Description

I recommend the purchase of CenturyLink Inc. common stock.  The stock currently yields 11.6%, making it the highest yielding stock in the S&P 500.  The market appears to view CenturyLink as a predominantly copper wireline business in secular decline with decreasing revenues and too much debt, making a dividend cut inevitable.  In other words, the market views CTL as a slightly healthier version of Frontier Communications, which suspended its dividend in February.  This view ignores the transformative effects of CTL's acquisition of Level 3 Communications in 2017.  The investment case for CTL is simple:  The dividend is adequately supported by cash flow.  As and when the market recognizes the viability of the dividend, the stock price will re-rate to a price providing a more industry-appropriate dividend yield of 5% to 7%.  A yield of 7% implies a stock price of $30, 66% higher than the current price.  In the meantime, you are paid nearly 12% per annum to wait. 

Company Background.  CTL is an integrated wireline telecommunications company providing services to business, wholesale, government, and residential customers.  From humble beginnings, CTL has grown to become the third-largest wireline telecommunications operator in the United States (behind Verizon and AT&T) and the second largest enterprise telecommunications provider in the U.S., second only to AT&T.  This growth was propelled primarily by acquisitions, the two most significant (prior to 2017) being Embarq and Qwest.

CTL acquired Embarq Corporation in 2009.  Embarq was the local wireline telecommunications division of Sprint, which Sprint spun off in 2006 when it merged with Nextel.  The Embarq acquisition positioned CTL as the fourth largest telecommunications provider in the United States.  In 2011, CTL acquired Qwest Communications, creating the third largest telecommunications provider in the United States.  Qwest's operations included US West, one of the original RBOCs (Regional Bell Operating Companies) that resulted from the breakup of (old) AT&T in 1984, as well as a national 210,000-route-mile fiber network and significant enterprise customer base.

For additional background, refer to hawaii21’s February 2013 CTL write-up, which provides a good overview of CTL pre-Level 3.

Level 3 Acquisition.  CTL acquired Level 3 Communications in November 2017.  Level 3 was a leading international provider of fiber-based communications services, providing local, national, and global communications services to enterprise, government, and carrier customers in over 60 countries across a platform anchored by fiber networks on three continents and connected by extensive undersea facilities.  Level 3's assets included intercity and metro fiber networks in the U.S. and Europe built or acquired in the 1990's and 2000's, with additional international and undersea fiber networks from its acquisition of Global Crossing in 2011 and additional U.S. metro fiber networks from its acquisition of tw telecom in 2014.

CTL's acquisition of Level 3 is transformative for two reasons.  First, the acquisition positioned CTL as the second largest enterprise telecommunications provider in the U.S., second to AT&T.  Level 3's extensive fiber network, combined with CTL's existing fiber assets (primarily Qwest) makes CTL a formidable competitor for national and international enterprise customers.  One can fairly argue that Verizon and AT&T are primarily focused on their wireless businesses (and, AT&T now, its media distribution and content businesses), leaving room for a focused enterprise provider with fiber assets to take market share, a strategy that Level 3 articulated and executed well in the past.  And CTL's (new – see below) management has made it clear that serving the enterprise market will be the primary focus of the company.

Post-acquisition, residential services (primarily but not exclusively copper wireline) constitutes 24% of revenues.  This is a relatively high margin business, and CTL's new management has stated that this business will be managed for cash flow, while making selective low risk investments to extend high speed data services to additional residential customers.  In this regard, in the first quarter of 2017, CTL exited its consumer over-the-top video business, and announced that it is no longer actively marketing its Prism television service.

Second, CTL is now being managed by Level 3's former senior management.  Jeff Storey, Level 3's former chief executive officer, became CTL's chief operating officer at closing and became CTL's chief executive officer this May, while Sunit Patel, Level 3's former chief financial officer, became CTL's CFO at closing.

Storey became CEO of Level 3 in April 2013.  From year end 2012 to year end 2016, Level 3's annual free cash flow increased from a negative $165 million to over $1 billion, while EBITDA margins increased from 25% to over 35%.  Storey also capably managed Level 3's integration of Global Crossing and tw telecom.  Based on his history at Level 3 and his public statements since the transaction, investors can expect Storey to manage the integration of CTL with Level 3 with a primary focus on maintaining customer satisfaction while realizing expense synergies.  Storey is a rational, solid operator, focused on profitable revenue growth, customer satisfaction, and cost management.

During his tenure as Level 3's CFO, Patel did an excellent job of navigating Level 3's (at the time stressed) balance sheet through the financial crisis, using tender offers, cash debt repurchases, and debt for equity exchanges to refinance and reduce debt.  Level 3 ended 2007 with debt/EBITDA of 8.3x (net debt/EBITDA of 7.5x) and ended 2009 with debt/EBITDA of 7.1x (net debt/EBITDA of 6.2x).  As the economy recovered, Patel continued to ably manage Level 3's balance sheet, reducing Level 3's net debt/EBITDA from 5.3x at the end of 2012 to 3.2x at the end of 2016.  This experience bodes well as CTL seeks to reduce its financial leverage (currently 4.3x) to its target range of 3x to 4x while maintaining its dividend.

Sustainable Dividend.  Based on consensus street estimates for revenues, EBITDA, and capital expenditures, and using my estimate of cash interest payments assuming no debt reduction, the dividend is easily supported through 2022, with the payout ratio never exceeding 81%.  (A note regarding the use of consensus estimates, which were taken from Reuters:  The sell-side is by no means bullish.  Of the 18 sell-side analysts tracked by Reuters, 10 rank CTL a hold, 2 rank CTL an underperform, and only 6 rate it a buy.)  Again based on consensus estimates, by 2022 net debt/EBITDA declines to 3.8x, with CTL accumulating a cash balance of over $3.5 billion. This cash can be used to reduce debt, thereby reducing interest payments and increasing the sustainability of the dividend.  Because of Level 3's large NOLs, CTL should not become a full cash taxpayer until 2023, and even then, with CTL's heavy depreciation charges and interest expense, and the effects of recently enacted tax reform legislation, cash taxes should not meaningfully affect the sustainability of the dividend.

Apart from the consensus estimates, I ran a rough model separately projecting, and then combining, revenues, EBITDA, and free cash flow for old Level 3 and old CTL.  I used the revenue assumptions listed below which, I believe, can fairly be described as conservative.  I estimated Level 3’s expenses based on a combination of historical expenses combined with Level 3’s stated 80% incremental gross margin on new revenues.  I estimated CTL’s expenses based primarily on historical expenses.

The model yields revenues and EBITDA lower than the sell-side consensus; nonetheless, the dividend is still fully covered, albeit with less margin for error.  In addition:

- The model demonstrates that the increasing revenues provided by Level 3’s business will, over time, more than offset the revenue declines from CTL’s existing business, ultimately resulting in overall revenue growth.  Assumptions moderately less draconian than those listed above result in an inflection point in less than five years.

- The model also demonstrates the positive effects of Level 3’s 80% incremental gross margins on new revenues.  These effects were reflected in Level 3’s historical financial results, which showed consistently increasing EBITDA margins.  In my view, the sell side underestimates CTL’s potential for increasing EBITDA margins.

Valuation.  On consensus estimates for 2018, CTL trades at 6.4x 2018 EBITDA and a 15% free cash flow yield, not a demanding valuation.

Miscellaneous Notes.  The pricing of CTL’s bonds does not reveal a market overly concerned about imminent financial distress.  Holding company debt due in five years trades over par with a yield to maturity of approximately 6.5%, while holding company debt due in 20+ years trades at 85 cents with a yield to maturity of over 9%.  Subsidiary debt originally issued by Qwest and Level 3 trades much tighter.

Finally, short interest is currently 9.1%; more than a few short sellers doubt the sustainability of the dividend.

Risks.

The primary risk to the investment thesis is that the economy enters a meaningful recession that negatively affects enterprise spending on telecommunications services.  In these circumstances, a dividend cut is feasible and, perhaps, likely.

Poor execution of the Level 3 integration, both in general and as it affects customer service.

Catalyst

Market acknowledgment that the dividend is sustainable

Gradual deleveraging