Is CenturyLink (CTL) Stock Cheap Or Junk?
The Stock Seems Inexpensive, But Is The Discount Enough To Account For The Numerous Challenges That It Faces?
(I am neither long or short CTL stock at the time of this writing. If I ever take a position in the stock, I will update this disclaimer.)
I was curious as to which stocks in the S&P 500 currently had the highest dividend yield so I ran the this screen on finviz. Currently, only 5 stocks in the S&P 500 sport a dividend yield of 5% or higher. Of these, the one that jumped out to me was CenturyLink (the other 4 either had negative earnings or belonged to hard hit sectors like real estate or energy).
The 5 year chart of its stock price looks pretty bleak, especially considering that the overall stock market is up around 45% over the same time period. This type of stock price performance implies that there are significant and sustained issues with the business. But it may also give us an opportunity to buy low.
So let’s do some quick due diligence to see whether CTL (I will refer to the company using its ticker as it’s easier to type… and I’m lazy) might be worth a deeper dive and potentially an investment.
How Does CenturyLink Make Money?
CTL owns telephone networks (which can also be used to supply low speed DSL internet) and a fiber optic internet for high speed internet. It makes money by providing internet service to both residential and corporate customers (similar to AT&T and Comcast).
Like most other ISPs (internet service provider), CTL charges customers a fixed monthly fee for phone and/or internet service. In 2019, corporate revenues accounted for 41% of total sales (with another 18% from wholesale — selling use of its network to other communication network owners and ISPs). Residential revenues accounted for 25% of the total and international customers accounted for the rest (16%).
What’s Going On With The Stock?
Obviously, owning a bunch of landlines (phone lines) is not the best business to be in these days. And because the bulk of its landline network is copper wire, the internet speeds that CTL can offer its customers are limited. With the proliferation of high speed internet providers (both traditional and wireless via smartphones), this has put substantial pressure on CTL’s residential business.
In 2017, in a bid to diversify away from its shrinking landline business and gain more enterprise customers, CTL acquired Level 3 Communications, owner of a massive fiber optic network (super fast internet). To do so, it took on more debt and also inherited Level 3’s existing debt (of around $11 billion). That explains the big increase in debt in 2017:
So did CTL’s big bet pay off? I’ve plotted their sales, net income (netinc), and cashflow from operations (ncfo)below. You can see the bump in revenues and cashflow starting in 2018 once the acquisition closed. But net income has really taken a dive. What gives?
Where Did The Profits Go?
Let’s plot CTL’s expenses by category to see what’s going on. We expect expenses like cost of revenue (cor), which measures the variable costs associated with providing the company’s product or service, to scale up with the acquisition (bigger company, bigger costs). The outlier and culprit is goodwill impairment (in red).
Goodwill is an asset on the balance sheet that acts as a filler for intangibles like brand, technical expertise, etc. When a company buys another company, the acquirer estimates a value for each and every asset that it gained in the acquisition. The difference between the acquisition price and the sum of the value of all the acquired assets is goodwill. Thus, the higher the purchase price relative to identifiable asset value, the higher the goodwill.
Every year, CTL has to review the value of its intangible assets for impairment. If it thinks that the value of something like say Level 3’s patents has permanently declined, then it needs to take an impairment charge, which brings the value of the intangible asset down to the new “fair” value.
That’s what’s going on here. CTL is in essence admitting after the fact that it overpaid for Level 3 and other previous acquisitions, and that it’s highly unlikely that it will be able to earn back what it paid out. An analogy for this is like if you were to buy a stock and the price starts dropping. It keeps dropping but in your records you don’t record a loss yet because “the price might come back and it’s not a loss until you sell”. Ultimately it becomes too painful to go on and you sell, permanently realizing the loss, and finally admitting to yourself that you made a bad investment.
The small silver lining of goodwill impairment charges are that they don’t negatively impact current cashflow (it’s an expense that reflects money paid out years ago). In fact, impairment charges are often a boost to cashflow because they lower the company’s taxable income.
Before moving on, we should also check CTL’s margins to see if there’s been a noticeable deterioration in profitability and the company’s unit economics. Margins have held pretty steady, so that’s good as its evidence of management’s commitment to cost discipline (both of the metrics I plotted are not impacted by goodwill impairment).
Tons Of Debt And No Competitive Edge
In my opinion, CTL has 5 main problems:
- It has a ton of debt. Adjusting for cash, CTL has approximately $33 billion in debt as of its most recent quarterly report. For a business that’s no longer growing, that’s quite the financial burden. Yes, it does produce around $6 billion in cashflow each year, but it also devotes around 60% of that cashflow towards the capital expenditures necessary to maintain its business. And on top of traditional debt, CTL also owes another $4.5 billion due to its pension plans. That’s a lot of financial liabilities.
- The reason that CTL is so indebted is that it competes in a very asset intense industry. Building and maintaining internet networks is expensive. And as internet usage evolves to feature more and more video (and streaming), the demands placed on its network will increase while CTL’s ability to monetize its network will probably decline (due to competition). It’s too bad for CTL that it’s unable to charge customers based on usage (Netflix addicts would revolt if ISPs attempted to move from a fixed monthly fee to a consumption based one).
- Half of its revenue base is shrinking fast (declining around 5% to 6% year over year). There are probably no good longterm business outcomes here, just less bad ones.
- It has no real competitive edge (product differentiation that provides pricing power, customer loyalty, etc.) in any of its business segments. CTL does business in a highly commoditized industry (everyone more or less sells the same thing — internet/phone service) where intense competition puts downward pressure on prices.
- It is smaller and possesses a lower quality network in comparison with its biggest competitors like Comcast and AT&T. Not only do CTL’s fiercest competitors own significantly larger networks, but they can also offer a wider variation of available internet speeds (price points) and have much more ability to bundle in other services (like cable TV). Thus, its key competitors are able to not only do business on a much larger scale (which lowers per unit costs) but also monetize each customer to a higher degree. This means that the average customer (in terms of lifetime value) is worth more to Comcast/AT&T than to CTL allowing them to more aggressively market to and pursue them.
CTL’s Pros And A Quick Valuation Of The Company
CTL’s main pros are its high operating cashflows (and to a lesser extant free cash flows). From a business perspective, its crown jewel (if you can call it that) is its enterprise business. But even that portion of its business is barely growing and accounts for just a quarter of its revenues.
So there’s really not that much to like here. I’m not at all a fan of investing merely to earn a high dividend yield — if the business is terrible, then the dividends are bound to decline along with earnings at some point. In fact that’s exactly what happened with CTL:
Lastly, what’s a good price to pay for this stock. Let’s do a quick valuation using an EBITDA (earnings before interest, taxes, depreciation, and amortization) multiple.
Our analysis has discovered a lot of bad and not much good about the business. On top of this, we need to account for the unprecedented levels of economic uncertainty right now. So we should only be willing to pay a low multiple of EBITDA for CTL. I’m a conservative guy, so in order to be enticed to buy such a bad business, I would need at least a 16% rate of return. This translates to a EBITDA multiple of 6.25. CTL’s EBITDA is around $8 billion (adjusted to be gross of the goodwill impairment). Also, given the negative trends in most of its businesses, an expected EBITDA of $7 billion probably makes more sense.
So 7*6.25 gets us to a fair enterprise value (EV) of $43.75 billion. Adjusting for debt and cash gets us to the fair market value:
EV - debt + cash = MV
43.75 - 36.34 + 1.59 = 9 billion
Our fair value for the company’s equity is $9 billion. Currently, CTL’s market cap is $11 billion — so it’s trading at a premium to our estimate. Thus, given how challenged the business is (and the economy too), we should probably wait for a cheaper price before we invest. If it all seems kind of anticlimactic, much of investment research is like this. We will likely examine 100 duds before finding a company we like enough (and that’s priced right) to invest in. The key is to stay patient and diligent. Cheers!