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Dividend Cut Overshadows CenturyLink's Improving Profitability

Despite the short-term pain, the cut is good news for long-term investors.

In conjunction with its fourth-quarter earnings release, CenturyLink CTL announced it will cut its annual dividend to $1 per share from $2.16. Given that management constantly implied support for its outsize dividend in the past, this news overshadowed performance by the company that we found encouraging. We believe CenturyLink’s businesses lack an economic moat and have long-term deflationary pricing trends, so we project virtually no sales growth over our five-year forecast. However, management is hitting its synergy targets following the 2017 Level 3 acquisition and showing an ability to increase EBITDA despite continuing revenue weakness. With the company’s 2019 guidance in line with our projections, we expect no major change to our $22 fair value estimate.

Although the dividend cut may be painful for shareholders in the near term because of the stock’s negative reaction to the news as well as the reduced dividend income, we strongly believe the move is good news for long-term shareholders, and we applaud management for making it, although it probably could have foreshadowed the cut in a better way. Given the stated commitment to the dividend, we thought management would hold out until sizable debt maturities hit in 2020, at which point we expected a 50% cut. However, we had also expressed our view that continuing to pay the dividend was not the wisest capital-allocation decision. With CenturyLink now planning to reduce its leverage ratio to around 3 times EBITDA over the next few years (down from 4-5 the past couple of years), we expect more flexibility to take advantage of business opportunities and fewer solvency concerns if market conditions weaken. We’re more comfortable with CenturyLink’s financial position because of this news.

Somewhat lost in the dividend conversation was that management said it had realized all planned Level 3 synergies ($850 million worth) by the end of 2018, two years sooner than it had publicly projected, and that it now expected to realize additional synergies from the merger. Results backed this up, as the 2018 adjusted EBITDA margin expanded 250 basis points from 2017’s pro forma 34.2% margin, while the fourth-quarter margin was up almost 5 percentage points from 2017’s pro forma fourth quarter. If management realizes the new synergies it now identifies, the 150 basis points of additional margin expansion we forecast in total over the next five years might be conservative.

However, even though management may find further cost savings, revenue remains a sore spot. Pro forma revenue declined 4% year over year in the fourth quarter and 3% for the full year, with business revenue down 2% (in both the quarter and full year) and consumer revenue down 8% in the quarter and 6% for the year. We forecast slight improvements from these levels over time--a return to growth (less than 1%) in the business segment and continued contraction, though improved, in the consumer segment--but we think the business remains extremely challenged as newer technologies depress pricing for business customers and consumer voice services are trending toward extinction. Still, we think growing demand for data traffic on the business side and a shift to improved broadband speeds on the consumer side will ultimately lead to a modest improvement.

First-Rate Network in a Second-Rate Industry We think CenturyLink plays an integral role in making up the backbone of the Internet, but the company faces overcapacity and numerous competitors. Its fiber holdings make it one of the biggest communications infrastructure providers in the United States, and its Tier 1 network is matched by few other companies in the world. While it is not the leader in the space, and we don't expect it to close much ground on the top players, the growing importance of our connected world gives us confidence that CenturyLink's network will remain vital.

However, technological advances continually improve networking efficiency and enable less costly solutions to store and transport data. Consequently, even in CenturyLink’s enterprise segment, which accounts for roughly 75% of total revenue, we see a path to only meager top-line growth. We think CenturyLink’s business customers will continue to benefit from shared networks, which the cloud advances, and strides that require less bandwidth and enable more efficient routing. We view the consumer business as being even worse, as we project the movement from consumers away from landline phones will more than offset CenturyLink’s improving broadband network. In all, we think CenturyLink will be challenged to meaningfully increase revenue.

With our outlook for sales growth dim, we think enhancing profitability is CenturyLink’s best path to improved financial performance. We see the merger with Level 3 as boosting that effort, given substantial overlapping costs. We also think the company stands to benefit greatly from its ability to use Level 3’s deferred tax assets, which should be a boon to free cash flow. In a challenging business, we think management has made the right strategic moves to enhance value. We see the shift toward business customers and the focus on enhancing profitability as the proper moves to make in its industry. While we don’t expect CenturyLink’s business to be a great performer, we think management has positioned it to remain viable for the long term, reducing the chances that it is on a slow path to fading away.

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