Lumen: A Contrarian Investment Case

Summary

• Lumen is legacy copper wire telco trying to adapt to a fiber optic world.
• Revenues have been declining for years, the dividend was just eliminated, and the stock has cratered.
• And yet I think Lumen is a huge bargain.

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I think the best way for me to start this article is with a little bit of personal background. I have no formal financial training; however, over the years I've learned enough to have a clue about how companies make money and how to value them. I try to only write when I think I might have something to add to the conversation and that typically happens when a company is so hated by Mr. Market that Mr. Market is essentially throwing the baby out with the bathwater and you don't need a nuanced evaluation of the company or financials to understand the investment thesis. I believe this is the case with Lumen (NYSE:LUMN).

I recently invested in Lumen based on Morningstar's analysis and $14 fair value. I'm a contrarian investor and typically avoid high flying story stocks; however, a few months ago I noticed Morningstar had a number of high growth stocks at 5 five stars which had come down on the order of 50% to 80% from their recent (bubble) highs. I've been spreading my chips across a number of them and at first glance I thought Lumen was going to be some sort of pure play on fiber optics that was coming back to earth after a bubble run up. Morningstar's analysis was not exactly glowing so I decided to dig into this one to try to get a better sense of what Lumen does and what the issues/ investment case are.

Here is what I found:

Morningstar provides financials going back to 2012 and the revenues told a tale of two companies. From 2012 to 2017 Revenues were essentially flat going from $18,376 to 17,689. In 2018 Revenues jumped to $23,443 but have been on a steady decline since to a TTM $18,525. Lumen just recently announced they were eliminating their dividend (to switch to stock buybacks) and this cratered what was left of the stock price after 4 years of steady revenue declines. Recent articles and message board posts paint a dismal picture of this company and (probably unfairly) management. The jump in revenues in 2018 stuck out and suggested some sort of acquisition and a little more digging turned up the acquisition of Fiber Optics backbone Level 3. I also noticed the company name in 2018 was Century Link and found a press release from 2020 announcing their name change to Lumen. At this point I had already suspected this was a traditional copper wire telco adapting to a fiber optic world and correspondence with Investor Relations confirmed this. The stock has gone from a trading range in the mid $30's in 2012 to a current price of $5.50.

The obvious question I'm sure anyone still reading this article has is why am I writing about this company. Let me start by pointing out Lumen's current market cap is $5.78B. The table below is Lumen's reported Cash From Operations from 2018 to TTM.

2018	2018	2020	2021	TTM
$7.027B	$6.696B	$6.427B	$6.622B	$5.526B

Click to enlarge

This is correct the current market cap is about the same as the actual cash generated from operations. While there has been a significant drop off in cash from operations over the TTM there have also been a number of large divestitures over this period that have probably contributed to this drop off (in addition to reducing debt by about 33%). The divestitures came in two basic categories. Non U.S. assets that required CAPEX that LUMN management didn't want to take from core U.S. assets and a 20 State ILEC or copper wire telco business. The ILEC business actually generates higher EBITDA than the remaining company but I assume the decline rate is also high so it was divested to slow down the revenue declines in the remaining company so that they can start to pivot back to growth. This is a high debt company but management going back to 2018 has been rapidly reducing debt and leverage. Net debt after divestitures is projected at $20.5B with a leverage ratio of 3.7x- 3.8X. In 2018 debt was in the mid $30'sB and management at the time announced a goal to get leverage under 4X. Management is currently guiding no change to leverage after divestitures and that they are at their target leverage and will work to keep it there. IE: while the divestitures will reduce debt by ~33% the goal of the divestitures is really to position the company for growth again.

On the message boards management takes a lot of heat; however, realistically I'm not sure what anyone expected from a copper wire telco trying to transition to a fiber optic world. A new CEO Kate Johnson just took over the company. I believe the retiring CEO joined around 2018 and was responsible for the Level 3 acquisition in addition to the heavy lifting of massive debt and leverage reduction. The stock has done a nose dive from high teens to the current $5.50 over this time period including a shellacking after a recent announcement that they were eliminating a dividend that was yielding over 13%. However, they also announced a $1.5B stock buyback program over the next two years which equates to ~25% of shares outstanding at their current market cap. Kate Johnson was brought in specifically for the pivot to growth although by all accounts this will not happen overnight. Kate was brought in to the decision making process for the recent divestitures before she was appointed to the CEO position so it can be assumed the divestitures fit within her game plan.

Circling back to points above I don't know what investors expected from the previous management but I can see how investors would not be happy with the performance of the stock. IMO this has to be put in the perspective of a market that has been fixated on a single metric "GROWTH". High growth story stocks with no or almost no earnings or cash flow that need to constantly dilute shareholders to raise cash to fund growth or pay employees got rewarded with valuations they will probably never live up to. LUMN is the polar opposite of this; it is a mature business that generates GOBS of cash that they can now use to fund growth that is priced like it's about to go belly up. The fact that revenues have been declining complicates evaluating the value of their massive cash flow in an era when investors already didn't care about cash flow unless you were in it for the dividend. Declining revenues affects the sustainability of the dividend which made LUMN unattractive to dividend investor which in turn created something of a self fulfilling prophecy in that management decided to scrap a dividend they were getting no credit for from Mr. Market. On the other hand when your market cap is equal to cash generated from operations, stock buybacks make perfect sense even if Mr. Market doesn't get it (for now).

Finally we get to the heart of the contrarian case for LUMN: "valuation". The quick take is to just point out that Morningstar has a fair value of $14 based on an adjusted EPS multiple of 11X. The analyst projects a 30% decline in EBITDA post divestitures so I applied this reduction to 2021 operating income and come up with ~$3,000 estimated 2023 operating income. Management disclosed an average interest rate of 5.75% going forward which equates to ~$1,180 interest and they guided to $500M taxes in 2023. Subtracting interest and taxes from operating income I ballpark net income of ~ $1,320. At 1,016 shares outstanding I ballpark 2023 EPS of ~$1.30 at 11X that equates to ~$14.3 share fair value or around 2.6X the current share price. I should point out management is also guiding to some sort of large one time tax event in Q1-23 due to one of the divestitures that I don't believe is included in the $500M so the above is "normalized" 2023 EPS.

This in itself is a pretty compelling case for an investment in LUMN but it gets much better. The valuation above is based on earnings which include a HUGE non cash expense for depreciation and amortization. This is why cash provided from operations reported on their cash flow statement is so much larger than operating income reported on their income statement. A good deal of my financial education came when I was a TMF sub a long time ago and they developed an "Owner Earnings" metric that I like to use. They define it as Net income adjusted to normal taxes plus depreciation and amortization and minus maintenance CAPEX. Morningstar is projecting post divestiture EBITDA of $6,000. I subtract: 1,180 interest, $500 taxes and $500 maintenance CAPEX (from management guidance) for an owner earnings of ~$3,820. This equates to ~$3.76/ share and a fair value of ~$41 at 11X.

I can see how many or probably most readers would be skeptical that this kind of valuation is realistic given how low the stock prices is and how far it's fallen. For a frame of reference 11X is a multiple used for low to no growth dividend paying utility stocks. As I pointed out earlier, a decade ago LUMN did sport a share price in this range but since then it's been a dinosaur business with declining revenues in a ZIRP, story stock, growth is all Mr. Market cares about world and they couldn't even sell themselves to dividend investors.

I'm going to use some proforma post divestiture adjusted metrics from LUMN recent Q3-22 earnings slide show for a frame of reference of where LUMN is at. Total adjusted revenues Q3 would be $4,328 and down 5.5% Y/Y. Management blames some of the decline on an environment where their large corporate customers are taking longer than they have in the recent past to green light large expenditures; however, as I will point out next, a good deal of the business is still in a managed decline but generating cash for the growth portion of the business. Management divides the company up in a few different ways but to keep this simple they describe two distinct growth categories with the rest of the business in managed decline but generating cash to support the growth.

The two growth categories are something they literally call "growth" that as far as I can tell is equipment or services to large enterprises that they reported Q3 adjusted revenue of $1,079 and 1.6% Y/Y growth. The second category is Called Fiber Broadband. Investor relations explained that this is a conversion of their Legacy DSL business to Fiber Optics that they have branded "Quantum Fiber". Adjusted revenues for Fiber were $145 and 17.9% Y/Y. growth. So added together the growth portion of the business is at $1,264 and 29% of the total business with the rest of the business in a managed decline but generating cash to support these growth initiatives. I couldn't begin to provide any color on enterprise portion of the growth but management has provided enough bits and pieces of information in the conference calls and presentations to start to get a sense of where the Fiber business is heading.

Clue one was an analyst on their Q3 cc questioning why they are spending billions in CAPEX on what amounts to 3% of revenues right now. Part of the answer is they are just getting started on this conversion and it takes time from laying fiber to actually signing up customers en masse. They have disclosed that their total addressable market is ~12M customers and that they plan to deploy at a rate of 1.5M to 2M customer locations per year. They are targeting a penetration rate of 40% and they stated that current customers adoption metrics are on target. ARPU is currently ~$60. This is HSI and probably VOIP (I didn't confirm this) not a triple play (no TV) so part of the marketing approach will be value compared to the MSO's. They also state that cable can't touch performance of their fiber so quality also seems to be a part of marketing. A little back of the napkin and 40% of 12M is ~4.8M customers. 1.5M to 2M customer locations per year is ~6-8 years to fully deploy. It will be a few more years after that before customer growth matures. So including a bit of inflation and maybe ~$3.0B in revenues a decade from now. I would imagine most of that will flow down to EBITDA and cash from operations so a potentially substantial boost to cash flow growth and valuations based on cash flow from this segment alone. Management also noted that they are deploying in growth communities so the TAM will likely be higher as time goes by. ARPU is lower now than it will be as they mature due to marketing and they noted they can add services to this offering so the $3.0B could be substantially higher.

To recap LUMN is a legacy copper wire telco that is adapting itself to a fiber optic world by using cash from its legacy operations to fund growth opportunities. The stock price has probably suffered more than deserved because the business is stuck in an investor no man's land but also because the cash has no value if it doesn't provide a benefit to shareholders. They are addressing part of this via the stock buyback. They probably need to show enough tangible results in getting back to growth to convince value oriented investors that the rest of their gobs of cash flow won't be wasted on failed growth initiatives. Even if they only just stop the declines they could re-instate a sustainable dividend and be valued like a utility company. A modest amount of growth and a higher multiple.

The risk is none of their growth initiatives pan out, the cash spent on them was wasted and revenues and cash flows decline even further. Every publicly traded company comes with risks. The slew of high flying story stocks that are now sporting Morningstar 5 star ratings because they've sold off 50% - 80% from their bubble highs suffered because they would likely never generate the cash implied in their valuations. LUMN IS generating the cash they are just not getting the credit for it. All LUMN has to do is prove they won't waste the cash to become a multi bagger. LUMN was trading about 40% higher before the announcement that they were scrapping the dividend tanked the stock. Tax loss selling is probably adding to pressure right now as well. I could see LUMN 40% higher into 2023 just on the elimination of dividend investor sellers, tax loss sellers and support from the stock buybacks.

Disclosure: I/we have a beneficial long position in the shares of LUMN either through stock ownership, options, or other derivatives. 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.