Thesis

Recommending CenturyLink (CTL) as a long. CenturyLink, a legacy wireline telecommunications company, recently cut its dividend by 25%. In the process, the company traumatized its income oriented shareholder base, sending the stock down ~23% and raising further questions about the health of the business. I believe the dividend cut is distracting investors from a stabilizing, high free cash flow yielding business that continues to offer attractive opportunities for capital returns to shareholders. I value CenturyLink at $40-$45/share.

CenturyLink is certainly one of those “slowly melting ice cube” investments. The stock’s quantitative cheapness is widely evident on a both a FCF and dividend yield basis. As a result, I will supplement my discussion of value with an examination of the stock’s risk-reward balance, which I believe is favorable due to large up-front capital returns to shareholders over the next two years (despite the dividend cut) totaling ~21% of the current market cap on an undiscounted basis. I will also address the issue of earnings and cash flow sustainability, which I believe is a key debate. I do not claim to have definitive answers to this debate, which I believe has strong contingents on both sides. I merely attempt to present my view as well as a investment opportunity with an attractive risk-reward profile, and then leave it to readers to develop their own conclusions.

Please see below for important disclaimers.

New Capital Allocation Plan

On February 13, CenturyLink announced 4Q12 earnings, modestly beating consensus estimates. However, investors were shocked by an unexpected 25.5% quarterly dividend cut (from $0.725/share quarterly to $0.54/share quarterly), with the stock falling by ~23% soon thereafter as a result. Interestingly, in addition to the reduced ongoing dividend management announced a $2.0b share repurchase plan, to be executed via open market purchases with free cash flow from the business through February 13, 2015. Management indicated on the 4Q12 call that given the substantial fall in stock price, the company may accelerate share repurchases through borrowing.

Beginning in 2015, CenturyLink will exhaust its federal income tax net operating loss carryforwards, increasing the company’s cash tax bill from near zero currently to ~39% of pre-tax income. These NOLs are largely from the acquisitions of Qwest and Savvis. As a result, to keep dividend payout as a percentage of FCF stable at ~60%, management would have to reduce the dividend starting in 2015. Most had expected the company to hold off changes to the dividend until 2015 is a little closer. However, management decided to bite the bullet early and cut ongoing dividend payments now. To return cash from the one-time NOL benefit to shareholder, management has opted for a $2.0b buyback program over the next two years. Buybacks will also reduce share count, thereby reducing cash required for future dividends.

Effectively, management slashed the dividend, sent the share price plummeting, and then got no credit for increasing total net capital returns over the next two years by a little less than ~$1b (when accounting for the lower dividend offset by the new $2b buyback program). Needless to say, the optics of the dividend cut were troublesome and sent the wrong message (i.e. is management saying that business fundamentals are deteriorating more than the market believes?), and the sheer surprise felt by many analysts and investors created negative sentiment as well. I believe management was trying to improve capital allocation by separating recurring from non-recurring capital returns, but the message was lost. The fact remains that total capital returns to shareholders over the next two years were actually increased by almost ~$1b.

Core Business Stabilizing

Management continues to execute on its strategy to stop the decline of business fundamentals as the company faces falling wireline revenues, regulatory changes, and competitive pressures. In 2012, CenturyLink reached a positive tipping point, where “strategic” revenue (i.e. revenue streams on which the company wants to increase reliance) roughly equaled “legacy” revenue (i.e. revenue streams on which the company wants to decrease reliance), with each making up ~48% of segment revenue. Management expects revenue to stabilize by 2014, with guidance for a 0.5%-1.5% decrease in 2013. Since strategic revenue is lower margin than legacy revenue (more expenses associated with providing advanced services than traditional wireline phone service), EBITDA is expected to stabilize after revenue, possibly by 2015.

To review the basics of the business, CenturyLink is a wireline telecommunications provider that offers a range of services to residential, business, government, and wholesale (other telecommunication companies) customers. Services include local & long distance telephone, private line access (i.e. fiber to the tower, fiber to the node), broadband & data, managed & cloud hosting, wireless, and video. The company is the “incumbent” local service provider in 37 states, and has 68 data centers globally. CenturyLink has completed three major acquisitions since 2009: Embarq (a local exchange carrier), Qwest (a fiber optics company that eventually merged with a baby bell, US WEST), and Savvis (a global cloud & managed hosting, colocation, and network services company).

There are a lot of moving pieces to the stabilization story, as revenue mix is changing as well as margin mix, layered on top of three transformative acquisitions as well as organic growth going forward. I do believe that management will need time to execute and work out the kinks of integrating businesses. But I believe the new CenturyLink platform offers strong opportunities for wringing out synergies and cross-selling benefits over time.

Making matters more confusing, the company just changed reporting segments starting in 1Q13, after changing them initially in 2011 and then again in 2012. The new segments are Consumer (the consumer part of the old Regional segment), Business (the small & medium enterprise part of the old Regional segment and the old Enterprise Network segment), Wholesale, and Data Hosting. I’ll briefly review segments as reported in 2012.

1) Regional Markets (57% of core revenue, 61% of core income, ~57% margin): The Regional Markets business sells the following to residential and small & medium enterprises:

a) Wireline local and long distance telephone service: Obviously a dying business, but I     believe it could endure longer than many believe. Older people will likely hold onto wireline service for some time, and CenturyLink offers VOIP services to recapture defections from the traditional copper service.

b) Broadband Internet: Remains a strategic focus and growth area, although subject to competitive pressures.

c) Video: CenturyLink offers its own cable-like video service Prism. The company is also a re-seller of DIRECTV. Video remains a strategic focus. The company offers bundling options with phone, internet, and TV.

d) Wireless: The company resells Verizon Wireless services. In the past, management had considered engaging in some wireless M&A to build an in-house capability, and the company owns some spectrum. But at the moment (and given the wave of consolidation in the wireless industry), I don’t expect any changes here. However, I wouldn’t be            shocked if CentryLink ends up with its own wireless service in the next 10 years (and there is plenty of FCF to pursue a project like this once the core business is stabilized).

2) Wholesale Markets (21% of core revenue, 28% of core income, ~70% margin): CenturyLink sells “last mile” service to out-of-region long distance and data carriers, a business not only in secular decline but also under regulatory pressure. The FCC’s “Connect America and Intercarrier Compensation Reform” (CAF) rule will reduce intercarrier payments for wholesale services, but could allow for some offsetting higher customer charges. The part of this business that management considers to be strategic is the private line offering, encompassing “fiber to the tower” and “fiber to the node” services. Certainly a capital intensive business, but a lot of upfront investment has already been made and the company generates more than enough cash to make the investments necessary and service all other obligations. The “fiber to the tower” business should continue to see growth as mobile data intensity increases and carriers move to 4G.

3) Enterprise Network (15% of core revenue, 8% of core income, ~28% margin): CenturyLink provides a mix of legacy telephone, broadband internet, and customized telecommunication solutions to large enterprises and government. Government business may come under pressure near term due to fiscal issues, but they still have to use the internet.

4) Enterprise Data Hosting (7% of core revenue, 3% of core income, 22% margin): This segment encompasses the Savvis business, and entails the provision of managed, cloud, and colocated data hosting services. Definitely a secular growth area, and there are lots of opportunities for cross-selling with CenturyLink’s deep corporate customer bench.

Balance Sheet

CenturyLink has $20.6b in long term debt, in addition to pension & OPEB liabilities (discussed below). The company expects to maintain leverage below 3.0x EBITDA, with current leverage of ~2.7x (and a credit facility covenant of a maximum of 4.0x debt to EBITDA). Interest was ~5.8x covered by EBITDA in 2012.

While the CenturyLink parent company is likely to be downgraded to HY from IG, the Qwest and Embarq subsidiaries, which hold some debt, will likely remain IG. The company plans to refinance maturities as they come due, and maintains access to capital markets despite the prospect of a parentco downgrade. Only ~$725m of maturities through 2015 are at the parentco level, allowing the company to refinance near-term maturities as IG issuances. The company has ~$1.7b out of $2.0b available on its credit facility.

Valuation & Risk-Reward

CenturyLink is a challenging company to value, as one faces the compounded ambiguity of uncertainty regarding future earnings power complicated by difficulty choosing a discount rate. I value CenturyLink at roughly ~$40-45/share today, accounting for excess returns in 2013 and 2014 before the NOLs run out as well as the value of the ongoing, stabilized business starting in 2015. The stock would also offer continuing annual dividend yield equal to ~6.2% of the current stock price.

CenturyLink is currently trading at a ~14.1% FCF yield on the mid-point of 2013 FCF guidance of $2.93-$3.13b (management guidance adjusted for ~$70m of integration capex), and a ~9.6% yield on estimated 2015 “steady-state” FCF of ~$2,066m (which incorporates the rolling-off of the NOL tax shield as well as some decline in core FCF as operations stabilize).

I calculate 2015 “steady-state” FCF assuming the following: 1) The company’s buyback program reduces diluted share count by ~8% over two years from ~623.7m to ~573.8m shares; 2) The quarterly dividend of $0.54/share remains stable at the new, reduced level; and 3) The dividend is in-line with management’s goal for a 60% payout ratio as a percentage of FCF.

A very basic DCF using an 8% discount rate, an 8% terminal value FCF yield, the mid-point of adjusted FCF guidance of $3,030m for 2013, flat FCF in 2014, and the estimated steady state FCF of $2,066m in 2015 yields a $44/share value. As a guidepost, Verizon (VZ) trades at a 5-6% FCF yield (once income attributable to the non-controlling interest in the wireless business is adjusted out), so an 8% FCF yield for CenturyLink seems reasonable once business fundamentals stabilize.

One of my favorite aspects of this stock is the extent to which up-front capital returns serve to de-risk the investment. Over the next two years, CenturyLink will return ~$4.6b in capital to shareholders through dividends and buybacks, almost $1b more than under the previous dividend-only capital allocation strategy. Capital returns will total over 21% of today’s market cap on an undiscounted basis, allowing for up-front income and serving to substantially reduce one’s cost basis. As a result, I believe the payout of such a substantial proportion of current market cap over the next two years serves to skew risk-reward to the upside and helps put a valuation floor under the stock (barring any substantial deterioration in results in the meantime).

Note: Some would argue that a buyback does not de-risk the investment, as buybacks are akin to doubling down. I believe this view has some merit, but the dividend vs. buyback debate is beyond the scope of this write-up. For current purposes, I focus on the magnitude of capital returns.

Risks

1) Challenging business fundamentals: As discussed above, CenturyLink faces a challenging business environment for wireline telecommunications companies. Management believes revenues will stabilize in 2014 (and EBITDA soon thereafter), but any setbacks executing on the company’s strategy could put FCF generation at risk.

2) Potential debt rating downgrade: I believe the market is generally aware that CenturyLink is at risk of a ratings downgrade from IG to HY. Management has explicitly stated that they have chosen continuing capital returns to shareholders and a full capex investment plan over maintaining the IG rating. The Qwest and Embarq boxes will likely remain IG.

3) M&A activity: CenturyLink management has been very active in deal-making over the past several years. The company acquired Embarq (local exchange carrier) in 2008, Qwest (wireline telecommunications and owner of a baby bell) in 2010, and Savvis (cloud infrastructure and IT solution) in 2011. At this point, management has indicated that they are focused on integrating Qwest and Savvis. Organic capex, capital returns to shareholders, and debt management remain stated priorities over M&A. However, given the company’s past deal cadence, the risk remains that a target catches management’s eye and interferes with capital returns.

4) Rising interest rates: Dividend oriented stocks are currently receiving lots of attention from yield hungry investors. Rising interest rates might reduce demand for dividend stocks. It appears that rates are set to remain low for some time to come, but as the Fed’s recent minutes indicate, there is some dissension on this topic. I believe CenturyLink’s high FCF generation will continue to have appeal even if rates rise.

5) Changes to dividend tax laws: As a high yielding stock, CenturyLink would be negatively impacted by any changes to tax law that increase taxes on dividends. At this point, it seems like this overhang may have been removed for now with the fiscal cliff deal. However, given the current fiscal uncertainty, this risk remains real.

6) Labor Issues: 40% of employees are unionized. The company’s collective bargaining agreements expired in 2012, and the Communications Workers of America executive board has authorized a strike. At this point, negotiations continue while the union President considers when to set a strike date. If a strike were to occur, I believe that it would be a short term negative, and would not change the long term thesis (and could potentially create an even more attractive entry point).

7) Legacy Liabilities: CenturyLink has ~$3.0b in after-tax pension & OPEB liabilities. The cash flows required to service these are accounted for in FCF. While these liabilities are meaningful, the company is able to support its ongoing contribution obligations without issue. Over the long term, rising interest rates will act to reduce the underfunded balance.

Catalysts

1) Accelerated share repurchases

2) Continued integration execution

3) Future guidance updates

4) Strike overhang resolution

CenturyLink Valuation

2012 P/E	~12.8x
2013 P/E	~13.1x
2012 EV/EBITDA	~5.4x
2013 EV/EBITDA	~5.6x
Current Dividend Yield	~6.3%
2012 FCF Yield	~14.8%
2013 FCF Yield	~14.3%
2015 “Steady-State” FCF Yield	~9.7%

Important Disclaimer

The above text is the view of the author and is for informational and educational purposes only. It should not be construed as investment advice or a solicitation to buy or sell securities. The author may hold a position in the securities mentioned, and does not have to provide updates for changes to his view. The author does not warrant his work for correctness or accuracy. Perform your own due diligence before making investment decisions.

1) Accelerated share repurchases

2) Continued integration execution

3) Future guidance updates

4) Strike overhang resolution