The share price of CenturyLink (CTL) dropped significantly following the company's dividend cut decision announced in February. Since then, the share price has been riding an uptrend and already recovered by about 15%. The stock is a buy to me at this level and there are 4 reasons supporting my view:
1. The shares are priced attractively based on the company's financial performance relative to that of its peers. According to the chart shown below, CenturyLink's consensus growth expectations are somewhat better than its peer benchmarks. However, the company's margin and capital return performance is below par. In terms of leverage and liquidity, CenturyLink carries a lower debt load and generates free cash flow with an above-average margin. Due to the lower leverage, the company is able to sustain a higher interest coverage ratio. Both the firm's current and quick ratios are below par, reflecting a mediocre balance sheet condition.
CenturyLink's current price multiples at 14.0x next 12-month EPS is 24% below the peer average at 18.5x. The discount appears to be supported by the firm's weaker profitability and lower dividend yield. However, given CenturyLink's better long-term earnings growth potential, above-average free cash flow margin, and its lower leveraged balance sheet, I believe the relative valuation discount should be smaller. Nevertheless, after accounting for the long-term earnings growth estimate, CenturyLink's PEG ratio of 3.3x is 65% below the peer average, further suggesting that the stock is likely undervalued relative to its peers (see chart above).
2. After the dividend cut, the stock's forward P/E multiple dropped drastically and is currently trading at a 4% discount to the same multiple of the S&P 500 Index (see chart below).
This relative valuation level seems quite reasonable provided that 1) CenturyLink's 5-year earnings growth estimate at 4.3% is below the average estimate of 8.2% for the S&P 500 companies; 2) the stock's dividend yield at 5.8% remains considerably above the 2.5% average yield for the S&P 500 Index; and 3) the company's double-digit free cash flow margin is fairly comparable to the market average.
3. Given that the underlying reasons for the dividend cut are to 1) maintain leverage at less than 3.0 times EBITDA and 2) create more flexibility in implementing the new $2.0B share repurchase program, the market appears to have overreacted to the news. The first reason is a potential way for shareholder value creation if CenturyLink were able to reduce its debt load instead of maintaining. Further, based on the 2012 annual dividend payment at $1.8B, the 26% dividend cut would only mean that investors will receive approximately $468M less return of capital in the form of dividend. Since the total value of the equivalent share buyback is substantially higher than that amount, the dividend cut will likely bring in a net benefit to shareholder.
4. The current 5.8% dividend yield remains at a lofty level relative to the market average. As a further cut is less likely given there is a sufficient free cash flow buffer (free cash flow payout ratio is about 58% in 2012), the stock will continue to attract institutional income investors under the low-interest market environment, and hence to enjoy the downside support by the dividend yield.
Bottom line, in the light of CenturyLink's attractive risk-reward profile, investors should acquire the shares at this level.
All charts are created by the author and all financial data used in the article and the charts is sourced from S&P Capital IQ.