Lumen Technologies (LUMN), formerly known as CenturyLink, has struggled for years to maintain investors’ confidence. The stock has lost two-thirds of its value over the past decade, including a 50% decline over the past five years. While some of that is attributable to the telecom company’s high dividend, the stock is also down over 25% over the past 10 years on a total return basis.
Part of this decline was justified by Lumen’s shrinking revenue base. Even so, the stock has appeared to be significantly undervalued over the past couple of years.
In any case, management has recently laid the foundation for a big recovery over the next 3-5 years. Between two big divestitures and a refreshed growth strategy, Lumen stock could double or more over that period, while continuing to reward shareholders with a generous dividend.
Selling off non-core assets
Lumen announced two major divestitures just eight days apart last year. In late July, the company agreed to sell its Latin American business to alternative investment firm Stonepeak for $2.7 billion: approximately nine times the unit’s estimated 2020 adjusted EBITDA.
The following week, Lumen reached a deal to sell its legacy ILEC telecom business in 20 states to affiliates of Apollo Global for $7.5 billion. Lumen’s operations in these states are mainly concentrated in less attractive rural markets. Management pegged the valuation for that deal at approximately 5.5 times estimated 2020 adjusted EBITDA.
Lumen expects to close the LatAm sale in the first half of 2022, with the ILEC deal closing in the second half of the year. While the gross proceeds of the two deals will exceed $10 billion, Lumen estimates its net proceeds at around $7 billion. The biggest driver of the discrepancy is $1.4 billion of debt that will be assumed by Apollo. Other adjustments include deal taxes, the cost of fully funding pension plans that will be transferred to Apollo, and general transaction expenses.
What do the asset sales mean for free cash flow?
The assets Lumen has agreed to sell generated approximately $3.3 billion of revenue and $1.7 billion of adjusted EBITDA in 2020. That equates to roughly 16% of the company’s revenue and 19% of its adjusted EBITDA for that year.
During Lumen’s Q2 earnings call, CFO Neel Dev estimated annual CapEx at $200 million for the LatAm unit and $400 million for the U.S. operations being sold. This implies that these assets generated about $1.1 billion of unlevered cash flow in 2020, excluding changes in working capital. In short, the asset sales will significantly reduce Lumen’s free cash flow, all else equal.
That said, interest cost savings will offset about half of the EBITDA and cash flow impact of Lumen’s planned asset sales. In Q4, Lumen repaid $950 million of senior notes that carried a 6.75% coupon. In March, $1.4 billion of debt with a 5.8% coupon will come due. The company also has $977 million of 6.5% baby bonds that can be called at par at any time, plus $660 million of 6.75% baby bonds that will be callable at par starting in June. Additional near-term maturities include $74 million at 7.125% due in mid-2023, $750 million at 6.75% due later that year, and $1 billion at 7.5% due in early 2024. Finally, Lumen’s Level 3 Financing subsidiary has $800 million of debt at a 5.375% coupon that can be called at a small premium to par starting in May.
If Lumen uses the cash proceeds of its asset sales to retire these maturities, interest expense would decline by around $540 million compared to 2021. (This includes the impact of transferring $1.4 billion of high-cost debt in the Apollo deal.) That would offset roughly half of the immediate impact on unlevered cash flow of selling these business units.
At first glance, this still might look like a bad deal for shareholders. However, the assets Lumen is selling (especially the ILEC operations) are poised for declining cash flow without massive incremental investments.
Lumen indicated that the voice/other product category accounts for about half of its revenue in the states where it is selling its operations to Apollo. Mass-market broadband constitutes most of the rest. On a companywide basis, voice and other revenue fell 12.5% year over year in the third quarter. And while mass-market broadband revenue has been roughly stable, growth in high-speed fiber connections has been compensating for declining DSL revenues. Just 3% of Lumen’s footprint is fiber-enabled in the states it is exiting, compared to more than 11% in the states it is keeping.
Thus, while Lumen will suffer an immediate cash flow hit from its asset sales, that cash flow wasn’t sustainable anyway. By contrast, its interest cost savings will be durable.
Investing in what’s left
After using its asset sale proceeds to pay off much of its high-cost debt and other near-term maturities, Lumen plans to invest more aggressively in its remaining ILEC footprint under the new Quantum Fiber brand.
In recent years, the company has expanded fiber internet availability to about 400,000 new locations annually. As of Q3 2021, Quantum Fiber had approximately 2.5 million fiber-enabled units in the states not being divested. But by the end of 2022, Lumen expects to increase the pace of fiber enablements to around 1.5-2 million per year.
Based on management’s estimate that it could economically deploy fiber to over 12 million locations among the 21 million it serves in the states it is keeping, Quantum Fiber should more than quadruple its fiber-enabled footprint by the end of 2027.
Fiber-based internet is vastly superior to DSL. As a result, fiber connections command higher prices and keep customers more loyal. Lumen will be far more successful at adding and retaining residential and small business subscribers as it deploys fiber to a greater proportion of its ILEC footprint.
The business case for an accelerated fiber deployment schedule appears quite solid. In the first nine months of 2021, Quantum Fiber increased the number of fiber-enabled locations from 2.4 million to 2.7 million. (That figure includes the states it plans to exit.) Over the same period, its fiber subscriber base rose 15%: from 675,000 to 774,000 users, as its fiber penetration rate (among enabled locations) increased from 28% to 29%. ARPU (average revenue per user) also ticked up from $56 to $59 per month.
This put mass markets fiber revenue at a run rate of $137 million per quarter exiting Q3. For comparison, mass markets broadband revenue totaled $754 million in Q3. In other words, fiber connections still account for a fairly small proportion of Lumen’s mass markets broadband revenue. However, that will change rapidly over the next few years.
A recipe for a return to revenue growth
By the end of 2022, fiber connections will already account for a higher proportion of Lumen’s mass markets broadband revenue than they do today. First, the company’s fiber revenue is currently growing at a 20%-plus annual pace. Second, the assets being divested account for a quarter of Lumen’s domestic ILEC footprint but well under 10% of its fiber-enabled locations.
The combination of this improved business mix and an accelerated fiber rollout should drive strong broadband revenue growth in the mass markets segment starting in 2023. In the long run, Lumen is targeting a 40%-plus penetration rate within its fiber-enabled footprint. That target seems realistic, and it would translate to 5 million or more fiber customers in the mass markets segment by the late 2020s.
At an ARPU in the $70-$75 range (which assumes a modest 3% CAGR over the next 6-7 years), Quantum Fiber would generate roughly $1.1 billion in quarterly broadband revenue. Including a small continuing contribution from DSL, Lumen’s mass markets broadband revenue could total $1.2 billion or more per quarter, or roughly $5 billion annually.
This would represent a $2 billion increase from today. On a pro-forma basis (excluding the regions Lumen is selling to Apollo), it would be closer to a $3 billion increase. That’s substantial relative to Lumen’s current revenue base, which stood at an annual run-rate of approximately $19.5 billion as of Q3 2021 and roughly $16 billion if one excludes the businesses to be divested and revenue from the recently-ended CAF II subsidy program.
Of course, Lumen will continue to face revenue pressure in other parts of its business: most notably voice services, which still account for about 30% of total revenue. However, as mass-market broadband revenue growth accelerates, it should offset further declines in legacy voice services. As a result, I expect revenue to bottom out in 2023 and return to growth in 2024, in line with management’s guidance.
Earnings growth will follow
Building out a sizable fiber-to-the-home footprint will be expensive. Lumen estimates a cost per location of less than $1,000, which suggests that the CapEx to add roughly 10 million locations might total $8-$9 billion over the next six years.
However, these investments will activate a high-margin stream of recurring fiber broadband revenue. Lumen estimates that the ILEC business it is selling generated $1.4 billion of EBITDA on $2.5 billion of revenue in 2020, implying an EBITDA margin of approximately 56%. Fiber broadband EBITDA margins should be even higher, thanks to fiber’s reliability and the company’s efforts to create a seamless, all-digital customer experience.
Thus, by the end of the decade, the Quantum Fiber business could be generating $3 billion or more of EBITDA. Assuming relatively stable results in Lumen’s business-focused segment, total adjusted EBITDA in the range of $8 billion seems achievable by 2028 or 2029. For comparison, I expect adjusted EBITDA to bottom out in the low $6 billion range in 2023.
The return to modest revenue growth with expanding margins beginning in 2024 is likely to drive a sharp change in sentiment with respect to Lumen. Adjusted EBITDA should rebound to $7 billion by 2025 or 2026, supporting an enterprise value of roughly $50 billion at a conservative EV/EBITDA multiple of 7.
Assuming no major changes to Lumen’s debt load aside from applying its asset sale proceeds to pay down debt, this would translate to a share price in the $25-$30 range. At a more aggressive (but still plausible) EBITDA multiple of 8 times, Lumen stock could surge past $30 within a few years.
Assessing the risks
Of course, no stock is risk-free. The most obvious risk for Lumen is that the decline of voice revenue accelerates further. Even after completing its divestitures, Lumen will get over a quarter of its revenue from the voice/other category in the near term. If that goes to near zero over the next five years, the declines in voice/other revenue could overshadow Lumen’s fiber broadband revenue growth.
Another risk is that Lumen’s new fiber broadband services face unexpected market share or pricing pressure. Getting to 40% penetration with a high ARPU should be fairly straightforward if Quantum Fiber essentially holds a duopoly with the local cable company. But if fixed wireless internet from the major cellular companies gains traction or satellite internet service improves, the competitive environment could shift, forcing Lumen to reduce prices or accept lower market share.
Either of these scenarios would cause revenue and EBITDA to be stagnant or even decline after the upcoming divestitures, keeping the stock under pressure. Missing EBITDA growth targets could also force Lumen to cut its dividend to free up cash for debt reduction, adding to the selling pressure. (Lumen expects to operate with a very high dividend payout ratio in the short term, due to the pressure on free cash flow from its divestitures, increased CapEx, and a higher cash tax rate. That leaves little room for error.)
On the flip side, Lumen owns attractive, hard-to-replicate fiber assets. They provide a durable earnings stream that should limit the stock’s downside and could likely be sold at favorable prices if necessary. In short, Lumen stock offers a very favorable risk-reward tradeoff, with its upside potential over a 3-5 year time horizon vastly outweighing the risk of further underperformance.
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