Investing in high growth business sectors comes at a cost. More often than not, stocks representing such industries trade at high valuation multiples, attaching a significant risk to those investment opportunities.
In some rare instances, however, market gyrations open up lucrative opportunities in growth companies, and investors who double down on growth stocks at cheap multiples often end up booking in handsome returns down the line. Lumen Technologies, Inc. (LUMN, Financial), previously known as CenturyLink, seems poised to grow exponentially in the coming years, but the market seems to be oblivious to that fact.
The outlook
The rollout of 5G technology has already made waves in the market, and smartphone manufacturers have been the primary beneficiaries of this movement as investors have rewarded them with high valuation multiples.
On the other hand, investors looked down on Lumen as its 250,000-mile fiber network in the United States and 300,000-mile network internationally were expected to become obsolete once 5G was introduced. The general expectation was that consumers will cancel their fiber-based internet subscriptions in favor of 5G technology.
However, investors seem to have missed the fact that telecommunication operators such as AT&T Inc. (T, Financial) and Verizon Communications, Inc. (VZ, Financial) will depend on fiber networks as an extraordinary number of small cells are required to equip the nation with 5G technology. This creates a solid business opportunity for Lumen, and the company is already capitalizing on this.
The new-look Lumen is focused on capturing market share from the growing cloud computing industry as well by providing robust connectivity solutions for cloud companies. Lumen's position as a key infrastructure developer to these growing concepts is illustrated below.
Source: Company presentation
Despite the initial expectation that Lumen will be hit hard by the growth of 5G and cloud computing, the company is well-positioned to convert these headwinds into tailwinds that drive earnings growth.
The smart money is already on the table
Investors constantly look for clues from gurus to identify investment opportunities. Most of these renowned investors beat the market consistently because of their skills and information.
Southeastern Asset Management, which is a well-known value investing company led by Mason Hawkins (Trades, Portfolio), added more than 2 million shares to its position on Lumen Technology between Oct. 16 and Dec. 1, according to a statement filed with the SEC. The shares were purchased at prices ranging from $8.75 to $10.55, which confirms the guru believes Lumen is significantly undervalued. Southeastern has a reputation for being an activist shareholder as well, and it will not come as a surprise to me if the guru leverages his stake in Lumen to push the company to achieve operating efficiencies in the coming months.
The stock is in deeply undervalued territory
Lumen is currently trading at a forward price-earnings ratio of just 8, but the stock has traded at a five-year average multiple of over 15 according to data from Morningstar. The communication services sector, in comparison, is trading at forward earnings multiples of close to 20, suggesting Lumen is significantly undervalued from a comparative perspective. Most other valuation ratios, including price-sales and enterprise value-to-Ebitda, suggest the same, as Lumen is trading at a significant discount to the sector averages.
A cheap valuation level, however, is not a standalone indicator of an attractive investment opportunity. There need to be catalysts that could drive the market value of a company toward the fair value estimate. In Lumen's case, expected earnings growth resulting from favorable macroeconomic developments, the strengthening balance sheet and the very attractive dividend yield will all act as drivers of value in the coming years.
How safe is the dividend?
There could be many reasons behind an unusually high dividend yield, and the expected decline in the profitability of a company could be one reason as it ensures a stock trades at very cheap multiples. In Lumen's case, however, the attractive dividend seems to have resulted from an anomaly between the economic reality facing the company and its market value. At the market price of around $9.75 on Dec. 23, Lumen stock yields just over 10%. Well before the Covid-19 recession, the company slashed its quarterly dividend from 54 cents per share to just 25 cents, but the yield remains very attractive despite this reduction in payout.
As illustrated below, the company has consistently covered its dividend distributions with free cash flow, which is a positive sign as this goes on to highlight that the company is closely monitoring its cash position when it comes to capital allocation decisions.
Source: GuruFocus
Another important metric that helps determine the safety of dividends is the stance of the management on its dividend policy. During an interview with CNBC, Warren Buffett (Trades, Portfolio) once said that the dividend policy of a company closely represents the quality of the management team as well. During the third-quarter earnings call, Lumen CEO Jeff Storey said:
"We remain committed to returning capital to shareholders through our dividend and are very comfortable with a dividend payout ratio in the 30s, one of the lowest payout ratios compared to our large peers. We believe the balance we achieved through this 3-pronged capital allocation has served us well through the COVID pandemic and the uncertainty in the economy, giving us ample liquidity to continue to invest for growth, reduce debt and return capital through our dividend."
Lumen's top executives seem to be very comfortable with the current payout ratio, which is a promising sign for dividend investors. Even though the current yield is very high in comparison to its peers, there are no alarming signs to suggest Lumen would have to reduce its quarterly dividend in the foreseeable future.
The financial position
At the end of the third quarter, Lumen had close to $33 billion of long-term debt on its balance sheet, and this debt burden has been one reason behind the lackluster valuation multiples at which the stock traded in the recent past. This, however, is not a good indicator of the expected financial performance of the company. What is more important is that Lumen has recently taken various measures over the last few months to deleverage. These actions fall into two categories.
First, the company has used the current low-rate environment to improve its short-term debt maturity profile by refinancing a portion of its debt. This is an important step as it enables Lumen to pursue growth opportunities in the next five years instead of being tied down by higher interest payments.
Source: Company presentation
Second, the company has focused on repaying some of its debt to improve its debt-to-equity ratio. According to company filings, Lumen has repaid over $9 billion in debt in the last 12 months, which is a clear indication that the company is moving in the right direction.
Combining the improving financial position of Lumen with the expected growth in earnings over the next few years, I believe the stock is mispriced at the current valuation level.
Takeaway
Lumen Technologies is a growth company that is being ignored by the market, and this presents a very good opportunity for contrarian investors who are looking to beat the market in my opinion. The healthy dividend yield of over 10% also compensates well for the risks of investing in the company.
Disclosure: The author owns shares in Lumen Technologies.
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