Since September 1 there have been 11 SA articles that mention CenturyLink (NYSE: CTL), formerly CenturyTel. Of those, 6 merely listed high yielding stocks without providing significant additional analysis. Another 2 provided lists of stocks that were overbought or oversold (CTL being on the overbought list) and another listed CTL as one of the least volatile stocks (in August). Of the remaining two, one discussed insider selling at CTL and the other provided an analysis of utility companies, but did not focus on CTL itself. I think that with all this focus on CTL it is time to take a closer look at the company.
Like so many others, I came across CTL after running a screen for high yielding stocks, but the company is so much more than just a dividend play. In this article, I hope to go through the highlights of CTL and convince you that CTL is an obvious buy.
For those of you that have not been following this stock, CenturyLink is a telecommunications company operating in the United States. In other words it operates phone lines, just like AT&T (T) and Verizon (NYSE:VZ). In fact, it the largest telco after the Regional Bell Operating Companies and once its merger with Qwest Communications (NYSE:Q) is complete (more on this shortly), it will be the third largest telco in the United States.
However, CenturyLink does not service some large geographic areas in the United States.
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It is as if New York, California, Massachusetts and many other states do not exist for CenturyLink. Instead of servicing every market, CTL has been focused on the less populated states; those places where cell phone coverage is spotty, and landlines, such as those provided by CenturyLink are a must. Additionally, CTL offers high speed internet which continues to be adopted by consumers.
About a year and half ago (then), CentuaryTel merged with EMBARQ and the merger seems to have exceeded most expectations. The merger allowed CTL to gain a wider presence in the United States and enhanced its ability to compete against the Baby Bells. Moreover, the merger has resulted in operating synergies. In the last quarter (ended June 30th 2010), CenturyLink reported synergies of nearly $75M up from $65M and $40M in the previous two quarters. CTL continues to increase its reported estimate of the synergies that the merger will result in (for 2010, CTL expects $330M worth of synergies, well above the $200M original estimate).
Shareholders have agreed to merge again, this time with Qwest. The merger will result in nearly 50/50 split between previous Qwest and CenturyLink Shareholders. The merger has been critiqued as it moves CTL away from its core of rural landline subscribes. I think these critiques are over stated. Despite a predominantly rural core there is a secular shift towards cell phones, which has resulted in a reduction in residential voice subscribers. Qwest, on the other hand, operates in larger urban environments and has a greater focus on commercial, rather than residential, clients. The merger with Qwest will diversify CenturyLink’s earning stream.
Moreover, the cost of the Qwest merger should not be significantly higher than the cost of the EMBARQ merger. To date CTL estimates that the merger with EMBARQ has cost nearly $365M (less than the total synergies). Many of these costs where due to accounting realization issues had have not been cash expenses. If the Qwest merger is equally successful, it should also be accretive.
Dividends Dividends Dividends.
With so many others talking about it, looking at CTL’s dividends is a good place to start. CTL is currently trading at around $40 and yields 7.25%. Few companies offer such a high yield. . (I ran a Yahoo stock screen for stocks with a market cap greater than $500 and found 86 securities with a yield better than CTL's. However, many of these securities are misreported.)
CenturyLink has a long and consistent history of paying a dividend. From the late 1980’s until midway through 2008, CTL has paid a dividend of between 3¢ and 6¢ a quarter. However in 2008 things changed. CTL went from a low dividend paying company to one that distributes most of its excess earnings. In 2008n CTL raised its dividend to 70¢ and has recently raised it again its present level of 72.5¢ a quarter. It does not appear that the company has missed of dividend in this 20yr history.
This history indicates that the dividend is safe. Likewise, the company also generates sufficient earnings to support its dividend. As seen in the chart below, the average dividend payout ratio is 85%, and the company, since instituting the higher dividend policy has only paid out dividends in excess of earnings one time.
Although an 85% payout ratio is fairly high, it does allow CTL to retain some of its earnings. Moreover, the nature of the business, which is effectively a utility, allows the company to maintain a steady and reliable stream of earnings, and therefore there is little need to tuck away earnings for a proverbial rainy day. The company maintains capital expenditures at between 10 and 20% of earnings. All these factors combine lead to the existence of high cash flows from operations which are well in excess of the quarterly dividend. Again demonstrating that the CTL dividend is safe.
Final evidence of the dividend safety is the fact that the company has 186M of cash on its balance sheet, or just about 62¢/share with an additional $2.34 of accounts receivable. Conversely, the company only owes interest of 47¢/share per quarterly. The company likewise will need to repay $482M, $317M, and nearly $600M of long-term debt in 2010, 2011 and 2012 respectively. The company is likely to rollover most of this debt, however, should it be unable to, as noted above, the CFO should be able to act as a buffer, and protect much of the dividend.
So with such a consistent and safe dividend, why does CTL yield so much? Why hasn’t everyone moved into CTL driving up its price and down its yield? I don’t know for sure, but I surmise that it has to do with the nasty trend of decreasing revenue and generally decreasing earnings.
This trend is seen in the above chart over the last year (since the EMBARQ merger) however in the previous year (calendar year 2009) a similar trend is noticed with respect to revenue (I did not include these numbers in the above chart because they were reported without including EMBARQ).
I believe that CenturyLink’s share price has remained low because most people are looking at the income and revenue numbers dwindle and are concerned about the future of CTL. However, I don’t share this concerns. I see the rate of decline as slowing and realize that the decline is driven by a loss in phone lines. Although CenturyLink is losing phone subscribers it is making up ground with its internet subscribers. The following chart shows the change in revenue over the last four quarters.
(Note the two axises to emphasize the affect.)
Although the company has had declining revenue from Q3-09 to Q2-10, over the same period it has begun to pick up internet subscribers. Moreover, as margins have been improving it appears that the internet is a higher margin business than phone lines. Therefore, as internet subscriptions continue to grow at a fast rate, decline in net income should be stifled.
To my mind, the key to the above chart is Q1-10 where the net change in subscribers (Δ phone lines - Δ internet subscribers) drifted to a mere 56,000 subscribers. In other words the rate of loss of phone line subscribers is starting to be out paced by the rate of gain in higher margin internet subscribers. If this trend were to continue, then the CenturyLink’s net income should stabilize. Of course, Q2-10 was disastrous in this regard, as, although internet subscribers were added, the additions were done at the slowest pace than in the previous 3 quarters.
Based on the fact that Q2-09 was also a slow quarter with respect to the addition of internet subscribers, I am of the opinion Q2 may be a seasonal blip. For this reason when Q3 is reported (at the start of November) the additions to internet subscribes should be monitored closely.
All the above analysis is to say, where most see CTL as a company with decreasing earnings, I see a company that is offsetting its loss in phone lines with gains in internet subscribers and will likely in the near future have stable and reliable earnings.
With such a high dividend and a fairly reliable revenue stream, what is CTL worth? With the upcoming Qwest merger, this is a difficult question to answer. However, based on the companies P/E and dividend yield I could say with some certainty that it is worth more than $40/share.
As seen in the following chart, CTL has one of the lowest P/E of its peers. It trades at just 13.9x earnings. Although an argument could be made that the multiple deserve a hair cut as earnings have been decreasing, this argument does not hold much water as CTL’s peers (e.g. Frontier Communications (NYSE: FTR), Windstream Corporation (NYSE: WIN), AT&T (NYSE: T), and Verizon Communications (NYSE VZ)) have typical seen a similar decrease in earnings. At minimum, I expect CTL price multiple to inflate to be inline with its peers. The peers have an average P/E multiple of just over 16x TTM earnings (VZ has been removed from the average due negligible TTM earnings). With earnings of $2.88, CTL should be trading closer to $52, or 30% above today’s price.
Looking at the dividend yield, CTL is trading inline with its peers. However a 7.25% yield, is well above Treasuries and is not likely sustainable. The current 30 year Treasury's yield 3.8%. Accounting for the fact that common stock is more risky than Treasuries, I am looking to exit CTL when its yield nears 5%. Assuming CTL safe dividend remains at $2.90 a year, this would suggest an exit price of $58.00.
Likewise, we could use the Capital Asset Pricing Model, to come to a value for CTL. With an historical average return on the stock market of about 7.5% and the 30 year Treasury of 3.8% the market risk premium is about 3.7%. CTL has a beta of 0.77, meaning that the expected return (based on the CAPM) is 6.7%. As I have indicated, I believe that earnings are stabilizing, and therefore discounting the TTM earnings at this 6.7% implies a price of $49.00 or 22% above the stocks current price.
Admittedly, these are back of the envelope calculation and are therefore very rough. The calculations do show however, that CTL is trading at a discount. Hopefully the above analysis has convinced you that CTL is a stock that will generate high returns not only through dividends but also through capital gains. If it did not, then hopefully at the least it has reaffirmed that the CTL dividend is safe, and that returns generate through the dividend will not be offset through capital losses.
There has been a lot of buzz surrounding CenturyLink because of its dividend. It seems that the dividend yield is so high because investors are undervaluing CTL. Investors see the declining earnings and are worried that this trend will continue. A closer look at CTL shows that the decline is caused by few telephone lines, however, the phone lines are starting to be replaced by internet subscribers in greater and greater numbers.
Disclosure: I am long CTL