Low Upside For Windstream And CenturyLink Warrants M&A

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Includes: CTL, WIN
by: Takeover Analyst

Despite the bullish sentiment on the Street, I am still reserved on Windstream (NASDAQ:WIN) and CenturyLink (NYSE:CTL). Telecommunications is an intensely competitive field and, in my view, excitement over data growth has already closed much of the discount to intrinsic value. With that said, strong upside can nevertheless be found in consolidation. However, leverage and a lack of cash will limit takeover activity. Windstream has net debt of $7.4B, which is greater than market value. CenturyLink has net debt of $21.1B, which is slightly less than market value.

From a multiples perspective, CenturyLink is the cheaper of the two. It trades at 19.6x and 13.4x past and forward earnings respectively, while offering a dividend yield of 8.3%. Windstream trades at 22.6x and 14x past and forward earnings respectively while offering a dividend yield of 8.7%. In addition to being more undervalued by this metric, CenturyLink also is preferred on the Street with its near "strong buy" rating. On the other hand, Windstream has done more to cut costs and expand profitability, as its gross margins of 62.2% are 940 basis points higher than that of its competitor.

At the third quarter earnings call, Windstream's CEO, Jeff Gardner, noted several favorable developments:

I am very pleased with the top line improvements we have accomplished this year. Our goal over the past few years was to transform our business to achieve revenue and cash flow growth.

Given our shifting revenue mix, success-based capital investments and expected deal synergies, we are on the verge of showing growth in both of these areas.

Our activity level is high, and we have made progress on a number of fronts, including business sales momentum, data center expansion, fiber-to-the-tower builds and integration. Importantly, we are seeing the benefits of this transformation and have created the unique opportunity to provide our investors with a combination of both growth and yield.

The type of "transformation" that I would like to see is consolidation and greater pricing power. The long distance network has been oversupplied for some time now, which has closed opportunities for extraordinary profits. Oligopolistic competition needs to emerge to sustain high dividend yields and meaningful innovation.

Windstream took a step in the right direction by acquiring PAETEC. This transaction increased the customer base and will result in approximately 70% of revenue coming from business and broadband services, which has solid growth potential. Meanwhile, wireless carriers have boosted plans for fiber-to-tower as a result of data growth and greater demand for broadband. Towards meeting this need, Windstream will be providing fiber to almost 90% of towers in ILEC by 2012's end. The company is further setting 2012 up to be an inflection point as capital expenditures could reach a historical high.

Consensus estimates for Windstream's EPS are that it will grow by 15.2% to $0.76 and then by 7.9% and 3.7% more in the following two years. Assuming a multiple of 18x and a conservative 2012 EPS of $0.79, the rough intrinsic value of the stock is $14.22, implying 23.5% upside. If the multiple were to fall to 15x and 2012 EPS turns out to be 13.4% below the consensus, the stock would fall by 7.5%. Accordingly, although the company is skewed towards reward over risk, I would hesitate to call an investment a value play.

CenturyLink has problems of its own. The giant Qwest acquisition and high amount of leverage raises concerns about the sustainability of dividend distributions. Throughout the years, the company has grown through acquisitions, but results have been weak as far as returns are concerned. Since about two years ago, shareholder value has declined by 2.3% while Windstream and the NASDAQ appreciated by 4.6% and 15.2%, respectively.

Consensus estimates for CenturyLink's EPS are that it will decline by 21.5% to $2.66 in 2011, decline by 1.9% in 2012, and then grow by 1.1% in 2013. Whether this kind of negative result could sustain a 8.3% dividend yield is questionable. Assuming a multiple of 15.5x and a conservative 2012 EPS of $2.55, the rough intrinsic value of the stock is $39.53, implying 13.2% upside. CenturyLink would need to trade at 16.5x the consensus estimate to meet Windstream's upside.



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