Lumen Technologies' (NYSE:LUMN) is trading well below its fair value because the company's declining sales and massive debt load mask the stock's true upside. Lumen has a competitive advantage as a telecom provider and the company is underpriced compared to the future cash flows it will generate. In this article, I'll break down everything you need to know about this company, so you can see why I invested in the stock, and so you can gain a better understanding of this company for yourself. I hope you enjoy.
Lumen is an international communications company that provides customers with internet services. Lumen Technologies is proud to have one of the most interconnected networks in the world, with over 450,000 miles of global fiber optic cable.
As a telecom service provider, Lumen's business is broken into five segments. Their IGAM segment (International and Global Accounts) serves over 200 multinational corporations and does about 15% of sales, and their Enterprise segment serves the public sector, including the Federal, state, and local government, doing about 30% of sales. They also serve Small and Medium-sized Businesses (about 10% of sales), they sell Wholesale rights to other telecom providers (about 20% of sales), and they sell some services directly to consumers (25% of sales). Together, Lumen serves a broad array of customers.
Source: 2020 10-K
Additionally, management is looking to redefine its segments in 2021. Lumen describes their plan in their annual report:
We plan to make changes to our segment and customer-facing sales channel reporting categories in 2021 to align with operational changes designed to better support our customers. Beginning in the first quarter of 2021, the company plans to report two segments: Business and Mass Markets. The Business segment will include four sales channels: International & Global Accounts, Large Enterprise, Mid-Market Enterprise and Wholesale. The Mass Markets segment will include both our Consumer and Small Business Group sales channels.
So going forward, the company will have a Business segment for business customers, and a Mass Markets segment for consumers and small businesses. This change should help investors to differentiate between the company's CenturyLink legacy segments on the consumer side and its newer Level 3 growth segments that will be primarily on the business side.
Below, I listed some of the company's Value Destroyers and Value Creators. These are some of the most important things about the stock, and these should help you to better understand the opportunities that Lumen presents for investors, and understand the risks with this stock.
One of the most disturbing things about Lumen as an investment is the company's declining sales. Lumen Technologies is a rebranded company that was formed upon the merger of an age-old CenturyLink and a newer edge computing company called Level 3. CenturyLink bought Level 3 in 2017 because they were a declining business and they needed to attach themselves to a new source of revenue.
Right now, Lumen's revenue is declining, as CenturyLink's legacy services become less and less relevant each year. Lumen's revenues have been declining since 2018, the first full year after the merger. In the red boxes, you can see their revenue dropped -5% from 2018 to 2019, and revenue dropped -3% from 2019 to 2020.
Source: 2020 10-K
The good news is, the revenue decline has been getting better. Lumen only lost 3% last year, while they lost 5% the year before. You can see in the green boxes in the image below that almost all of the individual business lines saw better year over year declines.
Source: 2020 10-K
Now of course, it's probably not much of a relief to see that the top line revenue is going from bad to not as bad. But eventually, the revenues will stop declining, and hopefully start to grow sooner rather than later.
First, a lot of the revenue losses may not be as bad as they look. You can see in the "Other" business line that from 2019 to 2020, the revenue declined -39%. That sounds awful, and makes it appear like the business is really falling apart! But when you look at the nominal dollars of the decline, this line of business decreased from $172M to $105M. Sales for this line of business dropped $68M. This contributes just a tiny fraction of Lumen's overall free cash flow of around $2.8 billion. So really, most of the huge percentage losses appear worse than they really are.
Additionally, something to keep in mind is that as the revenue number declines more and more, there's a smaller and smaller nominal impact on revenue. Think about it like this: would you rather lose 10% on $1,000 or 10% on $10,000? In the first scenario, you lose $100, but in the second scenario, you lose $1,000. On paper, both of the scenarios look equally bad, because you lose 10%, but the results end up being very different. In the same way, each year that the company loses a certain percent of revenue, it ends up having a lesser and lesser effect on nominal revenue loss.
At some point, the tide should turn, and we should see positive revenue growth, as the revenue declines slow down, and the lines of business that are doing well start to shine through.
One of the biggest problems with Lumen is their huge debt burden. They have $31,837 billion in total debt, and $11,162 billion in shareholder's equity. I think that one of the biggest reasons that Lumen's fair value hasn't been recognized is because they have ridiculously high debt.
However, Lumen's outlook has been improving as they rapidly pay down their debt. By the end of 2017, Lumen had $37.7B in debt outstanding. Just 3 years later, it's down to $31.8B. They've been using their high cash flow to pay down about $2B of debt every year. The company's debt position should continue to improve, as they free up more interest payments that can be used to pay down more debt.
Here's Lumen's plans to pay down more debt in 2021:
For the 12 month period ending December 31, 2021, we project that our fixed commitments will include (i) $125 million of scheduled term loan amortization payments, (II) $24 million of finance lease and other fixed payments and (III) $2.3 billion of debt maturities (excluding issuances made after December 31, 2020). We do not anticipate that the COVID-19 pandemic will interfere with our ability to discharge these obligations over the next year.
Source: 2020 10-K
They plan on paying down another $2.3B over the next year. This is really awesome because chipping away at the debt burden frees up interest payments that can be used for reinvestment, and it makes the company safer and more attractive for investors.
One of the things that Lumen's management likes to brag about is that they're one of the most interconnected companies in the world. To give credit to Lumen's management, this is one of their strongest advantages.
Lumen's competitive advantage stems back to 1984, when AT&T was deemed a monopoly, and had to split apart into 7 new companies.
These seven newly-formed companies were called RBOC's (Regional Bell Operating Companies), ILEC's (Incumbent Local Exchange Carriers) or my favorite, Baby Bells. Right now, AT&T, Verizon and CenturyLink are the only ILEC's, because they are the only companies that kept parts of the Baby Bells through mergers and acquisitions. Over time, other non-ILEC companies merged into the industry, and the telecom industry continued to consolidate, so what used to be seven different companies has pretty much become three companies, with Verizon, CenturyLink (now Lumen) and AT&T, which was able to reclaim four of the original seven Baby Bells.
As an ILEC, Lumen owns its infrastructure. No one can take that away from them. They are able to generate regulated revenue by selling out service to other telecom providers at wholesale prices, because Lumen is one of the only companies that owns the original infrastructure.
Additionally, as the world's focus shifts to wireless, telecom providers still need the underlying wires to provide service, and these will be even more useful for the network when 5G rolls around. Lumen has a distinct advantage of having a huge wire network.
Additionally, Justin Wiedeman's article explains how it would probably cost a company hundreds of billions of dollars and at least 3-5 years to be able to recreate Lumen's wire network and various other assets. And if you think about how much they've already invested to get to this point, then $100B or seems to make sense:
The Gross PPE, the original cost invested over decades, before accumulated depreciation is approximately $58B. This is separate of intangible assets. This is after retirements and disposals so the original cost could be much higher.
Source: Justin Wiedeman's Article
Basically, Lumen is one of few companies in the world with such a strong wire network. They've invested tens of billions of dollars over many years to build this network. This gives them a competitive moat.
High Free Cash Flow
One of the most interesting things about Lumen is that the company produces massive free cash flow for the price investors pay today. Since Lumen already owns its massive cable network, the result is that the company is able to generate a massive amount of free cash flow. The chart below shows their free cash flow over the past 3 years.
The free cash flow that Lumen generates is absolutely massive. With the company currently trading with a market cap of $14B, investors make a free cash flow yield of nearly 20%. Even with revenues and free cash flow declining, I expect free cash flows to stay in the $2-$3 billion range over the next 10 years, so investors should see great free cash flows over that time.
Huge Dividend Yield
Lumen is able to pay a massive dividend as a result of their high free cash flow. Lumen pays out $1.1B every year to shareholders through its dividend. At the current price of around $12.80, Lumen's market cap is $14B, and the company offers a strong 7.6% dividend yield. And if the stock were to drop even further, the dividend yield is 10% at $10 per share.
Additionally, Lumen made $2.8B in free cash flow for 2020. That means that the company paid out only about 40% of its free cash flows for the dividend. The dividend seems to be very conservative. This could make shares even more attractive, because while investors would make a very high dividend while they waited for the stock to return to fair value.
Rapid Debt Repayment
Lumen has been paying down tons of its debt. One of the greatest things about this is they've been able to massively free up their interest payments. When Lumen pays down its debt principal or negotiates better interest rates on its debt - the interest payments that Lumen doesn't have to pay essentially becomes pure profit that they'll make on an annual basis. This interest can be used every year to continue paying down more debt, or it can be reinvested in the business. Over the last year, Lumen freed up $350 million in annual interest payments from debt down payment and negotiating better interest rates:
Interest expense decreased by $353 million for the year ended December 31, 2020 as compared to the year ended December 31, 2019. The decrease in interest expense was primarily due to a decrease in average long-term debt from $35.4 billion to $33.3 billion and a decrease in the average interest rate of 5.75% to 5.23%.
Source: 2020 10-K
Restructuring debt is huge for Lumen. Moves like this directly translate into more profit for Lumen. Even as the top line continues to shrink, paying down and restructuring debt creates annual profits for the company.
All Lumen has to do is keep their free cash flows at about the same level that it's at right now to make this a good investment. It is likely they can do that.
Lumen is pretty undervalued. In a recent Investor's Presentation the company presented its view of what it's fair value should be. Since this is straight from company management, you can expect this to be a little overly optimistic. Of course management will probably present the business in the best possible light. However, I don't think their analysis of Lumen's fair value is too unreasonable.
Lumen's management took the company's consolidated EBITDA of $9B and multiplied it by a fair EV/EBITDA multiple to find the value of the company. After subtracting out debt, they figured that the per share value of the company should be around $24 to $35 per share. I don't think this is too inaccurate.
Source: Investor's Presentation
I chose to value Lumen in a little bit of a more complex way. Hopefully, it is more accurate, and gives you a better sense of what the company is worth.
To find my fair value of Lumen Technologies, I used a Discounted Cash Flow model. The Discounted Cash Flow models is one of the best ways to find a company's fundamental value. When portfolio managers use the DCF model to value companies, they make rough projections of what cash flows the company will produce in the future, and discount the future cash flows to find a fair price to pay for the business today.
For my DCF model, I projected future revenue, and made some estimations on what free cash flows the business was likely to make on that revenue. I outlined a few of the important assumptions that I used in red, that way you can see exactly what I did and get a good sense of what the stock is worth. Also, I tried to use reasonable, yet conservative estimates for this model. Feel free to mentally adjust any of my work, or send me a comment if you find any improvements that can be made. If you find a mistake, this wouldn't be the first or the last time I messed up a valuation, and I really appreciate your feedback because I'm always trying to learn.
In the first two red boxes, I estimated the future revenue growth rate and the operating margins over the next 10 years. Basically, after making revenue projections, it's important to get the NOPAT number. This is net operating profit after taxes - which is nearly the same as net income, except NOPAT can be used to find unlevered free cash flow. NOPAT does not include interest payments, which is very important for this model.
Next, I made some non-cash charge adjustments. The biggest thing here is I added back depreciation and amortization to NOPAT, because technically D&A is not a cash charge. Depreciation and amortization is an arbitrary expense, because it basically represents the annualized cost of having to replace an asset. But, you don't physically pay it; it's more of a mental thing. That's why we add it back.
And the last part of this valuation - I subtracted capital expenditures from NOPAT from what I had before, and found the final unlevered free cash flow. This is the best part, because you get to see what kind of cash flows the business is supposed to bring in. If I lost you with some of the technical stuff - don't worry, it's not super important. Right down below, you can see what these shares are worth.
Finally, we get to find out what Lumen is worth. Today, Lumen is worth about $60B from the free cash flows it should generate, and after paying down its debt, it's really worth about $28.5B. Today, the market cap of the stock is about $14B. That means there's about a 100% potential upside on the stock for it to return to fair value, which means that it's trading at a good price right now.
Lumen provides a good margin of safety at current prices. If you've been investing for a while, you might have found that buying with a margin of safety protects you from losing money while increasing the upside you can get from the stock. Lumen is a great business that is able to generate great free cash flows, available with a margin of safety.
Lumen Technologies appears to be a company that is misunderstood by the market because of the company's high debt and declining sales. Lumen has a competitive advantage because of its strong wire network, and the stock's huge free cash flow and dividend yield made this company fundamentally undervalued. I hope you enjoyed reading, and I would love to hear what you think about this company in the comments.