CenturyLink (CTL) surprised the market on February 13 by reducing the quarterly dividend to 54 cents from 72.5 cents per share. Why? Cash taxes are expected to increase substantially starting in 2015. The problem is not unique to CTL. Windstream (WIN) faces a similar problem in 2014 (discussed here). The difference between the two companies is while CTL reduced the dividend, WIN management is adamant they can maintain their dividend in the face of a substantial debt load, high leverage ratio and high FCF (free cash flow) payout ratio. Was reducing the dividend a sound strategy and if so, is now the time to invest in CTL? The current yield hovers around 6%. We'll present an overview of the company in an attempt to provide an answer. The discussion includes:
- Revenue stability
- FCF (Free cash flow) and the new capital allocation strategy
- Pension and Post-Retirement Benefits
- Industry Comparison
Financial data used for this article can be found here.
One problem the wireline industry faces is declining revenues. We'll look at the pro forma revenue (includes Qwest and Savvis) and measure management's performance using a "best fit" regression analysis. The curve reflects management's efforts going forward based on performance over the last 2 years:
As expected the Legacy services have been declining but other revenue (mainly Strategic services) have been picking up the slack. The trends forecast 2013 revenues of $18.28B, at the high end of the range given by CTL and down less than 1% from 2012. Given the data, the trend could turn positive in 2014. CTL's revenue is stable with no negative impact on FCF or operating income.
FCF & The New Capital Allocation Strategy
CTL has taken a similar road as Frontier Communications (FTR) and WIN when it comes to calculating FCF. All make adjustments to FCF and as you may guess, it's higher than actual FCF, calling it "Adjusted Free Cash Flow." Adjusted FCF can give the investor a false sense of security as to the safety of the dividend depending on how it is calculated. In FTR's case a dividend cut seemed to come out of nowhere when measured against adjusted FCF. Measuring the dividend against the traditional measure of FCF defined as net cash provided from operations less capex provides a more accurate picture for FCF. Both metrics for CTL are plotted below to highlight the difference:
CTL's dividend cut was not obvious since the dividend payout remained below FCF by either metric. So why the substantial dividend cut? The main reason discussed on the Q4 conference call was a substantial increase in cash taxes in 2015:
Stewart Ewing - Chief Financial Officer, Executive Vice President - …the decline that you can back into basically by looking at the dividend payout ratio or the approximate dividend payout ratio in 2015 is really due to the fact that we, in 2014, would utilize all of the federal net operating loss carryforwards that we have and our cash taxes will increase substantially….to increase substantially in 2015. …That's one of the reasons we decided to go ahead and take advantage of this at this point in time and be proactive and try to address the dividend and again try to return more cash to shareholders over the next two years before becoming a full tax payer…
Glen Post - President, Chief Executive Officer, Director - We decided to take advantage of the opportunity to get more cash to shareholders now and adjust the dividend to a level that will be closer to the payout ratio that we have historically maintained…
2015 FCF can be projected from the comments, "you can back into basically by looking at the dividend payout ratio or the approximate dividend payout ratio in 2015" and "adjust the dividend to a level that will be closer to the payout ratio that we have historically maintained." Our analysis resulted in a future payout ratio of 58.7% based on adjusted historical data. This would equate to a substantial reduction in FCF in 2015 as reflected in the graph above.
Management noted the higher cash taxes as "one of the reasons." Additional reasons are obvious from the graph which depicts a visual view of the new capital allocation strategy:
- Repurchase of up to $2.0 billion of the company's outstanding stock. Looking at the 2013-2014 time frame, the repurchase program would not have been possible given FCF minus stock repurchases would have encroached on the old dividend trend line.
- Longer-term ability to reduce debt, i.e., FCF should be well above the dividend after 2015.
Not so obvious are pension and post-retirement issues discussed later.
The same day the policy was announced, Fitch issued a press release with a credit downgrade noting:
The company will initiate a common stock repurchase program, which while accompanied by a dividend reduction, will result in a lower level of debt reduction over the next two years than previously incorporated in Fitch's expectations.
While true in absolute terms, the comment seems shortsighted. What is completely ignored is over the long term they will have twice the amount available to pay down debt had they not cut the dividend.
Deleveraging the balance sheet is a priority given debt exceeds $20 billion.
FCF/ share -ttm
FCF payout ratio
Verizon Communications (VZ)
CTL's leverage ratio is in better shape than FTR and WIN and should be able to reduce this number due to the substantial dividend reduction. Much of the debt is due well after 2017, shown below (adjusted for the March 18 press release).
Debt due through 2018 to 2020 is approximately $1,811m. When the Fed (Federal Reserve) eventually decides to pull back on its quantitative easing, interest rates will go north. The only question is when. CTL may find its cash interest start to rise due to less favorable terms when refinancing its debt. However, CTL has averted this long-term concern with the substantial reduction in the dividend.
Pension & Post-Retirement Benefits
Both the pension and post-retirement benefits are underfunded:
The post-retirement benefits look like a looming disaster with a plan value at $626m while being underfunded to the tune of $3,449m. There are reasons why this is not the case. The company pays most of the benefits directly. In 2012, the company paid $268m while the plan paid $147m. The company is winding the trust down. The liquid assets in the trust will be adequate to provide continuing reimbursements for approximately four years. Thereafter, the bulk of the benefits will be paid directly; probably why the company has contributed zero in 2011 and 2012 and expects to contribute zero in 2013. Estimated payments are:
The company paid 65% of benefits in 2012 and will eventually pay 100% in the future, resulting in an additional use of cash of approximately $70m per year.
The company expects their health care cost rate to decrease by 0.25% per year from 6.75% in 2013 to an ultimate rate of 4.50% in 2022. Each 100 basis point change results in a 70m decrease in the benefit obligation reflected on the balance sheet.
The pension plan is a different animal. Expect the company to contribute each year for the foreseeable future. They have contributed $587m in 2011, $32m in 2012 and have made their 2013 contribution of $147m in Q1. The expected contributions are based on a 7.5% expected rate of return. The following is our estimates if the rate of return falls short:
Each 100 basis points represents an additional cash requirement of approximately $118.5m.
The FCF cushion in 2015 is in excess of $1,000m per year, enough to address any pension shortfalls and the additional cash expense from winding down the post-retirement fund.
The following graph illustrates prior years' operating income and current trends:
CTL generates a healthy operating income per share along with Verizon and substantially higher than others in the group. CTL's operating income trend has turned positive in 2012 and there is no reason to expect the trend to change in 2013.
We'll examine trends based on management's financial track record to highlight longer-term trends. Data is on a per share basis to account for acquisitions and dilution.
EPS Trends: The following graph for EPS is arrived at by calculating the statistics for a trend line using the "least squares" method. This determines the line that best fits the historical data and consensus estimates.
The computed overall trend is 1.4%:
The above represents data shown previously with a drop in FCF in 2015. The computed long-term trend is 2.2%.
Valuation: The following fair value analysis is based on management's longer-term financial performance as measured by the previous data. Fair values are based, in part, on the following: Discounted cash flow and a modified Graham's intrinsic value formula.
An estimated long-term EPS growth rate of 1.4% and long-term FCF growth rate of 2.2% were calculated from the data described above. Analysts are more optimistic according to data presented at Nasdaq.com, projecting a five-year EPS growth rate of 2.8% as of this writing.
Running these projections through our pricing model produces a fair value of $42. Needless to say, the result is sensitive to changes in the growth rates as illustrated below.
The new capital allocation strategy caught many by surprise causing knee jerk reactions by the market, and at least one ratings agency, in addition to angering existing investors expecting no dividend cut. Our research indicates the capital allocation strategy is a prudent course to take. Benefits include:
- Reduction in dividend provides substantial additional cash retained.
- A stock repurchase program that potentially reduces the annual dividend payout up to $30m.
- Long-term strengthening of the balance sheet.
- Cushion to handle unexpected cash uses such as pension shortfalls, major storm damage, etc.
- Additional cash outlays associated with the Post-Retirement program are easily handled.
This is not a growth stock, so the attraction is the current yield measured against the safety of the dividend. Out of the companies we've penned articles about, CTL's dividend is more secure than FTR and WIN in that order.
So is it time to buy into CenturyLink's future? That would depend on each individual's financial situation, goals and tolerance for risk. The dividend is safe, so in this case we define risk as what discount to fair value (calculated earlier) an investor requires. The discount at the time of this writing is approximately 10%. Our model is conservative and has a buy target under $33 which represents a yield of 6.5% which would make the stock a hold at the time of this writing. Others may find the current discount acceptable on a risk-reward basis.