Description

LVLT - Level 3
Last:  $58.61
Shares:  360M
Market cap: $21B
Net debt $9B
NOLs: $9B

Summary

Buy LVLT ahead of the pending transformational merger with CTL.  LVLT and CTL are telecom businesses, which belong to the second most hated sector in the S&P 500, after energy.  CTL announced its intention to acquire LVLT on Oct 31, 2016.  While the transaction creates compelling shareholder value, the shares have declined partly for technical reasons and partly for unjustified fears around the dividend and new CTL’s balance sheet.  According to the transaction terms, LVLT shareholders will get $26.50/share in cash and 1.4286 shares of CTL shares worth $33.30. The shares are currently trading at a modest 2% discount to the offer price with the deal expected to close on Sept 30, 2017.  For more background on the deal please refer to the merger link on CTL’s website: http://ir.centurylink.com/CustomPage/Index?keyGenPage=329255

Another excellent resource is Corvex’s 13D filing on May 8, 2017. 

If the deal successfully closes, new CTL will have superior asset quality, growing cash flows, shielded by $9B of LVLT’s NOLs, a well-covered dividend, a de-levering balance sheet, and the benefit of LVLT’s superior management team.  The combined company will earn around $10B of EBITDA ($6B CTL, $3B LVLT, and $1B of synergies).   As the mix shift towards the “Strategic” growth segments which is currently 50% for standalone CTL and 65% (and growing) for the combined company, EBITDA growth on a blended basis, could accelerate to mid-single digits from low-single digits.  At a 7-8x blended multiple, new CTL shares could be worth $34-45 in 1-2 years and LVLT shares worth $75-90 (30-50% upside).  As the business quality stabilizes and improves so should the multiple.  Alternatively, at the current price, one is paying around 9x for the growth parts of the business and getting the Legacy declining (but cash flow positive) business for free.  Importantly, with roughly $10B EBITDA, $4B capex, $2.2B interest expense, $650M of pension and cash taxes, the combined company could generate around $2.80/share in FCF growing to $3.00/share in a few years which can support the current dividend. 

LVLT and CTL belong to the 2^nd most hated sector in the S&P500 and could benefit from any rotation out of the anointed technology FAANG stocks.

Finally, the telco companies with their large capex expenditures are prime beneficiaries of tax reform.

While an investment in CTL presents greater upside, LVLT shares presents lower downside risk because half the offer price is in cash and if the deal breaks then we continue to own a superior asset that could be worth a lot more in 4-5 years (more on LVLT’s standalone value later in the memo).  We owned LVLT before the merger announcement and we plan to hold the new CTL shares after the deal closes.  If post-merger execution is botched and CTL cuts its dividend by say 50% to $1.08/share, a 6% dividend yield would imply a 22% decline in CTL shares and only a 10% loss of capital in a LVLT investment.   On the other hand, investing directly in CTL shares has the risk of getting stuck with a declining business, if the deal falls through, in danger (absent a dramatic turnaround) of cutting the dividend as early as next year. 

The opportunity exists for several reasons:

·         Intense price competition in wireless which is more applicable to T and VZ and a rotation out of bond proxies into FAANGS has dragged down the broader telco sector.  YTD, LVLT shares are up only 4%, CTL is down 2%, T is down 8%, and VZ is down 10%, whereas the S&P 500 is up 10%.

·         Market concerns with CTL’s dividend (as evidenced by its 9.5% dividend yield) and risk of a credit downgrade due to the elevated debt load post-merger (3.7x leverage from 2.8x):  As discussed here, this is less of a concern because the combined business will have an improved Enterprise-focused business mix that could support a higher debt load, and growing FCF which covers the dividend.

·         Whistleblower lawsuit alleging questionable sales practices reminiscent of Wells Fargo.  While hard to handicap the impact, we take comfort in the notion that if this prompts CTL management to step down sooner than announced in the transition plan, it could bode well for the stock.   

As long-term shareholders of LVLT, we’re generally constructive of LVLT’s CEO Jeff Storey and CFO Sunit Patel who have built a good operating track record at LVLT integrating large acquisitions with a laser focus on FCF per share.  So we were heartened to see that Storey will take over as CEO of the combined company on Jan 1, 2019. In addition, a highly engaged shareholder base (including Corvex and Southeastern) will ensure that management actions are aligned with shareholder interests.

CTL standalone business

CTL standalone is a $6B EBITDA business with half the business (“Strategic”) growing mid-single digits and the rest (“Legacy”) declining at various rates.  On a blended basis, CTL’s EBITDA is currently declining and, even though the decline rate is moderating due to mix shift to the “Strategic” segment, unless there’s a dramatic improvement in the business, cash flows will not fully cover the dividend as early as 2018.  With shares trading at a 9.5% dividend yield, the market appears to have already priced in this risk.  If the deal closes, then the growing “Strategic” segments will be 65% (and growing) of the total business from 50% pre-deal and cash flows should comfortably cover the dividend.

Around 2/3 the business is Enterprise and 1/3 is Consumer.  While competition is intense in both segments, it’s somewhat greater in the Consumer segment where CTL is competing with the cable distributors that have superior technology.  The LVLT/CTL merger improves business quality because the mix shifts to 75% Enterprise (and growing) from 64%.

LVLT standalone business

Please note these are my notes on standalone LVLT from prior to the deal

LVLT is a relatively attractive standalone asset with a replacement cost in the $95/share area, FCF that can compound 20-25% per annum and a stock that could be worth $120-150/share in five years.  LVLT is managed by a good shareholder-oriented management team with a focus on FCF per share and a strong shareholder base with Southeastern and Temasek.

LVLT is a Colorado-based telecom infrastructure company that provides internet connectivity services to enterprises.  LVLT has the one of the largest fiber networks in the world with a reproduction value greater than $45 billion ($95/share equity value) which is greater than LVLT’s enterprise value of $30 billion.  The business has high quality subscription-like recurring cash flows with low churn.  LVLT currently has around low to mid-single digits market share and the incumbent telecom operators (e.g., Verizon, AT&T) have 85% market share.  With a superior fiber product and one of the most complete internet platforms for enterprise, built through a series of acquisitions, LVLT appears extremely well-positioned to capture market share from the incumbent telcos.  The telcos are more focused on their core consumer wireless business to pay attention to their fixed enterprise business and even a few points of incremental market share capture could be quite meaningful to LVLT.  As LVLT’s management likes to say, growth in this business is almost entirely in management’s control and depends on how quickly they can hire a salesforce and ramp up sales.  LVLT is also a prime beneficiary of the exponential secular growth in internet traffic which drives the need for faster connectivity making LVLT’s hard-to-replicate fiber network potentially even more valuable in the future.  

It appears this business is capable of generating FCF at 20-25% per annum for a long time.  LVLT could do anywhere around $5.00/share in five years which is more than 2x FCF in 2015 of around $2.00/share.  At a 20-25x multiple, stock could be worth $120-150/share, before use of balance sheet.

LVLT has two long-term oriented shareholders in Southeastern and Temasek who own around 35% of shares.  It is worth noting that Walter Scott Jr, Buffett’s friend and on Berkshire’s board, was a founder and ex. chairman of LVLT from the earlier Peter Kewitt split off days.

Management believes they can grow sales mid- single digits 8-10% per annum and my understanding is this growth is almost entirely within their control and largely dependent on their ability to hire a sales team and the productivity of the sales team.  It’s worth noting that this is a recurring business with low churn so there’s a strong growth-on-growth dynamic from layering on new business on top of existing business. 

[EBITDA/FCF Growth]  With fixed assets and high 65%+ incremental margins, 8-10% sales growth translates to 20-25% growth in FCF which is sustainable over five years.  LVLT has $10B in NOLs and will not be a cash tax payer for a while.  LVLT could do $5.00/share in FCF in five years.  At a 20-25x multiple, for a business with a potentially open-ended growth runway, LVLT stock could be worth $120-150/share. 

LVLT’s CEO Jeff Storey is well-respected and credited with turning around the business, which turned FCF positive for the first time in 2014. 

Risks

·         Botched execution leading to a dividend cut

·         As a levered equity, a recession or any loss of access to the credit markets could have an outsized impact on the shares

Catalyst

Deal close

Time