CenturyLink (CTL): Can The Level 3 Acquisition Save The Dividend?

In today’s era of historically low interest rates, telecom service providers such as AT&T (T) and Verizon (VZ) are often viewed as some of the best high dividend stocks for income thanks to their highly stable, recession-resistant, and subscriber-based business models.

 

While that may be a good strategy for blue chip names in the industry, it typically doesn’t work nearly as well for smaller, distressed regional telecom players like CenturyLink (CTL).

 

Let’s take a look at CenturyLink’s 11.5% yield to see if it is too good to be true or if the company’s $34 billion acquisition of Level 3 Communications (expected to close very soon) could make the dividend sustainable.

 

Business Overview

Founded in 1968 in Monroe, Louisiana, CenturyLink started off as a regional telecom company. Thanks to a series of large acquisitions over the years, CenturyLink is now America’s third largest telecom services provider with a total of 11.1 million customer connections in 37 U.S. states.

 

At the end of 2016, CenturyLink had:

• 5.9 million broadband internet subscribers
• 325,000 satellites TV subscribers
• 4.9 million landline phone connections
• 58 data centers in North America, Europe, and Asia

 

 

It operates through three major business units:

 

Strategic Services (47.3% of first half 2017 revenue): broadband internet and pay TV

Legacy Services: (42.5% of first half revenue): landline phone service

Data integration (3.0% of first half 2017 revenue): data centers

 

Note that CenturyLink signed agreements to sell its data centers to BC Partners and Medina Capital in November of 2016, meaning that this small portion of the business (about $500 million annualized revenue in 2017) will soon be gone.

 

Business Analysis

Like many telecom companies, CenturyLink suffers from two main factors that make it a questionable dividend growth stock.

 

First, the U.S. telecom market is highly saturated, meaning that profitable organic growth is often hard to come by since breaking into new markets (and stealing share from rivals) is very difficult given the oligopolistic nature of the industry.

 

More specifically, the majority of market share is typically held by just a handful of incumbents who maintain massive subscriber bases. They can afford to spend more on their networks, invest heavily in marketing, and offer their customers very competitive costs to protect their share.

 

Since the total number of subscribers isn’t growing much in most telecom industries and there isn’t much differentiation between services provided, telecom operators with less scale typically struggle to lure customers away from their larger rivals.

 

This means that the only meaningful growth most telecoms can achieve is through mergers and acquisitions, a strategy CenturyLink has pursued very aggressively over the years:

• 2008: $11.6 billion purchase of rural telecom operator Embarq
• 2011: $2.5 billion for Savvis (cloud computer data storage provider)
• 2012: $12.2 billion acquisition of Qwest Communications
• 2016: $34 billion merger with Level 3 Communications (LVLT), a global internet service provider

 

You can see that acquisitions boosted CenturyLink’s sales and earnings in the years they occurred, but the business has otherwise been challenged to grow its top and bottom lines.

 

 

Another major issue CenturyLink faces is the highly capital intensive nature of the business, specifically maintaining, growing, and upgrading fiber optic internet lines, as well as its legacy copper landlines. In fact, over the past 12 months CenturyLink has spent $3.3 billion on capital expenditures, or about 20% of revenue (most corporations spend less than 5% of revenue on capital expenditures).

 

This is because only 35% of CenturyLink’s internet is 40 Mbps or faster, the minimum speed required for streaming high-quality video on demand, which is a major trend that is expected to continue.

 

This high amount of fixed costs, combined with a fundamental deterioration in the company’s businesses (both top and bottom line are in decline), has resulted in steadily declining margins and returns on capital.

 

 

The major problem facing CenturyLink is that, even though it has managed to grow strongly via acquisitions during the last decade, its strategic businesses (i.e. internet and satellite TV) have failed to offset the strong secular declines in its legacy landline business, which accounts for more than 40% of company-wide revenue.

 

You can see that CenturyLink’s Legacy services revenue declined by approximately 10% year-over-year in its most recent quarter.

 

 

In addition, CenturyLink management has made questionable capital allocation decisions, such as spending $2.5 billion for data centers that have failed to provide the company with the expected diversification and growth benefits it used to justify purchasing them.

 

In addition, management showed poor judgment in even thinking it could compete with cloud compuing giants such as Amazon (AMZN), Microsoft (MSFT), Alphabet (GOOG), and IBM (IBM).

 

These rivals have far more capital and massive economies of scale that give them nearly insurmountable competitive advantages and allow them to offer customers better quality (including advanced data analytics) for less cost.

 

In fact, according to analyst firm Gartner, by 2019 Amazon’s AWS and Microsoft’s Azure cloud computing platforms will dominate 90% of the cloud computing market, with Alphabet (parent company of Google and the #3 in market share in cloud computing) and IBM taking the remainder of the market.

 

In other words, CenturyLink showed very poor judgment in acquiring Savvis, and when we look at the company’s total profitability profile, a good proxy for overall management quality, we find that CenturyLink is far behind its industry peers.

 

CenturyLink Trailing 12-Month Profitability

 

Most troubling is the company’s very low free cash flow margin. Free cash flow is what’s left over after the company has paid all expenses, including investing in maintaining, growing, and improving its infrastructure, and is what Warren Buffett calls “owner earnings.”

 

Free cash flow is ultimately what funds sustainable dividends, and right now CenturyLink is struggling to generate any free cash flow at all due to high capital costs and falling sales across the board.

 

Now there is some good news, specifically that the company’s Level 3 Communications acquisition (expected to close in October), which will be 60% funded with stock and 40% with cash and debt, appears to be the best large-scale purchase management has ever made.

 

This is because Level 3 Communications will make CenturyLink a much larger company with:

• Proforma sales of $26 billion, a 53% increase
• Operating profits of $11 billion (including expected $975 million in synergistic cost savings), a 92% increase
• Immediately accretive to FCF per share (Level 3 Communciations has a 14.5% FCF margin), and thus expected to increase the safety of the dividend (for now)

 

In addition, the merger will create a far more diversified business, with a presence in 350 large global metro markets, in over 60 countries, on five continents. That includes fast-growing emerging markets in Asia, Latin America, and Africa.

 

 

However, the news isn’t all good because while Level 3 Communications appears to be a far better run (and more profitable) business, it’s similarly facing strong growth pressures from much larger rivals in all of its key markets.

 

The large organic growth opportunities in emerging markets are attracting a lot of attention from major global telecom giants such as Vodafone (VOD), for example.

 

In other words, while CenturyLink has thus far managed to grow quickly enough through large-scale acquisitions to help maintain its generous dividend, the company ultimately appears to be a poorly run collection of declining businesses, in challenging industries, that are being cobbled together as quickly as possible in a race to somehow keep the company growing and relevant.

 

When you factor in the very large risks facing the company, CenturyLink is likely a terrible dividend stock and certainly not suited for conservative income investors looking to live off dividends in retirement.

 

Key Risks

While the Level 3 merger will greatly diversify Centurylink, especially away from its legacy landline business, and give it a much bigger focus on enterprise services, the acquisition is far from a cure-all for the company’s long-term problems.

 

Key to those challenges is that CenturyLink’s legacy business is in a secular decline, one that could eventually take it to zero.

 

 

Worse yet, because landline phones are heavily regulated, the company may not be able to exit that business as quickly as it wants.

 

As a result, CenturyLink could be stuck paying high (and rising) fixed costs to maintain its copper phone cables to service a constantly shrinking customer base. That in turn would mean a need to divert precious cash flow towards a dead industry, further straining the company’s ability to maintain its dividend.

 

And while the Level 3 merger will make CenturyLink a major player in enterprise internet access, behind only AT&T in absolute scale, keep in mind that CenturyLink is still going to need to compete with far larger and better capitalized rivals, including Charter (CHTR), Comcast (CMCSA),  and Verizon.

 

 

Telecom is also a rapidly evolving industry, with 5G wireless on its way (in the early 2020’s). The problem for CenturyLink is that 5G should enable 1 gigabit, broadband speed internet (with unlimited data) to be provided wirelessly, thus greatly decreasing the value of the CenturyLink’s 450,000 of miles of fiber optic cables.

 

In other words, AT&T and Verizon, thanks to their massive wireless networks, could ultimately end up stealing a large percentage of CenturyLink’s internet customers over the next 5 to 10 years.

 

Even if 5G wireless broadband doesn’t totally disrupt CenturyLink’s internet business, the fact remains that Comcast, Charter, and Cox offer competing internet in 40%, 25%, and 8% of CTL’s markets, respectively.

 

In fact, the company’s total overlap with cable companies is 90% which means that its consumer internet business will likely continue to face margin pressure as it has to defend its overall 30% market share in the areas it serves.

 

In addition, while the Level 3 merger will greatly increase the size of the company’s sales, earnings, and free cash flow, it will also add approximately $19 billion to CTL’s $25 billion of debt, according to Morningstar.

 

The new shares of CTL the company is issuing to buy Level 3 means that CenturyLink’s dividend cost is also going to rise by $1.1 billion to $2.3 billion a year.

 

That means that Century Link’s precarious payout is going to continue to be a major drain on this distressed telecom, especially in a rising interest rate environment.

 

That’s because both CenturyLink and Level 3 have junk bond credit ratings, which means that they could have to refinance the combined company’s $44 billion in debt at higher rates in the future, which will only add to its interest burden and could further weaken the dividend’s shaky security.

 

The bottom line is that, while the latest mega deal seems to make strategic sense on paper, management has a lot to prove on the operational side of things (it’s consistently failed to live up to promises of returning to organic growth), particularly that the larger company can ultimately prevent a major dividend cut which is looking increasingly inevitable.

 

CenturyLink’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

CenturyLink has a Dividend Safety Score of 2, indicating an extremely unsafe payout that’s at high risk of being cut in the future. That’s not surprising given that fellow struggling regional telecoms Windstream (WIN) and Frontier Communications (FTR) recently cut their dividends by 100% and 62%, respectively.

 

Windstream and Frontier had Dividend Safety Scores of 0 and 5, respectively, before their dividend cuts were announced.

 

CenturyLink has already cut its dividend in the past and has been forced to freeze the current dividend since 2013, so a sizable dividend reduction wouldn’t come as a major surprise.

 

 

Worse still, due to its declining top and bottom line, courtesy of several negative secular trends in the telecom industry, the company’s EPS and FCF share payout ratios are dangerously high and headed in the wrong direction.

 

For example,  in the past 12 months CTL’s FCF payout ratio has soared to 277%. Next year is not expected to be much better with analysts projecting a payout ratio above 100%.

 

 

 

When combined with a highly leveraged balance sheet, CenturyLink’s dividend is arguably one of the least secure on Wall Street.

 

 

Thanks to numerous acquisitions over the past decade, none of which have addressed the company’s key problems, CenturyLink has a very large debt position. Due to high interest rates on its junk bonds, the current interest costs, when combined with the price of the dividend, only further add to the risk of a major payout reduction.

 

 

What’s worse is that, even compared to other telecoms, which have high leverage ratios and low current ratios (short-term assets/short-term liabilities), CenturyLink looks exceptionally vulnerable, with a very high leverage ratio (debt/EBITDA) and an interest coverage ratio just half of the industry average.

 

CenturyLink’s leverage ratio is expected to decline to 3.7 after the Level 3 merger, and its interest coverage will likely rise as well.

 

However, the company’s expected $44 billion debt load isn’t likely to help its credit rating any, meaning steadily rising debt refinancing costs in the future, which will only further strain CenturyLink’s ability to maintain its dividend.

 

The bottom line is that CenturyLink’s dividend safety profile is among the weakest of any stock you can find today. Even highly risk tolerant, contrarian value income investors should probably steer clear of this value trap.

 

CenturyLink’s Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

CenturyLink has a Dividend Growth Score of 1, courtesy of the fact that the dividend is almost certainly doomed, barring a massive (and unlikely) turnaround in the company’s fortunes.

 

That means that rather than ask “how quickly can the dividend grow,” investors more likely need to worry about “how badly will it be cut” in the coming years. Based on Windstream’s and Frontier Communication’s recent dividend actions, CenturyLink shareholders should be prepared for a potential 50% to 75% payout reduction within the next year or two.

 

Valuation

Over the past year, CenturyLink shares have underperformed the S&P 500 by about 60%. However, just because CTL shares are trading near a 52-week low doesn’t necessarily mean that they are worth buying today.

 

CTL’s forward P/E ratio of 10.2 is far below the S&P 500’s 18.1, the industry median of 21.5, and the stock’s own historical norm of 16.4.

 

In addition, the dividend yield of 12% is not just higher than the S&P 500’s 1.9% and the industry median of 3.8%, but also the stock’s historical norm of 7.2%. In fact over the past 13 years, CenturyLink’s yield has never been higher.

 

 

However, since CenturyLink is very likely to slash its dividend severely in the coming years, this stock remains a speculative investment today, even at historically low valuations.

 

That’s especially true for anyone looking to build a conservative retirement portfolio where CenturyLink, due to its horrible fundamentals and total lack of competitive advantages relative to its peers, would be a terrible choice.

 

Conclusion

In today’s overheated market, high-yield shares that have been beaten down can appear especially attractive. However, it’s vitally important to know the difference between a safe dividend stock and a value trap.

 

In this case, CenturyLink’s long, steady, and continuous business deterioration doesn’t seem likely to stop anytime soon. Combined with a high debt load and dangerous payout ratios, which make for an unsafe dividend, there is no compelling reason for conservative, long-term dividend growth investors to consider this troubled stock.