Lumen: Continued Strong Income Opportunity

Summary

• While revenues miss, adjusted earnings beat nicely.
• Buyback authorized as another asset sale announced.
• 2022 dividend raise looking more likely.

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After the bell on Tuesday, we received second quarter earnings from communication services company Lumen Technologies (NYSE:LUMN). The dividend favorite has done a lot to improve its balance sheet in recent years, and now it is moving on to the next major stage of its transition. While there was plenty of good news in this report, the stock did fall on Wednesday, providing investors and the company a great opportunity.

Let's first start out with the bad news. Total revenues came in at $4.92 billion, missing street estimates by about $65 million. This was a decline of more than 5% over the prior year period, and is a continuation of the top line struggles seen in recent years. Overall revenues will likely continue to decline for another year or so as the company has announced two major asset sales, the latest of which was a $7.5 billion deal to sell certain telecom assets to Apollo (APO).

While the top line is still declining, management is doing a much better job of controlling costs. Total expenses are coming down even faster, which is why the Adjusted EBITDA margin (excluding special items) jumped 1.7 percentage points over the prior year period. I've continued to detail the company's progress on the debt front, which lowered quarterly interest expenses by $30 million over Q2 2020. Net income, excluding items, jumped from $420 million in the year ago period to $521 million in this year's Q2. Adjusted earnings per share of $0.48 beat street estimates by 7 cents.

When it comes to guidance, management cut its capital expenditures forecast range for the year by $300 million. As a result, free cash flow guidance was boosted by that amount for the year, now forecast to be at least $3.1 billion. After dividend payments, that leaves $2 billion left over, which is mostly going to go to debt repayments. As the graphic below shows, the net debt amount has come down nicely over the years and should continue to do so moving forward.

(Source: Company earnings reports, seen here)

One of the biggest pieces of news this week was that the board of directors announced a two year program to repurchase up to $1 billion in common stock. A buyback had been discussed in recent quarters, and I was a bit skeptical of the company doing so when the stock was nearing $15 a share. However, the recent pullback certainly changes the narrative, now that the annual dividend yield is several hundred basis points above what the company could be paying for new borrowings at this time.

I said previously I just wasn't a fan of the stock above $14, and part of that was because the income potential was down quite a bit from where it had been. With shares closing at $11.62 on Wednesday, that dividend yield is now back up to 8.60%, one of the best yields out there. With the asset sales announced, deals expected to both close next year, along with the buyback, it is possible that the dividend could be raised a little in 2022. With long-term US Treasuries not even getting you 2.00% currently, the rising dividend yield seen below is a much better income generator for investors.

(Data sourced from Yahoo! Finance)

That dividend is an important item for investors. As management stated on the conference call, it is going to lose over $1 billion of yearly cash flow after these asset sales are completed. However, that would still put the name in the $1.5 billion to $2.0 billion annual range for free cash flow, and the dividend is only costing $1.1 billion per year right now. With the buyback helping to keep the share count steady, that leaves some room for the dividend to increase in the long run. Even a 5% dividend raise from current level would still leave plenty of free cash flow for the buyback as well as future debt reduction.

Lumen shares didn't start off Wednesday well, but things worsened throughout the day. As the chart below shows, the stock lost its 200-day moving average (orange line), which probably added to the selling pressure. The stock is now more than $2 below its 50-day moving average (purple line), which generally is a better place to buy. If shares don't recover soon, we likely will see the dreaded death cross, but buyers would likely rather shares are where they are now then when they were multiple dollars above both key technical lines.

(Source: Yahoo! Finance)

One other item I find important is what analysts think of the name. A year ago, the average price target on the stock was $10.37. However, as adjusted earnings have grown and the balance sheet has strengthened, the street average has risen by roughly $2 since. Currently, the street sees 6.2% upside from Wednesday's close, and that would be in addition to the strong income investors are receiving from this name.

In the end, Lumen reported a mixed quarter with its headlines, but the story was more about the long term trajectory of the business. Adjusted profits are growing and solid free cash flow is still being generated. The company will look a lot different by the end of next year thanks to two major asset sales, but that will free up a lot of capital that can be used for debt repayments, buybacks, and dividends. With the stock having sold off recently, investors are treated to a lot more annual income and the buyback will be stronger at these levels. While there could be a little more selling thanks to near term technical weakness, I think the name remains a good long term hold for those looking for solid income with some potential upside.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.