Description

I recommend the purchase of Lumen Technologies' 5.625% senior notes due April 1, 2025 (the "Series X Notes").  The issue's status as the earliest bond maturity in Lumen's debt stack and the relatively small amount outstanding make it quite likely that the notes will be paid in full at maturity, providing a yield to maturity of approximately 14%.

Background.  Lumen Technologies, Inc. (formerly known as CenturyLink) is an integrated wireline telecommunications company providing services to business, wholesale, government, and residential customers.  LUMN's current business is the end product of a series of acquisitions since 2009:  (1) Embarq Corporation in 2009 (Embarq was the local wireline telecommunications division of Sprint); (2) Qwest Communications in 2011 (Qwest's operations included US West and a national fiber network and significant enterprise customer base); and (3) Level 3 Communications in 2017 (Level 3, which was itself the product of numerous acquisitions, most significantly Global Crossing and tw telecom, owned extensive Tier 1 intercity and metro fiber networks and had a growing enterprise business).

LUMN's common stock has been written up three times on VIC since 2018, including once by me (big mistake).  The bull thesis was (1) Level 3's and, to a lesser extent, Qwest's fiber networks were valuable and would be extremely expensive to duplicate, (2) the growing revenues from LUMN's fiber based enterprise services would eventually overtake the declining revenues from CenturyLink's legacy copper services leading to an inflection after which overall revenues would begin growing rather than declining, and (3) Jeff Storey, who became CEO of LUMN in 2018, led an impressive turnaround of Level 3's business (increasing annual free cash flow from a negative $165 million to over $1 billion, increasing EBITDA margins from 25% to over 35%, reducing Level 3's formerly sky-high leverage to slightly over 3x, capably managing Level 3's integration of Global Crossing and tw telecom, and ultimately doing right by shareholders by selling Level 3 to LUMN) and would perform similarly at LUMN.

Unfortunately, that is not how events transpired.  The inflection never came and LUMN's overall revenues continued to decline each and every year.  Storey "retired" in November 2022 and was succeeded as CEO by Kate Johnson, formerly of Microsoft.  This May 14, 2023 post from Petition provides a good overview of the current state of affairs - One to Watch:  Lumen Technologies Inc.

Recent Developments.

Elimination of Dividend.  LUMN finally eliminated its dividend in November 2023, a move which was long overdue.

CEO Transition.  Kate Johnson assumed the position of CEO in November 2023.  Prior to joining LUMN, Johnson served as the President of Microsoft U.S., a division of Microsoft Corporation, from 2017 to 2021.  Prior to Microsoft, Johnson had stops at GE Digital and Oracle.  Since assuming the CEO role, Johnson has been incessantly pushing a growth narrative, and LUMN has significantly ramped its capital expenditures (primarily but not exclusively through its Quantum Fiber FTTH project) in a bid to drive revenue growth.  If buzzwords, jargon, and mission statements were monetizable, LUMN's credit would be rated AAA.  Nonetheless, management's plan appears rational and they are incentivized to make it work.

Asset Sales.  In August 2022, LUMN sold its Latin American business to Stonepeak for pre-tax cash proceeds of approximately $2.7 billion.  In October 2022, LUMN sold to affiliates of Apollo Global Management the portion of its ILEC business conducted primarily within 20 Midwestern and Southeastern states, receiving in exchange approximately $7.1 billion after closing adjustments.  The purchase price was partially paid through the buyer's assumption of approximately $1.5 billion of long-term debt, resulting in pre-tax cash proceeds of approximately $5.6 billion.  LUMN incurred taxes of over $1 billion from the two divestitures, resulting in net cash proceeds of approximately $7 billion.  The proceeds were used primarily for debt reduction.

In November 2022, LUMN agreed to sell to Colt Technology Services Group its operations in Europe, the Middle East, and Africa (EMEA) for $1.8 billion in cash.  LUMN expects to close the transaction by the end of 2023 or in early 2024.  LUMN currently expects to receive $1.5 billion in after-tax cash proceeds from the sale.

Debt exchange.  In Q1 2023, Lumen undertook a debt exchange, issuing Level 3 Financing secured debt in exchange for certain issues of Lumen Technologies' senior unsecured notes.  The exchange is described in more detail later in the write-up.

Enterprise Value.  LUMN's enterprise value is as follows:

Capital Structure.  LUMN's capital structure is divided among several borrowing groups.  At the top of the structure is debt issued by LUMN's subsidiary Level 3 Financing, which includes both secured and unsecured debt.  Then lies the debt issued by LUMN's subsidiaries Qwest Corporation and Qwest Capital Funding.  At the bottom of the stack lies the debt issued by Lumen Technologies (the parent company) itself, with the unsecured debt issued by Lumen Technologies at the very bottom.  The Series X Notes are Lumen Technologies unsecured debt and thus reside at the bottom of the debt stack.

Debt Exchange.  Pursuant to several contemporaneous exchange offers, on March 31, 2023, Level 3 Financing issued $915 million of its 10.5% senior secured notes due 2030 in exchange for $1.535 billion of Lumen Technologies' outstanding senior unsecured notes.

Debt Schedules.  A summary of LUMN's debt stack is below, in relative order of seniority.  Immediately following is a more detailed schedule of the debt issued by Lumen Technologies and its subsidiaries.

Immediately below is a schedule of the various issues of debt issued by Lumen Technologies and its subsidiaries, in relative order of seniority and maturity.  All prices and YTM figures are from Bloomberg as of June 22, 2023 except for the Series X Notes and Qwest baby bonds, which reflect prices and (for the Series X Notes) YTM as of June 23, 2023.  The principal balances shown in the schedule below reflect the effect of the exchange offers completed in Q1 2023 but do not reflect the additional issuance in Q2 2023 of $9 million of Level 3 Financing's 10.5% senior secured notes in exchange for $19 million of various Lumen Technologies senior unsecured notes.

The Series X Notes lie at the bottom of the debt stack in terms of seniority, as they are structurally subordinate to the Level 3 Financing debt and the Qwest debt, and contractually subordinate to Lumen Technologies' secured bank debt and senior secured bonds.  However, the Series X Notes have the earliest maturity of LUMN's bond issues, preceded in maturity only by Lumen Technologies' credit facility which matures in part in January 2025.

A purchase of the Series X Notes represents a bet that LUMN does not restructure prior to April 2025, and more specifically a bet that LUMN is able to successfully extend the maturities of its Lumen Technologies credit facility from January 2025 to beyond April 2025.

Lumen Technologies' credit facility is governed by an Amended and Restated Credit Agreement dated January 31, 2020 and consists of the following facilities:

• $2.2 billion senior secured revolving credit facility maturing January 31, 2025 (currently undrawn)
• $977 million senior secured Term Loan A credit facility maturing January 31, 2025
• $279 million senior secured Term Loan A-1 credit facility maturing January 31, 2025
• $3.9 billion senior secured Term Loan B credit facility maturing on March 15, 2027

The credit agreement includes the following financial covenants:  (1) LUMN's Total Leverage Ratio (roughly defined as the ratio of LUMN's consolidated debt to its consolidated EBITDA) cannot exceed 4.75 to 1.00 and (2) LUMN's Consolidated Interest Coverage Ratio (roughly defined as ratio of LUMN's consolidated EBITDA to its consolidated cash interest expense) cannot be less than 2.00 to 1.00.

I believe that LUMN should be able to successfully extend the maturities of its Lumen Technologies credit facility to beyond April 2025, primarily because of the receipt of the EMEA sales proceeds by early 2024 and because LUMN continues to generate decent amounts of discretionary cash flow.

LUMN's projected EBITDA, cash flow, and debt covenant ratios through 2026 are as follows:

The figures for 2023 include the projected results of the EMEA business through the end of 2023, i.e., I assume the sale of the EMEA business closes December 31, 2023.  However, the cash interest figures and financial covenant figures do not account for any debt reduction resulting from the application of the EMEA sales proceeds.

Management has earmarked the EMEA proceeds for debt reduction.  While the expected after-tax proceeds would be sufficient to repay the January 2015 credit facility maturities, I believe that, because the EMEA assets are held by the Level 3 borrowing group, the terms of the Level 3 Financing debt may require that these proceeds be applied, in whole or part, to repay Level 3 Financing debt rather than Lumen Technologies debt (management has been vague about this).  Nonetheless, any debt repayment, regardless of the borrowing group, will improve LUMN's consolidated debt metrics.  In any event, I believe the most likely credit facility outcome is a maturity date extension rather than a repayment at maturity.

As noted above, I believe LUMN will be able to extend the credit facility maturities, although this is complicated by the looming $3.9 billion Term Loan B balance due March 2027.  LUMN has various levers to pull to make a maturity date extension more attractive to lenders.  To the extent EMEA proceeds can be applied to Lumen Technologies debt, these proceeds can be used to reduce the balances under the credit facility (and, as stated above, any debt repayments, regardless of borrowing group, will improve LUMN's consolidated debt profile).  I view the Quantum FTTH cap-ex as primarily discretionary; this gives LUMN up to approximately $1 billion per year in cash flow to aid negotiations with lenders.  Finally, LUMN may engage in further debt exchanges to reduce debt; that LUMN comfortably exceeds its interest coverage covenants gives it flexibility here.

A final note on the Series X Notes – assuming the credit facility maturities are extended, the relatively small amount of the Series X Notes that remains outstanding makes it extremely likely the notes will be paid at maturity.  (In this regard, note that the original Series X issuance was $500 million; through debt repayments in 2022 and the Q1 2023 debt exchange, the outstanding balance has been reduced to $158 million.)

Risks

• Business conditions deteriorate faster than projected.
• Massive draws on the Lumen Technologies revolver (current unused capacity of $2.2 billion), which LUMN is unable to repay or refinance prior to maturity in January 2025
• Unable to extend the January 2015 credit facility maturities and/or insufficient cash to repay the outstanding balances due January 2015.

Catalyst

• Successful modification of the Lumen Technologies credit facility extending the initial maturities beyond April 2025.
• Payment of the Series X Notes at maturity.