CenturyLink: When A Dividend Cut Secures A 9% Yield

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About: CenturyLink, Inc. (CTL)
by: Arturo Neto, CFA
Summary

Dividend cuts may hurt current investors in the short term, but if done to improve a company's financial stability, this can help drive future price increases and dividends.

CTL had declined considerably before announcing a dividend cut, which led to a total decline in the stock of 44% over the last 12 months.

With a stronger cash flow position, we believe the 9% dividend with price appreciation potential offers an attractive risk/return opportunity.

"Be fearful when others are greedy and greedy when others are fearful."

That's the infamous motto of iconic investor Warren Buffett. Some of you might recall that he came to the rescue of some of the US banks that got themselves into trouble during the great recession. The deal he got was very attractive in hindsight, but his preferred shares in some of the largest financial institutions in the US could have gone wrong - very wrong.

As mere mortals, we don't have access to those deals nor do we have access to the capital to fund those deals. But we can be on the lookout for companies that have been beaten up and have a strong possibility of coming out of the doldrums a much stronger company and a much higher stock price.

What we try to do at The The Income Strategist is find opportunities that generate income, and they range from low-risk, stable income plays to higher-risk, higher-yield, upside potential plays. For example, we found an opportunity with Omega Healthcare (OHI), and shared it in our article A High Dividend REIT Chugging Along to Safety.

OHI had been struggling with the financial stability of several of its tenants but seems to have found solid ground and is well on its way to reestablishing itself as a premier healthcare REIT.

We also found another opportunity, this one a deep value stock which we think has hit bottom and where management has taken painful yet necessary steps to reverse the downward trend in the stock. In fact, they cut the dividend - one of the last resorts a company should take when trying to improve a company's financial stability. In this case, we think it was necessary and will help the company recover and thrive. It is one of the holdings in our High Income Portfolio.

CenturyLink: Get A 9% Dividend Yield Now That It's Getting It's House In Order

Image result for centurylink CenturyLink (CTL) cut its dividend by more than 50% in February, resulting in another sell-off in the shares, which had already been on a downward trajectory since late last year. The stock is now down 44% over the last 12 months, and dare I say, it looks like a good entry point.

(Source – Morningstar)

I know you're thinking I'm crazy saying this, after all, the company just cut its dividend. The good news is that I wasn't invested in the stock so the dividend cut had little effect on me financially. Hopefully, it didn't affect you either. However, the reasons for the cut is what makes this an interesting situation.

When Dividend Cuts Are Good

Not all dividend cuts are bad. I mean, yes, they are bad for shareholders that own the stock at the time of the dividend cut, but if the dividend cut is made for the right reasons, it could lead to improved operational performance and a recovery in the shares.

Morgan Stanley wrote a research report that was published back in 2016 that analyzed the performance of stock prices leading up to and for the period after a dividend cut, and the results were surprising but made sense.

The price of the stocks studied declined by almost 30% over the 12 months preceding the dividend cut announcement, but then showed both absolute and relative outperformance to both the market and sector in the 6, 12, and 24 months that followed.

The pre-cut underperformance makes sense if you agree that the market is a leading indicator, in this case investors sold off shares in anticipation that the dividend was not sustainable. The post-dividend cut outperformance, however, is probably dependent on the reason for the dividend cut, even though that wasn't necessarily a part of the analysis.

My assumption is that if the dividend cut improves the company's cash flow generation and financial stability, it will likely lead to outperformance over the subsequent period. After all, you now have a supposedly more financial stable company that's trading at a considerable discount – so long as the business model is still intact, this should be an attractive investment opportunity.

This is why I like CenturyLink (CTL), which still pays a forward dividend yield of 9% even after the cut. The stock recently hit a 52-week low and although it will take some time to return it to its previous level, the company recently beat analyst estimates for earnings by $0.08 for Q1 2019, on the back of a revenue miss.

Business Description

CenturyLink is one of the largest U.S.-based telecommunications carriers serving global enterprises connecting Europe, Asia, and Latin America. The company primarily focuses on providing 360-degree enterprise solutions to cater to various communication requirements of global enterprises including data center services, data transportation, and end-user phone and Internet services.

CenturyLink operates a fiber network of more than 450,000 route miles, which makes the company one of the leading providers of fiber solutions on a global scale. Historically, CenturyLink benefited from the increased adoption of fiber solutions by enterprise customers but is now faced with the challenge of growing revenues and earnings in a macro-economic situation where the costs associated with fiber solutions are expected to come down along with the growth of lower-cost solutions.

Given certain industry and macro headwinds, CenturyLink has focused on inorganic growth opportunities to drive sales and earnings. The standout acquisition of Level 3 increased CTL's network by 200,000 route miles of fiber. The Level 3 acquisition has helped CenturyLink focus more on enterprise customers as well, which provides the opportunity for the firm to shift away from the declining residential business segment.

Most recent acquisitions of CenturyLink

(Source – Crunchbase)

The addition of Level 3 gives the company a much denser network as shown in the map below.

(Source – Company presentation)

By combining two of the Top 5 enterprise solutions providers, the merged company will be second to AT&T (T) in the segment.

(Source – Company presentation)

Another primary objective of the firm is to reduce the debt level to a more desirable level, hence the dividend cut. Management views an adjusted EBITDA to debt level of 2.75-3.25% as a desirable, sustainable level and is committed to achieve this target within the next three years. While bringing down the total debt level to this range will drive management to make decisions that would not be favored by shareholders in the short term, I expect this to stabilize the financial position of the company in the long term and allow it to resume a more robust dividend policy.

Dividend cut in February

The 50% dividend cut in February was an initiative by management to free-up cash to repay debt. As highlighted in the previous segment, management views the current debt level as undesirable for the continued financial stability of the firm.

Jeff Storey, the Chief Executive Officer of CenturyLink, had this to say about the proposed dividend cut in February.

First, we continue to believe returning cash to shareholders in the form of a dividend is an important part of our equity value proposition. However, as you saw, we announced today that we plan to reduce the annual dividend to $1 from the current $2.16 per share beginning with the next dividend declaration. This decision is not based upon any concern for the outlook of our business. Our business fundamentals are strong, and we believe our free cash flow could sustain the dividend at the prior level through 2019 and beyond. As I said, this change in policy isn’t about a diminished view of our business; it is driven by our view that the long-term interest of shareholders are best served by proactively accelerating, de-levering to a new lower target range of 2.75 to 3.25 times net debt-to-adjusted EBITDA.

(Source – Q4 2018 earnings conference call)

The company already has made progress in reducing its debt levels to the target level over the last five quarters. The dividend cut announced earlier in the year will only help accelerate the timing of reaching that lower level.

Net debt to adjusted EBITDA

(Source – Investor presentation)

To put the dividend cut in perspective, CenturyLink paid out $2.3 billion in dividends for the year ended December 2018, so the dividend cut will save more than $1.2 billion annually, assuming a constant number of shares outstanding. Long-term debt on the other hand skyrocketed to over $37 billion in 2017 due primarily for debt to finance the acquisition of Level 3 in November 2017.

(Source – Author prepared based on data from company filings)

The company already has paid $1.9 billion of its debt in each of the last two years, however debt repayments are expected to accelerate even further as the company allocates more of the cash savings to repay its debt. Overall, the move to cut the dividend distributions and allocate more cash to repay debt is a positive strategic move.

Trimming the amount of debt on the balance sheet will lead to cash savings in the future, a more stable financial position, and potential share price and dividend boosts. As the table below shows, some of the current outstanding debt has interest rates in excess of 8% and the senior notes, which have over $8 billion outstanding, are likely to cost almost $500 million in interest annually.

(Source – Form 10-Q)

In addition to redeeming some of the higher interest notes in 2018, the following remark by CenturyLink CFO, Neil Dev, confirms the strategy of the company to focus on redeeming high-cost notes while simplifying the capital structure.

Is there any part of the structure that you will be targeting to reduce, is it focused on higher coupons potentially at the Qwest Corp level or where would you look to reduce the debt?– Ana Goshko, analyst

So obviously we want to reduce our net cash interest expenses. So we'll look at that but we also want to simplify the capital structure. And so, yes, we'll be opportunistic, we'll look at simplifying the capital structure and reducing our costs and also manage the maturity profile. – Neil Dev, CFO

(Source – Q4 2018 earnings call)

Financial performance

CenturyLink reported Q1 2019 earnings on May 8 that beat analyst estimates for earnings for the fourth consecutive quarter.

(Source – NASDAQ)

It reports its financial results under four different segments, and all of these segments reported negative revenue growth both on a quarter-on-quarter and a year-over-year basis.

(Source – Investor presentation)

However, despite revenue declines across all segments, CenturyLink was able to beat analyst estimates by 7 cents driven by cost reduction initiatives. The company's gross margins improved to 55.4% while operating margins improved over 250bps on a QoQ basis to 17.8%.

Management's decision to divest unprofitable business segments in 2018 contributed to the lower revenues reported in Q1 2019, but this is part of a quality over quantity strategy that should reignite revenue and earnings growth in the future.

The results for EBITDA and adjusted EBITDA also were positive, as EBITDA margins improved to more than 40%.

(Source – Investor presentation)

In the Q1 earnings conference call, management made several remarks about their expectations for further margin expansion as synergies of the Level 3 merger continue to materialize.

Finally, I want to point out an interesting and positive trend within the consumer broadband business segment. While this segment does not account for a major part of the business, it's expected to grow significantly in the future, as more subscribers switch from slower speed (20Mbps) to higher speed (20Mbps+ and 100Mbps) services.

(Source – Investor presentation)

Even though the below 20 Mbps customer segment declined at a faster clip than the growth of the above 20 Mbps customer segment, the latter is expected to grow at a much faster rate in line with the expectation of higher demand for high-speed Internet connectivity.

The dawn of 5G technology, cord-cutting movement, increased popularity of work-from-home contracts, the growth of Artificial Intelligence powered solutions, and Internet of Things (IoT) are some of the factors contributing to the increasing popularity of high-speed Internet solutions. CenturyLink is expected to capitalize on this opportunity, which should support profit margin expansion as high-speed Internet solutions provide higher margins than their low speed alternatives.

Guidance for FY2019

Management reiterated guidance for FY2019 of adjusted EBITDA of $9 billion to $9.2 billion, FCF above $3 billion, and dividends of just over $1 billion, which results in FCF after dividends of over $2 billion.

(Source – Investor presentation)

Valuation

CTL is trading at a forward P/E of 8.50, which is a considerable discount to its three-year median of 16.1 and average of 17.9. The discount is a result of the selloff already mentioned, which was disproportionate relative to earnings and was likely driven by the unsustainability of the dividend.

Fifteen analysts covering CenturyLink have a median target price of $13, which represents an upside of 20% from the current market price.

Insiders Are Buying

Over the last 12 months, insiders had sold a staggering number of shares in comparison to what they had bought. However, the trend over the last three months tells a different story. While the number of shares bought in the last three months does not compare to the number of shares sold over the previous 12 months, the reversal is a positive indication of management's conviction in the business.

(Source – NASDAQ)

My Take

Investors might be reluctant to take a plunge with a company that has recently cut its dividend, but if its done for the right reasons, and the business is sound, it makes for a fairy tale recovery if things go well. A 9% dividend yield is much more sustainable when dividends paid are less than half of free cash flow after dividends.

I like the prospect of a strong price recovery in the stock barring a catastrophic turnaround in an industry that has high demand and demographic trends in its favor.

Note that any stock with a dividend yield of 9% is risky and that the company operates in an industry that can be fickle, is loaded with competition, and requires big sums of capital to be invested regularly. Despite this, I believe this is an attractive risk/return situation and suggest readers take a close look at the stock for their own portfolios.

Disclosure: I am/we are long CTL. 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.

Additional disclosure: This article is meant to identify an idea for further research and analysis and should not be taken as a recommendation to invest. It does not provide individualized advice or recommendations for any specific reader. Also note that we may not cover all relevant risks related to the ideas presented in this article. Readers should conduct their own due diligence and carefully consider their own investment objectives, risk tolerance, time horizon, tax situation, liquidity needs, and concentration levels, or contact their advisor to determine if any ideas presented here are appropriate for their unique circumstances. Furthermore, none of the ideas presented here are necessarily related to NFG Wealth Advisors or any portfolio managed by NFG.