EUR 850.00 For Business Accounts Only

Morningstar | Top-Line Growth Remains Elusive at CenturyLink, but Synergy and Margin Expansion Story Is On Track. See Updated Analyst Note from 08 Nov 2018

CenturyLink disappointed the market with third-quarter revenue well below consensus estimates, but while we agree the acceleration of the revenue decline looks bad, we see no change to the narrative management has been promoting since the merger with Level 3 last year. The firm has avoided giving revenue guidance and told us it's focusing on profitable revenue growth, willing to let unprofitable revenue leave. It is also intent on achieving massive synergies, expanding EBITDA margin, and growing free cash flow. Those goals appear on track. We do not believe CenturyLink has a very attractive business, as we see fiber, which underlies the core of its operations, as commoditized and plentiful, hence the firm's no-moat rating. However, our projections reflect that bearishness, with average revenue growth below 1% annually over our explicit forecast and long-term contraction in earnings before interest. We are maintaining our $22 fair value estimate, and as long as CenturyLink stems the revenue bleeding at some point in the near future, which we believe it will, we think the stock is fairly valued.

Revenue fell 3.2% year over year on a pro forma basis--a significant acceleration from the roughly 2% drop each of the prior three quarters--and displayed weakness virtually everywhere, in both the business and consumer segments and across each type of product the firm discloses. We don't think the business services CenturyLink provides lead to much pricing power, but we do think they're integral for businesses, so we expect declines to stop in 2019. With a new management team in place, we think it's reasonable to believe it is now choosing to dismiss unprofitable revenue.

The quarter's adjusted EBITDA margin jumped nearly 400 basis points year over year to over 39%, with both the consumer and business segments achieving their highest levels since the merger. We expect modest expansion to continue in both segments as the firm shifts to more profitable offerings.

Management announced it has now achieved $790 million in run-rate synergies from the merger and is on track to get to an $850 million run rate this year, constituting nearly all the synergies it expected at the time of the acquisition. The synergies and NOLs the firm acquired from Level 3 were central to our belief that CenturyLink would be able to maintain its outsize dividend in the near term. As the benefits have been realized, the company appears to be covering its dividend without a problem (the dividend payout will be 50% of free cash flow this year; 70% if excluding some one-time benefits and assuming normalized capital spending levels) and maintains its commitment to it, despite the double-digit yield it has continuously displayed for over a year. Our view has been that cutting the dividend won't be on the table until the firm faces sizable debt maturities in 2020. However, with 2019 around the corner, we believe that if debt markets continue tightening and the firm doesn't turn around its revenue outlook within the next year, a cut could be on the horizon. In our model, we assume a 50% cut in 2020.

The company boosted its 2018 free cash flow expectation, but we don't see that as any additional indicator regarding its business. Apart from one-time benefits, much of the boost coincides with a decline in expected capital expenditures. A long-term shift away from capital expenditures would be concerning, but management did not deviate from its long-held declaration that capital expenditures will generally be about 16% of sales, with 2018 being an outlier due to new management analyzing where capital spending is best allocated and pulling back in areas it thinks are unwise, such as copper-based plant for the consumer business. We think that is a smart decision.