If you missed it, we recently wrote a public article titled "7 Deadly Sins of Long-Term Investing." Number 5 on that list was the terrible pitfall of "Yield Chasing" (buying stocks simply because they offer a high yield instead looking under the hood at the fundamentals). This article reviews a specific very-high-yield company that is increasingly tempting to some investors. However, based on our fundamental review, we strongly recommend you stay away from this value trap!
The Value Trap:
CenturyLink (CTL) provides local phone service to 10 million lines and broadband Internet to 6 million customers across 37 states. It's the 3rd largest telecom company in the US, and unlike the larger AT&T and Verizon, CenturyLink does NOT provide wireless (mobile) services. CenturyLink provides "old-school" wireline services, and its network is its principal asset.
It's understandable why some investors may be attracted to this stock. For starters, it's dividend yield is huge (+11.6%), and it's recent price decline (as shown in the following chart) has a lot of bargain hunters sniffing around.
We've included a more detailed report below, but here are a few of the big reasons why you should stay away from this Value Trap!...
- CenturyLink's revenues and net income are consistently declining because it does NOT have a mobile network and because it faces increasingly intense competition from cable companies (CenturyLink overlaps with cable competition in about 90% of its footprint).
- CenturyLink's upcoming Level 3 acquisition is simply another "near-term" patch (such as the 2009 Embarq acquisition, and the 2011 Quest acquisition) on it's long-term problem (see #1 above).
- CenturyLink's conservative dividend payout ratio (~70%) will erode over time, and the dividend will likely become unsustainable within a few years considering the company's shrinking revenues, shrinking margins, growing competition, rising interest rates (CenturyLink has a lot of debt), and the likelihood of widening credit spreads as its financial position deteriorates.
- Just look what has happened to other "old-school" wireline telecom companies like Frontier (Frontier dramatically reduced its dividend earlier this year, and the price tanked, although we do still like some Frontier bonds) and Windstream (Windstream announced the total elimination of its dividend).
- We suspect we may see some near-term benefits to CenturyLink's stock price following the Level 3 acquisition, but in the long-term this is a deteriorating company. It's a value trap. The dividend will eventually be cut. Stay away.
A Summary of the business and the industry
CenturyLink provides local phone service to 10 million lines and broadband Internet to 6 million customers across 37 states. CenturyLink’s network is its principal asset. The company operates a 265,000-route-mile U.S. fiber network and a 360,000- route-mile international transport network connecting millions of businesses and consumers around the world.
CenturyLink’s pending acquisition of Level 3 is expected to add approximately 200,000 additional route miles of fiber to the network, thereby making it the second largest domestic communications provider serving global enterprise customers in terms of enterprise revenues. Level 3 Communications is a global provider of data, voice, video and managed services.
CenturyLink believes growth opportunities, sourced from the network, will be driven by the remarkable increase in data traffic from video streaming, new applications and services related to the Internet of Things (IoT), virtual and augmented reality and 5G wireless technology.
However, revenues have been declining across all of CenturyLink’s business segments.
CenturyLink has been profitable in recent quarterly, but profits are also declining.
Following the company’s acquisition of Embarq in 2009 and Qwest in 2011, CenturyLink became the third-largest landline phone company in the United States, yet its revenues have been declining in recent years. The Level 3 acquisition is now expected to close in October, following the recent contingent regulatory approval from California. More than 75% of the combined company’s core revenue is expected to come from business customers. The company expects the Level 3 transaction will be free cash flow accretive in the first year thereby improving financial flexibility and dividend coverage. However, over the longer-term, declining revenues will likely continue, in our view due, to lower margin enterprise customers and declining demand for wireline. The Level 3 acquisition seems like the latest short-term patch for a long-term problem (an industry with steep competition and no growth).
Brief History of the Company and its founding:
The earliest predecessor of CenturyLink was the Oak Ridge Telephone Company in Oak Ridge, Louisiana, which was owned by F. E. Hogan, Sr. In 1930, Hogan sold the company, with 75 paid subscribers, to William Clarke and Marie Williams, for $500. Through a history of sales and acquisitions, CenturyLink is now a member of the S&P 500 index, providing services to residential, business and governments in 37 states.
CenturyLink currently trades at 5.9 times forward EBITDA which puts the company in the middle relative to other telecoms as shown in the following chat.
On a historical basis, CenturyLink is closer to the higher end of its EV to EBITDA range.
CenturyLink’s EBITDA margin has been decreasing steadily as shown in the following graphic, and we expect this margin to compress further as the company continues to transition to more lower margin enterprise customers.
Further still, we expect CenturyLink’s dividend payout ratio (currently around 70%) to benefit in the near-term from the Level 3 acquisition, but it will become increasingly challenged in the years ahead considering the industry is not growing and margins are increasingly pressured.
CenturyLink is the third largest telecommunications company in the US behind AT&T and Verizon. However, unlike AT&T and Verizon, CenturyLink does not have a wireless business (only wireline). CenturyLink’s rural peers include Frontier Communications and Windstream. CenturyLink also competes with cable companies. CenturyLink overlaps with cable competition in about 90% of its footprint. Additionally, CenturyLink competes with mobile telecommunications providers in some cases.
Management- (Capital Allocation):
CenturyLink’s recent acquisitions of Embarq (2009) and Quest (2011) did achieve near-term costs savings, but the long-term strategic benefits are not clear considering the company’s revenues and profits are shrinking.
In 2011, CenturyLink acquired data center operator Savvis for $2.5 billion in cash and stock. However. In May of 2017, CenturyLink sold Savvis to private equity for $2.1 billion in cash. Interestingly, Verizon sold its data center assets to Equinix in early 2017, and AT&T continues to consider a sale of its data center assets.
The main catalyst for CenturyLink is the possibility of cost savings by more efficiently managing the combined entity (CenturyLink plus Level 3) than either company could achieve on a stand-alone basis.
Recent Price action:
CenturyLink’s stock price has declined 21.7% year-to-date, while the S&P 500 has gained 11.7%. Short Interest is currently, 20.8% of CenturyLink’s shares outstanding.
The only thing "special / unique" about CenturyLink, arguably, is its size. CenturyLink is larger than many smaller purely wireline telecoms, and this provides some economies of scale.
The Last Downturn:
As a telecommunications company, CenturyLink should be less sensitive to overall market moves. However, it’s beta of 0.9 is close to the marketwide beta (+1.0), and CenturyLink’s stock price did decline significantly during the financial crisis of 2008-2009, as shown in the earlier charts.
CenturyLink focuses on customer service, and its recent acquisition integrations have been successful from a customer retention and cost-savings standpoint, as opposed to peer Frontier Communications’ recent acquisitions of Verizon and AT&T assets which have been unsuccessful due to higher than expected integration costs, and a significant amount of customer attrition.
Inside ownership is currently 1.3%, not a significant amount. This level of inside ownership has remained fairly consistent.
Like most telecoms, CenturyLink has a significant amount of debt. The debt load may become increasingly challenging as interest rates rise, and CenturyLink is forced to refinance at higher rates. Additionally, if revenues continue to decline, CenturyLink will face increasing financial pressures, and this also could cause the cost of new debt to rise.
CenturyLink has used additional shares and cash to fund acquisitions in the past. The upcoming Level 3 acquistion will be financed with a combination of cash and stock. If CenturyLink does not stop its anemic revenue declines, it will eventually face challenges in meeting the dividend payments.
CenturyLink faces significant uncertainty related to its upcoming acquisition, its constantly shrinking revenues, growing competition (mainly from cable, but also from peers and from mobile), and its significant debt load (widening credit spreads could create significant challenges). Additionally, CenturyLink currently faces several lawsuits, including one from the state of Minnesota alleging widespread overbilling.
The Bottom Line:
Stay away from CenturyLink and its big dividend. In our view, CenturyLink is a value trap! Stay away.
For your reference, you can view all of our current holdings here.