With solid and improving Free Cash Flow ratio not too many people were expecting a dividend cut to be announced at last week's CenturyLink (NYSE:CTL) earnings call, but that exactly what happened. Citing a desire to be cautious in the face of potentially higher taxes down the road and a trend towards lower margins, management cut the dividend payout 26%.
This dividend cut came as a surprise to everyone, and any stock jockey will tell you that Wall Street does not deal well with surprises. The dividend cut was especially shocking light of the fact that management had previously stated that they were predisposed to share repurchases more than any significant change to the dividend. The fact that the company is doing both - cutting the dividend, while using FCF to fund share buybacks did little to reassure investors. Management cited the stock buyback and a desire to keep the payout ratio on the dividend to less than 60%. Thus, the company is looking to have some wiggle room and a bit of dry powder on the payout ratio as well as some cash to spend on acquisitions, should the opportunity afford itself.
Therefore, concerns that something is amiss with the business outlook are misplaced. The company has a strong balance sheet with an experienced and disciplined management team that is continuing it's strategic transition towards reducing debt leverage and building more consistent and reliable revenue streams. Even with the recent 26% cut, the company remains a top dividend yield company. The $2 billion share buyback that was also announced last week will further enhance the value of shares.
Going forward, Investors need to know (1) is the dividend safe or will we see more cuts down the road? (2) How is free cash flow to be used? And (3) What is the stock worth today?
Is the Dividend Safe?
Naturally following any dividend cut, investors start looking for the other shoe to drop. Usually a dividend cut implies some kind if deterioration of business and more cuts may be in the offing down the road. However, management guidance implies a FCF payout ratio of less than 40% for 2012 - compared to over 70% for the industry - and as the NOL's expire and the company becomes a full cash taxable entity in 2015, the payout should not exceed 60%. In addition the $2 billion stock repurchase program provides support in that it reduces the total payout of dividends by about $125 million per year.
How will Free Cash Flow be used?
After dividend and share buybacks in 2013 how will the still approximately $750 million of cash flow remaining be used? First, it should be noted that, in the past, management has made good on it's share buyback commitments. However, even though the company has paid down almost $2 billion in debt it was recently downgraded by Fitch to BB+ due to excess leverage. Notwithstanding any acquisitions that may come their way, I would expect management to use any excess cash flow to continue to pay down debt and keep leverage below their stated goal of 3.0x.
What is the Stock Worth?
If we use an average of target dividend yield and Deferred Cash Flow, the target implies a 5.2% yield assuming an improved payout ratio. I arrive at $41/share, which implies 20% upside potential.
What Should Investors Do Now?
As a result of knee-jerk investor reaction to the dividend cut, CTL is considerably oversold. If you are already long, find some comfort in the fact that nothing fundamental has changed with the business outlook. FCF is growing and the stock buy back will return value to you in a non-taxable format. If you have some dry powder, now would be a perfect time to average down and lower your cost basis. Then sit back and collect what is still one of the best dividend yields in the sector.
For investors who may want to take advantage of this pullback to get into the stock but would enjoy some hedge against further downside, I could consider a buy/write trade. By purchasing the stock at it's current price of around $34/share and at the same time selling the April $36 covered call for about $.45, you'd get the benefit of not only the call premium and any capital gain in the prices of the stock up to $36. Additionally, if the stock is not called away before the ex-div date (usually in early March) you would collect an additional $.54 dividend payment. This would, of course cap your upside to a maximum gain of about $3/share but that's a 8.8% return for the approximately seven weeks that the contract is in force - or about a 62% annualized return.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.