By Jonathan Weber
CenturyLink (CTL) is a telecom company that has seen its share price falter over the last year. This was due to a combination of debt worries, a dividend cut, and a recent announcement that some of its past SEC filings had material weaknesses.
Even after the recent dividend cut, CenturyLink offers a dividend yield of well above 8%, which makes CenturyLink one of the high-yield dividend stocks that we cover. CenturyLink's dividend looks highly sustainable at the new level, and thanks to the strong cash flows that the company generates, CenturyLink should be able to lower its debt load aggressively over the coming quarters and years.
Combined with a focus on the company's most profitable business units, this provides some earnings growth potential that could result in share price gains on top of the already high returns that investors receive through CenturyLink's dividend.
CenturyLink is a telecom company that provides integrated communication services to residential as well as to commercial customers. The company operates through two segments, which it calls Business and Consumer. Its services include long-distance voice, VPN data networks, broadband, data center services, network security, etc.
CenturyLink was founded in 1930 and is headquartered in Monroe, LA. The company is currently trading with a market capitalization of $12.9 billion, while the company's enterprise value is significantly higher, at $49 billion, due to CenturyLink's huge debt load.
Source: CenturyLink presentation
CenturyLink owns and operates a large number of network assets in several geographic markets, with the most important one being the United States. The company's acquisition of Level 3 Communications, which closed in late 2017, at a deal price of $34 billion, has broadened CenturyLink's asset base substantially about one and a half years ago. Several members of CenturyLink's management have served at Level 3 Communications previously, including CEO Jeff Storey, who was CEO of Level 3 Communications before the takeover by CenturyLink.
Recent results and CenturyLink's dividend cut
CenturyLink reported its fourth quarter earnings results on February 13. The company announced that it had generated revenues of $5.78 billion during the quarter, which was 3.7% less than the revenues that CenturyLink had generated during the previous year's quarter. This revenue decline was not a surprise, though, analysts had estimated a drop of this magnitude.
The declining revenues were primarily due to CenturyLink's decision to exit low-margin or unprofitable businesses. This means that the businesses that CenturyLink has exited do not provide any top line contributions any longer, but the impact on CenturyLink's profitability is not negative. In some cases, when these businesses generated losses, exiting them has a positive impact on CenturyLink's bottom line. In any case scaling down these unattractive businesses allows CenturyLink to focus its resources on more profitable and promising opportunities, which results in rising margins for the company:
Source: CenturyLink presentation
CenturyLink's management points out that the company's EBITDA margin (adjusted for one-time items) has risen from 35.5% to 39.8% over the last one and a half years, partially due to synergies after the Level 3 Communications takeover, but also due to the company's decision to exit unattractive businesses.
Despite CenturyLink's revenue decline it is thus not surprising to see that the company was able to beat the consensus estimate for its net profits during the fourth quarter. CenturyLink's earnings-per-share came in at $0.37, which was 16% more than what analysts had forecasted.
CenturyLink's EBITDA, as well as its free cash flows, were quite solid during the fourth quarter as well as during all of fiscal 2018. It was thus surprising for the analyst community and for many retail investors to see that CenturyLink has decided to cut its dividend. The company announced that the new quarterly payout would be $0.25 per share, which is slightly less than half of the previous payout.
This was all the more surprising as management had been pretty clear about its plans to maintain the dividend at the previous level in the past. The payout also was covered by the free cash flows that the company generates, so there was no immediate need to cut the dividend. Management believes that a dividend cut is in shareholders' best interest, though, as this frees up additional cash for accelerated debt reduction. Management also stated that it plans to reduce the company's leverage further than its previous guidance indicated; the company now aims for a debt to EBITDA ratio of 2.75 to 3.25, versus a previous goal of achieving a debt to EBITDA ratio of 3.50.
The dividend cut came as a shock for many retail investors that have been holding CenturyLink for its generous dividend yield primarily. Selling by some f these investors has hurt CenturyLink's share price further, which is why CenturyLink's shares trade at just above $12 right now, which is the lowest level shares have traded at over the last decade:
Data by YCharts
This chart shows that CenturyLink has not been a great investment for anyone that bought throughout the last decade, even when we factor in dividend payments. This does not necessarily mean that CenturyLink will be a bad investment for those that buy the stock right here, though. The very low share price, which goes hand in hand with a high initial dividend yield (even after the dividend was cut by more than 50%), and the low valuation could result in compelling total returns over the coming years if everything goes as management plans.
CenturyLink's earnings growth outlook
The telecom industry is not a high-growth industry, and it hasn't been a high-growth industry for many years. Even in low- or no-growth industries companies can achieve meaningful earnings-per-share growth under certain conditions, though.
One such option for earnings growth is margin improvement. If CenturyLink's revenues are stable (once the company has exited the businesses it wants to exit) or grow at a low-single-digits pace, CenturyLink likely will be able to squeeze out some more points of EBITDA margin through cost-cutting and the ongoing integration of Level 3 Communications. The company plans to capture additional synergies, which will result in more operating cost reductions during the next couple of years.
Another factor that will play a role for CenturyLink's earnings growth is the company's plan to reduce its debt levels considerably. This will not only make CenturyLink a less risky investment, but it will also result in higher net profits and cash flows, all else equal.
CenturyLink has not released its 10-K filing for 2018 yet, but we can look at the company's 10-Q from the third quarter to determine what the bottom line impact of the company's tax reduction efforts will look like.
The company had long term debt of $36.5 billion at the end of the third quarter, including the current portion of the company's long term debt. During the first three quarters of 2018 CenturyLink has reported interest expenses of $1.64 billion. By annualizing this number and dividing it through the company's debt load, we get to a weighted average interest rate of 6.0%. This means that CenturyLink will save about $60 million in interest expenses for every $1 billion in debt that the company pays down.
The after-tax impact of CenturyLink's lower interest expenses is a little bit smaller, as we have to adjust this amount for the higher taxes that CenturyLink will have to pay once its interest expenses decline. CenturyLink has only paid a tax rate of 15% through the first three quarters of 2018, though, thus even the after-tax impact of paying down debt should provide a return of slightly more than 5%.
CenturyLink has generated free cash flows of $4.2 billion during 2018, while the company will pay out roughly $1.1 billion in dividends per year going forward (using the new dividend of $0.25 per quarter). Going forward CenturyLink's free cash flows will not be this high, due to higher capital expenditures, but CenturyLink nevertheless expects to generate free cash flows of $3.1 billion to $3.4 billion during fiscal 2019. Using the midpoint of this guidance range, CenturyLink would generate excess free cash flows of $2.18 billion during 2019 after making its dividend payments.
If all of these excess cash flows are diverted towards debt reduction, the company could buy back or pay down ~$2.2 billion worth of debt during the current year. If CenturyLink manages to repurchase bonds that trade below par, the debt reduction could be even more meaningful.
When we assume that CenturyLink will spend roughly $2 billion on debt reduction and that the debt that the company pays down has an average interest rate of 5% (after tax), CenturyLink's net profits will rise by $100 million this year, all else equal. This equates to an earnings growth rate of 11% versus the profits that CenturyLink has generated during 2018.
CenturyLink thus does not have a bad outlook when it comes to growing its profits during the next couple of years: A focus on the most compelling businesses, further synergies following the Level 3 Communications takeover, and the positive impact of CenturyLink's debt reduction could result in meaningful earnings growth over the coming years.
Data by YCharts
Analysts are also forecasting that CenturyLink's profits will rise going forward, as they see earnings-per-share of $1.21 in 2019, whereas 2020's earnings-per-share are forecasted at $1.31, which implies an earnings-per-share growth rate of 8% in 2020.
Battered stock provides sizable future return potential
Even if CenturyLink's long-term growth rate is substantially lower than that, the company's shares could still produce meaningful total returns going forward. Let us look at what would happen if CenturyLink manages to grow its earnings-per-share by 3% a year beyond 2020. If we start at $1.31 in earnings-per-share in 2020, 2024's earnings-per-share would total $1.47.
Data by YCharts
CenturyLink has been trading at valuations in the mid-teens range throughout the majority of the last decade. That will likely not be the case going forward, but shares would surely not be overvalued at a price to earnings multiple of 11. This would, quite on the contrary, still represent a substantial discount relative to how CenturyLink's shares were valued in the past.
When we put a 11 times earnings multiple on CenturyLink's forecasted earnings-per-share of $1.47 in 2024, we get to a share price of ~$16 in 2024. CenturyLink's shares would therefore rise by 34% over the coming five years, which equates to an annual growth rate of ~6%.
When we add in CenturyLink's dividend yield that stands at 8.3% right now, CenturyLink's shares could thus produce total returns of 14% over the coming five years, with the majority of that coming from dividends, while earnings-per-share growth and multiple expansion would add about 6% a year on top of that.
CenturyLink is highly leveraged; the company's debt load is roughly three times as large as its market capitalization. CenturyLink also has not been a good investment throughout the last decade at all.
Going forward CenturyLink could produce compelling returns from the current level, though. The company offers a high dividend yield (even after the dividend cut), and thanks to management's cost cutting plans and debt reduction efforts some share price gains are likely as well. If the turnaround proves successful, shareholders could see double digit total returns over the next several years.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.