By Michael Hodel, CFA
CenturyLink's (CTL) management believes that the four growth initiatives it has put in place - broadband, fiber to the tower, television service, and cloud/hosting services - provide a platform to expand the business. As such, additional transformative acquisitions aren't needed and are probably off the table for the foreseeable future. We believe CenturyLink will succeed in stabilizing its top line, but we also expect margin pressure will cause cash flow to decline modestly over time. If the company holds pat with the assets it has today, investor attention is likely to shift to shareholder returns in 2013 and beyond. We expect the firm will favor reducing leverage over increasing the dividend or buying back large amounts of stock.
Stabilizing Revenue Is a Key Priority
CenturyLink has shifted its revenue mix heavily toward enterprise services via acquisition over the past couple of years. This area provides stronger growth potential than the legacy consumer and wholesale businesses and will also benefit from investment in managed hosting services. Enterprise growth, coupled with diminishing impact from declining legacy services, should provide top-line stability. We believe CenturyLink will be able to begin posting modest revenue growth over the next couple of years.
Even with the Savvis IT services business posting weak growth and the economy restraining growth, CenturyLink has shown steady improvement in the rate of pro forma revenue decline over the past five quarters, with sales down only 1.2% during the second quarter of 2012. Savvis has struggled to grow recently because of the loss of a major customer and the impact of the acquisition on its salesforce. Management says sales bookings of late at Savvis have been the strongest since 2008 and that sales growth in this business will return to double digits in the second half of 2012. In addition, CenturyLink's enterprise segment has posted sequential recurring revenue growth over the past two quarters.
Also important, declining businesses are becoming a smaller portion of total sales. Switched access and Universal Service Fund receipts now constitute 7% of total revenue. Legacy CenturyTel derived around one-fourth of its revenue from these sources. With the changes to intercarrier compensation set to go into effect in the second half of 2012, these revenue streams will decline at an accelerating pace.
Each Growth Initiative Faces Challenges
While we believe that each of CenturyLink's growth initiatives will contribute new revenue, each also faces challenges. We expect that these challenges will limit growth and margins over the longer term. Two initiatives - broadband enhancement and television service - are focused primarily on the residential market, where we believe the firm will continue to operate at a disadvantage relative to its cable rivals. On the broadband front, CenturyLink has improved the performance of the businesses it has acquired. Although management highlighted the fact that CenturyLink's incremental broadband penetration has surpassed that of peers like AT&T (T) and Verizon (VZ) over the past three quarters, and our estimates based on company filings confirm this, the firm still trails its cable rivals here.
In terms of network quality, CenturyLink significantly trails the cable companies. The firm has passed 6.3 million "living units" with its fiber-to-the-node network, which we estimate is equal to about a third of its total territory. In terms of speeds, CenturyLink can offer 20 Mbps or more to about one fourth of its footprint and 10 Mbps or more to about half. Following the Qwest acquisition, CenturyLink has heavy exposure to the major cable companies, each of which is largely done with its DOCSIS 3.0 deployment, enabling far greater speeds. Management claims that 5-7 Mbps is the sweet spot in terms of customer demand. We suspect there is some self-selection bias in this figure, though, and we also believe consumers' speed demands will steadily increase over the next couple of years. We expect cable will retain its speed advantage for the foreseeable future and CenturyLink will need to continue spending on network enhancement to stay competitive.
On the television front, CenturyLink has reported early positive results with its Prism service. The firm has about 85,000 TV customers, representing about 8.5% penetration of 1 million homes passed. Given the capability of its network, CenturyLink should be able to expand its television footprint fairly rapidly, though it remains committed to not spending more than $250 million annually to roll out the service (including the cost of set-top boxes in customer homes). As we've seen with AT&T and Verizon, offering television service should help stabilize consumer revenue, but margins will take a hit. The cost of programming probably absorbs around 40% of television revenue.
The fiber to the tower, or FTTT, initiative should provide long-term growth at very strong margins, but returns on capital are likely to be only adequate, in our view. CenturyLink expects to have built fiber out to 15,000 towers by the end of 2012, equal to about half the towers in its footprint. On average, the firm is signing 7- to 10-year contracts for service on these links. However, revenue in the first year of these contracts typically doesn't equal business cannibalized as a result of decommissioned copper-based connections (T-1 lines, generally). As a result, the FTTT program will actually put some pressure on revenue growth initially. As wireless data demand grows and carriers need more capacity to each cell site, CenturyLink will see revenue growth at very low incremental cost. Our biggest concern about the FTTT business is that customers of the service, including AT&T and Verizon Wireless, are extremely savvy buyers who clearly understand the economics of the business. With the major cable companies and some competitive local exchange carriers attacking this market, we're uncertain of the potential return on investment. CenturyLink expects to invest about $250 million in FTTT during 2012, equal to about 10% of its capital budget.
Savvis and cloud/managed services also face competitive headwinds and lower margins than CenturyLink's legacy businesses. While this segment should produce solid growth as market demand steadily expands, CenturyLink will face stiff competition from pure-play vendors, large IT firms, and other telcos that are pursuing a similar strategy. In the cloud segment, which management believes is the fastest-growing part of this market, the firm trails Amazon (AMZN), Salesforce.com (CRM), Rackspace (RAX), and Verizon in size. CenturyLink is strongest in the co-location market, where it trails only specialist Equinix (EQIX). However, AT&T and Verizon are also big players in this segment. As it stands today, Savvis was producing EBITDA margins in the low 20s, well below the firm's low 40s corporate average. CenturyLink is also investing heavily to expand this business, expecting to spend $300 million-$350 million during 2012.
Focus on Financial Strength Likely to Limit Near-Term Shareholder Returns
Attention is likely to shift to shareholder returns heading into 2013. Planned debt repayment will consume most of cash flow in excess of dividends during 2012, but many investors seem to hope that stabilizing revenue will translate into a higher dividend or share repurchases next year. Management sounds disappointed with the current stock price, which could push the firm to institute a buyback. Given the firm's leverage targets, however, we suspect debt reduction will continue to take priority over the next couple of years.
CenturyLink believes that maintaining a strong balance sheet provides the flexibility needed to invest in the business and create shareholder value. The firm targets a ratio of debt/EBITDA in the 2.0-2.5 range versus 2.7 times currently and is very focused on maintaining its investment-grade ratings with Moody's and Fitch (Baa3 and BBB-, respectively). CenturyLink committed to paying down $1.5 billion-$2.0 billion of debt through 2012 following the Qwest deal. Management will again meet with the agencies early next year to gain a clear understanding of what it needs to do in 2013 to remain investment-grade. As with revenue growth, though, management has declined to give a target date for bringing leverage within its targeted range.
CenturyLink has done a lot of work on its debt profile thus far in 2012, issuing long-term debt at decent rates while calling high-coupon debt early. As a result, the firm's debt maturity schedule has lengthened considerably. Management said it will continue to call debt during 2012, in addition to repaying maturing debt, to hit its debt-reduction target. With $1.5 billion in cash on the books and our expectation that CenturyLink will generate solid cash flow in excess of dividend payments, we believe it can now repay maturing debt through 2015 without tapping the debt markets.
Based on our forecast that EBITDA will decline modestly over the next couple of years, we expect that CenturyLink will look to repay big chunks of maturing debt over that time frame, rather than refinance, and use the cash raised to fund an increased dividend or share repurchases. Based on our estimates, if the firm diverts all cash flow in excess of the current dividend rate to debt repayment or building cash on the books, net debt won't fall into management's target range until 2014. Even at the end of our explicit forecast horizon (2016), we expect net debt will remain above the bottom of the range.
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