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CenturyLink, Inc. – A Qwest for Growth

November 22, 2010 | About:
wax

wax

Author's Website
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Back in April, CenturyLink, Inc. (CTL) announced that the company and Qwest Communications International, Inc. (Q) had agreed to merge, subject to regulatory and shareholder approval.

At the time, we didn’t think much about the announcement, nor have we paid much attention to how things are progressing, in the last 7 months.

Truth be told, had one of our clients not sent us a Worksheet Request for Qwest, we probably would not have thought about the proposed merger again.

But as we began to build the requested worksheet, we came across a Raw Value Report we had written in September 2009 for what was, at the time, CenturyTel, Inc., known today as CenturyLink.

Since our CenturyTel report, we have completed our proprietary valuation model, and curious, we applied our model to both CenturyLink and to Qwest.

What we found was, to us, good news for Qwest stockholders but not such for CenturyLink stockholders.

Basis

Financial information presented in this report for CenturyLink, Inc. is based on the company’s most recent SEC Form 10-K filing for year ending December 31, 2009, as filed with the Securities and Exchange Commission on March 01, 2010.

Financial information presented in this report for Qwest Communications International, Inc. is based on the company’s most recent SEC Form 10-K filing for year ending December 31, 2009, as filed with the Securities and Exchange Commission on February 16, 2010.

Debt

The merger of these two companies is being called “compelling”, with many “synergies”, providing the merged companies with greater “scale”, “scope”, and “expertise”.

Quite frankly the first thing we do when we hear words like these is grab our wallets and head for the exits, having learned over the years that these words generally mean soemthing is going to cost us.

Once the merger is complete, CenturyLink, Inc. which we think should be renamed CQ, Inc., may indeed have lots of synergies, executive washrooms, and gold inlaid water closets, we have no idea.

Nor do we have any idea if the new company will be able to provide more, better, or more far reaching services that current customers, will want to buy.

But one thing we do know, is that after the merger, Century will have a mountain of debt so vast we believe once interest rates start to increase, the company will simply not be able to service its debt and will have to seek protection through the courts.

We admit that $22 billion worth of debt may not seem like a big deal to many investors, especially considering that only $0.085 out of every Sales dollar goes to pay the interest on that debt.

But look around.

The current prime interest rate is 3.25%. Yet based on the combined companies FY09 financial statements, we estimate the interest rate for Century will be close to 6.5%, not the 4.75% that Century paid in FY09.

Why do we think this will be the case? First off, there will be a good deal more debt. Secondly, we think the merger at the very least will temporarily weaken the financial position of Century.

Accordingly, we think the company’s lenders will increase the company’s interest rate to compensate for the initial increase in risk.

Of course there is no guarantee that the company’s lenders will reduce the company’s interest rate once the company has completed integrating its new purchase.

As the matter of fact, we think that by the time Century has finished assimilating Qwest into its business model, the days of cheap interest rates will have ended.

So we seen no we see no potential decrease in interest rates for the company, maybe ever.

Other Metrics

Based on our review of both company’s current annual financial information, we think that after the merger, Century will have a Current Ratio of 0.84, a Quick Ratio of 0.69, and a Cash Ratio of 0.38, none of which are to us, investment quality.

We also believe that after the merger, at least 30% of the company’s Total Assets will be made up of Goodwill and Intangibles, and that Total Debt will exceed EBITDA by an almost 3.5:1 ratio.

Certainly there are potential bright spots such as Free Cash Flow, which we think will level out in the $3 per share range, and Return on Invested Capital which we believe will consistently be in the 20%-25% range.

Valuation

Based on our review of both company’s latest annual financial information, our Reasonable Value Estimate for the stock based on a 5-Year hold once the merger has been completed is $25, with a Buy Target of $15, a First Sell Target of $29, and a Close Target of $31.

We also believe that after the merger, Century will have an Enterprise Value of about $52 per share, an Equity Value of about $33 per share, and an Earnings Value of about $35 per share.

In addition, we estimate that EBITDA will run about 38% of sales, meaning that when our Enterprise Value estimate is considered, and assuming EBITDA stays at or near current levels, it should take Century approximately 16 years to pay for its investment in Qwest.

Final Thoughts

We said at the outset that we believed the merger with Qwest would be good for Qwest stockholders but not so good for Century stockholders.

Certainly we have no idea what the basis is for the current stockholders of Qwest, but coupling an entry point in the stock sometime in the past 5 years with an acquisition price of $6.02, the company’s current stockholders should recoup the vast majority of their investment.

In addition current stockholders of Qwest would be left with shares in CenturyLink, which we estimate will have a value of about $25 after the merger.

The same cannot be said for the current shareholders of CenturyLink. Considering our valuation estimate, many of them that took a position in the stock within the last 5-years are simply going to end up underwater.

In the end, Century must grow, and to do that they need access to additional markets, so merging with Qwest makes good business sense.

Our issue comes down to the assumption of more than $11 billion of debt, making us wonder if this merger is a Qwest for growth or grope for Qwest.

Wax

About the author:

wax
Wax Ink is a baseline equity research company not licensed or registered with any government agency

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Rating: 1.9/5 (11 votes)

Comments

roke6362
Roke6362 - 4 years ago


I purchased CTL in 2006. I sold out of it in 2007. I broke even, except for a small amount of dividend return.

My concern was the balance sheet. Without goodwill and intangibles, CTL had a negative equity. That bothered me.

Then, I saw where they drastically raised the dividend to a payout ratio of over 80%. A negative tangible equity and an 80% payout ratio is unsustainable.

I think the lesson of the past few years is that earnings are irrelevant if they do not produce adequate amounts of FCF, and are based on some tangible balance asset.

Good article.
davethebooker
Davethebooker - 4 years ago
When the merger was announced or I read it on 4/20 or so . Bought shares immediately. 5.28 or so.

When it passed 6 dollars a share I sold it at 6.03 on 9/20/10. 14.77 percent or annual 28 or so. That is fine.

It is a work out. So short time frames okay and there was another work out that much more profitable.

Also Land line communications are dino poo. And the merger was the only thing I really valued. I wasnt long here , just playing the merger.

Well the dividend was really good too. Yes. And collected some .

The Creator of Quest also was like a very creative individual. And did a great job of creating quest infrasturture. This merger in takeing the quest position I was worried about the strength of Quest.

So the power here was the offer price. And since it was a while to get by the regulators. Once I have a dividend payment and a good run up. And I felt and still feel q is overvalued. So I got out.

Nice work out. I am happy. Thank you Warren.

I
riley
Riley - 4 years ago
Your analysis is so far off base it's painful to read. Let's start here where you argue that the risk of rising interest rates will somehow bankrupt CenturyLink:

"The current prime interest rate is 3.25%. Yet based on the combined companies FY09 financial statements, we estimate the interest rate for Century will be close to 6.5%, not the 4.75% that Century paid in FY09.

Why do we think this will be the case? First off, there will be a good deal more debt. Secondly, we think the merger at the very least will temporarily weaken the financial position of Century.

Accordingly, we think the company’s lenders will increase the company’s interest rate to compensate for the initial increase in risk."
First, the prime interest rate is irrelevant. All outstanding debt at both Century and Qwest are in the form of fixed-rate bonds - they make the same interest payments every year until maturity. The only variable rate notes are based on LIBOR, not prime, and there is no outstanding debt on their lines of credit. Also, lenders can't just "increase the company's interest rate" when they feel like it. The rate is contractual for the life of the loan and is publically availble in the company filings. Secondly, Century will assume more debt AND MORE FREE CASH FLOW by acquiring Qwest. You can't say that Century will be weaker just because they will have more debt. Even the most basic analysis considers cash flow leverage, which is only marginally higher post-merger.

Moving on:

"Based on our review of both company’s current annual financial information, we think that after the merger, Century will have a Current Ratio of 0.84, a Quick Ratio of 0.69, and a Cash Ratio of 0.38, none of which are to us, investment quality.

We also believe that after the merger, at least 30% of the company’s Total Assets will be made up of Goodwill and Intangibles, and that Total Debt will exceed EBITDA by an almost 3.5:1 ratio."
So... a quick analysis of a typical telecom company balance sheet shows that current assets consist of 30-45 days of sales in receivables, no inventory, and cash balances sufficient to support operating expenses. Your calculations of current ratio, quick ratio, and cash ratio prove that you can perform simple arithmetic, but that's about all they prove. Just curious, what's your definition of an investment grade current ratio?? By the way, Qwest's debt to EBITDA is below 3.0x today and CenturyLink is around 2.0x. It is simply impossible that the combined company will be anywhere near 3.5x levered. Your math is fundamentally wrong.

If your objective here is to dispense investment advice, your best move would be to remove this article completely. You have misrepresented the risks of the merger so badly that you should be embarrased that anyone else is reading it. It's irresponsible.

wax
Wax - 4 years ago
Riley;

Thank you for your comments and in answer to them, the prime rate is extremely relevant. All outstanding debt of the two companies is not in the form of fixed-rate bonds, the two companies have almost $2.7 billion in short-term debt. Since the Century is merging with Qwest, thus in effect changing any loan covenants, lenders are now free to "adjust" any outstanding loan agreements.

As to our definition of investment grade for a current ratio is 2 or better, and as to our math being fundamentally wrong, that may be. But consider that had you looked at the companies latest ANNUAL financial information instead of their latest QUARTERLY information, you may have come away with a different answer.

As to our objective, it is simply to put forth a reasonably considered investment point of view, ours, and to share that with other interested parties.

As to misrepresenting the merger, again, we believe that reasonable people making reasonable decisions, would conclude that there is more risk for current Century stockholders than Qwest stockholders, which is really what the basis of the article was all about.

Wax
wax
Wax - 4 years ago
Roke;

Thanx for you comments. We think many investors have had similar experiences owning telecoms, we know we have.

Wax
wax
Wax - 4 years ago
Dave;

We are glad that you had a good trade and made a little money, we think you played this one perfectly. And as we noted in the article, the infrastructure is, at least to us, the only thing that has any potential value, and since any services are still going to be based on selling them to the customer. And at the moment, customers don't seem real interested in buying.

Wax
riley
Riley - 4 years ago


Wax, the $2.7B in short term debt CONSISTS of bonds at CenturyLink plus bonds and convertible notes at Qwest, all of which are fixed rate bonds that were issued many years ago and were paid off in 2010. Neither company borrows on their bank credit facilities. You can't be negatively affected by rising interest rates if you don't have any floating rate debt!! How can you say that a company with over $2.6 billion in cash balances and no floating rate debt will be negatively impacted by rising interest rates?? They would earn more return on their cash, therefore the OPPOSITE is true - they would actually benefit from rising interest rates because net interest expense would be lower. This is not a matter of opinion or "reasonably considered investment point of view" as you put it. It's just wrong - plain and simple.

I did use the quarterly financials for my basis, primarily because the annual financials are over 10 months old and issued prior to the merger announcement. The terms of the merger require Qwest to pay down a significant portion of debt prior to being acquired, the majority of which has already been paid down. I can't tell if you're defending your use of old financial statements, but obviously you need to consider more current information before making a risk assessment. You should not be using company reports issued 10 months ago and 4 months prior to the merger announcement.

I also disagree with your conclusion that Qwest shareholders are currently exposed to less risk than Century. Qwest stock went up after the announcement, thus the market views the acquisition as positive for Qwest stockholders - a fact which you do not dispute. Thus, the acquisition risk/reward is already baked into the stock price of both companies. Following this logic, if the merger agreement falls apart for some reason, Qwest stock price will go back down because the acquisition price would no longer support the enterprise value of Qwest, right? And all things being equal, CenturyLink shares would go back up because the acquisition would no longer threaten to dilute CenturyLink's existing equity, right? So, to recap, if the acquisition doesn't go through, CenuryLink goes up, Qwest goes down. How can you then conclude that CenturyLink shareholders are exposed to more risk than Qwest shareholders?
wax
Wax - 4 years ago
Riley;

We may be "just wrong - plain and simple", but we are very happy to be wrong, since we believe that any company with access to capital markets, ANY company and ANY capital markets can be impacted by interest rates at any time.

So being wrong simply provides us with a more conservative approach to investment considerations, something we believe over time, will be in our best interest.

The following is from Century's 10-K. We highlight it here because this same language is in almost every 10-K we read. The point is, this company and every other company with fair management knows they have a susceptibility rising interest rates.

"We have a substantial amount of indebtedness, which could have material adverse consequences for us, including (i) hindering our ability to adjust to changing market, industry or economic conditions, (ii) limiting our ability to access the capital markets to refinance maturing debt or to fund acquisitions or emerging businesses, (iii) limiting the amount of free cash flow available for future operations, acquisitions, dividends, stock repurchases or other uses, (iv) making us more vulnerable to economic or industry downturns, including interest rate increases, and (v) placing us at a competitive disadvantage to those of our competitors that have less indebtedness."

Please also consider, a point we did not mention in our article, that the company's customers are also faced with the same challenges with rising interest rates.

As to our use of financials, here's the deal. We write an article. The idea is to create discussion. The more discussion, the more everyone learns. Not just about a specific topic, but about investing in general. The issue we have is that our articles are taken from OUR perspective.

What we don't want is for someone to take the information we include in an article and decide it's gospel and then take a position in a stock. Don't laugh, it has happened many many times.

Because of this, we try to be as conservative in our approach as practical and that includes using audited financial statements which for the most part, happen to be annual financial statements. We also use tangible book value instead of book value for the same reason.

As to Qwest shareholder risk exposure, all we can say is that if you have a penny in the market then you have a penny at risk. The conclusion that we drew we thought was fairly straightforward.

We took each company's annual financial information and determined a value based on that information. For Qwest, we came up with an estimated value of about $18, assuming a 5-year hold, and for CenturyLink we came up with an estimated value of about $41. Then we took the financial information from both companies and combined them to create one set of financial data and based on that combined data we estimated that the value of THAT company, would be about $25.

Next we went back and looked at the historical close for Qwest over the last five years. Remember we are talking generalities here, and decided that a price in the $6-$7 seemed reasonable. The conclusion that we drew then, was that an investor in Qwest, taking a position in the stock in the last five years would have an average basis of about $6.

Based on what we read, Century has agreed to pay about $6 per share for Qwest. The conclusion then was that Qwest shareholders got their investment back, and still had something, shares of Century, worth about $25.

Conversely, shareholders in Century ended up with a stock that based on OUR valuation is worth $41 without Qwest and $25 with Qwest, so it seemed to us, that the based on the combined financial data, the shareholders of Qwest were exposed to less risk than the shareholders of Century.

We hope this response speaks to all of the items you mentioned in your last response. If not, please keep challenging us.

Wax
riley
Riley - 4 years ago


The risk of rising interest rates is completely negated when the company's cash balances exceed its variable rate debt. All the other enumerated risks of debt highlighted in the standard boilerplate excerpt you copied from the 10-K are in fact relevant (i.e. limiting access to capital markets, limiting cash flow, etc.), but if interest rates went up, only a very small percentage of debt (less than 3%)would be affected. In fact, if the spread on that debt doubled (highly unlikely) from 3.25% to 6.5%, the increase in annual interest expense would be about $25 million, or about one half of one percent of their annual cash flow. It's immaterial. There's a big difference between being "conservative" and misguided.

I don't understand how you calculated the value of Qwest at 18 and Century at 41 using the annual financial statements, and how the combined company should be at $25??, so I can't really debate it with you. I will debate this statement however:

"Based on what we read, Century has agreed to pay about $6 per share for Qwest. The conclusion then was that Qwest shareholders got their investment back, and still had something, shares of Century, worth about $25."

I don't know what you read, but check the SEC filings on April 22 and you'll see the actual terms of the merger. Century is not paying $6 cash to Qwest shareholders, they are exchanging Qwest shares for 0.1664 shares of Century (1 share of Century = 6 shares of Qwest approximately). So Qwest investors do not get their investment back, 100% of their investment transfers into Century. The actual value of the transaction (or the value Qwest shareholders will receive for their position) depends on the value of Century stock on the day the merger closes. If you're predicting Century will be trading at $25, then Qwest is only worth about $4.17 per share ($25 divided by 6), which means Qwest shareholders would lose money if they bought at $6, right?

I don't know man, I guess none of your arguments make any sense to me, and I don't know what you mean by "OUR perspective". I assume it means the perspective of a freshman undergrad who is halfway through Investing 101 and almost knows enough to be dangerous?
davethebooker
Davethebooker - 4 years ago
To me ... for my clients I am shooting for 15 to 20 percent returns. And the Qwest work out was within that frame work. With a low risk. Undervaluation was the key. Simple. Thank you Warren
wax
Wax - 4 years ago
"I don't know man, I guess none of your arguments make any sense to me, and I don't know what you mean by "OUR perspective". I assume it means the perspective of a freshman undergrad who is halfway through Investing 101 and almost knows enough to be dangerous?"

What can we say Riley, apparently we just don't have your intellect.

Wax

riley
Riley - 4 years ago
Hey, sorry my comments came across so arrogant. Nothing personal, just trying to understand your original post a little better. Good luck to you Wax.

-Riley
wax
Wax - 4 years ago
Riley;

Looking back, now that I'm almost 60 and have been doing this for 32 years, and considering that Wax Ink will turn 27 in a few months, maybe your right, maybe it's time to let the younger folks have it. Anyway...thanx.

Wax
davethebooker
Davethebooker - 4 years ago
Guys we are all one. If you are 60 or 27 , who cares ? To be able to allways be in a state of learning untill we die. Somethings the elders know , somethings the youngsters know. The ability to learn from each is important. Adaptation is the greatest investment tool anyone has , filters are another. We all are in the same boat headed towards the same destination. Make money .

wax
Wax - 4 years ago
Dave;

Learning is what is has always been about.

Wax

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