Keith
Meister of Corvex Management presented his
thesis on CenturyLink at the Sohn Investment Conference back in May 2017.
The essence of his thesis was that CenturyLink (CTL), with a dividend yield then
of 9.2%, was a credit investment with equity upside. What has changed since
then? The market now offers the stock at an even better yield of 11.35%, and
the equity kicker still exists. It is even more of a buy than it was back in
May.
The bears
will rightly point out that the high yield is a reflection of the credit risk
and the dividend may not be secure. But I disagree. The clincher is the merger between CTL and Level3 which is set to complete by the
end of October 2017 and will be truly transformative for the combined group. Once things settle down post-merger, the
market’s focus should turn to the substantial benefits this merger offers for
the combined new group.
Below is a
list of my investment pros and cons for CTL. My free cash flow forecast and
valuation analysis is included below.
Pros
|
Cons
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11.35%
dividend yield
Based
on forecast free cash flows (provided below), I believe that the dividend
is secure and management have made their intention of retaining the dividend
clear. The current yield is ~930bps above the 10 year treasury and also significantly above peers.
|
Competition
and revenue pressure intensifies
Competition
in intense and it has been showing in the declining revenues at CTL. While
Level3 offers a better revenue mix and growth, it will be key for the combined group to
arrest revenue decline and stabilise. Any sign of integration risk could make enterprise customer nervous.
|
Transformative
merger with Level3
But
for the merger with Level3, I wouldn’t
be recommending CTL. The merger offers the following benefits:
-
scale to compete effectively (CTL+L3 will be the
second largest domestic communications
provider serving enterprise customers with significant network); and with demand for data set to explode, the combined group should be well set to capitalise.
-
Post-merger, the group should be well positioned in the growing
enterprise services market, with enterprise revenues constituting a growing
percentage of sales. This should help offset the declining legacy segment.
-
Significant synergies on offer: to the tune of $850m of
operating synergies and $125m of capex synergies, giving further boost to free cash flows.
-
Level3’s ~$10 billion of NOLs should substantially reduce cash
taxes for the combined group, again a positive for free cash flows.
All of the
above means an improved EBITDA margin, better free cash flows, and most importantly,
an improved dividend coverage securing the current yield.
|
Integration
risk
The
investment case for CTL is predicated on a successful merger and integration with Level3. It
will be important that the group achieves revenue stabilisation, projected synergies and
cash tax benefits indicated by the merger. That said, I note that most
analyst expect managements projected synergies to be on the conservative
side and achievable.
It
is worth noting here that the market seems to be linking CTL with what’s happened
to Frontier Communications Inc. Frontier was another high yielding stock
which was all set to take-off after its acquisition of Verizon’s nonwireless
services in 2016. But a disastrous integration resulted in massive loss of
customers. The stock tanked and dividend was cut. CTL’s current share price is a reflection of
market’s nervousness owing to this recent event with Frontiers. The advantage
for CTL and Level3 is a management team who have rolled up and successfully
implemented several acquisitions in the past with success.
|
Cheap
to peers; should rerate down the line
CTL
trades well below peers: peers trade at 7.3x FY18(E) EV/EBITDA whereas CTL+L3 is
at ~6.5x; and peers trade at ~14x FY18(E) Price/FCF whereas CTL+L3 is at ~7.6x. In addition, CTL's dividend yield of 11.3% is a spread of ~9.3% over ten year treasury.
Once the merger with Level3 is cemented, market’s focus should return to the positives for the combined group and the stock should rerate. |
Legacy
business declines at a faster pace
The
emergence of wireless has been detrimental to CTL’s fixed-line business. The
number of fixed-lines CTL offers has been declining steadily over the years
and there is no doubt that fixed-line and all the revenue streams attached to
it will slowly wither and die. If the decline is dramatic, it will impact
free cash flows. The key is the shift to enterprise and strategic revenue mix offered by L3, it will be important and the decline in legacy revenues is offset by enterprise.
|
Valuation analysis
CTL+L3 proforma forecast
