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CenturyLink: An Undervalued Stock Yielding 8%

Investment thesis

CenturyLink Inc.(NYSE:CTL) shares have declined a staggering 37% over the last 12 months. In addition, the company was forced to cut its dividend by over 50% in February. Many investors see a dividend cut as an early warning sign of a failing company.


The company has failed to grow its revenue in the last three quarters and profit margins have declined as the rise of low-cost fiber solutions is proving to be an obstacle for CenturyLink.

Despite these adverse developments, the company has improved its financial health over the last six quarters and management is positive about its ability to repay and retire debt aggressively to strengthen the balance sheet.

Even though dividend cuts usually spell trouble for investors, CenturyLink's decision to do so was the right choice at the time. Trading around $11.77 on Wednesday, shares yielded 8.24%, indicating the dividend is safe. More importantly, shares are trading at a discount of 43%.

Company profile and business strategy

CenturyLink is a Monroe, Louisiana-based communications company operating a network connecting the U.S., Europe, Asia and Latin America. The company operates under two broad segments: business and consumer. It offers VPN data services, ethernet services, internet protocol services, satellite TV services and broadband services.

According to its 2018 annual report, CenturyLink operates a fiber network of approximately 450,000 route miles, making it one of the most significant players in the global communications market.

During the first and second-quarter earnings calls, management highlighted a few business priorities. The first is to reduce the debt burden to an acceptable level as they believe the current level of debt is not ideal. The second priority is to focus on efficiently integrating the Level 3 acquisition, which was completed in November 2017.

Financial health is improving despite revenue decline

CenturyLink has hit a speedbump from a revenue growth perspective. In the last three quarters, revenue declined on a year-over-year basis on the back of net subscriber losses in its broadband business, the growth of low-cost fiber solutions and a loss of customers.

Period

Revenue growth/decline

Fourth-quarter 2018

-11.43%

First-quarter 2019

-11.98%

Second-quarter 2019

-41.43%



Source: Company filings.

This decline in revenue is one of the main reasons investors remain bearish on CenturyLink's prospects and ignore the high dividend yield the shares are offering. Profit margins are deteriorating as well, which has significantly impaired the company's profitability.

One positive development for CenturyLink is the subscriber growth it is recording for its high-speed internet.

Source: Earnings presentation.

Even though the net change in the subscriber base was negative in the second quarter, the company added 22,000 customers for its 20 megabits per second or above offering. With the expected rollout of 5G technology, the demand for high-speed internet will likely increase further over the next two years. This is a tailwind for CenturyLink's broadband business.

The company's already high long-term debt spiked in 2017 as CenturyLink issued $7 billion in new debt to fund the acquisition of Level 3 Communications. As per second-quarter filings, the company currently has $33 billion in long-term debt. More importantly, it is working to reduce the debt burden by allocating a higher amount of free cash flow to repay loans. This is undoubtedly a positive sign for investors.

Source: Company filings.

In total, CenturyLink has retired approximately $2.7 billion in debt since the first quarter of 2018. This, in turn, has helped the company come closer to achieving its net debt-to-adjusted Ebitda target of 2.7 to 3.25.

Source: Company filings.

Since mid-2018, the financial health of CenturyLink has improved significantly. The rising adjusted earnings before interest, taxes, depreciation and amortization margin is also an early indication that the company will be able to achieve this target debt ratio.

Source: Company filings

The debt maturity schedule also confirms CenturyLink will not be experiencing any liquidity concerns in the next couple of years. For instance, according to second-quarter filings, $22 billion in debt (out of the $33 billion total) is due after 2024. This provides sufficient time for the company to arrange financing options.

Dividend safety analysis

As of Oct. 2), CenturyLink shares yield 8.01%. This is despite the dividend cut in February. According to GuruFocus dividend data, the company has declared and distributed dividends every year since 1986. This extensive history of dividend distributions has helped CenturyLink be recognized as a dividend stalwart by investors.

When management decided to cut the quarterly dividend from 54 cents to 25 cents, it was cited as a necessary initiative to free up cash to facilitate debt repayments. By then, management had already concluded the debt level as undesirable to the financial health of the company.

In the fourth-quarter 2018 earnings conference call, CEO Jeff Storey reiterated the company's ongoing commitment to distribute dividends.


"First, we continue to believe returning cash to shareholders in the form of a dividend is an important part of our equity value proposition. However, as you saw, we announced today that we plan to reduce the annual dividend to $1 from the current $2.16 per share beginning with the next dividend declaration. This decision is not based upon any concern for the outlook of our business. Our business fundamentals are strong, and we believe our free cash flow could sustain the dividend at the prior level through 2019 and beyond. As I said, this change in policy isn't about a diminished view of our business; it is driven by our view that the long-term interest of shareholders are best served by proactively accelerating, de-levering to a new lower target range of 2.75 to 3.25 times net debt-to-adjusted EBITDA."



The quarterly dividend of 25 cents, which translates to an annual dividend of $1 per share, will require the company to allocate just over $1 billion a year. This is based on 1.069 billion shares outstanding at the end of the second quarter. Historically, CenturyLink has been able to cover its distributions with free cash flow.

Source: Company filings

Except for in 2017, CenturyLink has never paid out more than it earned in free cash flow to investors, which is a promising sign and indicates the safety of the dividend. Considering the recent dividend cut, it becomes evident the company is in an excellent position to honor its commitments to shareholders in the foreseeable future. The improving Ebitda margin adds a degree of safety as well.

The dividend is relatively safe, and the company will be able to maintain a dividend per share of $1 over the next several years as well.

Growth opportunities

CenturyLink has completed multiple acquisitions over the last four years; the most important one of these was the Level 3 Communications transaction.

Source: Crunchbase.

With the full integration of Level 3, the combined company will become the second-largest enterprise solutions provider in the U.S.

Source: Company presentation on the synergies of Level 3 acquisition.

This increased scale will help CenturyLink bring in more subscribers to its more expensive business communications solutions. Eventually, such subscriber additions should drive profit margins higher. Storey said on the second-quarter earnings call that management has identified $800 million to $1 billion in savings resulting from this business combination.

Management also revealed the company is focusing on divesting low-margin products to ensure the long-term sustainability of earnings. For instance, CenturyLink ended its plans to expand the Prism TV service in April 2018 on the back of low profitability. In the short term, such de-emphasizing choices will result in lower revenue, but in the long term, profit margins will receive a boost because of such bold initiatives.

Another growth opportunity for CenturyLink is the expected increase in demand for high-speed internet facilities. The legacy business segments of the company, including voice and regulatory services, are under pressure, which is evident from the second-quarter earnings results.

Source: Earnings presentation.

The broadband segment reported year-over-year growth in revenue and remained as the top contributor to consumer segment revenue as well. Importantly, the outlook for this segment is positive as the growing popularity of data-driven concepts such as the internet of things will increase the demand for high-speed internet.

In anticipation of this higher demand, the company is investing in building the necessary infrastructure. For example, in the first quarter of this year, CenturyLink reported adding 4,500 new fiber-fed buildings and followed up with 5,000 new additions in the second quarter. The idea behind these investments is to build a better network infrastructure than its competitors. Capital expenditures for the second quarter were $800 million, up from $771 million in the prior-year quarter.

The execution of these plans will likely offset some revenue losses in the next five years, but not all.

Valuation

A discounted cash flow model was used to calculate the intrinsic value for CenturyLink.

The company will likely report declining revenue in the next five years due to the loss of subscribers in its legacy business. However, the decline can be expected to slow down toward the end of the five-year period as higher demand for broadband solutions kicks in. The table below illustrates the revenue expectations for CenturyLink over the next five years.

Fiscal year

Revenue (billions)

Implied growth rate

2019

22.3

-4.9%

2020

21.6

-2.9%

2021

21.07

-2.7%

2022

20.62

-2.1%

2023

20.29

-1.6%



Source: Reuters Eikon and author's estimates.

Below are the critical assumptions used in the DCF model to derive CenturyLink's intrinsic value.

  • Capital expenditures as a percentage of revenue to average 14.5% in the next five years.
  • Depreciation and amortization to average 22% of revenue.
  • A cost of capital of 7%.
  • A revenue multiple of 2.5 to calculate the terminal value.



With these inputs, the intrinsic value per share comes to $17.94, which represents an upside of 43%.

Insiders have also increased their ownership of CenturyLink shares over the last five years despite the bearishness of general market participants. While this is not a standalone indication of possible mispricing, management seems to be bullish on the company's prospects.

Risks

The primary risk to this thesis is a failure by CenturyLink to realize the expected synergies from the Level 3 Communications acquisition. In this case, Ebitda margins will likely deteriorate along with subscriber losses, exerting pressure on the company's ability to sustain the current dividend.

Conclusion

Despite the fears of many investors, CenturyLink's financial health is improving and the company is pursuing a growth strategy that will deliver better operating performance in the future. The dividend cut in February enables the company to save much-needed cash that could be used to repay debt. The macroeconomic outlook is favorable and the company is in an excellent position to honor its debt repayments and dividend distributions. CenturyLink is a buy with a target price of $17.94 per share, which represents an upside of 43%.

Disclosure: I do not own any stocks mentioned in this article.

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This article first appeared on GuruFocus.