CenturyLink (NYSE:CTL) is the third largest telecommunications company in the United States. Prior to 2011, this company was primarily a "telephone" company with a declining asset (access lines) and revenue base. That year, however, CTL made some pricey acquisitions for Savvis, a cloud computing company, and Qwest, a broadband company with high-speed fiber optic assets. Those acquisitions were quite pricey leading to a fairly hefty debt level for an otherwise staid telecom company. More troubling today is that growth seems elusive as revenue from the acquisitions has not offset declines in their legacy business. Based on our analysis, we see revenues declining again for 2014 while operating income will remain negative for at least the next two years. And that is if all goes according to plan. While recently buybacks have supported the share price, they are withering and we see little room for further share repurchases. All told, we see little support for the share price until its dividend yield is more consistent with stagnant growth and declining shareholder equity - a mid to lower $20 share price.
In 2013, CTL should generate $18.06bn in revenue, down 1.75% from 2012's $18.38 bn. Operating income is slated to be down 6% as synergies associated with the acquisition mergers dissipate and a lower margin product mix prevails. Operating cash flow will down 8% but still a healthy $5.25bn. After capital expenditures of $3.2bn, dividends of $1.3bn, and a very low cash tax bill, the company will report free-free cashflow of about $1.2bn. The low tax bill is due to amortization of net operating losses inherited in the acquisition and bonus depreciation but is slated to reverse in 2015. The dividend payments were reduced to just north of $500mn in 2013. When the company announced the dividend cut, about a year ago, they also announced a $2bn stock repurchase program over a two year period. Since then, the company has repurchased $1.5bn in an accelerated fashion, spending over $1bn more than saved by the dividend reduction. Given their cash flow, however, one might argue the company did the right thing using buybacks to return shareholder capital versus the higher dividend payment. However, Moody's didn't exactly see it that way (line here and here) stating, "CenturyLink's decision to abandon its prior longstanding leverage target (Debt to EBITDA) of the low two's to 2.5 times and resume share repurchases is a strong negative for its credit rating."
The company's leverage (long-term debt to EBITDA) stands at about 3 times and will not decline this year given their repurchases. With the $1.1bn impairment CTL took in 2013, against their rather large goodwill of $21bn, the leverage is even higher. A large chunk of this goodwill came from the two acquisitions named previously where acquisition prices were well in excess of tangible equity. These acquisitions were supposed to provide the growth engine (strategic revenues) to overcome the slide in so-called legacy revenues. To date, that has not happened as legacy revenues, which are about 45% of the mix, have declined about 7.5% while the strategic revenues have only averaged about 4% over the last year or so. Last quarter, the comparison was stark with a 4.8% YoY increase in strategic but a 8.3% decline in legacy revenues. Even if strategic revenues were to increase to the mid 5% range and legacy declines slow down, in all likelihood revenue will continue to decline in 2014. The street estimate is for a decline to $17.95bn in revenue and CTL confirmed that a flat to decline is likely in '14. Looking beyond, we don't see revenues exceeding 2013 numbers until 2016 at best and that is assuming strategic growth in the high single digits with legacy declines waning further. With the product mix, according to company statements, shifting toward lower margins it is hard to see how operating income will improve until 2016 also.
For 2014, we look for the company to generate about $1bn in cash flow after capex and dividends. This will get used to finish up their buyback program by mid year and pay down debt slightly (~500mn). However, for CTL to get leverage down to the more traditional 2-2.5 times, a $5bn reduction in debt is required. Needless to say, credit concerns will still weigh on the name and this can be seen in CTL's long term bonds which trade at a discount and an 8.5% yield. We would argue that given the lack of growth prospects, the senior position of their bonds, and the equity risk, CTL's dividend yield should be at least the same as their bond yield. This would put CTL's share price at $25. A deeper concern however is that given CTL's depreciation rate, low capital expenditures, and little to no retained earnings, shareholder equity will continue to slide even with share buybacks. From $33.5 per share in 2011, book value has already declined about $5 per share (roughly equal to dividend payments) and we expect this trend to continue with a book value per share of about $25 in 2-3 years. With little cash flow growth and, therefore, multiple expansion, we believe CTL's yield will be offset by share price declines offering little in total return from today's price.
CTL's earnings estimates for next year are in the high $2s but those estimates ignore amortization of intangibles which we find as incongruous as the flip side of intangibles is tangible debt. We see GAAP earnings as somewhere between $1-1.25 going forward implying a rather high multiple and payout ratio, reinforcing our overvalued view. In 2015 and beyond, CTL will find its cashflow further constrained by an additional $700-800 mn in cash tax payments that will be made as tax benefits (e.g., NOLs) roll off. This will result in little, if any, room for further buybacks or debt reduction. In fact, it is entirely feasible the company may find itself in the unenviable position of needing to reduce their dividend further in order to reduce debt and/or to try, once again, to acquire that elusive growth engine. CTL is not a bad company. It was just a dying company and, like most dying companies, they pay up dearly to sustain life. Acquisitions that were paid for handsomely with hard currency but are not living up to expectations make for a tough row to hoe. As such, we feel a CTL share price in the mid to lower $20 range would more adequately reflect the fixed income style reward but with the equity risk.
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.
Additional disclosure: We do own CTL long term bonds