Overview
CenturyLink (CTL, Financial), a telecommunications company providing internet services to both business and consumer customers, in November 2017 acquired Level 3 Communications, which was the third-largest provider of fiber-optic internet access, for around $24 billion.
The company is under market scrutiny as most investment managers are doubting it can sustain the next wave of new wireless technology, namely 5G.
Jeff Storey, the former CEO of Level 3, stepped in as new CEO of CenturyLink in May 2018, replacing Glenn Post, who had been in that role for more than 26 years.
The acquisition strategic target is clear: CenturyLink intends to become the leading internet and private networks provider by leveraging its huge asset base of fiber-rich networks.
Risks and misunderstandings
Because the stock price is quite depressed (capitalization is only slightly more than $13 billion at the time of writing), it is important to understand the criticisms the investment community has raised against the company and which are real risks or negative points, as opposed to potential misunderstandings.
Revenue decline
Total revenues were $23.4 billion in 2018, compared with (pro-forma) $24.1 billion in 2017. This is mainly due to the fact that the company is exiting unprofitable businesses lines, which is a wise way to divert precious cash resources to higher margin businesses. As a proof of that, adjusted Ebitda margins actually increased in the fourth quarter of 2018 to 39.8% from 36.8% in the prior-year quarter.
Debts and dividends
Another factor that contributed to negative sentiment was the widely shared opinion that the dividend was in jeopardy.
The fear of a dividend cut has existed for several quarters, even if the CEO continually reassured investors that the payout was nicely covered by projected free cash flow. However, at the end of the third quarter of 2018 it came clear that the company could not keep its promises of generating free cash flow in the range of $4.00 billion to $4.20 billion, declaring a more comfortable range of $3.60 billion to $3.80 billion.
During the fourth-quarter earnings call, the company capitulated, and the CEO announced that the board is “reducing annual dividend to $1.00 from $2.16 per share, lowering leverage target to 2.75 to 3.25 times net debt to adjusted Ebitda and accelerating the timeframe to be within the target range.”
While announcing this cut after delaying the decision for several quarters (and continually stating that it was not needed) can harm CEO and board credibility, this was the best decision they have recently made, as high debt is a real risk, especially for a company with more than $2 billion of yearly interest expenses in a market with potentially higher cost of money in the future. As a side note: Even after the cut, the dividend yield is currently more than 8% with absolutely good free cash flow coverage.
Landline and 5G
The main worry about CenturyLink operating business' future is linked to its old landline business. Actually, the company's name has so long been associated with consumer fixed-line services that most ignore that CenturyLink derives only 23% of its revenues from a pure U.S. consumer business.
Of course not all institutional investors think the same. Here is what Mason Hawkins' (Trades, Portfolio) Longleaf Partners investment managers stated in their fourth-quarter 2018 shareholders letter: ”CenturyLink remains an overweight position given its deep discount and the quality of both its management team, led by CEO Jeff Storey, and its fiber assets, which we believe are of high strategic value to numerous infrastructure investor.”
The modern CenturyLink is investing heavily in the enterprise business by replacing old fiber with new long-haul fiber and has a heavy base of fiber assets (networks and conduits). During the last earnings call, the CEO recently stressed that “adding our next long haul fiber cable is a simple matter of pulling the cable into a spare conduit, no new rights of way, no permitting, no trenching, just pull and splice.” That is possible because it is simply leveraging its (mostly underground) assets, which were built over many years by investing billions and billions of capital.
Another serious risk for the company is the advent of 5G, as it promises to be much more reliable than other wireless technologies. Maybe it's too early to say if 5G will seriously harm the fiber business or not. My idea is that it will be used increasingly by the consumer segment, but the enterprise segment will continue to rely heavily on the newest fiber connections, both because they are improving network speed and because companies have invested in it in order to have stable networks, insulated by bad weather conditions and other possible interferences, not to mention the recent fears (triggered by a National Toxicology Program research) about the relation between electromagnetic pollution and health issues.
On a positive note, the integration process with Level 3 was successfully executed. Here is what the CEO had to say: “With respect to synergies, we achieved the full run rate savings of $850 million in one year rather than the 80% in three years as initially projected and we believe we still have more to come.” This was possible due to a very competent management team that is taking cost reduction (and in general, capital allocation) seriously.
Valuation and conclusions
I estimated the value of CenturyLink with a simple DCF model, in conservative conditions. Assuming that the company hits the lower bound of the 2019 estimated free-cash-flow range ($3.6 billion) and stays constant for 10 years (and beyond), with a WACC of 10%, the estimated fair value comes to around $20 (which is 66% higher than the current market price).
Of course things could get even worse, and free cash flow could decrease over time or even collapse. This depends on how much fiber network solutions will be around in 10 or 15 years from now and on management’s ability to leverage those assets and wisely allocate capital to the benefit of CenturyLink shareholders.
Disclosure: I currently do not own shares of CenturyLink.
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