Will A Level 3 Communications And A CenturyLink Combination Provide Value?

| About: CenturyLink, Inc. (CTL)

Summary

CTL to benefit from LVLT NOL’s.

FCF payout and leverage required for a secure dividend.

CTL and LVLT trading at a discount to fair value in two of three scenarios.

CenturyLink (NYSE:CTL) and Level 3 Communications, Inc. (NASDAQ:LVLT) announced merger agreement where CenturyLink will acquire Level 3 in a cash and stock transaction. Under terms of the agreement, Level 3 shareholders will receive $26.50 per share in cash and a fixed exchange ratio of 1.4286 shares of CenturyLink stock for each Level 3 share they own. CenturyLink expects to maintain the annual dividend of $2.16 per share. The deal is expected to close 3Q17.

Top line growth has stalled for both companies and the last quarter was below expectations. So why merge? Both companies appear to be a good fit since both are targeting the enterprise customer, complemented by an expanded network. From their October 31, 2016 press release.

Highly Complementary Businesses with Expanded Fiber Networks: This transaction increases CenturyLink's network by 200,000 route miles of fiber, which includes 64,000 route miles in 350 metropolitan areas and 33,000 subsea route miles connecting multiple continents. Accounting for those served by both companies, CenturyLink's on-net buildings are expected to increase by nearly 75 percent to approximately 75,000, including 10,000 buildings in EMEA and Latin America. Overall, the complementary domestic and international networks will provide cost efficiencies by focusing capital investment on increasing capacity and extending the reach of the combined company's high-bandwidth fiber network.

Enhanced Competitive Offerings in Business Network Services: The combined company will have significantly improved network capabilities, creating a world-class enterprise player with approximately $19 billion in pro forma business revenue and $13 billion in business strategic revenue, for the trailing twelve months ended June 30, 2016. Together, CenturyLink's and Level 3's revenue will be 76 percent derived from business customers…

Another big plus for CTL is LVLT's NOL's of approximately $10 billion. CTL's cash tax expense was going to increase substantially but with the addition of LVLT NOL's this transaction will be accretive to FCF (Free Cash Flow) in first year and significantly accretive on an annual run-rate basis with low single digit revenue growth.

This analysis looks at three possible outcomes. The three cases are based on; no improvement in top line growth (Case 1), stand-alone revenue forecasts provided by LVLT and CTL management (Case 2), and synergies from the combination (Case 3).

We'll base case 1 on recent results and then build a pro-forma picture. CenturyLink's revenues are organized into the following categories:

  1. Strategic
  2. Legacy
  3. Data Integration
  4. Other

We'll simplify this into two categories', growing represented by combining 1 & 3 (Strategic/Data) above and declining revenue base; 2 & 4 (Legacy).

CTL Revenue:

Level 3's revenues are organized into the following categories:

  1. CNS Enterprise
  2. CNS Wholesale
  3. Other

We'll simplify this into two categories', growing represented by 1 (CNS Enterprise) and declining revenue base; 2 & 3 (Wholesale).

LVLT Revenue:

Case 1 - This projection assumes the combination will not improve top line growth as existed as standalone companies. Projections were compiled based the recent quarter results and exclude any benefit from the combination (synergies, cost benefits, etc.) except for continued use of NOL's. Comparing YoY (year over year) quarterly results CTL's legacy revenue fell 10.8% in 3Q16 while the strategic and data revenue expanded to 4.6% growth. LVLT's enterprise revenue grow at an anemic rate of 0.2% while wholesale and other fell by 5%. YoY 3Q numbers are worse than TTM numbers. Truely a worse case scenario.

Not a pretty picture. FCF tracks above the dividend line slightly. (The increase in the dividend is due to dilution not a per share increase.) The dividend could be maintained in theory but the FCF payout ratio is far too high to make this a reality. Once they use their NOL's the cash tax expense will increase by hundreds of millions of dollars so a large cushion is needed to protect the dividend and service the debt. FCF payout ratio should be in the 60% range by year end 2020, obviously not the case here. The debt is too high to sustain higher ratios while maintaining the dividend.

This case translates to a CTL fair value of about $19.20. (LVLT - $53.93)

Case 2 - Projected growth based on management stand-alone forecasts. These forecasts do not give effect to the combination. This case approximates total revenue estimates by both management teams achieved by 2020.

Case 2 produces an acceptable FCF and leverage ratio:

Long term growth measured from 2017:

  • EPS - 16.9% ($1.10 - $1.76) after non-cash taxes
  • FCF - 11.8% ($2.33 - $3.25)

This case translates to a CTL fair value of about $27.30. (LVLT - $65.50)

Case 3 - Projected growth based on the complementary nature of the combined portfolios as described in their October 31 press release (listed earlier). This case approximates total revenue estimates by both management teams achieved by 2020 along with synergies obtained by the combination. I'll call this the best-case scenario although it ignores additional top line growth while concentrating on improvements below the top line.

Long term growth measured from 2017:

  • EPS - 23.9% ($1.10 - $2.09) after non-cash taxes
  • FCF - 16.6% ($2.33 - $3.69)

This case translates to a CTL fair value of about $30.50. (LVLT - $70.07)

Conclusion:

We talked about a catalyst that would spark top line growth for LVLT (in our last article) which up until now was a hindrance to growth. Before CTL's offer LVLT found themselves on the wrong end of the stick when it came to lockout agreements. These agreements benefited the incumbent LEC AT&T (NYSE:T), CenturyLink, Frontier (NYSE:FTR), and Verizon (NYSE:VZ) by incorporating a complicated web of all-or-nothing bundling, loyalty and term commitments, complex enforcing penalties, circuit migration rules and other provisions that in effect lock up substantial proportions of carrier and end-user demand, which locked out competition like LVLT. There was hope the FCC would eventually rule against the incumbent LEC's but that hope has faded with a republican political sweep. LVLT has been brought in from the cold, so to speak, going from being locked out to being the party benefiting from lock out agreements.

I believe we lie somewhere between cases 2 and 3 and there is room for the top line to expand not considered here. The dividend is secure in either case and only becomes questionable if results fall below case 2. LVLT has the higher discount but the risk is higher since it depends on the deal being approved. CTL has an attractive yield, 9% at the time of this writing. The yield for case 2 would be 7.9% and 7.1% for case 3.

Disclosure: I am/we are long LVLT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.