CenturyLink: A Compelling Buy Candidate For 2012

Apr. 2.12 | About: CenturyLink, Inc. (CTL)

CenturyLink (CTL) has grown through a series of acquisitions into the third largest US telecommunications company. Wireline connections in 37 states accommodate voice transmission and broadband internet access. Most CenturyLink markets are located in Western, Midwestern, and Southern US locations. The company's financial future depends upon integrating acquisitions to increase cash flow that is ultimately deployed in a successful broadband strategy. These circumstances are the focus of this article.

Acquisitions

The purchase of Qwest Communications by CenturyLink occurred on April 1, 2011. This doubled the number of access line subscribers to 15.1 million. In 2009, Embarq was acquired and CenturyLink completed the integration of this company in the last quarter of 2011.

CenturyLink acquired Savvis on July 15, 2011. This move transitions CenturyLink into managed hosting and collocation services. These virtual environments permit delivery of cloud-based computing options to businesses. That is a growth area with which CenturyLink can soothe the sting of losing traditional wireline subscribers. A rising market of business consumers is attracted to the utility and low lost of cloud platforms.

Integration of Savvis management into the CenturyLink channel is scheduled to begin in the second quarter of 2012. Moreover, CenturyLink has revised its operating structure to serve all Savvis customers along with large corporate and government entities by a single unit. With the addition of Savvis to its portfolio of services, CenturyLink is competing with a different industry comprised of many hosting and collocation service providers rather than merely basic telecommunication companies.

CenturyLink's strategy to avoid a slow death spiral from wireline losses has been accumulation of customers by purchasing other telecom businesses. The company has successfully absorbed past acquisitions by integration of network traffic and billing. This created a scale of realized cost savings.

Sales of bundled services by CenturyLink are aimed at limiting the loss of fixed wireline customers. The annual decline in CenturyLink wireline subscribers has stabilized in recent periods at 7 to 8%. Alternatively, an increase has occurred in the number of subscribers to high-speed broadband internet access.

CenturyLink is gradually deploying cash generated from its large base of wireline customers to transition toward broadband data services. This follows the company's history of buying wireline accounts.

Broadband Expansion

CenturyLink plans to use broadband to obtain new wireline users and increase revenue from existing customers. The company has tested a faster data and video technology. As a result, over 70,000 households subscribed to CenturyLink's Prism service at the end of 2011. This network is similar to the digital fiber network of Verizon (VZ) and the AT&T Uverse® services delivered by AT&T (T). However, millions of Verizon and AT&T broadband subscribers make these enterprises much larger than CenturyLink. In addition, the offerings of these competitors include wireless services.

Deployment of Prism television in more markets is anticipated during 2012 as a sales substitution for CenturyLink's current agreement as a reseller for DirectTV. Significantly, about half of the 16,000 new subscribers for Prism TV in the fourth quarter of 2011 were new CenturyLink customers. Rollouts of Prism television will incur initial capital outlays, which are well within CenturyLink's cash generation capacity.

Whereas Verizon has a market penetration of over 35% for its fiber solution, with most subscribing to the television service, CenturyLink's penetration rate for Prism TV is just 7%. This reflects the more rural nature of CenturyLink markets compared to Verizon's primary position within urban areas.

Broadband penetration has unfolded slowly in CenturyLink's traditional operating areas of rural communities and small metropolitan locations. CenturyLink subscribers have been slower than urban consumers to make technology conversions. But, the rural aspect of CenturyLink's customer base presents an advantage over the encroachment of cable providers with VoIP service. The challenge for CenturyLink is to present its own broadband solutions before competitors attain traction in penetrating small markets.

Cable telephone service and wireless providers present formidable competition for CenturyLink. However, telecom companies have successfully captured market share for broadband access away from higher cost cable operations. CenturyLink had 5.55 million broadband subscribers at the end of 2011. This compares to regional telecom company FairPoint Communications (FRP) with 314,000 broadband customers and Frontier Communications (FTR) with slightly fewer than 1.7 million.

Customer conversions to wireless offerings have also been slower in CenturyLink's markets. Currently, CenturyLink bundles its wireline services with Verizon Wireless.

Overall fixed line access subscribers in CenturyLink's markets declined 6.6% for the fourth quarter of 2011 compared to a year earlier. But, this is a slower rate of decline than the 7 to 8% range experienced by CenturyLink in prior periods. This contrasts with the anticipation of accelerated wireline losses because of CenturyLink's higher number of urban customers accumulated from the Embarq and Qwest acquisitions. Embarq's operations include large cities in Florida and Nevada. In addition, Qwest serves large markets in Colorado and Washington. Many of these markets were among the hardest hit by the housing market recession. Yet, retention of wireline accounts by CenturyLink is exceeding expectations and its peers. Wireline customers declined 8.4% in 2011 at FairPoint and 9.9% at Frontier.

Nevertheless, the loss of wireline accounts does adversely impact company revenue. CenturyLink's pro forma revenue for 2011 - which treats Qwest and Savvis as if they were owned for the entire year - declined 3.8%. Pro forma operating cash flow declined 8.8%. Unadjusted operating cash flow at CenturyLink increased by two-thirds in 2011, driven by the purchase of Qwest.

To the extent that wireless losses are slowing, CenturyLink is positioned to create rising cash flow from synergistic integration of its 2011 acquisitions. There is, however, considerable risk from integrating Qwest. This purchase doubled the size of CenturyLink. The smaller Savvis acquisition presents a separate set of integration concerns due to the differential technology entailed in the purchase.

Summary

While maintaining its investment goals, CenturyLink has also remained an attractive dividend payer. The company's dividend was significantly increased in 2008 and 2010. About 60% of free cash flow was used for dividend payments in 2011.

The ratio of debt to total capital for CenturyLink is 51% at the end of 2011. That is an increase from 43% one year earlier. Credit rating agency Moody's ranks the company Baa3, which is the lowest investment grade rung. Meanwhile, S&P downgraded CenturyLink in 2011 to below investment grade at BB.

The negative long-term credit outlook is justified given that CenturyLink's net debt at the end of 2011 is about 2.8 times cash flow. Management at CenturyLink has pledged to use excess free cash flow in 2012 for debt repayment. Following $3 billion of free cash flow in 2011, company guidance for 2012 is $3.2 billion to $3.4 billion - before integration expenses.

In the near term, the company is reasonably expected to generate cash flow that supports the current dividend plus capital investment plans. By maintaining the current dividend, CenturyLink is rewarding patient investors with a dividend yield of about 7.5% based upon early 2012 stock price.

The shares of CenturyLink appear fully valued for the near term. CenturyLink is trading at about 1.6 times revenue, which is near the highest price multiple in the telecom stock universe. Future stock price appreciation requires the company to meet its integration goals for cost reduction in order to increase cash flow while facing the headwinds of lower revenue.

A buy recommendation on CenturyLink is deserved based upon my expectation that management will meet its synergy targets for Qwest and Savvis. However, caution is warranted if any setbacks appear in the integration process. With a share price of only 1.16 times book value, the stock is compelling.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.