Description

Business Overview 
CenturyLink is the result of the $32bn October 2017 merger between Legacy CenturyLink and Level 3 Communications (~$7bn cash, resulting in 51%/49% PF ownership split). Both legacy companies themselves were the product of numerous acquisitions. CenturyLink was historically an incumbent local exchange carrier (“ILEC”) with significant exposure to secularly declining businesses like voice and DSL, on an antiquated copper-based (as opposed to fiber) network. Through acquisitions (Embarq for ~$12bn in 2009, Qwest for ~$22bn in 2011), however, Legacy CenturyLink also had a sizable fiber network and large enterprise business. Legacy Level 3 is a tier-1 fiber network serving primarily business end markets and is also the product of numerous acquisitions (Global Crossing for ~$3bn in 2011, TW Telecom for ~$6bn in 2014.) 
Legacy CTL represents ~2/3 of combined EBITDA. The combined company now has ~75% of revenue from business customers. Approximately 1/3 of combined company revenues are secularly challenged – voice, DSL, wholesale UNE. 

Situation Overview 
Shares have declined ~50% since August. However, given the significant (4x EBITDA) leverage, the enterprise value has only declined ~20%. Shares have re-rated from ~6.8x consensus NTM EBITDA in August 2018 to ~5.5x today. Legacy CTL historically traded from 5.5x to 6.5x EBITDA; legacy LVLT (now ~1/3 of EBITDA) traded from 9-10x EBITDA, sometimes higher. Zayo is also a fiber business, albeit with a more transit-focused (as opposed to services) model, and trades at ~10x EBITDA and has historically ranged from 9-12x EBITDA. However, Zayo is under pressure from Starboard to consider a sale and has also considered a REIT transformation, which impacts the comparability of multiples. 
Since closing the merger in October 2017, integration got off to a strong start, with management significantly outperforming synergy targets (hitting full target 2+ years ahead of time) and raising 2018 EBITDA guidance ~3% and FCF guidance 30%+ in 1H. While management was able to hit the increased guidance (beat high end of initial 2018 guide), 2018 FCF benefitted from a few non-recurring items (tax, working capital) which led to disappointment following 2019 FCF guidance. 
Furthermore, in September 2018, well-regarded CFO Sunit Patel departed for T-Mobile and subsequently, in Feb 2019, CTL cut their sizable dividend, which management had previously assured investors (many dividend-focused) was safe. Management contended this was not due to a change in their view of the businesses trajectory, but rather to focus capital allocation on de-leveraging more rapidly, with a target of 2.75-3.25x within 3 years. 

Summary Long Thesis: 
This is a high fixed cost business facing secular pressures in an industry known for price deflation and over-building, the product of two decades-long roll-ups, with significant financial leverage, a recent CFO change, and a recent financial controls disclosure. It’s basically everything a short-seller could wish for. However, after the dramatic re-rating of the shares and all of the bad news you were likely playing for short (dividend cut, FCF guide down) having already played out, there is real value and scarcity in the fiber-based enterprise business ($50bn+ of gross PP&E), particularly hard to duplicate metropolitan fiber. While fiber faces pricing pressure like all of telecom, it is a secular share gainer driven by both long-term growth in data consumption as well as the shift from copper to fiber. While new technologies will always come and go, they are likely to continue to ride on top of a fiber infrastructure. Additionally, new CTL is now the #2 player in the ~$90bn commercial market and is likely well positioned to gain share. AT&T and Verizon represent ~50% of the commercial market, are not focused on enterprise, and are consistent share donors. CEO Jeff Storey had a strong operational and integration track record at LVLT, driving a 1000+ bps increase in EBITDA margins and a triple in the shares during his tenure. Near-term debt redemption issues are minimal and well-covered by cash flow. 

Target Valuation: 50-100%+ Upside vs. 20% Downside
My base case target valuation is based on ~6x ’21 EBITDA (burdened by SBC and excluding CAF II income) of $8.6bn which implies a share price of ~$17 + $1.75 of interim dividends for 50% upside and an ~28% IRR. My bull case is 6.6x 2021 EBITDA (burdened by SBC and excluding CAF II income) of $9bn for a share price of $24 + $1.75 of interim dividends for 100% upside and a 50% IRR. My bear case is 5.3x $8.2bn of 2021 EBITDA (burdened by SBC and excluding CAF II income) for a share price of $8 + dividends for ~20% downside. 

Key Thesis Points 
#1: Conduit-based fiber footprint is best-in-class and nearly impossible to duplicate (>$50bn of gross PP&E). 
CTL has 450k route miles of fiber, 37.5k miles of subsea fiber, 16k miles of conduit, >150k on-net fiber buildings. AT&T, Verizon, Comcast, and Zayo have 1.1mm, 520k, 145k, and 113k route miles of fiber, respectively. Building a fiber network in a high density metropolitan area is difficult – requires significant permitting, similar to tower businesses; however, once “on-net”, a building delivers revenues at high incremental margins; CTL’s conduit-based network is an important advantage. 

#2: New CTL is the #2 player for business end-market and a likely long-term share gainer 
Combining Legacy CTL and Legacy LVLT’s sizable commercial businesses results in the #2 enterprise connectivity provider after AT&T and ahead of Verizon. AT&T and Verizon represent ~50% of commercial wireline market and are steady share donors. Their networks are predominantly copper and management is not investing heavily in the commercial market. Combining Legacy CTL and LVLT network allows for both an improved value proposition to customers as well as a better cost structure with more buildings “on-net” in the combined network. Further, without having to pay other providers (“off-net”), not only is there a large cost opportunity in network access costs, new CTL can price business and compete more effectively. 
“Our chances of winning go up a fair bit more, because on any given bid, we can serve more locations on-net than each of the companies could on a standalone basis. And the more locations you serve on-net, meaning the less you have to rely on your competitors to win the business, which is always a good thing” – JPM Conf, 5/16/18 
Additionally, given their newly combined scale, CTL has found they are invited and able to bid more competitively on larger business. Given the longer sales cycle of large enterprise deals, there could be a lag before this benefit begins to take hold. 
“We see that as the second largest in wireline, enterprise business, we use that to fight at Level 3. We had to fight to be included in the competition. Now, we're automatically included in the competition, so that gives us greater opportunities to win business from customers.” – GS Conf., 9/12/18
“Given the scale and the size of the combined company, we're now seeing interest from customers being invited to the table for larger deals which we view as a positive” – JPM Conf. 5/16/18

Customers also believe CTL is more likely to invest in their network than AT&T and Verizon who are distracted by other businesses (5G build-out, entertainment). The business market is ~75% of revenue for CTL vs. teens for AT&T and Verizon. 

"To industry consolidation point, now that we are the second largest provider, it'd be tough to someone who is soon to invite CenturyLink to look at this, because chances are with our connectivity fabric, we can probably give them a sharper offer than anyone else. And more importantly, as they change from where they are to where they want to go, we actually are willing to put the capital to work to establish a new connectivity fabric and willing to spend the capital, which is a very different situation from what our competitors are facing with huge demands on 5G infrastructure, huge debt loads for media purchases and so on and so forth. So I think that that really helps us.” – BAML Conference 9/6/18
Competition from cable is on the much lower end of commercial end-market. Legacy LVLT previously gave disclosure that 75%+ of North America CNS revenue was from customers paying >$10k/mo vs. cable companies serving <$2k/mo ARPU customers, and often much lower. It's more likely that the integrated CTL sales infrastructure with larger on-net footprint is able to more aggressively pursue the cable companies’ lower end SMB market than the reverse. 

#3: Execution on integration has been strong – shares have declined as estimates have gone up. 
Management initially guided to achieving 80% of $850mm opex synergy target over 3 years; instead they hit the full amount within a year. In tandem with the synergy outperformance, management increased initial 2018 EBITDA guidance ~3% during the year and beat the high end of initial guidance. Subsequent to achieving the synergies 2+ years ahead of schedule, management introduced an incremental $800-1bn “transformational” savings target. While management is guiding for these to scale linearly over ~3 years, and current guidance only considers such, their track record indicates they are being highly conservative. 

#4: Cost opportunity is large enough to drive EBITDA growth; consensus expectations are skeptical. 
Despite delivering on synergy targets and raising guidance, consensus expects flat EBITDA. At the initial time of deal, management guided to 500-700bps of EBITDA margin expansion opportunity; in the first year, they’ve gone from 36% to 38%. Additionally, management has consistently spoken to the company being capable of consistent EBITDA growth. 
“I think when I am sitting here saying, I look out the next five years and we should generally be able to grow EBITDA every year, that sums up a lot.” – BAML Conf, 9/6/18
“Clearly the driver for EBITDA growth in the short-term is driven by the cost savings and there is plenty next year. I don't think there's any air pockets if anyone is thinking that. But over time, as you narrow the revenue declines, and make that grow the total revenues of the company, it transitions well. So the summary I would say is we're an EBITDA growth company. I think that's the bottom-line, and you can have your views on it, but that's we firmly believe in that and that's what you'll see out of us” – BAML Conf., 9/6/18 
While investors reasonably fear that increasing EBITDA margins through synergies on declining revenues eventually hits a wall, expenses appear deflationary as well. In 2017 and 2018, excluding the benefit of synergies, expenses fell at ~60% the rate that revenues declined, with an improving trajectory in 2018. 

#5: Transformation efforts may drive growth/stem revenue declines after front-loading some lower or no-margin revenue pressures. CTL has experienced significant “voluntary” revenue pressure from self-inflected actions to move away from low-margin/unprofitable business that will fade away post 2018. New management has reset a number of unprofitable contracts and walked away from unprofitable Prism video business. Some reports suggest Prism revenue is down ~50% in 2018, this alone could be as much as an ~300bps consolidated revenue headwind. Additionally, moving away from low-margin to unprofitable CPE sales and individual contracts are also impacting revenue ($30-40mm quarterly impact disclosed in Q3). As these one-off revenue headwinds fade in 2019, revenue pressures should moderate. 
Importantly, the next step of cost-saving “transformational” activities are focused on improving the customer experience: 
“I love telecom, one of the things about it is and I firmly believe this, and I've talked about this for a long time that if you drive costs down, you drive customer experience up” – GS Conf., 9/12/18
“Most of the things that drive cost in our business, are dissatisfaction points for our customers. We take 40 to 50 million calls every year. And I had our call center people when I came to CenturyLink say hey you know if we could if we could cut this each call by 30 seconds, think how much money that would save. And my answer is, you're looking at the problem wrong.
I want you to save the 30 seconds figure out how to do that. But how do you make the 40 million or 50 million calls 20 million calls, because these calls are coming to us because the customers are dissatisfied about something whether it's their bill or their modems not working properly or they're calling us about something. How do you reduce those number of calls, if we can do that we drive cost down, we don't have to handle 20 million calls. And we drive customer experience up” – GS Conf., 9/12/18
“We can continue to upgrade technology to make sure that as we go into a building that we can serve a variety of services. And if a customer calls us, it's a matter of typing in commands to provision service as opposed to doing truck rolls and other things. And so, we'll continue to expand not only the footprint of the network, not only to add new buildings but the fundamental capabilities of the network.” – Q4’18 Call 

#6: CTL is now being managed by LVLT’s highly capable CEO Jeff Storey. Storey joined LVLT via acquisition as COO and became CEO when LVLT faced integration challenges in 2013. During his tenure at LVLT, EBITDA doubled with margins expanding from 25% to 35%, resulting in share price tripling. Over ~4 years with Storey at the helm, LVLT outperformed synergy expectations and successfully integrated numerous large acquisitions with a focus on enterprise end-markets (shifting enterprise mix from ~55% to 75%+). Additionally, Storey took LVLT from negative FCF to >$1bn

Key Risks/Bear Case & Related Thoughts 
This is obviously a hairy, levered situation and I will do my best to address many of the key issues as well as my thoughts on a few mitigants. 

Significant financial leverage: at 4x leverage, cutting dividend to hasten de-leveraging is likely the right call. Maturities are not imminent; company generates ~$2bn of post-dividend FCF p.a. vs. ~$3.5bn of debt maturing in next 3 years. 

Synergies run out; secular revenue pressures may not: history of telecom has required managing costs through deflationary technology cycles and loss of legacy revenues. Given large reputational difference in operational capabilities between prior CTL management and new (former LVLT) management, combined with success on initial synergies, opportunity for cost transformation could be larger than appreciated. 
Competition from cable in business end-markets: cable competes on much lower end of market – average ARPU of <$2k/mo vs. >$10k for CTL. Historically, CTL has not focused heavily on lower end of business market; believes they can compete more aggressively there given scale and cost structure 

MPLS -> SD-WAN transition: Deflationary pricing from software-defined networking has been a consistent fear. I’m not an engineer so I will provide management’s commentary and acknowledge this is a key point for further diligence. 
“The question we get a lot is, "well, is SD-WAN cheaper than MPLS." Yes, on a node basis, yes. Well SD-WAN is also cheaper than 100 gig wave. But other than the really small end of our SMB business, we are not selling single node networks. We're selling 200, 300, 400 node networks. And when you think about SDWAN, that's just another capability that enables us to win more business. So especially when you think about a customer with a lot of international locations or locations that were not addressable to us before is now addressable. So the more of the customer's network becomes addressable, your chances of winning goes up. So we think SD-WAN -- any technology has positives and negatives, but net-net, we think, is positive for us from an Enterprise perspective” – UBS Conf., 12/4/18
5G may displace usage of fiber:
“I think with 5G, we're excited about the opportunities. We are big, we're obviously the largest provider of long haul fiber in the U.S. We are a substantial provider of metro fiber. You can expect us to be fairly aggressive at trying to win 5G builds or being part of that build up. And so you'll see us play in that market.
We like it because it extends our fiber in the metro. We think that business in itself should be profitable for us, but in addition we get to extend our network to both take down cost and extend our addressable market within any city. So, I think you can expect us to be pretty aggressive on that front. And especially where we are the local phone company, we should be able to do quite well. We already have a lot of fiber and we can extend fiber easier than somebody trying to do from scratch. So, I think we have advantages in quite a few markets, and even the Level 3 fiber footprint in urban areas has been pretty strong. So I think that – together that's an advantage.” – BAML Conf., 9/6/18
“Wireless means exactly what the word implies, which is just a little less wire. Communications wants to get to glass (fiber) as quickly as it possibly can” – Oct. ’16 Deal Call 
“The world talks about wireless and everything is going wireless, but it's – and it's not even in the last mile anymore. It's the last hundred feet that are wireless.” – GS Conf., 9/12/18

CFO Change: He did leave for a larger scale integration opportunity (T-Mobile + Sprint), but this is certainly alarming. Sunit Patel was a critical part of the team (along with Storey) that delivered Legacy LVLT’s strong integration track record. This is certainly a point worth further investigation. 

Key Modeling Considerations/Assumptions Behind Target Valuation: 
Base Case: ~1% EBITDA growth primarily driven by cost saves; trade at 6x EBITDA. Blended multiple based on 5.25x for legacy CTL, 7x for legacy LVLT. In this scenario, steady EBITDA + de-leveraging sub 3.5x likely leaves the implied fully-taxed FCF yield (14%) too high; could argue for higher multiple. 
Bull Case: LSD EBITDA growth primarily driven by cost saves; trade at 6.5x EBITDA; shares traded above this multiple recently. Blended multiple based on 5.5x legacy CTL, 8x for legacy LVLT. This 2021 EBITDA is more conservative than simply taking 2019 and adding stated synergies/transformation benefit (flat revenue). 
Bear Case: Accelerating EBITDA declines (synergies fail to offset revenue pressures); trade at ~5x EBITDA (blend of 4.5x and 6.5x) . 
Additionally, to sanity check the multiples, I ran two simple DCF’s: 
One could argue for a wide range of WACC’s given the leverage as well as the combination of a low beta, but high cash flow/equity yield; I used PV8-9. 
Run-off DCF: PV8-9 imply 6.2x and 5.5x EBITDA, respectively. EBITDA holds flat for 2 years driven by cost saves, but declines essentially into perpetuity with EBITDA margins bottoming in the low-30’s; capital intensity declines from 16% to 10% over time as management realizes this is a run-off business. 
Modest EBITDA Growth: PV8-9 imply 6.7x and 7.6x EBITDA, respectively. EBITDA grows 1-2% for ~10 years before fading down to a terminal low 30’s EBITDA margin. Capital intensity remains 100-200bps higher than run-off case, but does decline as business begins to decline. 

Other Key Analytical Considerations:
I include $3.2bn of tax-affected pension and retiree healthcare liabilities in Adj. EV. I also include ~$1.5bn of federal NOL’s at PV8 based on $7.3bn of federal NOL’s. While legacy LVLT traded at >10x EBITDA, we must acknowledge that there was superior top-line growth (and higher expectations) at the time. Additionally, Frontier is a comp for parts of Legacy CTL and trades <5x EBITDA; however, Frontier has more exposure to copper infrastructure and consumer business which faces more aggressive challenges from cable.

Catalyst