rate cut by the BoE (such a decisive move is to be applauded), the BoE is well on the way to creating a steeply-positive yield curve which will enable the banks to make lots of profits (against which they can recognise their losses).  The Government has re-engineered confidence in the banks.  It is all over bar the shouting.