- CTL’s primary focus is on driving growth in profitable revenue and free cash flow per share.
- No revenue growth is expected in 2020.
- Maintaining or growing FCF is the key factor for success in 2020.
- Long-term investors have multiple ways to win.
CenturyLink (CTL) is a fiber-based communications service company. It has about 1.1B shares outstanding. At $10.8 per share, its market cap is around $11.9B. CTL has net debt of about $33B as of 1Q2020, resulting in an EV of about $44.9B.
CTL has been making steady progress since former Level 3 managers took over as CEO and CFO in mid-2018. The new management team has been executing a strategy to stabilize and eventually grow revenue. It is executing a well-planned transformation plan, a well-articulated capital allocation plan and a realistic balance sheet de-leveraging plan. Everything is going well until the Covid-19 pandemic, which puts execution of these plans at risk. The share price fell. While share price gain may be muted in the near term, CTL remains an attractive long-term investment given management's focus on growth of profitable revenue and FCF, and its history of good execution. Management's commitment to the dividend also helps to support its shares.
CTL's primary focus is on driving growth in profitable revenue and free cash flow per share
To understand the strategy and to measure the progress of execution, we have to understand management's primary focus. In the 4Q2019CC, management said that "our focus is on driving growth in both profitable revenue and free cash flow per share." Free cash flow "FCF" is the key metric that investors should focus on, as it is the means to accomplish the capital allocation plan shown in Figure 1. Figure 1 shows the plan to reduce the leverage ratio (net debt to adjusted EBITDA) to within the range of 3.25 to 2.75 by the end of 2021, to maintain the annual dividend of $1 per share and to continue to invest capital to drive profitable revenue growth. Growing profitable revenue results in growth of FCF. Growing FCF enables CTL to reduce net debt while maintaining the dividend and to increase investment to further drive profitable revenue growth, creating a virtuous cycle.
Figure 1: CTL capital allocation plan. Source: 4Q2019CC presentation.
No revenue growth is expect in 2020
Many investors are concerned with continuing revenue decline results as shown in Figure 2. The primary drivers behind the decline are management's plan to exit unprofitable businesses and continued decline in legacy services such as voice and low speed internet.
Figure 2: CTL revenue by quarter. Source: 10-Q, 10-K and conference call presentations.
CTL's emphasis is on growth of "profitable" revenue. The legacy CTL was saddled with some revenues that are unprofitable. Investing in these unprofitable businesses results in poor capital allocation, reducing the return on invested capital. Since new management came onboard, management has set a goal to exit these businesses.
To help put the revenue decline in perspective, management presented a chart during the 1Q2020CC to show that YoY decline continues to moderate. This is shown in Figure 3. The weeding out of unprofitable businesses is largely completed by the end of 4Q2019. However, the decline of legacy business will continue.
Figure 3: Moderating YoY decline in revenue. Source: 1Q2020CC presentation.
Figure 4 provides further insights on where CTL is investing for profitable growth. Figure 4 shows CTL's business segments. While Broadband is within the Consumer Segment, I split it out to shows its significance to CTL's investment for growth. Figure 4 shows that CTL is targeting about 70% of its business for growth. While the Wholesales segment is expected to continue to decline, investment in this segment provides scale for CTL.
Figure 4: CTL's business segments. The green segments are growth segments. The light green SMB segment is targeted as a growth segment even though it is not growing due to decline of legacy services. Source: 10Q and 10K filings and conference call transcripts.
The Enterprise segment has achieved a 1% growth in 2H2019 vs 1H2019. iGAM was flat. Consumer Broadband was flat for several quarters as well. Arresting the decline in these segments is an achievement in itself. CTL has generated sales and booking momentum in the last several quarters, especially in Enterprise. Unfortunately, the pandemic has slowed the booking growth in 1Q as customers pushed back purchase decisions as they deal with the pandemic's impact on their business. In addition, the pandemic is causing delays in installation, which typically follows booking, but prior to provisioning of services and recognition of revenue. As a result, CTL expects that its revenue will be under pressure at least in 2Q, perhaps even longer. I expect that we will not see revenue growth in 2020. The best we can expect is to build booking momentum in 2H that will lead to growth in 2021.
Maintaining or growing FCF is the key factor for success in 2020
For 2020, FCF is the key metric to watch. Here again, the economic contraction resulting from the pandemic will challenge CTL management. However, there are many levers that management can pull. I shall look at these levers and assess their potential effectiveness. Before I do that, I should mention that in the 1Q2020CC, management indicated that dividend payment, which amounts to about $1.1B, is expected to be in the range of 30-ish% of FCF under all the scenarios that management has modeled. This means that management expects FCF to be in the range of $2.8B to $3.5B. This compares to about $3.1B for 2019. If management can pull this off, it would be a great accomplishment given the economic back drop.
Outside of growing profitable revenue to grow FCF, CTL has the following levers: reduce capex, reduce operating expense, reduce cash interest payment, and improve working capital. CTL has been working on all these levers before the pandemic.
CTL has been increasing its capital investment to drive profitable revenue growth. This is shown in Figure 5. Figure 5 shows that capex has continued to trend higher, both in dollars and as a percent of revenue as CTL invests to drive growth. The jump in 1Q2020 capex included some inventory to buffer against potential pandemic-induced supply chain disruption.
Figure 5: CTL capex trend. Source: 10-Q and 10-K reports.
Generally, CTL's capex investment is success-based. Given the environment, management said during 1Q2020CC that "capital spending is well-aligned with sales and volume growth on the network". For example, SMB is expected to be under pressure and as such, CTL "may reduce spending in certain areas in the near term, such as buildings that are predominantly driven by SMB or other high-risk demand". The original 2020 budget for capex was $3.75B +/- $0.15B compared to $3.63B for 2019. Since the pandemic, the capex guidance has been withdrawn. CTL can reduce capex to as low as $3B and still maintains an investment level of around 15% of revenue. This translates to a $630M reduction from the 2019 actual. Since adjusted EBIT margin is about 18% and tax rate is about 27%, a $630M reduction in capex may neutralize the effect on FCF due to a decline of revenue of about $4.8B. A $4.8B decline in revenue is about a 22% YoY decline. Management certainly does not expect such a large drop. The point is that managing capex budget is the lever with the biggest effect on FCF.
The second lever is expense reduction. Prior to the pandemic, management has been aggressive in transforming CTL's operations. By the end of 1Q, CTL has achieved a $510M annualized run-rate cost saving in adjusted EBITDA from transformation efforts. This is against a goal of $800M to $1B. I estimated that this efficiency improvement will translate to about $300M YoY saving at the EBIT level, which translate to about $220M of YoY FCF improvement.
The third lever is the work done to improve the balance sheet. CTL reduced its net debt by $2B in 2019. It also refinanced a significant portion of its debt, moving out maturity as well as reducing interest rate. As a result, interest expense has been reduced to $449M in 1Q2020, compared to $523M in 1Q2019. Annualized 1Q2020 interest expense as compared to 2019 interest expense shows a savings of $225M YoY. Netting out the impact of taxes, this translates to an improvement in operating cash flow of about $160M.
Hence, between capex reduction, transformation efficiency improvement and interest expense reduction, there is an opportunity of as much as $1B drop through to FCF with constant revenue. This is about 32% of 2019 FCF of $3.1B! Decline in revenue will certainly trim back some of the FCF gain opportunities. However, I feel comfortable that CTL can achieve its goal of flat YoY FCF growth or better.
There may be some operating cash flow headwind at the working capital level. AR may lengthen as CTL's customers who are most impacted by the pandemic (mostly SMB and Consumer) may stretch out their payment. Here again, CTL has options to counter the AR impact. In addition, CTL indicated that highly impacted customers represent only about 5% of overall revenue. We will just have to see how it pans out in the 2Q results.
Long-term investors have multiple ways to win
A long-term investor has multiple ways to win at today's share price level. As the foregoing analysis shows, FCF may stay robust in 2020. Given CTL's commitment of returning cash to shareholders through dividend, the annual dividend of $1 per share is safe barring further significant deterioration in the economy. Hence, investors get paid about 9.3% to wait. Even without an EV-to-adjusted-EBITDA multiple expansion, the market cap portion of EV expands concomitantly with net debt reduction, increasing the share price. The big gain, of course, comes from multiple expansion, which will probably happen when CTL demonstrates more consistent growth in profitable revenue (see Table 1).
Table 1: Model of deleverage and concomitant increase in share price, with and without multiple expansion. Source: Author's model with conservative assumptions of no growth in adjusted EBITDA and FCF. Note: with the multiple expansion scenario, I assumed a discount when compared to AT&T (T) and Verizon (VZ), whose multiples are in the range of 7.5 to 8.5.
The immediate risk is the resurgence of Covid-19 cases as the country reopens, which will cause re-imposition of lock down of the economy. This will impact CTL's revenue and lengthen the subsequent recovery. Legacy services may decline faster than anticipated, causing both revenue and EBITDA to decline. Lengthening of AR is expected and some of it may have to be written off eventually. We will not know the extent until the 2Q results are released.
Revenue growth is not expected for 2020. However, successful execution by CTL to maintain or grow its FCF will support its dividend and de-leveraging plans, which will provide support for its share price. Between the levers of capex management, cost reduction and interest expense reduction, CTL is well positioned to at least match the FCF of 2019. This will buy time for management to grow profitable revenue. Successful deleveraging will cause share price to increase, even in the absence of multiple expansion. The big share price gain will materialize when CTL demonstrates consistent profitable revenue growth.
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Analyst’s 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.
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