The Reason CenturyLink Stock Is Priced So Low

Summary

• Bottom line metrics bolstered by cost cutting and declining interest payments.
• Current revenue trends pushing gross margins lower.
• Total revenue declines for the foreseeable future implying a melting ice cube for some and a turnaround story for others.

My last CenturyLink (CTL) blog post illustrated the effects of cutting unprofitable revenue on EBITDA and why that phase of integration has come to an end. The company's focus has since moved to cost cutting and lowering interest expense through debt reduction and rolling existing debt taking advantage of lower rates.

So, why is the stock stuck in the 10ish range when management thinks the stock should be 25 plus? The reason is simple; no visibility given on forward total revenue. This is no surprise. From my last blog post:

"Management could provide some clarity on revenue but will not. Why, because in the past management stated several times, they will not give long-term guidance on the top line. I believe it is a policy they have been following for some time now and I have seen nothing that tells me this will change. Maybe they will, hope so. In the meantime, we can only speculate …"

First, the good. The stock reacted well to 2Q20 results because revenue appears to be developing a trend of "declining declines" illustrated as follows:

(Source: Author SEC Filing Research)

I believe long-term revenue is the "elephant in the room" issue holding down the stock that management does not want to address head on.

Now, the bad. Gross margins continue to deteriorate. This must be made up through interest savings and cost cutting.

(Source: Author SEC Filing Research)

If the runway for cost cutting and interest savings is long enough to turn gross margins around, the stock is cheap; if not, then bottom line metrics will eventually start to deteriorate along with the stock. Also concerning is GM% has declined over the last two quarters from 57.5% to 57%. This percentage must increase to make up for declining revenue, which I see continuing to decline for the foreseeable future. As you can see, the above picture would not have investors busting down the door to invest.

Old Level 3 vs Old CTL

We know old CTL was/is the main culprit when it comes to revenue losses. Now, the Level 3 parent appears to be showing a downtrend, albeit exceedingly small. Maybe a COVID-19 effect, but it bears watching. That said, the Level 3 parent EBITDA is starting to trend up, albeit exceedingly small, while old CTL continues its downtrend.

(Source: Author SEC Filing Research)

(Source: Author SEC Filing Research)

Deciphering Future Revenue Trends

One indicator is capex. More was put into capex than at any other time since 4Q17. Neel Dev made the following comment on the conference call:

"We also continued to lean into capital spending during the quarter, driven by customer upgrades and supported by strong leading indicators."

Customer upgrades are positive for growth. Revenue for "strong leading indicators" are yet to be determined but is a positive sign, considering a record capex spend during COVID-19. The record-high capex spend was a surprise during the pandemic and can only be taken as positive when combined with Jeff Storey's comment from the conference call:

"we saw strong improvement in revenue performance and growth in the sales during the quarter. While we still see uncertainties related to COVID-19, we're optimistic about our ability to drive revenue growth in the core areas of our business and we're focused on reducing costs for the legacy services we provide."

However, it will be some time before overall revenue returns to growth, but signs are emerging that some core segments may be turning. On the business side, the Enterprise segment made a pivot this quarter. IGAM has been a disappointment and needs to improve to meet expectations, i.e., show revenue growth.

(Source: Author SEC Filing Research)

Consumer broadband has been the best performer in terms of increasing revenue over the past six quarters of all segments. Probably, a surprise to some, considering past talk of selling this side of the business. Broadband is the largest consumer segment and growing. Why they would sell this is beyond me unless it is a price that is richly valued.

(Source: Author SEC Filing Research)

What Needs To Occur

As I said earlier, overall revenue will fall for some time to come reinforcing claims that CTL is a melting ice cube. They need to slow total revenue declines to the point where gross margins, in terms of dollars not percent, start to level off and increase. One scenario toward this goal is to extend the current trends in Enterprise and Broadband. Two down and two to go being IGAM and SMB. We will see if the recent capex push starts to pay dividends so to speak. It appears to be showing up in Enterprise and Broadband.

The stock would be much higher if based on bottom line metrics. Free cash flow and EBITDA are healthy which leaves one piece of the puzzle left depressing the stock. Revenue visibility is still the main event that is pushing investors to the sidelines. Management's refusal to discuss long-term revenue when they have a long-term leverage target that is indirectly dependent on revenue is a mystery. What we can extrapolate from the leverage ratio target is, overall revenue will continue to fall through mid-2022. The declines will continue to shrink over time as reflected in the chart at the start of this article, which should eventually calm concerns over revenue and gross margins, assuming the trend continues.

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.

Comments

[Justin Wiedeman]

Very interested in your review of my Article.

Did Kate price in recession, skeletons, flexibility?

Certainly appears so but I'm very interested in a thoughtful critique.

Perhaps I'm on the wrong track with unsecured Hold Co and replacing equity with Leap Calls.

[Justin Wiedeman]

It's all about CAPEX and the lag. But it has so many complexities over last 5 years. Cleaned up.

[ted lujan]

LUMN remains under valued. I added to my position today.

[mpmassey]

@ted lujan You did this a bit over two years ago. Stock at $2 now. Bad move as I predicted then.

[David Klein]

Preliminary projections along with actual results posted (links below) Quick summary. They slightly underperformed my conservative projections (need to stop using that word going forward). I see GM$ continuing to decline through 2023 along with revenue, FCF mostly flat, EBITDA starting to erode in 2022 given GM$ deterioration starting to have an impact. Given this time line they still have a runway to reverse the trends but for now I see no evidence of this given guidance.

The dividend is sustainable through 2023 however if this scenario plays out it could be on the table as early as 2022 for the same reason it was last time. The melting ice cube theory is alive and well and it's starting to show, at least in my projections. That doesn't mean this cannot change but based on real results (not rhetoric) I see no basis to apply rosy growth rates. The model produces a fair value of $12.7

www.iiex.club/...

www.iiex.club/...

These are preliminary until I can get through all info including the 10-K. That's my take today and I know most would vehemently disagree.

[David Klein]

The LUMN poll is ready for everyone's new fair value input at www.iiex.club/...

[David Klein]

The 10-Q has been filed so segment EBITDA has been updated at www.iiex.club/... along with 4Q trend.

[David Klein]

Actual 3Q results recorded and projections updated at www.iiex.club/...

[David Klein]

Added a new financial view showing TTM by quarter for cash provided by operating activities, FCF and dividend at www.iiex.club/... toward the bottom of the web page.

[manfredthree]

Yes, if this were a prison REIT, for example, renaming it "Comfort Suites" might be appropriate. We're happy with a month or two for the market itself to refocus in a slightly calmer political environment, recognizing the recoil affect we're going to see.

[ted lujan]

LUMN is still been sold off. For what ever, the market is just not interested in buying the stock. it seems to be a matter of sustaining a history of earnings. The company has to start growing. The dividend could be cut unless the earnings increase

[ESP equity research]

@ted lujan ;

Earnings have been increasing - did you even spend 15 seconds to look before posting? Revenues have been falling slightly - that is why the market is not interested. LUMN is not a growth play - now or in the future. It will be a stable cash cow. The Divy is fully covered...

ESP

[manfredthree]

The slight most recent slide in revenue will end as dark fiber utilization and new service offerings expand both revenue and margins without major capex risks.

[TMV1]

Energy Solutions Partners &

manfredthree - LOL, revenue has fallen slightly?!?!? Revenue has fallen by the billions since the current CEO took over...

Dark fiber is nothing new and our services are so behind the cutting edge which is why we can't seem to grow revenue because our overpaid incompetent CEO doesn't know how to innovate.

Did you know that the combined proxy created by our current CEO and previous management at the time of the LVLT purchase estimated that revenue should have been 7 BILLION dollars higher this year!! That is the guy running this company, CLUELESS!!!

[DavidBe]

Your financial analysis of this stock has been excellent. For CTL, the financial numbers are not necessarily telling the story. This company has a serious reputational problem. If CTL can improve its image toward its customers, the stock will follow your analysis. They should overhaul their customer service, bring in JD Power or some other company to praise them, and, then, watch the stock rise.

It's almost like investing in prison REITS or tobacco stocks. Numbers are better than the stock price, but there is an ick factor. That's what is holding it back.

[David Klein]

Thanks and you're right about the image problem but the financials still have some problems to overcome before the needle starts to move. Declining gross margin$, segment EBIDTA stuck in the mud only to be helped out by cost cutting, i.e., the EBIDTA not assigned to any segment. If these continue to deteriorate the stock will go lower but there are some positive signs that we are at an inflection point. We'll see.

[manfredthree]

We somewhat disagree with DB. Only frosted losers are focused on the rearview . Stock 'investing' has been for several years overweighted by a 'Lotto mentality'; in which investors demand the allure or perception of unrealistic outsized gains. Having definable growth available cheaply loses to the 'big bonus potential' . And few are willing to wait a few months . Examine everything here and it tells you that LUMN is a screaming bargain, potentially aided by the press of more social programs in the wings. There are lots of 'lotto pulls' here if you care to look out just a few months while taking the divvy dole. The dire downside is hard to rationalize , especially confirmed by current er's like VZ's.

[DavidBe]

@manfredthree

I don't think there is a downside. However, changing the name of the company indicates there is a problem with the old one. This stock has been chronically underpriced based on financial metrics. Markets can be irrational up to a point. When a stock is performing below what its numbers indicate for a pretty long time, perhaps there is a rational explanation. That explanation is in how it conducts its business with its customers. Word gets around. They need to focus on customer satisfaction. The numbers will take of themselves in many ways if they fix the real fundamental- the customer. That is the problem now, not in the rearview mirror.

[David Klein]

I’ve added some detail on the LUMN-CTL webpage at www.iiex.club/...

I have added a lot more color to the segment EBITDA graphs including data points and 3Q projections and in addition to the TTM graph a quarterly graph with totals added to both.

If you scroll to the bottom of the page there is a chart based on PE and FCF with actual data from 2010 - 2020 and projecting to 2024. This program closely reflects the modeling at the top of the page. When the Price/PE (blue line) dips into earnings territory (green) it is a signal of a cheap stock or a value trap which one could point to 2017. If earnings start to recover as I am projecting the price/PE should come back in line with earnings. In any case what this shows is the stock could more than double by 2024. I still will use the words “conservative projections” especially since I have extremely low FCF growth although the market is pricing in negative growth. These charts are computer generating based off my data so take with a grain of salt. The whole point is determining if the stock appears cheap based off the numbers and it appears so (although 2017 was a head fake so we will see if I really am conservative in my thinking). However, if trends continue to deteriorate than the analysis is as good as the LVLT-CTL merger proxy showing increased revenue and EBITDA.

What I am looking for: Small things like a turn in segment EBITDA. Afterall the business segments are why they are in business for the long haul to begin with; cost cutting buys them time. Gross margin dollar stabilization. I am buying long term $12 calls (small downside) but if I see hints of the above, I may just switch to buying stock not that I don’t have enough already.

[David Klein]

I've added segment EBITDA and Gross margin $ trends to my LUMN page at www.iiex.club/...

These reversal of these trends are key for the stock to turn around.

[Simeroth1]

And shows no sign of occuring

[David Klein]

I'd disagree, there are some positive signs, now whether these develop enough to move the needle (think segment EBIDTA & GM$) is another question.

It is obvious the market doesn't think it will.

[manfredthree]

All the right things have been done, the 10,000 foot view is those things are working, and Covid has supplied a subtle but longer term growth catalyst in terms of pricing and depth of services. Markets will fill in the blanks.

[Simeroth1]

hasn't for last 3 yeard

[manfredthree]

You seem to remain caught in a time warp.

[David Klein]

Added a quick follow up on my thoughts about the dividend at www.iiex.club/...

[Justin Wiedeman]

I appreciate the update. Would remind you that proforma combined revenue did not take account of deferred revenue that would be eliminated as a result of GAAP rules on purchases and other changes as well as inter-company revenue. That accounts for about a billion. Discussion on that here:

seekingalpha.com/...

The company decided to unwind the Prism service and the Streaming service that was under development. That is about $350M a year.

I'd also go further and say that cash flow on a comparable basis is consistent over the period with a few anomolies. This reflects in my opinion based on numerous channel checks that LUMN is providing a great deal of the savings benefits to customers. The "synergy" and other cost reduction benefits including interest. I believe that has bottomed.

More on comparable cash flow here:

seekingalpha.com/...

Not questioning your knowledge of the Company just supplementing. Cheers!

[David Klein]

@Justin Wiedeman Not a problem the more researched information the better.

[Justin Wiedeman]

A piece on the regulatory revenue forward. You should enjoy it.

seekingalpha.com/...

[DavidBe]

Saved by the tax department. Take it where you can get it. Certainly not from running a good and honest business.

[David Klein]

My 3Q benchmarks (in $mil):

Revenue: 5166

Gross Margin: 2946

*FCF: 817 (capex 809)

*EBITDA: 2104

*includes integration and special charges

Hopefully they will exceed these.

If there are any unexpected news or events I'll post an update(s).

[Justin Wiedeman]

IGAM up organic (sales and market share increase) and currency tailwind.

Enterprise up organic - data caps reimposed as well as sales and market share increase and edge services.

Wholesale flat to down - depends on leasing progress.

SMB - down moderately.

Consumer - Flat to up depending upon success of targeting newly fibered areas. 102 notices filed for areas to retire copper in September indicating the new fiber services are on are coming online. Some of these areas are very large.

Very good shot at Q over Q growth. Expenses back down. I'm more optimistic about Operating Cash Flow, but I expect high CAPEX again because the construction environment (low traffic etc.) is so constructive for "leaning into growth". I see FCF higher Q over Q and year over year.

[manfredthree]

Expect Wholesale to remain solid due to the abundant amount of dark fiber. He was trying to relate that at the GS event.

[preterist]

Here are comments by 4 of our neighbors on CTL's service:

Internet???? Can anyone help me with a good internet provider. I’m with Centurylink!!!!! Please help!!!!!!

I’m so sick and tired of Century Link, between their horrible service and even worse customer service.

I can’t even pay my bill every month without a huge hassle. I Can’t do it online . when I call they say that my account # on my bill doesn’t exist. Every month it’s the same song and dance...., and the internet is sooo slow!

Century link sure has a racket going on out in our neck of the woods.

[Justin Wiedeman]

@preterist

So this is the basis for your investment or non-investment?

[rbaa1]

@Justin Wiedeman Yeah, probably antecdotal, but if you check various sources and find a pattern of complaints, including BBB's rating of: 'BBB files indicate a pattern of consumer complaints filed against this business.' Same thing happened with FTR, and can lead to a continuation of decline in revenue in the consumer segment, rather than the expected 'declining rate of decline' (I love that as justification for an investment!) or leveling off. Definitely one factor to consider in making an investment in a business with such a high level of intangible assets, as that level is supposed to indicate, in part, a beneficial relationship contribution to the profitability.

[coroscant72]

Ever have to deal with Comcast customer service?

No one likes their internet provider. Be it AT&T, Comcast, Dish, FTR...

I expect everyone who doesn't have fiber run to their house to switch to whatever 5G provider works the best in their area as soon as they can. I know I am.

[David Klein]

Looking over my projections I have them on track for lower gross margins in 2020 by about $500m from 2019 (Revenue down over $700m). Below the GM line I have them on track for reducing interest/other expense and SG&A by $500m+ making up for the lower GM. This is what I meant when I said, “If the runway for cost cutting and interest savings is long enough to turn gross margins around, the stock is cheap” in the article.

The pieces to the puzzle are starting to come into view. Decelerating revenue declines should, at some point, reverse the decline in GM$, the last piece of the puzzle IMO. When/if this occurs, I think will be a powerful catalyst to attract interest and accelerate gains in the stock price over what we have seen to date (It is an easy metric for any investor/analyst to grasp and would expect some major upgrades). When will this happen? That is the $64,000 question.

[Justin Wiedeman]

Q3 is my guess on revenue.

Watch what is happening to GTT and other resellers that provide no value. They are going the way of the Dodo bird. That "lean into growth" capex spend of $1B was a tell. I thought it would be much, much lower.

Listening to the Cowen presentation yesterday, the CTO made it clear that the vast majority of CAPEX was/is success based and they are investing in their customers.

Yes, legacy continues to decline but the number of opportunities aside from the useless resellers (getting their Clients) include leasing of fiber as well as facilities as well as cloud and managed services using the Edge locations. Further, redundancy and reliability will become a greater imperative for more and more remote compute as well as cloud.

CTL has significantly reduced on-net prices to provide incentives. At the same time they are producing exceptional cash flows. The strategy is already materializing.

I've never seen anything like this in my investing life.

[David Klein]

Well Justin lets hope we are right because in the last few months CTL has become my largest holding by far.

[Justin Wiedeman]

Me too brother. Never seen anything like it.

But then again I've never seen anything like Tesla valuation so what do I know about market participants - only that they do not do the work and they love momentum. Be greedy when people are fearful and fearful when people are greedy...

[Justin Wiedeman]

@David Klein

A very thoughtful piece. Funny to read the comments to your article.

I think Management is doing the right thing by not providing revenue guidance. They have been cutting costs and sharing the savings with Customers. I like that approach. It is pulling demand on the network and pulling increased traffic thru the Super Highway Intersections. It is a competitive issue that belongs in the secret war room. Why share your strategy with Wall Street and your Competitors? No way.

Also, a number of the Sell Side Analyst Firms have conflicts of interest and CTL is screwing up there plans - best example is GTT. I was short GTT until recently. But the effect of passing on a portion of the expense savings to Customers is devaluing the potential GTT asset sale. I think they will be bankrupt within a year. They will no longer be able to bump revenue based on MA. Funny that so many of the analysts who say sell CTL have buy recommendations on GTT. You just can't make this stuff up.

Justin

[David Klein]

Thank you Justin, it's appreciated. I agree on GTT. No way I would touch that stock. (Now that I said that someone will probably swoop in and buy them at 100% premium :).

BTW I look forward to your next CTL writeup, assuming you still plan to share with the public.

[Justin Wiedeman]

@Stone Fox Capital @David Klein @Steve Rasher

Just finished analysis of comparable operating cash flow which adjusts for changes in balances for current assets/liabilities and other assets/liabilities.

How much operating cash did you produce outside of paying down liabilities or prepaying for inventory as examples?

That is what I'm evaluating in the analysis of comparable cash flow. Otherwise an analyst would be lost, but it requires a lot of work.

I think the critical piece of this is the tax shield. Looking at gross margin is not what I think you need to be looking at. Amortization of purchased intangibles as well as the deferred tax assets increase the after tax cash which at the end of the day - is what we as value investors are focused on.

If you look at net margin and I'm simply going to define that as after tax comparable operating cash flow divided by total revenue - it has grown substantially. Q1 2018 was 30% net cash produced by operations to 35% in Q2 2020. The trend is consistent but has some chop quarter by quarter.

Q1 2018 $1,716/$5,720 = 30%

Q2 2020 $1,823/$5,192 = 35%

You should be aware as I'm sure you are that the Contract Liabilities account (Enterprise/IGAM customers mostly) is critical to understanding the cyclical nature of GAAP reported net cash from operating activities which is adjusted for balance changes. Q1 GAAP cash flow from operating is always low because the balance reversals (otherwise known as installations and service upgrades) that takes place in Q1.

What is also indicative of sharing cost savings with Customers (my previous comment), just a share of it, is the ASC 606 Contract with Customers Revenue versus non ASC 606. Strongly suggest you go thru that. Glad to answer questions.

The non-ASC 606 includes leasing income and it has grown substantially from 2019 to 2020 and I expect it will continue. Dish, T-Mobile and others. But I also expect more leasing of Edge facility space as traffic continues to climb higher on those routes.

Redundancy and reliability are big issues that the Federal Reserve has been advised to evaluate in terms of Systemic Risk to our economy of our communications infrastructure in addition to banks.

Q1 2019 non ASC 606 was $358M vs Q2 2020 of $481M.

The increase is from lease income and is more than offsetting declines in regulatory and "other" revenue which have been falling.

While ASC 606 Revenue has declined, we know they have increased demand for services substantially. They have also told us that they have reduced pricing in Peering Agreements and I have other channel checks that show major cost reductions to various customer classes.

Moving on to sales funnel and other items now, but I'm very pleased with what I'm seeing.

This is a really sharp leadership team and sorry if investors and analysts don't have the time, inclination or skill sets to evaluate - but it is very clear to me. They are managing for cash as they have stated many times and they are succeeding.

Justin

[Steve Rasher]

@Justin Wiedeman Much thanks for the very informative and insightful comment that goes quite a bit deeper into the business. Yes, this is a strong management team that the BoD is permitting time to execute on the plan approved by both. I appreciate that the amortization of purchased assets and the tax shield preferred by the deferred tax assets are important to understanding the true cash flows. I agree that Cash is King and that, therefore, that is a metric of paramount importance. Nevertheless, it is also useful to understand gross margins and the changes in that metric as that provides a glimpse into how the core business is operating. Steve