CenturyLink: Bond with an equity kicker

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
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

Using a combination of peer multiple, dividend yield, and discounted cash flow analysis, I get a per share value for CTL of $28.6 per share, equating to a return of ~50% based on the current share price of $19.03.

CTL+L3 proforma forecast