It isn't very often that a stalwart of the FTSE 100 takes everyone by surprise with a shock profit warning. It's even less common for the warning to be shrouded in a murky accounting scandal. But telecoms giant BT managed it recently, causing its share price to plummet by a fifth.
It was a reminder that even blue-chip household names aren't immune from setbacks. But was it possible to have seen the problems coming?
Back in 1984, British Telecom was one of the first big state-owned companies to be privatised, with more than 750,000 individuals became new shareholders. These days, many millions have exposure to BT's performance through direct holdings, pensions and funds.
However, arguably signs of trouble long before January's warning. Accounting irregularities in Italy were first flagged in October 2016, but even before then the investment case for BT was waning.
RISK OF EARNINGS MANIPULATION
As the board of BT are finding out, detecting earnings manipulation can be extremely difficult. But it's not impossible.
One academic called Professor Messod Beneish has developed a forensic checklist for finding accounting frauds. His so called M-Score has been credited for flagging warning signs at well-known frauds like Enron and Worldcom.
On this checklist, BT was actually rated 'High Risk' because its accounts showed some of the hallmarks typically seen in accounting fudges.
In particular, there had been a disproportionate increase in its receivables suggesting that it may have been inflating sales figures by booking sales earlier or extending better credit terms to customers.
It also showed signs of unstable asset quality, which can point to improper capitalisation of expenses and cost deferral.
FALLING QUALITY AND MOMENTUM
From a low of 73.5p in 2009, BT's shares had peaked above 460p by early 2016. Based on a blend of fundamental and technical leading indicators, BT was in the top 10 per cent of the market.
But there were warning signs as early as June 2015, when BT's strong quality and momentum began to break down.
Taken together, the group's financial characteristics, valuation and momentum all started to lose their appeal. It was essentially taking on the profile of a stock that tends to underperform.
THE DEBT PROBLEM
Ask professional fund managers what they hate most in a stock and many will say 'debt'. After the £12.5 billion acquisition of EE, BT's balance sheet liabilities rose above £30 billion.
And while that's not necessarily a problem, a closer look suggests signs of weakness.
In particular, there were signs that point to a moderate risk of financial difficulty. BT's liquid assets are a very low proportion of its overall asset position.
Plus, its liabilities are very large relative to its market capitalisation. This debt burden put the stock on the watchlist of potential short sellers.
A MAJOR PENSION DEFICIT
Pension deficits are a thorn in the side of investors because companies are obliged to soak them up using shareholder funds. BT's enormous pension deficit is no secret.
In fact, it was reported by MSCI to have the second-worst funded pension plan on the planet.
When you combine BT's debt pile with its pension deficit, you get a group that is very highly geared indeed.
This may not be a problem. Highly geared companies can perform well while profits are growing and stable, but they react dramatically when they are not.
WEAK PRICE TREND
After a strong six-year run, shares in BT came under the cosh in 2016, suggesting that market sentiment was cooling.
Ahead of the profit warning, BT shares had underperformed the market by 35 per cent over the past year, not helped by sustained selling pressure.
With momentum being one of the strongest leading indicators of future price trends, BT's price performance was a warning that institutions were backing away from it.
In the 12 months before the profit warning, analysts covering BT had been trimming back their earnings forecasts. The adjustments were relatively small, but it was a signal that the outlook was less certain.
Most of those analysts retained 'buy' recommendations on the stock, suggesting that they were wrong-footed by the profit warning, too.
WHERE NOW FOR BT?
One of the consequences of the sharp fall at BT is that its forecast dividend yield has shot up from 4.4 per cent to 5.5 per cent. At that level, it's no surprise that there are tentative signs of recovery in BT's share price.
Some of those with long-term horizons will likely feel that the shares can only go up from here - and that the dividend makes it worth it.
Even so, profit warnings are extremely damaging events, and research shows that the market will be wary of more problems to come.
The average profit warning typically comes after six months of price pressure, and sees shares collapse by 20 per cent on the day. They can then take up to a year before showing any signs of recovery.
For Gavin Patterson, BT's chief executive, the recovery will mean rebuilding confidence and fixing the many weaknesses that have caused investors to lose their enthusiasm for the group.
Ben Hobson is investment strategies editor at Stockopedia.com, the rules-based stock market investing website. He is also the author of several ebooks including "How to Make Money in Value Stocks" and "The Smart Money Playbook". Click here to enjoy a completely FREE 5-day trial of Stockopedia.
This article was originally published on our sister website Interactive Investor.
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