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CenturyLink: A High-Yield Telecom Stock Combatting Secular Decline

Founded in 1968, CenturyLink (CTL) started off as a regional telecom company. Thanks to a series of large acquisitions over the years, CenturyLink is now one of America’s largest telecom services provider with about 10 million customer connections in nearly 40 U.S. states.

In November 2017, the company completed its $34 billion acquisition of international internet service provider Level 3 Communications. That deal gave CenturyLink one of the largest fiber optic systems in the U.S. as well as 4.8 million U.S. broadband subscribers as of May 2019. 

Today CenturyLink operates through two major business units:

  • Business Segment (75% of revenue): provides telecom services to domestic and global enterprises, small and medium businesses, federal, state and local governments and wholesale customers, including other communication providers. 

  • Consumer Segment (25% of revenue): provides broadband and local and long-distance voice (legacy landline) telecom services to residential homes. 

Note that CenturyLink is considering selling its consumer segment to focus exclusively on enterprise (following the Level 3 merger, CenturyLink is the second largest enterprise internet provider in the U.S., second only to AT&T).

CenturyLink's weak dividend track record has been marked by a 26% cut in 2013 and a 54% cut in early 2019. A combination of excessive debt and ongoing secular declines in its landline operations made those cuts necessary. Unless management can reduce debt and stabilize the core business, even the much lower dividend may not be sustainable in the long-term. 

Business Analysis
CenturyLink has built itself into a major regional telecom player thanks to years of acquiring other telecom players including:

  • 2008: $11.6 billion purchase of rural telecom operator Embarq
  • 2011: $2.5 billion for Savvis (cloud computer data storage provider)
  • 2012: $12.2 billion acquisition of Qwest Communications
  • 2017: $34 billion merger with Level 3 Communications

However, the problem for CenturyLink is that telecom is an industry where scale, while a critical factor in achieving good profitability, is hardly sufficient. That's because much of what these acquisitions brought it were legacy wireline phone services, which have been in secular decline for years as wireless phones have replaced the need for landlines.
Source: Statista
This has created an unenviable position in which CenturyLink piled on declining assets onto its own troubled landline business, which has seen steadily falling subscribers result in eroding margins and cash flow. 

CenturyLink's continued declines in its legacy landline business resulted in a $2.7 billion write-down in 2018, which is the company's way of admitting it overpaid for its previous telecom acquisitions.  

CenturyLink has attempted to pivot into becoming a major internet service and cable provider, and management even invested in the booming data center industry as well. However, the company has faced challenges in this area. For one thing, data centers are a specialized business and have not panned out for most telecoms who entered the space. 

Margins are typically lower, and rising competition has only increased pricing pressure. This is why telecom giants such as AT&T and Verizon have both either sold or announced plans to sell their data centers. In 2016 CenturyLink followed suit, with a $2.15 billion sale of its data centers, representing a $350 million loss. 

The company also sold over 50 data centers to private equity funds for $1.8 billion in May 2017 in an effort to pay down its large debt that resulted from previous acquisitions. 

Outside of data centers, another problem with management's diversification plan is that in recent years more consumers have "cut the cord" and ditched pay-TV in favor of cheaper streaming subscription alternatives. The good news is that streaming requires a fast and reliable internet connection. 

However, only about 35% of CenturyLink's internet offerings are 40 Mbps or faster, the minimum speed required for streaming high-quality video on demand. In addition, the acquisitions the firm has made have largely put it in urban markets where fierce competition from large cable companies (Cox, Comcast, Charter) have resulted in very little pricing power.

The company's struggles with cord cutting and ongoing declines in landlines have continued into early 2019, with total consumer revenue declining 8% year over year in the first quarter (and driving -5% revenue growth for the entire company).

Broadband internet subscriber losses have slowed, and thanks to rising prices, the broadband business achieved modest sales growth. However, it wasn't enough to offset double-digit declines in legacy phone services.
Source: CenturyLink Earnings Presentation

Selling its Consumer segment could go a long way in paying down CenturyLink's elevated debt levels, but it would also mean a significant decline in revenue and cash flow. 

However, a sale isn't guaranteed to occur, or at least not quickly, according to comments by the firm's CEO in May 2019 that investors should expect a "lengthy and complex process" as CenturyLink begins engaging advisors.

Regardless of the Consumer division's ultimate fate, management will continue plowing ahead with a vision to turn CenturtLink into more of an enterprise-focused service provider. In 2016 CenturyLink decided to make a very strategic move, announcing a $34 billion merger with Level 3 Communications (which closed in November 2017). 

Level 3 is far more focused on enterprise IT solutions than CenturyLink, running telephone and internet lines primarily for small and mid-sized businesses. The margins this business generates are slightly lower, but its higher switching costs mean that existing customers are less likely to move to competing offerings.

The acquisition of Level 3 meant that CenturyLink could greatly diversify its cash flow away from declining legacy residential landlines, and also gain access to faster-growing international internet markets in emerging economies.
Source: CenturyLink Investor Presentation
The closing of this deal resulted in a 2018 revenue jump of $5.8 billion, or a 33% increase, for CenturyLink. Gaining scale in this extremely competitive industry is an important component of the deal since it's expected to result in substantial cost synergies and greater free cash flow generation. 

In fact, management claimed that the merger would deliver $850 million in cost savings in 2018 and then another $1 billion over the next few years. 2018's cost-cutting efforts appear to have been a success, with adjusted EBITDA margins (which exclude merger integration expenses) rising 460 basis points since the deal closed.
Source: CenturyLink Earnings Presentation

Another benefit to the deal is that several Level 3 executives (with far better track records than their CenturyLink peers) joined CenturyLink's management team. This includes Level 3 CEO Jeff Storey who became CenturyLink's new CEO at the urging of activist investor Keith Meister, who hopes the former Level 3 CEO can deliver the growth that CenturyLink has been lacking for the past decade.

In 2017 Meister compared Storey to Tom Brady for his ability to lead Level 3 to outperform the S&P 500 by an impressive 125% from 2013 (when he became CEO) to 2017. 

Combined with the success of that final $1 billion in cost-cutting, the larger CenturyLink, now run by what investors hope is more capable management, might potentially stabilize free cash flow and improve its dividend safety over time. 

In 2019 CenturyLink expects its cost-cutting to deliver about $3.25 billion in free cash flow which, when combined with its much lower dividend of $1.075 billion, should allow it to retain about $2.2 billion in cash flow.

Assuming such a performance level can be sustained, that will provide the company with enough retained free cash flow to repay about 80% of its maturing debt over the next four years and significantly reduce its balance sheet risk.

However, the firm's lower payout ratio and plans to more aggressively pay down debt are only part of the story. The new and improved CenturyLink still faces meaningful obstacles in the coming years, which could ultimately require a third dividend cut. 

Key Risks
At first glance, you might expect that a more than 50% reduction in the dividend might make CenturyLink's. However, the company's path back to sustained profitable growth will not be an easy one. 

First, Level 3's new management, specifically Jeff Storey taking over as CEO, seems like a necessary change, but the team's strategy might not be able to deliver a bright new future for the combined company.

Here's what Storey wrote in the company's 2018 annual letter to shareholders, regarding CenturyLink's painful dividend cut:

"As you know, earlier this year we modified our capital allocation policy to reduce the annual dividend to $1.00 from the previous $2.16 per share. This was obviously a significant decision, but one that we are confident is in CenturyLink’s long-term interest. 

Our business generates significant Free Cash Flow – enough to continue to maintain the dividend at its prior levels. However, by lowering the amount of capital distributed through dividend, we not only increase the pace at which we delever our balance sheet – which can free us up to consider inorganic growth options over time – we also gain greater flexibility to increase our capital investment to fund both growth and cost reduction initiatives." 

– Jeff Storey, CenturyLink CEO

One of the reasons the company chose to cut its dividend by over 50% was to potentially allow it to make more M&A deals in the future. CenturyLink's capital allocation track record is abysmal in this area, so such a strategy could lead to further headaches.

CenturyLink has made more than $60 billion in acquisitions since 2008, including the Level 3 merger. However, these deals have failed to restore the firm to top or bottom line growth or prevent two dividend cuts totaling over 75%.

Simply put, companies can't always buy their way to profitable growth. Income investors are right to feel somewhat concerned that part of management's rationale for the firm's second dividend cut in six years is to potentially allow create more financial flexibility to continue this previously unsuccessful strategy.

Remember that the idea behind acquiring Level 3 was to transform CenturyLink into a mostly enterprise-facing telecom provider. Selling internet and data services to businesses and government agencies was supposed to lead to sales and cash flow growth that would enable the company to pay down debt over time while maintaining a generous and safe dividend.

However, since the Level 3 merger closed, CenturyLink hasn't had much luck in growing its revenues, in any business unit. As of early 2019 sales growth continued to be negative in enterprise, international, and wholesale, where fiber pricing has been in decline due to competition from larger rivals.
Source: CenturyLink Earnings Presentation

Another challenge for CenturyLink is that improving technology, which enables more efficient data networks and routing, is allowing greater data transfer per unit of fiber. In addition, companies are increasingly using shared rather than private data networks which are reducing future growth opportunities in the very enterprise services that management once hailed as the future of the company.

Struggling growth puts all the more pressure on management to deliver on their cost savings target and shore up CenturyLink's balance sheet. The firm's high debt load (junk credit rating from Standard & Poor's) is a key reason why its dividend safety profile continues to look shaky, even despite its low payout ratio.

While CenturyLink's new lower dividend only consumes 33% of the company's 2019 forecast free cash flow, that figure would rise significantly should the company sell its Consumer segment. Even if the Consumer business stays, 2019 company guidance calls for $3.25 billion in free cash flow which is a 17% decline from the prior year's level.

Essentially, despite possessing greater scale and owning stronger assets, including fiber optic lines that are the backbone of the internet for corporations, CenturyLink has yet to demonstrate it can even hold its free cash flow flat. This limits the safety of its dividend and certainly minimizes its future dividend growth potential.

Until management can stabilize CenturyLink's operations and reduce the firm's debt load, this is not a business for conservative income investors. CenturyLink still has $35.5 billion in total debt on its balance sheet, compared to just $441 million in cash. Interest expenses alone cost the firm over $2 billion annually.

With approximately $10.3 billion in debt maturing over the next four years, CenturyLink faces refinancing risk and could be on the hook for higher interest rates should credit conditions tighten for junk-rated businesses.

While management likes to point out the much lower dividend will allow for faster deleveraging, CenturyLink's net leverage ratio was still almost 4.0 in early 2019.
Source: CenturyLink Earnings Presentation

Management plans to get the firm's leverage down to a safer level within three years, but remember what management said about potentially making future acquisitions. CenturyLink's plan appears to be to reduce leverage just low enough to allow it to once more embark on acquisitions which have failed to drive any growth in free cash flow per share over the past decade. 

Basically, the dividend cut CenturyLink made in early 2019 doesn't solve its core problem, which is that it continues to struggle with shrinking revenue and cash flow. Management's strategy to focus its investments on the growing enterprise and fiber industries of tomorrow sounds good in theory, but the company's still bloated balance sheet might not give it the time to pursue that strategy while maintaining even its much smaller dividend. 

Closing Thoughts on CenturyLink
Long-suffering CenturyLink shareholders had hoped that the Level 3 merger, and new management, might be able to turn the ship around, with a renewed focus on more stable enterprise and business telecom services. 

However, Level 3's enterprise-focused assets have failed to rekindle CenturyLink's growth thus far, and unfavorable secular technological trends have caused its future growth potential to dim substantially. 

Management has delivered impressive cost-cutting to boost margins, but only time will tell whether the firm is able to stabilize its overall business units, much less drive sustained growth in free cash flow. 

Meanwhile, the vast debt load on its books means that CenturyLink remains a junk bond-rated company with limited financial flexibility, so its ability to sustain its dividend while investing for the future is questionable. 

Basically, CenturyLink's dividend still appears speculative due to the company's continued inability to address its core issue, which is stemming a secular decline in sales and cash flow. Conservative income investors should likely continue to avoid this struggling telecom and focus instead on more reliable cash cows in the sector such as Verizon.

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