As we approach the end of the first half of this year, I wanted to circle back to communications company Lumen Technologies (NYSE:LUMN). The high yielding stock was my top income play for 2022, and while shares are down 14% so far this year, that's actually beating the S&P 500 index by about 7 percentage points as seen in the chart below. Unfortunately for investors, the company has a bit of a headwind coming in the near term, one that will depress results a little bit moving forward.
A few years before the pandemic started, the company that was then known as CenturyLink had a more than $37 billion debt pile after its Level 3 acquisition. Since then, management has used cash flow to repay certain debts while taking advantage of low interest rates to refinance others. From Q3 2018 to Q1 2022, the company's quarterly interest expense dropped from $557 million to $352 million. That's an annual run rate savings of more than $800 million, pretty significant for a company that only does about $20 billion a year in revenue.
As investors know, however, bond yields have been soaring lately across the board. This won't impact Lumen in the traditional sense, because it has almost no debts coming due during the rest of this year, and just about one billion maturing in 2023. However, the company has more than a third of its current debts based on variable rate financing, with the following verbiage taken from its most recent 10-Q filing:
In 2019, we executed swap agreements that reduced our exposure to floating rates with respect to $4.0 billion principal amount of floating rate debt. Certain agreements relating to $2.5 billion of such debt expired on March 31, 2022, with the remainder expiring on June 30, 2022.
As of March 31, 2022, we had approximately $10.7 billion of floating rate debt, $1.5 billion of which was subject to the remaining hedging arrangements described above. A hypothetical increase of 100 basis points in LIBOR relating to our $9.2 billion of unhedged floating rate debt would, among other things, decrease our annual pre-tax earnings by approximately $92 million. Additionally, our credit agreements contain language about a possible change from LIBOR to an alternative index.
Global markets are in the process of changing from LIBOR to SOFR (the secured overnight financing rate), but I don't think Lumen's borrowing agreements will change to the new rate for at least a few more quarters. If this was a year ago, the $4 billion worth of hedging expiring during this roughly four month period wouldn't have been a big deal, as LIBOR rates were mostly steady. However, take a look at the 1-Month LIBOR chart below:
As of Tuesday, the 1-Month rate stood at more than 1.64%. That's still quite low for historical standards, but it's up roughly 120 basis points so far during this quarter. Based on the statement above, that means that Lumen will have more than $100 million in additional annual interest expenses, and that's before the next hedges expire at the end of this month. With at least one more Fed rate hike coming next month and Europe about to start raising rates, Lumen's interest expenses are likely to give back a bit of their recent gains in the coming quarters. Management had guided to $1.35 billion in GAAP interest expense for the year, but that number will need to be adjusted higher at the next earnings report (likely in early August), holding all else equal.
At that Q2 report, investors will be expecting an update on the company's two planned divestitures - the pending sales of Lumen's LATAM business and 20-state ILEC business are expected be completed in the third quarter of 2022 and the fourth quarter of 2022, respectively. This will result in a net inflow of about $7 billion in cash, enough to retire about a quarter of the company's debt, or buyback about two-thirds of outstanding shares at current prices.
When looking at the name in the long run, it will be interesting to see how the business looks after the two divestitures. Lumen is currently paying about $1.1 billion in annual dividends, which is more than covered by the company's free cash flow. However, the pre-asset sales run rate of around $3 billion in free cash flow will not continue, but management is looking to preserve the dividend. Paying back debts and reducing interest expenses will help profitability and long term cash flow, while buying back stock will reduce how much cash is needed for the dividend at its current quarterly payout rate. Management has not yet laid out an exact plan for the two deals' proceeds, which isn't out of the ordinary because it probably wants to complete the sales process first.
As of Tuesday, the average price target on the stock was $11.20, but that only implies about 4% of upside from the day's closing price. Given the need to increase the interest expense forecast at the Q2 report, and the fact that the Fed has only just started its quantitative tightening, I'd be hesitant to add to the stock at current levels. With the stock having traded mostly between $9 and $14 over the past couple of years, I'd look at building a position should shares head back into the single digits, at which point the stock starts yielding more than 10% again.
In the end, this is a bad time for Lumen to be having $4 billion of variable rate debt hedges expiring. LIBOR rates have surged so far in Q2 with the Fed hiking rates and starting quantitative tightening, with other central banks joining in the process. The company's interest expenses will start to rise again, hurting profitability and cash flow, until the two major asset sales are completed and management decides what to do with the proceeds. With it possible that markets could take another leg down as this monetary policy shift continues, I believe we could see single digits again, at which point investors could start looking at the name.
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