U.K. investors woke up to some shocking news on Tuesday morning. BT Group (BT, Financial), one of the country’s largest companies, had issued a profit warning.
BT controls virtually the entire U.K. telecommunications network. While there are other providers in the country, they have to pay a service fee to BT, which maintains the country’s telecommunications infrastructure. The monopoly nature of the company, as well as the fact it operates in a non-cyclical business, means it is popular with U.K. retail investors. When the business was privatized several decades ago, the government offered shares to the public at a discounted price, which means the company is one of the largest retail shareholder bases of all U.K. companies and many of its investors have held the shares for decades.
When BT announced today that its profits would take a 530 million-pound ($663.6 million) hit due to problems in Italy, the speed at which investors decided to jump ship may have surprised many. Indeed, BT shares plunged by as much as 20% in early deals, extending losses booked over the past 12 months. Last year, the company's shares lost more than a fifth of their value. Alongside the Italy disaster, BT also announced that normalized free cash flow for 2016 and 2017 is expected to come in at 2.5 billion pounds. This compares to the forecast of 3.1 billion to 3.2 billion pounds. Further, revenue is now not expected to grow for the next two years.
Losing the moat
BT’s stumble is a great lesson for investors of what can go wrong for a company that is generally perceived to be highly defensive with steady growth. The company’s market dominance has long been under threat by new upstarts, which are using technology to bypass the company’s monopoly and offer similar services at a lower cost.
Companies such as Vodafone (VOD, Financial) have been using their own telecommunications networks to offer BT-like services with promotional deals to lure customers away. The number of competitors using such tactics has grown steadily and today’s warning shows just how far they have come.
Beware disruption
The degree to which new technologies are disrupting older industries that were previously considered to be defensive is starting to become a serious threat to traditional investors’ portfolios. This trend will only become worse as the tidal wave of money unleashed by quantitative easing continues to fund new start-ups using new technologies, which are able to easily disrupt traditional monopoly business models.
Along with balance sheet strength, growth potential and management trustworthiness, disruption potential should now be near the top of investors’ checklists when evaluating potential stocks.
Companies such as Amazon (AMZN, Financial), Uber and even the likes of Tinder have had a hugely disruptive effect on the markets they operate in. The risk that a disruptive technology will completely undermine an investment thesis is greater than it has ever been before. Even the old-fashioned, dirty oil industry is reeling from the development of new technologies and have pushed down extraction costs, allowing small shale producers to begin low-cost onshore production, rendering old technologies obsolete.
Hidden nasties
The curious case of BT is not just a warning of how technology can disrupt existing defensive business models. It also shows that no matter how much research you do, a company can still surprise to the downside if a large-scale fraud is uncovered. Unlike protecting against disruption, it is almost impossible to protect against such unforeseen fraud. Sure, you can protect against company-level fraud when you have a company like Enron that continued to report increasing revenue and profits despite hemorrhaging cash and growing debt. But for cases like BT, where the accounting mistakes committed were hidden away in a subsidiary and even top-level management had no idea, it is impossible to see these mistakes before they are exposed.
In BT’s case, it is unlikely the fraud will floor the company. Over time, today’s declines will correct themselves. For existing holders, it would be unwise to sell. For astute value investors, it may be time to buy shares of BT.
Disclosure: The author owns no stock mentioned.
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