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Morningstar | Adding CenturyLink to Our Best Ideas List in June, as We Think the Market Is Overly Pessimistic

CenturyLink clearly faces challenges with declining sales. Its subpar consumer network, relative to cable competitors, has led to net customer losses each quarter over the last few years, and enterprise networks are being hurt by multiple secular trends and a deflationary pricing environment, especially harmful for a firm that we determined is not protected by a moat. However, we think market bearishness has gotten carried away, and we added CenturyLink to our Best Ideas list in June. At current levels, the stock is trading 40% below our $18 fair value estimate; the dividend, which we view as safe, yields 9%; and the firm's free cash flow yield is greater than 25% based on our 2019 estimate.

In our view, the market is pricing in top-line declines continuing at around the 4% rate we forecast for 2019. We've accounted for the challenges, and we think that rate is too high. We anticipate voice services are in mid- to high-single-digit perpetual decline, and higher-priced enterprise network offerings are being cannibalized by software-defined solutions. However, as time passes, we expect legacy products will make up a lower proportion of sales, improvements to the consumer network will reach more customers, and further integration of 2017's Level 3 acquisition will stabilize the acquired customer base. We forecast sales declines to improve each year, though we still estimate sales to fall 2% in 2023.

While the sales outlook looks bleak, we don't think the stock is getting credit for the firm's significant free cash flow generation or margin expansion opportunities. We expect the shift toward newer technologies to result in higher margins and for the firm to realize additional synergies from Level 3. We forecast CenturyLink's adjusted EBITDA margin to expand 300 basis points between 2018 and 2023. When combined with the firm's use of its past net operating losses to shield taxes, we project free cash flow to be around $3 billion for each of the next several years.

Our enthusiasm for the stock is somewhat tempered by the firm's heavy debt, which totals roughly $35 billion and accounts for about three fourths of CenturyLink's enterprise value. However, given the firm's free cash flow potential and maturity schedule, we don't think the debt currently endangers the company. Even after it pays the current $1 per share stock dividend each year, we estimate the firm will maintain close to $2 billion in annual free cash flow. CenturyLink's upcoming maturities include $1 billion in 2020, $3 billion in 2021, and over $5 billion in 2022. We expect the firm to continually pay down debt and reduce its leverage ratio, which currently results in net debt roughly 4 times EBITDA, to about 3 times over the next five years.

CenturyLink cut its dividend from $2.16 per share to $1 per share at the beginning of 2019. Because of the optics of a further cut and the free cash flow generation that we think will allow the firm to easily cover the dividend, we see the dividend as safe.