Lumen: No dividends or buybacks for you (NYSE: LUMN)

I need to switch to an energy efficient bulb. Lumen’s dividend cut will be a budget breaker.

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The last time we covered Lumen Technologies Inc. (New York stock market :LUMN) we had a neutral outlook for the stock and reported our bullish bond trends.

With debt to EBITDA close to 3.2X, when all the smoke has cleared, one only has to believe that the whole company is worth more than 3.2X EBITDA to consider these bonds. We think that’s an extraordinarily low hurdle to jump over. Interest coverage should be close to 5X and if you like 2X dividend coverage, you should like 5X interest coverage. We rate the bonds as a buy (yes, the 2042 bonds with a 10% YTM was what the title was referring to) and have a hold rating on the stock.

Source: A 10% return we can get

Most Lumen bonds are down around 10-14% net of accrued interest, so it can hardly be called a win. But it avoided that.

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Looking for Alpha

So we have that to ourselves, which is good. We take a look at Q3-2022 results and see how that changes our thesis.

Q3-2022

Market conditions were difficult in Q3-2022. Keep in mind that official measures of real GDP fell in the first and second quarters of this year. It is therefore not surprising to see the decline in corporate investment spending. That said, LUMN’s Q3-2022 numbers were really weak. We’ve highlighted the key numbers to focus on below.

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Press release LUM Q3-2022

There were quite a few elements to that and it’s hard to gauge that against analysts’ expectations, as the Latin America divestiture was completed mid-quarter. Other factors that weighed heavily were the end of the Connect America Fund II (CAF-II) program and extreme currency headwinds. We generally shouldn’t forgive if management attributes currency strength or weakness to weak earnings. If you’re going overseas, that’s part of the game. But this quarter was definitely unusual from that perspective, and we sympathize with the issues the company has had. Adjusted for extraordinary events and currency headwinds, total revenue decreased 4.3% year-over-year and 2% quarter-over-quarter. Many had hoped that adjusted earnings would stabilize year over year, or even increase. After all, inflation is a huge tailwind for at least nominal parameters like income. This obviously did not happen and the results were worse than Q2-2022 where LUMN noted a slight improvement from Q1-2022.

On an adjusted basis, revenue fell 3.4% in the second quarter, an improvement from the adjusted year-over-year decline of 5.5% in the first quarter of this year.

Source: Transcript Q2-2022

The side effect of declining revenues in an inflationary environment is that your margins tend to decline even faster, and we’ve seen this with the company’s declining adjusted EBITDA margin.

Outlook

LUMN surprisingly maintained its full-year adjusted EBITDA expectation of around $7 billion. It also raised the free cash flow outlook to $2.3 billion (midpoint). This increase stems from an outlook for lower capital expenditures. In parallel with the elimination of the dividend, LUMN has sufficient leeway to pursue its deleveraging. Looking ahead to 2023, we expect EBITDA of $5.4 billion (adjusted for the sale to COLT announced with Q3-2022 results) and that, combined with the company’s likely spending plans (more than 3 .0 billion), creates strong free cash flow. These basic calculations suggest that LUMN might have been able to sustain the $1 billion in annual dividends, but that could put things in jeopardy down the line. Free cash flow is also likely to be less than cash tax payments in 2023.

Also be aware that these transactions caused a taxable event and we expect to pay approximately $900 million to $1 billion in taxes in the first half of 2023 related to these transactions. This tax impact will be included in the overall 2023 cash tax guidance, which we plan to share with you when we release our fourth quarter results.

Source: Transcript Q3-2022

The risks are also high when revenues decline quarter after quarter. This is even truer with 7-year bonds having a yield to maturity of over 11%.

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FINRA

Any CFO who makes a buyout with this bond yield should be fired.

We would therefore expect minimal redemptions within a reasonable time frame.

So no dividends and no redemption for you. What can you expect?

Verdict

LUMN is a clearance sale and in a clearance sale you really want to be part of the debt. If you apply a mixed valuation based on recent asset sales, you could argue that stocks are undervalued to extremely undervalued.

As Jeff mentioned, since the level three merger in 2017, we’ve reduced debt by about $16 billion, sold our LatAm business for about nine times EBITDA, sold our ILEC business for about $5.5 times EBITDA and announced today that we have entered into an exclusive arrangement for the proposed sale of our EMEA business to Colt for $1.8 billion.

This represents a very attractive multiple of approximately 11x EBITDA, and most importantly, Jeff has positioned our business well as we move towards profitable revenue growth.

Source: Q3-2022 transcript

Indeed, it is not difficult to imagine a residual equity value of $12 to $18 per share in such a scenario. But those deals will become harder to execute as market conditions for junk debt tighten. The new CEO, kate johnson, also comes from a “growth mindset” and is unlikely to liquidate the entire company to end shareholder suffering. On the other hand, debt looks rather attractive with double-digit yields to maturity for medium-term bonds. Another large asset sale at 10-11x EBITDA multiples could send bonds up 20-30%, especially if it coincides with the end of the Fed’s hike cycle. This 30% is also what we would consider the rise of common stocks over the next year, albeit with much more risk. Therefore, we are maintaining a buy rating on the bonds and keeping the common shares on hold.

Please note that this is not financial advice. It may seem, seem, but surprisingly, it is not. Investors are required to do their own due diligence and consult a professional who knows their objectives and constraints.

About Meredith Campagna

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