Analyzing Centurylink Inc (CTL)
Telecom companies have long been a favorite among income investors thanks to their utility-like business models, which make for steady cash flow and allow for generous, secure, and slowly growing dividends (learn about the best sectors for dividend income here).
With global interest rates at their lowest levels in human history, it’s understandable why high-yield seekers might be attracted to CenturyLink (CTL) and its 7.7% yield, which is one of the highest in the telecom industry and broader market.
But always remember that if something seems too good to be true, especially in the world of investing, it usually is. Let’s take a closer look at this regional telecom for consideration in our Conservative Retirees dividend portfolio and see just why the market is discounting its shares enough to create this sky-high yield.
CenturyLink – Business Description
Founded in 1968 and headquartered in Monroe, Louisiana, CenturyLink is the nation’s third largest landline phone company. It serves 11 million, 6 million, and 285,000 phone, internet, and subscriber TV customers, respectively, in 37 states.
In addition, thanks to its $2.5 billion acquisition of Savvis Inc in 2011, the company also operates over 50 cloud computing data centers in North America, Europe, and Asia.
In its most recent quarter the internet business, which the company refers to as “strategic services,” comprised 49% of its revenue, with 33% coming from its legacy landline business and the remainder from its data integration, and hosting (cloud computing) segments.
As you can see below, CenturyLink has been struggling for years with falling sales in its legacy landline phone business. Over the last two years, “Legacy services” revenue has dropped 15%.
With the rise of wireless phones this is a trend that is likely to continue, putting major pressure on the ability of the company to grow its overall revenues, earnings, and cash flows.
Management, led by CEO Glen Post, whose has been with the company since 1976, has attempted to overcome this secular decline by large scale acquisitions, such as the 2008 $11.6 billion acquisition of rural telco Embarq, and 2011’s $12.2 billion purchase of Qwest Communications.
The idea was that consolidating rural telecom companies would give CenturyLink sufficient cash flow from internet and small business customers to allow continued top line sales, achieve economies of scale that boosted margins, and thus lead to a secure and growing dividend.
Similarly, the Savvis acquisition would provide global diversification in data centers and give CenturyLink a foot in the door of the fast-growing cloud computing sector.
However, in reality, management has struggled to execute on its vision. For example, the data center business has found itself unable to compete with larger, better capitalized rivals such as Amazon (AMZN), Microsoft (MSFT), IBM (IBM), Alphabet (GOOG) or Cisco (CSCO). The company’s two top cloud executives left the company last year as well.
Meanwhile, stronger competitors in internet such as AT&T, Verizon, and Comcast have steadily encroached on the company’s strongest urban internet markets, especially Minneapolis, Las Vegas, and Phoenix.
The trouble for CenturyLink is that the telecom industry is brutally capital intensive, especially in broadband service, where consumers are constantly demanding faster and more reliable service.
For example, the company expects that by 2019 11 million customers in its service areas will be able to purchase 100 Mbps internet access, while another 3 million will be eligible for 1 Gbps speeds.
In other words, thanks to rising competition from cable and wireless giants, CenturyLink has had to really step up its capital spending in order to be able to compete with similar speed internet access. All while legacy customers cut their phone cords, starving it of the cash flow it needs to fund its expensive broadband upgrades.
And as you can see, fierce competition, flat sales growth, and poor capital allocation decisions have hurt margins over the last five years.
Meanwhile, the company’s data center business has been a disappointment thanks to constant price wars with the likes of Amazon Web Services and Alphabet’s Google. In fact, management is now looking to sell the data center business, whose EBITDA margins are about half that of its consumer businesses.
While such a move would certainly help boost profitability going forward, it would also mean the loss of about 20% of the company’s revenue. This, in turn, would mean even less future cash flow with which to fund its high capital spending needs.
Overall, CenturyLink looks like a business that is struggling just to tread water. Close to half of its business is growing, but the other half is shrinking. Unfortunately, the growing half carries below average margins, compressing long-term profitability as CenturyLink’s legacy cash cow slowly dries up.
Judging from the company’s costly and largely unsuccessful move into cloud computing several years ago, management’s capital allocation skill should certainly be questioned as well. In my view, these actions reek of desperation as CenturyLink’s legacy markets are declining faster than the company can find new, profitable opportunities for sustainable growth.
There are several risks facing CenturyLink and its dividend which, in my view, make the shares a “pass.”
First, CenturyLink’s legacy landline phone business is beyond saving and will almost certainly continue to decline. As it does so, it faces the problems of reverse economies of scale.
In other words, the company needs to maintain its copper phone lines in order for any customers to be able to have service. However, as more and more customers cancel their service, this segment’s margins will deteriorate and eventually turn negative, ultimately forcing the company to completely discontinue it down the road.
The problem is that landline phone service is a regulated utility and requires states to pass laws allowing telcos such as CenturyLink to discontinue such services. This means that there is always the risk that, in the future, the company will be forced by regulators to continue offering an obsolete service that’s bringing in almost no revenue but consuming precious and scarce capital that is needed for its struggling internet business.
Speaking of regulators, don’t forget that the businesses in which CenturyLink operates are heavily regulated by the FCC. This means there is the ever present risk that changes in regulations can lead to lower sales, and margins. For example, the FCC is now considering changes to regulations affecting business data services, which could lead to even greater competition from the likes of AT&T and Verizon for the company’s struggling revenues.
And we can’t forget that back in June of 2016 the FCC officially declared its ability to regulate internet service providers such as CenturyLink, in order to enforce net neutrality. In a joint statement with