Leveling The Field For CenturyLink

My services began covering CenturyLink (NYSE:CTL) right after its merger with Level 3 (NASDAQ:LVLT) was approved by shareholders, back in March. At the time, I noted that the deal had a long way to go but offered great promise, both from a dividend perspective and with respect to further M&A in the telecommunications industry (NYSEARCA:IXP). Since then, I’ve watched and commented on the progression of media attention and bad analysis with increasing interest. This article will recap some of the more educational highlights, in addition to providing math for valuing the combined company, the sustainability of its dividend, and a forward outlook. It is being published now because the game is almost up and gains are just starting to be realized.

Deal Rationale and Valuation Math

From the beginning, pretty much everyone recognized the union as beneficial, and even necessary, for both companies. It provides Level 3 shareholders with 1.4286 CTL shares, plus $ 26.50 in cash for each LVLT share. More importantly, it brings much-needed backhaul capability right at a time when being a communications toll taker is set to grow. The combined company will be the second-largest business service provider in the United States, behind AT&T (NYSE:T). CenturyLink will be able to continue decreasing CapEx and gain $ 10 billion in NOLs (net operating losses) for tax credits. The last point is particularly important because CenturyLink has one of the highest effective tax rates at well over 30% and an average of 45% for the past 5 years and quarters, respectively. As shown below, the NOLs will be like regaining those amounts in pure profitability for almost 3 years to come, or 5 years at 15% if tax reform shakes out to be anything like the PotUS projects. Either way, it’s a huge benefit. Here’s the comparative math I presented to subscribers:

CTL LVLT CTL+LVLT VZ T
Debt-to-Equity 1.92 0.96 1.60 4.67 1.15
P/CF 2.9 8.6 2.8 5.7 5.7
P/E 9.6 30.3 5.7 12.5 17.8
P/S 0.6 2.4 0.9 1.6 1.4
P/B 0.8 1.7 1.1 7.8 1.9

The comparisons are not apples to apples, but I think they show the extreme value in CTL both pre and post merger. The Long Term section below will explain why I think the comparisons are actually very kind. I use the recent round CTL market price of $ 20 for the price ratios. For the combined values, I’m using 2017 consensus, which is actually harsher than the TTM values used for the other columns. For FCF, below, I’m also adding in the projected $ 975 million in operational savings for the combined company and the $ 550 million mid-point of management’s 2017 tax projection.

What’s most important is that these numbers make the 54 cent per share dividend quite sustainable, as shown by the following free cash flow and payout ratio calculations, using the same data that fed into the table above.

CTL LVLT Combined
FCF $ 1.63 $ 1.01 $ 4.16
Shares 0.55 0.36
0.55 0.52 1.07
Dividend $ 1.19 $ 1.12 $ 2.31
payout 73% 55%

All figures except payout ratio are in billions, and the LVLT dividend figure is its post-merger share; the independent company does not pay a dividend. As you can see, even though the dividend burden almost doubles, the payout ratio drops from 73 to 55% due to the operational synergies and, to a lesser extent, the tax relief. For the record, that’s below the 66% payout ratio sported by AT&T and Verizon (NYSE:VZ). Normalizing the CTL dividend back to a conservative 6% yield implies a $ 36 price target.

Market Reaction (“But why has it dropped so much?”)

I can’t imagine that I am the only one to have seen this, but instead of presenting the math I do, Big Money started arbitraging the deal as soon as it was announced, and then the media reports began to flow. A brief history follows, but you can see the overall effect in the chart below.

CTL/LVLT 1 yr chart

The most immediate implication is that closing of the merger should be good for a 10-20% gain in CTL.

I think taxes also help explain some of CTL’s market movement and treatment by the financial industry. I’ve mainly looked at the merger from CenturyLink’s side, because a sustainable dividend is hands down the best way to value a company, and I’m happy to collect while I wait for the deal to close. However, in a dysfunctional financial system that is burdened by excessive capital, simply owning shares of companies and getting a cut of the profits isn’t enough for Big Money. That’s why we’ve been living in a short-sighted trader’s market in recent years. Most of us pay 15% tax on dividends and a much higher rate on income, but that’s not how it works for much of Wall Street. Goldman Sachs, for example, quoted a 19% tax rate in its most recent report, up from 11% in the prior quarter. Since dividends complicate hedging, I suspect that Big Money is preferring LVLT to CTL pre merger, and that such institutions benefit from a relatively lower CTL price for market making and arbitraging between the two. Another sign of this happening is the shorted float nearly doubling since the deal was announced, while the rebate rate went nowhere. Such a dynamic was enhanced by a barrage of media reports over the summer; you can judge the merit of these examples for yourself.

In June and July, reports of lawsuits from an ex-employee and the state of Minnesota got lots of attention, accompanied by comparisons to Wells Fargo (NYSE:WFC). As always, I covered these events in real time, noting that Minnesota had already approved the merger and that the comparison to Wells Fargo was both poorly made and moot:

Although the situations sound similar, and there is no doubt some sales pressure at CenturyLink amongst many other organizations, I have to wonder how an employee working from home has any idea how many accounts might have been created…

Regardless, the whole affair wound up costing Wells Fargo about $ 300M and it has almost 20 times the market cap and over 5 times the revenue… We’ll have to see how things progress, but that’s not nearly enough to change my take on an investment that wasn’t particularly concerned with current operational growth anyway.

In mid-August, media reports caused CTL to drop over 15% in the course of a few days.CTL mid-August chart

The moves for the week lined up pretty well with media mangling of a simple and expected event: a publication from the CUPC (California Public Utilities Commission) at the beginning of the week, which set a 60-day limit for final decision. A blogger interpreted this as meaning there is “virtually no chance that the CPUC will approve the deal before the end of September”, and then Barron’s echoed that speculation on Thursday, dropping all of the relevant detail in the process. The only thing Barron’s eventually did to mitigate such bad reporting was to update with a quote from CenturyLink:

We are aware of the procedural timeline laid out in the California order. The California procedural rules allow a decision to be rendered earlier than the 60-day standard timeframe. We continue to work constructively with the California Public Utilities Commission and other regulatory agencies to secure approval for our combination with Level 3 and continue to target closing the transaction by the end of the third quarter 2017.

In response, I noted that CenturyLink’s business in California is minimal and gave the following color at the time:

The CPUC will review the merger, and we always knew that California would be one of the final hurdles. Despite consistent statements like the one above, I’ve never relied on this deal closing by any specific time before the end of this year. A delay of a month or so may rial the market, but it doesn’t change the long-term business fundamentals. I find analysis that claims otherwise right before CenturyLink should announce its next dividend (which now represents over 11% yield) highly suspect.

Again, all I care about is that the merger does go through and that the dividend is maintained… I think that reasoning holds more true than ever in the wake of pricing which, again, was mostly likely the result of stop-limit orders and algorithmic trades, rather than fundamental analysis or a true change in outlook. In that way, this situation strikes me as similar to when the InvenSense deal also went through the media meat grinder.

These are just a couple of highlights from many reports that affected CTL throughout the summer. Many others, such as Cramer flipping from a positive stance on the merger to saying that the yield is a red flag, and analysts ignoring CenturyLink’s transformation by referring to it as primarily a provider of landlines to consumers, also contributed to the atmosphere of fear, uncertainty and doubt. I never expect quality analysis out of Wall Street in a timely fashion, but it seems to me that in this case the mainstream financial industry has been exceptionally negative. The overall situation led me to make the following statement to subscribers:

If I’m correct about what’s going on, we shouldn’t expect any relief in the press… until the merger is complete.

It was only at the end of September that I followed up with news of confirmation of Delrahim to lead antitrust review at the DoJ:

He has spoken in favor of the AT&T/Time Warner merger and I think his appointment will grease the wheels with Level 3 as well.

DoJ clearance followed just 4 days later, and CTL has risen 6.5% in the two days that followed. Only the CPUC and FCC remain. As discussed above, the CPUC approval should come mid-month, and though the FCC is capable of much madness under former Verizon lawyer Ajit Pai, obstruction in this matter would be out of character. I continue to think the merger will be finalized in the month to come.

Other Risk Factors and Long-Term Outlook

My services have outlined how 5G is shaping up to be the next big push in telecommunications . However, when it comes to actual mass implementation, the one sure thing is that optimization and data gathering will involve shortening the wireless leg and providing more backhaul. The FCC backing away from true innovation via spectrum sharing in order to protect its licensing revenue will only intensify this need, and history shows that the deployment costs on the wireless side are tough to recoup, as shown by Verizon’s whopping Debt-to-Equity ratio. That’s why I actually like the fact that CenturyLink simply resells Verizon’s mobile service to its customers rather than playing the FCC’s expensive game. I also prefer that over three quarters of revenue comes from businesses for things like cloud services, rather than from consumers. CenturyLink is bringing in $ 2.15 billion by shedding cloud infrastructure that would be redundant to a company like Google (GOOG, GOOGL). In the meantime, Level 3 is bolstering its encrypted access infrastructure to such services. I’ve long said the U.S. telecommunications market (IYZ) is ripe for disruption, and I see all these moves setting the combined company up for a further wave of consolidation.

That would be a welcome development. Most of the income investments that I cover are characterized by excellent, share-holder friendly management. CenturyLink is improving as a result of the merger, but in my opinion it is still not quite of the same calibre. Some analysts have suggested that management change might also favor buybacks over maintaining the dividend. I’ve already shown that there is no reason for this to happen and regard this as another part of the summer media campaign, again taken out of context by Barron’s. However, even if new management did cut the dividend, I would regard that as a prelude to another transaction. In fact, I first added CenturyLink coverage in conjunction with my analysis of Vodafone (NASDAQ:VOD), as it freed capital from India and monetized its African assets. The associated move netted a nice gain for subscribers, but the potential for deployment of capital back into the U.S. is more interesting and possibly foreshadowed by Vodafone’s rebranding. Furthermore, though I regard buybacks as less shareholder-friendly than dividends, such a move would improve the Free Cash Flow metric dramatically. As a result, even if the U.S. communications market soured, I would still expect to be able to sell CTL somewhere in the high $ 20s under such a scenario.

Conclusion

Choosing good entry points is extremely important with respect to income investments. The dysfunction caused by excessive capital in developed markets is causing them to function inefficiently with respect to standard valuation principles, but that does not mean these principles do not work. CenturyLink is about to become an excellent example of how inefficiency can equal opportunity for investors who maintain their focus on valuation and stay up to date on company fundamentals. The market acumen that comes with experience is also crucial, along with patience, but the time for patience is almost over in this case. CTL should rise 10-20% once its merger is final later this year and arbitrage on the deal unwinds. I expect those gains to be extended into next year as it becomes clear that the dividend is secure under new management. Counting those, I have high conviction on doubling my investment off the August lows well before the end of next year.

Inefficiency means opportunity in telecommunications, as well. Further industry consolidation could bring greater upside, and the valuation means asymmetrical risk/reward even if new management or the industry take a different path than I am envisioning. If the unfortunate status quo is maintained, I see that benefiting CenturyLink with its large fiber backbone, which will be increasingly used for backhaul and inefficient content delivery. In functional system, participants would simply upgrade and share the infrastructure, as is being done more and more across the rest of the world. There is little hope of that in America just yet, so costs are likely to continue to spiral out of control while quality suffers, making backbone owners the only U.S. telecommunications (NYSEARCA:VOX) entities that I’d be willing to own in the meantime. CenturyLink certainly hasn’t been the most predictable investment I’ve covered, but it looks very much like it will still wind up rivaling some of my highest annualized long-term returns. I suppose I should thank Wall Street and regulators for the opportunity they’ve created :-/

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Disclosure: I am/we are long CTL.

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.

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