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CenturyLink: A High-Yield Telecom Stock Combatting Secular Decline

Incorporated 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.

Today CenturyLink operates through two business units:

  • Business Segment (75% of revenue): provides internet, hybrid networking, cloud connectivity, security solutions, and voice services (about 20% of segment revenue) to businesses, governments, and wholesale customers.

  • Consumer Segment (25% of revenue): provides broadband internet (50% of segment revenue), voice (landline phones – about a third of segment revenue), video, and other services to residential homes. 

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 phone 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
In 2008 CenturyLink was one of the largest providers of rural telephone services in America. Since then, the company has spent more than $60 billion on acquisitions which meaningfully changed its customer base, geographic footprint, and mix of services. CenturyLink quickly became a major telecom company. 

However, the problem for CenturyLink is that telecom is an industry where scale, while a critical factor in achieving good profitability, is hardly sufficient. Many of the acquisitions the company made brought CenturyLink additional legacy wireline phone services, which have been in secular decline for years as wireless phones have replaced the need for landlines. 

At the end of 2018, voice services still accounted for 28% of the company's total revenue. This part of the business continues declining close to 10% annually.

CenturyLink has attempted to pivot into becoming a major internet service and cable provider, but the company has faced challenges in these areas. For example, 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. CenturyLink isn't known for having the fastest network, but its consumer broadband business (about 13% of company-wide sales) is at least treading water rather than sinking. 

Due to ongoing challenges in its Consumer business, CenturyLink is considering selling off this segment. A divestiture would help the company reduce its elevated debt levels, but a sale isn't guaranteed to occur, or at least not quickly. In May 2019 CenturyLink's CEO said 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 CenturyLink 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 was done to help CenturyLink significantly diversify its business away from declining legacy residential landlines, and also gain access to faster-growing international internet markets in emerging economies.

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, higher margins, and greater free cash flow generation. 

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 final cost-cutting activities, the larger CenturyLink, now run by what investors hope is more capable management, could potentially stabilize free cash flow, reduce leverage, and improve its dividend safety over time. 

However, the firm's lower dividend 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
CenturyLink's path back to sustained profitable growth will not be an easy one. 

First, installing new management seems like a necessary change, but the Level 3 team's strategy might not be able to deliver a bright new future for the combined company.

Here's what CEO 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 was to 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. Through the first half of 2019 sales growth continued to be negative across each Business segment subdivision, reflecting in part weaker fiber pricing due to competition from larger rivals. 

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) and declining free cash flow are key reasons why the firm's dividend safety profile continues to look shaky.

Until management can stabilize CenturyLink's operations and reduce the firm's leverage, this is not a business for conservative income investors. 

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 the firm's 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 weak 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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