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Morningstar | CenturyLink's Ugly Top Line is No Surprise; Opportunities Exist and Shares Are a Bargain

On one hand, CenturyLink's first-quarter results, where declining revenue missed consensus estimates while growing EBITDA outpaced them, are a microcosm of our long-term outlook for the firm. On the other hand, we think the pace of this quarter's revenue decline is likely to moderate, but we think the stock is pricing a similar magnitude of deterioration long term. When and if CenturyLink shows substantial improvement on the top line, we think investors will realize the opportunity that existed at this time. With this quarter's results tracking our full-year forecast, we maintain our $20 per share fair value estimate and no-moat rating, and we think the stock is attractive.

Revenue fell 5% year over year, slightly worse than the 3.5% full-year decline we project. However, we think revenue declines are currently exacerbated by management's decision last year to let unprofitable revenue roll off and focus on growing profits, a decision we like. We expect the pace of decline to improve over the next several years, and we think it's likely the second half of 2019 will be better than the first, as CenturyLink also renegotiated down a big customer contract in the second quarter last year and saw slower enterprise spending in this year's first quarter due to the government shutdown.

In our view, CenturyLink remains undervalued despite gloomy revenue prospects because of its ability to nonetheless grow EBITDA, and this quarter supported that notion. Adjusted EBITDA margin expanded nearly 350 basis points from last year's first quarter, resulting in 4% adjusted EBITDA growth despite the revenue decline. The firm reached a 40% margin much quicker than we anticipated, though it's likely inflated a bit by the new lease accounting standard. We will likely raise our margin projections, as we think there is still room for expansion due to incremental synergy opportunities with Level 3, the greater number of on-net buildings, and the shift away from unprofitable revenue.

Management believes some of its biggest reporting segments can shift to revenue growth later this year or next year, while acknowledging others are in long-term secular decline. We are likely less optimistic, but with the company changing its reporting segments beginning this quarter by separating its former business segment into four individual segments, we will re-evaluate the new segments, each of which produced low- to mid-single-digit year-over-year revenue declines in the quarter. Unlikely to change is our view on the business segments in aggregate, where we project perpetual decline—at an average rate of 3% annually over the next five years. In general, we think these businesses are challenged by robust competition, technological advances, and deflationary pricing trends that will make sustained revenue growth difficult to achieve.

Consumer revenue was down nearly 8% year over year, and the firm indicated it is now looking into strategic alternatives for that business. We have our doubts CenturyLink will find an attractive offer, so we were happy to hear management indicate that it will continue investing in the business during these preliminary stages of review. Voice revenue, which declined 12% year over year, was far worse than the mid-single-digit decline we project for the full year, and management's commentary leads us to believe that this quarter was not an anomaly. However, broadband revenue grew 1.5% year over year versus our full-year projection of a slight decline. Supporting broadband revenue growth was flat subscriber numbers over last quarter and a substantial shift toward customers receiving speeds of greater than 20 and greater than 100 megabits per second. CenturyLink now has 45% of its broadband customers receiving at least 20 Mbps. We think the trend is very encouraging, as it makes CenturyLink more competitive in one of its only businesses that we think has secular growth prospects. Still, while the improved quality may portend better broadband growth than we've projected, the more sizable declines that may still exist in voice leave us likely to hold firm with low-single-digit consumer revenue declines each year of our forecast.

Though working capital fluctuations led to a free cash flow decline this quarter, we think the firm's ability to hold down cash taxes as it uses net operating losses will contribute to growing cash flows, contributing significantly to our fundamental valuation. The stock is currently trading at about four times the low end of management's 2019 free cash flow guidance. However, CenturyLink is debt laden, so its enterprise value is about 15 times free cash flow.