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.
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.
Source: CenturyLink Earnings Supplement
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.
Source: CenturyLink Investor Presentation
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 fellow rural ISPs Frontier Communications (FTR) and Fairpoint, CenturyLink warned that “regulatory rate reductions for broadband data services in the highest cost areas will prevent or slow competitive growth and make it difficult for current providers to continue with planned upgrades and future investments.”
In other words, in the future CenturyLink faces the risk of both negative regulatory decisions that could hit its top and bottom lines from both its legacy, dying landline business and its bread and butter internet service division.
But of course the company’s largest risk comes from competition from both cable companies such as Comcast, and Charter Communications (CHTR), as well as wireless providers AT&T and Verizon, both of which also compete with CenturyLink in the ISP arena.
Worse yet, 5G, the next generation of wireless technology, could prove to pose an existential risk to the company. That’s because 5G wireless will allow what Verizon has dubbed “Wireless Broadband,” a way of providing ultra-fast internet through the air, and thus making CenturyLink’s 250,000 miles of buried cables pretty much obsolete.
It’s not just deep pocketed Verizon that’s hoping to disrupt the internet business with 5G. AT&T is currently testing “Project AirGig,” which AT&T’s Chief Strategy Officer John Donovan says “has tremendous potential to transform internet access globally – well beyond our current broadband footprint and not just in the United States.”
Specifically AirGig would allow AT&T to offer fiber optic-like internet speeds though next gen wireless tech fitted onto its own existing utility poles.
This potentially breakthrough technology, backed by some of the richest corporations on earth, is something that the much smaller CenturyLink simply couldn’t compete with. Of course, these technology developments are filled with plenty of their own risks and will likely take many years to rollout.
CenturyLink investors also need to be aware of rising interest rates. Any interest rate increase would prove costly for CenturyLink, which has a total debt load of approximately $20 billion.
Worse yet, because CenturyLink doesn’t have an investment grade credit rating, its average debt cost is a high 6.6%; a figure that will only climb along with interest rates, and one not shared by investment grade rivals.
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. CenturyLink’s dividend and fundamental data charts can all be seen by clicking here.
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 track record has been, and how to use them for your portfolio here.
CTL has a Dividend Safety Score of 26, suggesting that the company’s dividend is riskier than the average dividend stock and should be approached with some caution. This is due to a combination of several factors.
First and foremost is the highly capital intensive nature of the telecom industry, which naturally means the need to take on a lot of debt. CenturyLink’s debt-to-capital is relatively high and has increased over the last decade to fuel the company’s acquisitions.
[drizzle]Source: Simply Safe Dividends
As you can see below, CenturyLink has far more leverage than either AT&T or Verizon. That’s despite the fact that both of those telecom blue chips are still paying down debt from major acquisitions; DirecTV for AT&T, and Verizon’s $130 billion buyout of Vodafone’s (VOD) 45% stake in Verizon Wireless.
|Company||Debt / EBITDA||EBITDA / Interest||Debt / Capital||Current Ratio||S&P Credit Rating|
Sources: Morningstar, FastGraphs, Simply Safe Dividends
Now much of CenturyLink’s debt is also due to acquisitions, which can be a great way for telecom companies to grow their sales, earnings, and cash flow. But the difference for CenturyLink is that it’s junk bond credit rating means that it’s cost of debt, and thus overall cost of capital, is much higher than AT&T’s or Verizon’s. This means that any acquisitions are less accretive to free cash flow, or FCF per share. That in turn makes it much harder to grow the dividend.
And let’s talk about that dividend. As you can see, while CenturyLink’s EPS payout ratio is consistently over 100%, the current payout is far safer than this might indicate. That’s because the high levels of depreciation that CenturyLink includes in its earnings calculations actually hides the fact that its FCF is actually quite strong.
In fact, the FCF payout ratio has been highly secure and sits at 49% over the last 12 months. However, that doesn’t necessarily mean that the dividend is secure or likely to grow anytime soon.
Note the 25% dividend cut in 2013. That happened because management decided it needed to focus on deleveraging the balance sheet, a wise long-term move. However, it still resulted in a painful cut in income for company shareholders.
Source: Simply Safe Dividends
With over $2.9 billion of the company’s long-term debt was set to come due from 2017-2019 (according to CTL’s latest 10-K) and interest rates potentially set to rise significantly, I consider CenturyLink’s dividend risky despite the low FCF payout ratio due to the likelihood of another deleveraging payout cut becoming necessary.
That’s especially true if high-margin legacy businesses continue deteriorating and management decides that it needs to do another major acquisition to kick start growth. Goldman Sachs also noted in a report from early 2015 that “the key driver of thinning dividend coverage is an estimated increase in cash taxes to $1.25bn in 2016 from $32mn in 2015. This drives the FCF payout from 49% in 2015E to 95% 2016E, with a recovery to only 80%+ thereafter.” Rising cash taxes are another issue to consider.
Of course, not everyone believes the dividend will be cut. A more recent report by Evercore ISI believes the company’s dividend will remain steady through 2020, although it seems to gloss over many of my concerns listed above. Time will tell, but chasing yield to buy what appears to be a low-quality business usually doesn’t work out well for long-term investors.
Dividend Growth Analysis
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’s Dividend Growth Score is 33, which indicates that the company’s dividend growth potential is somewhat weaker than average. That’s not surprising given the company’s highly leveraged balance sheet, high interest costs, and the threat these pose to the current dividend, much less a higher future one.
As seen below, CenturyLink’s dividend grew at a compound annual growth rate of 24.6% over the last decade. However, the company’s dividend contracted by 5.7% per year over the last five years, resulting from the large dividend cut in 2013.
Source: Simply Safe Dividends
Given that CenturyLink’s internet network remains largely inferior to that of its rivals in most markets, which has resulted in falling market share, it’s not surprising that the analyst consensus is for slightly negative EPS growth over the next decade with zero dividend growth.
Now remember that analyst forecasts, especially long-term projections like this, always need to be taken with a grain of salt. However, given the massive amount that CenturyLink will need to spend to make its internet service competitive in the highly competitive, 5G internet world of tomorrow, this estimate seems pretty reasonable.
CenturyLink’s shares trade at a forward P/E multiple of 11.7 and offer a dividend yield of 7.7%, which is above the stock’s five-year average yield of 7.2%. At first glance, CTL shares look cheap.
With annual earnings growth expected to be flat to slightly negative over the next decade, CenturyLink shareholders would be fortunate to receive an annual return equal to the current dividend yield (7-8%). That’s below the market’s long-term compound annual growth rate of about 9% despite the riskier nature of CenturyLink’s standalone operations.
However, doesn’t the high dividend yield potentially justify owning shares? After all, if your main concern is income, then perhaps a 7.7% yielding telecom might still make sense, especially since analysts think that the dividend might survive at its current level and the stock’s beta is relatively low (0.80).
If my concerns over the company’s debt prove true and management cuts the dividend again, say by 25% like they did the last time, then suddenly CenturyLink’s dividend yield would fall to about 5.7%.
Before you run out and buy this under the “dirty value” banner, remember the wise words of history’s greatest investor, Warren Buffett. “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price” (read Warren Buffett’s top 10 pieces of investment advice here).
In this case, I consider CenturyLink a classic example of a fair company at best and given the headwinds it business and dividend are facing, I wouldn’t consider the current price of about $28 “a wonderful price.”
There are definitely worse stocks to hold for a rather speculative 8% yield as part of a diversified portfolio, but income investors can’t forget the importance of capital preservation and total return. An 8% dividend does one little good if the stock’s price permanently drops 30% as the business terminally shrinks.
In my view, only highly risk tolerant investors should give CenturyLink a look. Even then, the stock should be approached with great caution. It is an investment that I will avoid due to business quality, financial leverage, and long-term growth concerns. Management sure has a lot of work to do to turn the ship around, if they can.
CenturyLink represents a high yield that looks somewhat safe…for now. However, with its most important and highest margin business segments under pressure from much larger, better capitalized, and investment grade rated rivals, it’s likely that the company will struggle to merely hold the line in terms of top line sales and could suffer further margin erosion.
Combined with management’s penchant for big acquisitions and CenturyLink’s already highly leveraged balance sheet, the threat of rising interest rates, and the risk of 5G disrupting its bread and butter internet business down the road, I consider the current payout at risk of another 2013-like dividend cut over the next few years.
In other words, dividend growth investors are likely better off going with larger, more established rivals such as AT&T or Verizon than with this smaller, and frankly outgunned, regional telecom provider.
While the yields these safer stocks offer may not be quite as attractive, these companies’ payouts are far more secure, have better growth prospects, and are far more likely to deliver better long-term, risk-adjusted returns.
Article by Simply Safe Dividends