In our September 26th research report on CenturyLink (CTL), we compared this rural telecom titan against its closest rival Windstream (WIN) based on previous strategic deals these companies struck with Verizon Communications (VZ) as well as each firm's cloud computing operations and the dividend yield and payout ratios for each company. We concluded that CenturyLink had a slight advantage over Windstream with regards to dividends based on its slightly higher free cash flow to market cap yield and its significantly lower payout ratio. We also concluded that CenturyLink had a slight advantage in its Verizon deals versus Windstream because CenturyLink is an authorized reseller of Verizon Wireless products and services while Windstream does not yet have a reseller agreement with a mobile carrier. As for the cloud computing infrastructure piece, that is the segment that attracts us to Windstream and CenturyLink and we concluded that CenturyLink's Savvis subsidiary is a much stronger player in this segment than Windstream. Despite the fact that CenturyLink is a bigger company than Windstream, we believe that Windstream is CenturyLink's closest competitive rival in terms of business model, revenue trends, business strategy and even corporate logo colors. In this report, we will be comparing Windstream against CenturyLink based on each firm's fiber-based networks, its revenue trends and its dividend trends.
Source: Windstream and CenturyLink's TTM Earnings Releases
Evaluating Company Fiber Networks
Windstream: Windstream was formed in 2006 from the merger of Alltel's wireline business with VALOR Communications Group. When Windstream was formed, it only had 24K miles of fiber in its fiber transport network. As of H1 2012, Windstream's fiber transport network has grown to approximately 115K miles due to acquisitions and ranges from local and long-haul transport. Windstream's management has pursued the expansion of its fiber transport network through acquisitions and organic growth to enhance its ability to provide wireless transport services, which are also known as backhaul services. We expect wireless data usage to continue to increase (especially after analyzing and evaluating the quarterly results for Verizon Wireless and AT&T Mobility) and this will drive the need for additional wireless backhaul capacity. Windstream spent $60M in Q1 2012 and $70M in Q2 2012 in fiber-to-the-tower investments. Windstream's acquisition of PAETEC (PAET) added 36.7K miles to its fiber network.
CenturyLink: CenturyLink is also a player in the fiber transport business. It acquired fiber assets in 16 metro markets from KMC Telecom to enable CTL to offer broadband and competitive local exchange services to customers in these markets. In 2008, it sold the assets in six of those markets in two separate transactions. CTL provides private line services to wireless service providers that use its fiber to the tower services (wireless backhaul), to support next generation wireless networks. CTL has been investing in fiber to the node deployment to provide higher speed broadband services. CTL anticipate that its fiber investment, which includes fiber to the tower, or FTTT, will be slightly lower to that spent in 2011. CTL was still able to complete approximately 1,350 fiber builds during the second quarter and over 2,000 year-to-date, ending the quarter with about 12,150 fiber-connected towers. CTL is currently on track to complete 4,000 to 5,000 fiber builds in 2012. CTL's fiber network has grown to over 220K route miles, which is double Windstream's network.
Advantage: So far, CenturyLink has a commanding lead in this fiber fight. We are impressed with Windstream's growth by acquisition of fiber properties and we can see the rationale for it. We are also impressed by CenturyLink's continuous growth in FTTT and FTTN builds. As of right now, we would believe that CenturyLink would be the likely winner in this fiber fight because its Wholesale Markets Division only saw its revenue decline by 3.7% on a year-over-year pro forma basis in Q2 2012 versus Q2 2011 while Windstream saw its Wholesale Division revenue decline by 11.9% in the same period on the same basis.
Sources: Windstream and CenturyLink's MRQ Earnings Releases
Evaluating Revenue Trends
Windstream: We give high marks to Windstream for its transparency in reporting pro forma revenue growth due to its acquisition history. We were envious of Windstream's pro forma revenue results in 2011 as Windstream had pro forma revenue decline of -0.25% for the year versus the -3.8% revenue decline we saw with CenturyLink. Unfortunately for Windstream, a court case involving Verizon that provided clarification on billing practices for certain wholesale products inherited from PAETEC which led to Windstream discontinuing and modifying certain wholesale products. While Windstream's Q2 2012 wireline access decline of -4.2% year-over-year is narrower than CenturyLink's -6.05%, CenturyLink has seen faster growth in broadband internet customers (4.4% for CTL versus 1.9% for CTL) and proprietary Internet Protocol TV services (9K new customers for CTL in the most recent quarter versus 2.1K for WIN in the last 12 months) during the same period. This is a surprised because these are areas we would not expect to see CenturyLink surpassing Windstream based on WIN's reputation in these services.
CenturyLink: CenturyLink began reporting its pro forma revenue metrics in 2010 as it was the first year that it included the results of legacy EMBARQ, which CTL acquired in 2009. We believe that the acquisition of Qwest Communications (Q) and Savvis had served to partially offset the rate of pro forma revenue decline that CenturyLink and EMBARQ was incurring. CenturyLink's Qwest acquisition also added a company that was part of the old Bell System rather than a small rural incumbent local exchange carrier and it enabled CenturyLink to strengthen its business customer and internet communications services. The acquisition also positioned CenturyLink in fast-growing metro markets like Phoenix, Denver, Seattle and Portland. Despite facing revenue headwinds from the bankruptcy of key customers like American Airlines and Kodak as well the change in control over Savvis Inc, Savvis has still generated positive pro forma revenue growth under CenturyLink's ownership. While we have no illusions about Savvis's role in CenturyLink (Savvis accounts for less than 6% of CTL's revenue) and profit margins (OIBDA margin of 24% for Savvis versus 53.4% for CenturyLink as a whole), we think that Savvis is a neat little operation that offers potential for top line growth and bottom-line improvements.
Advantage: Up until last year, we could see that Windstream had a slightly negative annual pro forma revenue decline from its 2006 merger of VALOR and Alltel's wireline operations to the present even with the recent declines in its Wholesale markets. CenturyLink had a significantly wider pro forma revenue declines in 2010 and has been narrowing its pro forma revenue declines since the beginning of 2011 with the acquisition of Qwest and Savvis. This year, we have seen Windstream's pro forma revenue show slight declines based on weakness in its wholesale market operations acquired in the PAETEC deal while CenturyLink's revenue decline has narrowed thanks to pro forma revenue growth at legacy Qwest and Savvis. We believe that both companies are evenly matched in terms of revenue trends and that CenturyLink has the opportunity to reach revenue stability before Windstream.
Sources: Windstream and CenturyLink's MRQ Earnings Releases
We are glad to see that Windstream's dividend yield of 9.71% is surpassed by its free cash flow and its market capitalization yield is 12.36%. We are even more impressed that CenturyLink's dividend yield of 7.1% is surpassed by its FCF/Market Cap yield is 12.45%. Based on these yields, we can calculate the payout ratio for each firm and we find that Windstream has a payout ratio of 78% versus 56% for CenturyLink. We are pleased that the payout ratio for both companies in 2012 is lower than the adjusted payout ratio (excluding impact of large-scale strategic acquisitions) recorded for 2011. Windstream's adjusted payout ratio for 2011 was 98.55% and CenturyLink's 2011 adjusted payout ratio was 86.16%. We see that CenturyLink would be more likely to provide shareholders with a slight increase in the per share dividend payment than Windstream because CenturyLink has a lower level of debt to assets than Windstream, a lower level of Goodwill and Intangible Assets to equity and a strong desire to maintain its investment grade credit rating.
Source: Morningstar Direct
Because both companies need increases in strategic communications services such as broadband internet, cloud computing infrastructure services, business communications and wireless backhaul services to offset steady declines in consumer wireline revenues, we do not expect any material dividend growth from either company. At the same time, these companies offer exceptionally high yields relative to the S&P 500. In fact, Windstream is the third highest dividend yielding stock in the S&P 500 and CenturyLink is the sixth highest dividend yielder. While each of these companies pays dividends well in excess of GAAP-basis EPS, each firm's EPS has been influenced by large depreciation and amortization expenses which has served to increase operating and free cash flows well in excess of GAAP-based net income. We are pleased to see that both companies have had dividend payout ratios between 55-80% in H1 2012.
Source: Morningstar Direct
In conclusion, we are intrigued by Windstream's annualized dividend yield of 9.71%, as it represents a yield pickup of over 260bp versus CenturyLink's. However, we have continued to reinforce our thesis in which we prefer CenturyLink to Windstream in the rural telecom company. We can see why InformationWeek named CenturyLink to its Top 250 North American Technology Innovators on September 12th. While Windstream still has a narrower access line decline than CenturyLink, CenturyLink has greater growth in broadband internet and premium proprietary internet protocol TV services. CenturyLink has also seen narrower wholesale market revenue declines and we believe that CenturyLink's Savvis operations are stronger than Windstream's cloud operations. We agree with Merrill Lynch's Media, Communications and Entertainment team when they said that CenturyLink's COO Karen Puckett has made CenturyLink "think like a Competitive Local Exchange Carrier". Even though Windstream and CenturyLink were historically rural incumbent local exchange carriers, we agree with the executives of these companies that WIN and CTL have evolved and are continuing to evolve into strategic enterprise communications services firms. Although we like Windstream enough to keep analyzing and evaluating it along with CenturyLink, we prefer CenturyLink for our portfolio because we believe that CenturyLink will continue to generate higher risk adjusted returns versus Windstream.
Source: Morningstar Direct
Disclosure: I am long CTL.
Additional disclosure: This article was written by an analyst at Saibus Research. Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this article. We have no business relationship with any company whose stock is mentioned in this article. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.