Tag Archives: Verizon

CTL: Pain before gain?

Before I unleash my musings on the latest Centurylink (CTL) results, building on this recent CTL post, I will touch on some industry trends and some CTL specific items that are relevant in my opinion. As regular readers will know, the increased use of artificial intelligence (AI) by businesses, particularly in business processes, is an area that fascinates me (as per this post). How such process improvements will change a capital- and labour-intensive sector such as telecom (as per this post) is one of the reasons I see such potential for CTL.

Whilst reading some recent articles on digital developments (such as this and this and this), I cannot but be struck by the expanded networking needs of this future. All this vast amount of new data will have to be crunched by machines, likely in data centres, and updated constantly by real time data from the field. Networks in this era (see this post on 5G) will need to be highly efficient, fluid and scalable, and have a deep reach. Very different from the fixed cost dumb pipe telecoms of old!

CTL have outlined their ambition to be such a network provider and are undertaking a digital transformation programme of their business to achieve that goal. CEO Jeff Storey has gone as far as saying that CTL “is not a telecom company, but that we are a technology company”. Time will tell on that one!

Today, industry trends from business telecom revenues (i.e. enterprises from SME to global giants plus wholesale business) are flat to declining, as highlighted in this post. Deciphering recent trends has not been made any easier by the introduction of the new revenue recognition accounting standard ASC606. Where possible, the updated graph below shows revenues under the new standard from Q1 2018.

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This data shows an estimated annual decline in overall annual revenues for 2018 of 1.5%, compared to 1.2% in 2017 and 2% for each of the preceding 2 years. Over the past 8 quarters, that’s about a 33-basis point sequential quarterly drop on average. Different firms are showing differing impacts from the accounting change on their business revenue. Comcast showed a 6.5% jump in Q1 2018 before returning to trend whilst AT&T showed a 4% drop in Q1 2018 before returning to more normal quarterly changes. Rather than trying to dismantle the impact of the accounting change, its easier to simply accept the change as its obvious the underlying trends remain, as the bottom graph above illustrates. Whilst accepting these 5 firms do not make up all the US, let alone the global, telecom market, some interesting statistics from this data are shown below.

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Although the accounting change has likely skewed figures in the short term, the exhibit above shows that AT&T is losing market share whilst the cable firms are growing their business revenues albeit from lower bases than the big players. Verizon and the new CTL have performed slightly below market trends (i.e. 50 basis point average quarterly sequential declines versus overall at 33 basis points).

Before I get onto CTL’s Q3 results, this article from Light Reading illustrates some of the changes underway at the firm to transform its business. The changes are centred around 4 themes – increasing network visibility, delivering business-owned automation, encouraging a lean mindset, and skills transformation.

On network viability, CTL is layering federation tools on top of its existing systems. Federated architecture (FA) is a pattern in enterprise architecture that allows interoperability and information sharing between semi-autonomous de-centrally organized lines of business, information technology systems and applications. The initial phase of this federation was with customer and sales systems such as those used for quoting, order entry, order status, inventory management and ticketing. The goal is to move towards a common sales ecosystem and standard portals that automate customer’s journeys from order to activation and beyond. A common narrative of CTL’s transformation is to give customers the tools to manage their networking capabilities like they do using the cloud. This is more of a network as a service or network on demand that CTL say is the future for telecom providers. This interview with the newly appointed CTO of CTL gives further insight into what the firm is doing in this on demand area, including changes underway to meet the increased SD-WAN demand and the upcoming deluge of data in the 5G era.

Business owned automation is allowing different business units to own their own automation projects, whilst been supported by centralised centres of excellence in areas such as robotic process automation (RPA), digital collaboration, mobility and analytics. Training is provided by the centralised units. Empowering the business units encourages a key cultural change in adopting a lean mindset across the firm. Ensuring that people in the firm are retrained and motivated is a core part of CTL’s plans as change only comes from within and as the firm continues to downsize (they have already reduced headcount by 12%) its important that staff morale and skills transformation is a focus as the business changes.

So, moving on to CTL’s Q3 results. The market has not reacted well to the Q on Q drop of 3.6% in revenues, with weakness seen across all business segments, and the stock is trading down around $19 as a result. The trends highlighted above have been exasperated by CTL dropping or renegotiating lower margin business such as contracts involving customer premises equipment (so called CPE). Of the $80 million quarterly revenue drop (under ASC606) in Q3, $30 million was attributed to the culling of low margin business. The remaining $50 million drop is about twice the average drop in recent times, thereby raising analyst concerns about an increase in trend revenue declines.

However, there are two points to note here. Firstly, using revenue figures before the application of ASC606, the net drop was more in line at $37 million (i.e. $67-$30) and comparable with the Q2 non-ASC606 drop of $40 million. Secondly, and more importantly, the trend is lumpy and given CTL’s transformation focus, it makes total sense to me for CTL to cull low margin non-network centric revenues. Management were explicit in stating their intention “to focus on the network-centric things” and that this business is “distracting our organization and it’s not giving us anything, so we’ll stop it”. To me, that demonstrates confidence in the direction of the business. As Storey emphasised, when referring to culling low margin business, “we manage this business for free cash flow, free cash flow per share, these are good things to be doing”.

Analysts concern that cutting expenses longer term cannot be a sustainable business plan without revenue growth at some point is certainly valid (and is one of the key risks with CTL). Indeed, I estimate that there is about $900 million and $500 million of quarterly legacy business and consumer revenues respectively (about 15% and 10% of total quarterly revenues) that could fall off at an accelerated pace as CTL refocuses the business over the medium term. CTL’s return to top line growth could be several years off yet. More on this later.

Another area of concern from analysts was the fact that CTL will spend approx. $500 million less on capex in 2018 compared to original projections (with levels projected to return to a more normal 16% of revenues for 2019 and beyond). This could be interrupted as a desire not to invest in the business to inflate free cash-flow, never a good sign for any company. However, again management explained this as a desire to refocus capital spending away from items like copper upgrades and towards strategic areas. They cited the approval to bring on-net another 7,000 to 8,000 buildings and the use of strategic targeting of capex (using AI) across consumer and business geographies to maximise returns in urban areas where 5G infrastructure will be needed in the future. Again, a more disciplined approach to capex makes total sense to me and demonstrates the discipline this management team is imposing on the business.

What seems to have been missed in the reaction to Q3 results is the extraordinary progress they have made on margin improvements. The EBITDA margin again grew to 39.3% with the projected operational synergies of $850 million now targeted to be achieved by year end. Management are keen to move the focus from integration to digital transformation from 2019. Achieving the targeted operational synergies so soon, particularly when we know that network expense synergies do not come through until 2 to 3 years after a merger, is an amazing achievement. It also highlights that their projected cost synergies of $850 million were way way under-baked. As I highlighted in this recent CTL post, I suspected this under-baking was to protect against the risk of any further acceleration in the underling margin erosion at the old CTL business as legacy business declined.

CTL’s discipline in extracting costs, as seen by actions such as the (painful) 12% headcount reduction, is central to my confidence in CTL’s management achieving their strategic aims. I do not believe that a further $250 million and $200 million of cost synergies in 2019 and 2020 respectfully through further synergies, network grooming efforts and the digital transformation initiative is unreasonable. That would bring overall cost synergies to $1.3 billion, a level consistent to what LVLT achieved in the TWTC merger.

So, given the likelihood of an increased purposeful erosion in low margin legacy business over the next several years combined with a higher level of cost extraction, I have recalculated my base and pessimistic scenarios from my previous post.

My base scenario, as per the graph below, shows annual revenues effectively flatlining over the next 3 years (2019 to 2021) around $23.3 to $23.6 billion before returning to modest top-line growth thereafter (i.e. between 1% and 1.5% annual growth) with an EBITDA margin of 42% achieved by the end of 2021 and maintained thereafter. This revenue profile mirrors that of previous LVLT mergers, albeit a longer period of flatlining revenues due to the amount of old legacy CTL to burn off. Capex is assumed at 16% of revenue from 2019 onwards. My projections also include further interest rate increases in 2019 and 2020 (as a reminder every 25-basis point change in interest rate results in an 8.5 basis point change in CTL’s blended rate). The current dividend rate is maintained throughout with FCF coverage ratio reducing from the low 70’s in 2019 to around 60% by the end of 2021. My DCF valuation for CTL under these base projections is $23 per share. That’s about 20% above its current level around $19 plus a 11% dividend yield.

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My pessimistic scenario, as per the graph below, assumes that the hoped-for revival of CTL into an on-demand service provider in the 5G age does not result in revenue growth after the legacy business has eroded for whatever reason (other technological advances over the need for a deep fiber network optic been the most likely). Annual revenue continues to decline to below $22 billion by 2021 and does not get above that level again until 2025. Although this scenario would be extreme, its not unknown in the telecom industry for future jumps in data traffic to result in falling revenues (eh, remember the telecom winter!). EBITDA margin levels get to 41% by the end of 2021 and slowly rise to 41.5% thereafter on further cost cutting. Capex and interest rate assumptions are as per the base scenario.

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In the pessimistic scenario the dividend level of $2.16 per share must be cut by 50% from 2020 to reflect the new reality and to deleverage the balance sheet. Although the share price would likely suffer greatly in such a scenario, my DCF valuation is $14 per share, 26% below the current $19 share price, not forgetting the reduced dividend yield after the 50% cut.

As per my previous post on CTL, I see little point in contemplating an optimistic scenario until such time as revenue trends are clearer. A buy-out at a juicy premium is the most likely upside case.

Consideration should be given in any projections over the medium term on the impact and timing of the next recession which is certain to happen over the 2019 to 2025 period. Jeff Storey has argued in the past that recession is good for firms like CTL as enterprises look to save money through switching from legacy services to more efficient on demand services. Although there is an element of truth to this argument, the next recession will likely put further pressures on CTL’s top-line (alternatively, an outbreak of inflation may help pricing pressures!!). Higher interest rates and lower multiples are a risk to the valuation of firms like CTL and the uncertainty over the future macro-economic environment make CTL a risky investment. Notwithstanding the inevitability of a recession at some time, I do feel that the revenue projections above are already conservative given the explosion in network demand that is likely over the next decade, although increased signs of recession in late 2019 or 2020 would temper my risk appetite on CTL.

To me, one of the biggest risks to CTL is the CEO’s health. Given Sunit Patel has left for T-Mobile (who I hope may be a potential buyer of CTL after they get the Sprint deal embedded and/or abandoned) and the new CFO will take some time to get accepted in the role, any potential for CTL not to have Jeff Storey at the helm over the next 2 years would be very damaging. Identifying and publicly promoting a successor to Jeff Storey is something the Board should be actively considering in their contingency planning.

For now, though, I am reasonably comfortable with the risk reward profile on CTL here, absent any significant slow down in the US economy.

CenturyLink levelled

It’s been over 6 months since I last posted on the upcoming merger of Level 3 (LVLT) and Centurylink (CTL). Since then, LVLT’s CEO Jeff Storey has been named COO of the combined entity and CEO from January 2019, after a gentle push from activist investor Keith Meister of Corvex Management (here is an article on their latest position), effectively meaning the merger is an operational LVLT takeover of CTL. In June, CTL also got hit by a lawsuit from an ex-employer alleging a high-pressure sales culture which ripped customers off (an avalanche of class action suits followed). And, potentially more damaging, the recent results of CTL continue to point to deteriorating trends in the legacy part of their business and lackluster growth on the strategic part of the business. CTL missed their quarterly estimates again in the most recent quarter, the third miss in a row.

Picking up on my recent telecom industry post, the sector will struggle in the short term to find top line growth before the full impact of new “digital lifestyle” opportunities emerge. The figures below for enterprise, including public sector, and wholesale revenues for some of the biggest US players (which have been adjusted judgmentally for items such as the impact of the XO acquisition on Verizon’s revenues and the ever-changing classifications and reclassifications that telecom’s love) illustrate the current struggle in getting newer IP enabled services to fully compensate for declining legacy revenues.

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These figures imply average quarterly declines since 2014 of -0.3% and -1.2% for enterprise and wholesale business respectively. However, the trend has been getting worse. The average quarterly change was 0.2% and -1.1% for enterprise and wholesale business respectively from 2014 to 2015. Since 2016, the average quarterly change is -0.9% and -1.3% for enterprise and wholesale respectively. Not exactly a cheery trend when contemplating the prospects of a merged CTL/LVLT!

As can be seen below, the share price of LVLT and deal implied price have converged, particularly as CTL’s dividends get paid, albeit with a sharply downward bias in recent weeks over worries about dividend sustainability, valuation, sector trends, lawsuits and uncertainty over the closing date of the merger (a delay by California, the last State approval needed, may mean the end of September deadline is missed).

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My estimates for a standalone LVLT compared to analyst figures and those presented by LVLT management in the S4 (figures presented for merger negotiations are generally on the optimistic side) are below. Even factoring in higher interest rates (about 40% of LVLT’s debt is floating) over the coming years, I am comfortable with a standalone share price around the current mid-50’s, in the unlikely event the merger falls apart.

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To recap on my confidence in the ability of LVLT’s current management team to deliver, the results of the last merger between LVLT and TWTC show that management delivered a 40% uplift in the amount of free cashflow (e.g. EBITDA less capex) on flat revenues from 2014 to 2017 (e.g. combined FCF of both entities in the year prior to the merger to actual H1 results and my estimates for H2 2017). Some of my many previous posts on LVLT are here, here and here. Such a repeat in FCF in the CLT/LVLT merger is not a realistic expectation given the larger scale and different business mix, as the analysis below illustrates. Of course, the flat revenues over the past 3 years is a key concern (but worthy of praise given the industry trends highlighted above) and one of the catalysts for the CLT deal. Also, the health of designate CEO Jeff Storey may also be a factor over the next few years given his heart issues a few year ago.

My knowledge of CTL’s business is not as deep as that of LVLT’s and my confidence in their prospects on a standalone basis is nowhere near as lofty. My projections, split over a conservative base scenario and a more conservative low business scenario, can be seen below. My projections are primarily based upon the more recent trends in their business lines across their legacy and strategic enterprise and consumer businesses. The vast variance in my estimates, based upon recent trends, and those presented by management in the S4 (again, acknowledging that these are generally optimistic) illustrates why the market has lost such confidence in the outgoing management team at CTL, in my opinion.

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In terms of trying to model the merged CTL/LVLT, I have assumed the deal closes by the end of 2017 with 2018 being the first year of the merged entity. I have made a number of judgmental adjustments in my model, including assuming some loss of revenue due to the merger and cost reductions above published target synergies (e.g. $1 billion of operating synergies by end 2020 and $150 million of capex synergies by end 2019, higher than the announced target savings of $850 million and $125 million for opex and capex respectively). I have taken analyst estimates as an optimistic case (in CTL’s case I have taken their EBITDA estimates but still can’t get anywhere near their revenue figures) and called it the high scenario. My two projections above are used for the base and low scenarios. The resulting operating metrics for each scenario is shown below.

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The high scenario shows revenues flat-lining slightly above $24 billion for 2018 and 2019 with top-line growth returning in 2020 (YoY above 2.5%). EBITDA margins hit 40% by 2019 and remain stable around 40% thereafter. Capex is assumed to hit 15.5% of revenues by 2019 and remain at that percentage thereafter. This scenario assumes that management will be able to generate an approximate 30% uplift in the amount of free cashflow (e.g. EBITDA less capex) from 2017 (e.g. combined FCF of both entities in the year prior to the merger) to FY 2020.

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The base scenario shows revenues flat-lining around $23.5 billion for 2018 through 2020 with top-line growth returning in 2021 (YoY just below 2%). EBITDA margins hit 40% by 2019 and slowly trend down toward 39% thereafter. Capex is again assumed to hit 15.5% of revenues by 2019 and remain at that percentage thereafter. This scenario assumes that management will be able to generate an approximate 22% uplift in the amount of free cashflow (e.g. EBITDA less capex) from 2017 (e.g. combined FCF of both entities in the year prior to the merger) to FY 2020.

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The low scenario shows revenues around $23.5 billion for 2018 and drifting down to $23 billion before slowly hitting $23.5 billion again by 2022. Thereafter revenue growth builds slowly from 1.5% to 2.5% by 2027. EBITDA margins hit 39.5% by 2019 and slowly trend down toward 38.5% thereafter. Capex is again assumed to hit 15.5% of revenues by 2019 and remain at that percentage thereafter. This scenario assumes that management will be able to generate an approximate 18% uplift in the amount of free cashflow (e.g. EBITDA less capex) from 2017 (e.g. combined FCF of both entities in the year prior to the merger) to FY 2020.

I also assume the merged entity will carry $38 billion of debt from the offset (resulting from merger expenses, the cash payout to LVLT shareholders, and existing debts from both firms, after factoring any proceeds from recent CTL divestitures). I estimate that only 30% of this debt load is subject to a floating rate. In all scenarios, I assume the LIBOR rate linked to the floating rate increases incrementally by 275 basis points over the next 3 years (the current 12 month US rate is about 175 basis points). With a net debt to EBITDA ratio of approximately 3.8 at the end of 2018 across all scenarios, I believe that getting that ratio below 3 within 4 years by 2021, at the latest, will be a primary objective of the new management team. That would only be prudent in my view given the likely tightening monetary environment over the next few years which will punish valuations of corporates with high debt levels. Also, management will want to remain flexible if higher capex is needed to compete in new technologies for the IoT and digital lifestyle era (see recent sector post). I haven’t factored in an upside from LVLT’s CFO Sunit Patel proven ability to actively manage debt rates and maturities (his ability is highlighted by the fact that LVLT’s fixed debt costs 5.5% compared to CTL’s admittingly much larger fixed debt costing 6.8%)

That leads to the thorny question of the sustainability of the annual dividend of $2.16 per share (particularly given that share count will double, amounting to $2.3 billion per year). Under the high scenario, maintaining the current dividend and getting the net debt multiple below 3 by 2021 is doable if a little tight (primarily due to the cashflow benefits of LVLT’s NOLs). For both of the base and low scenarios maintaining the current dividend level is not realistic in my view, with a cut in the dividend to $1.30 and $1.00 needed in each scenario respectively (a 40% and a 55% cut). The current dividend yield on CTL is over 10%. Each of the cuts above would reduce that yield to approximately 6% and 5% for the base and low scenarios respectively based upon the current share price. Addressing the uncertainty over the dividend should be one of the priorities of the new management (and may even result in Jeff Storey’s move to the CEO position ahead of the planned January 2019 date).

Finally, before I reveal my per share valuations, I haven’t given any consideration to the financial impact of the current legal cases on alleged aggressive sales tactics as the level of current detail makes any such estimate impossible. Some of the class action cases claim anything from $600 million to $12 billion but these claims are always bloated and the eventual settlement figure, if there even is one, are often for a lot less than that claimed. Nor have I considered the potential impact of a spin-off of the consumer business (that’s for another time!).

So, based upon the analysis outlined in this post and using a discount rate of 8.5%, my valuation estimates for each of the three scenarios are below.

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The market’s current valuation of CTL around $20 indicates scenario 3 as the current expectation. This emphasizes the need to address the uncertainty over future dividend levels and the validity of the legal cases. Uncertainty over the closing date of the deal is overblown, in my view, and a few months of delay will not prove material. I do think the current valuation is harsh, given the potential upsides from the deal and longer-term industry trends. Interestingly, my base scenario valuation of £31 is not too far off the value of $34.75 by BofA Merrill Lynch and Morgan Stanley in the S4 (see this post on the S4). The base scenario is the one I would have the most confidence in, based upon my current knowledge, rather than the high scenario of $43 which does look too optimistic to me given current market trends.

I was never going to reinvest the cash component of the deal for LVLT shareholders given my current reservations about market valuations and move to cash across my portfolio. The analysis presented in this post indicates to me that the CTL shares due from the deal for LVLT shareholders are worth holding from a valuation perspective. For now.

For new investors, I’d wait to see how some of the uncertainties play out, particularly the dividend issue.

Warring Wireless

The M&A permutations being talked about in the US telecom sector are fascinating. The AT&T/Time Warner deal has commentators frothing at the mouth about possible tie-ups, particularly given the laissez faire attitude to regulation of the new FCC Chairman, Ajit Pai. Names such as DISH, Comcast, Disney, Netflix, SiriusXM, Charter are regularly tied to the big telcos and/or each other in the speculation.

Existing wireless revenues from AT&T and Verizon have plateaued and are now starting to decrease due to cut throat competition on unlimited plans from T-Mobile and Sprint, as the graph below shows.

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The T-Mobile/Sprint merger is now been talked about again, after the year long FCC spectrum moratorium on competitors talking has passed. The current bidding frenzy between AT&T and Verizon over Straight Path’s millimetre wave frequencies that can be used to carry large amounts of data over short distances has brought the hype over 5G services to a new high. Verizon’s purchase of XO last year enabled them to lease XO’s 102 LMDS licenses in the 28 GHz and 39 GHz bands so it is somewhat surprising to see them be so aggressive in bidding for Straight Path.

The analyst Craig Moffett believes that the winning bidder for Straight Path will have significant leverage with the FCC in determining how these wave frequencies are repackaged for use by competitors. Although wireless margins are not under significant pressure, as the graph below shows, it is obvious that there is now a full scale war for control of the wavelengths that will be critical to 5G services in the search for new revenues. T-Mobile and DISH are also holders of high frequency wavelengths been touted as suitable for 5G.

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The fascinating thing about the frenzy over Straight Path is that the hype over high frequencies such as the 39 GHz band is not new. The reason such spectrum has gone largely unused in the past is that it has been historically difficult to create reliable, secure, mobile connections in those bands. Variable weather conditions, often something as common as a rainy day, can impact coverage in high frequencies. I wonder what’s changed?

Confused but content

As regular readers will know, I have posted on Level 3 (LVLT) many times over the years, more recently here. I ended that post with the comment that following the firm was never boring and the announcement of a merger with CenturyLink (CTL) on the 31st of October confirmed that, although the CTL tie-up surprised many observers, including me.

Before I muse on the merger deal, it is worth looking over the Q3 results which were announced at the same time as the merger. The recent trend of disappointing revenue, particularly in the US enterprise business, was compounded by an increased projection for capex at 16% of revenue. Although the free cash-flow guidance for 2016 was unchanged at $1-$1.1 billion, the lack of growth in the core US enterprise line for a second quarter is worrying. Without the merger announcement, the share price could well have tested the $40 level as revenue growth is core to maintaining the positive story for the market, and premium valuation, of Level 3 continuing to demonstrate its operating leverage through free cash-flow growth generation.

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Level 3 management acknowledged the US enterprise revenue disappointment (again!) and produced the exhibit below to show the impact of the loss of smaller accounts due to a lack of focus following the TW Telecom integration. CEO Jeff Storey said “coupling our desire to move up market, with higher sales quotas we assigned to the sales team and with compensation plans rewarding sales more than revenue, we transitioned our customers more rapidly than they would have moved on their own”. The firm has refocused on the smaller accounts and realigned sales incentives towards revenue rather than sales. In addition, LVLT stated that higher capex estimate for 2016, due to strong demand for 100 Gig wavelengths and dark fibre, is a sign of future strength.

click to enlargelvlt-q3-revenue-by-customer

Although these figures and explanations do give a sense that the recent hiccup may be temporary, the overall trends in the sector do raise the suspicion that the LVLT story may not be as distinctive as previously thought. Analysts rushed to reduce their ratings although the target price remains over $60 (although the merger announcement led to some confused comments). On a stand-alone basis, I also revised my estimates down with the resulting DCF value of $60 down from $65.

Many commentators point to overall revenue weakness in the business telecom sector (includes wholesale), as can be seen in the exhibit below. Relative newcomers to this sector, such as Comcast, are pressuring tradition telecoms. Comcast is a firm that some speculators thought would be interested in buying LVLT. Some even suggest, as per this article in Wired, that the new internet giants will negate the need for firms like Level 3.

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However, different firms report revenues differently and care needs to be taken in making generalisations. If you take a closer look at the revenue breakdown for AT&T and Verizon it can be seen that not all revenue is the same, as per the exhibit below. For example, AT&T’s business revenues are split 33%:66% into strategic and legacy business compared to a 94%:6% ratio for LVLT.

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That brings me to the CenturyLink deal. The takeover/merger proposes $26.50 in cash and 1.4286 CTL shares for each LVLT share. $975 million of annualised expense savings are estimated. The combined entity’s debt is estimated at 3.7 times EBITDA after expense savings (although this may be slightly reduced by CTL’s sale of its data centres for $2.3 billion). LVLT’s $10 billion of NOLs are also cited by CTL as attractive in reducing its tax bill and maintaining its cherished $2.16 annual dividend (CTL is one of the highest yield dividend plays in the US).

The deal is expected to close in Q3 2017 and includes a breakup fee of about $2 per LVLT share if a 3rd party wants to take LVLT away from CTL. Initially, the market reaction was positive for both stocks although CTL shares have since cooled to $23 (from $28 before the deal was announced) whilst LVLT is around $51 (from $47 before) which is 13% less than the implied takeover price. The consistent discount to the implied takeover price of the deal since it was announced suggests that the market has reservations about the deal closing as announced. The table below shows the implied value to LVLT of the deal shareholders depending upon CTL’s share price.

click to enlargecenturylink-level-3-merger-deal

CTL’s business profile includes the rural consumer RBOC business of CenturyTel and nationwide business customers from the acquired business assets of Qwest and Sprint. It’s an odd mix encompassing a range of cultures. For example, CTL have 43k employees of which 16k are unionised. The exhibit below shows the rather uninspiring recent operating results of the main segments.

click to enlargecenturylink-consumer-business-operating-metrics

CTL’s historical payout ratio, being its dividend divided by operating cash-flow less capex, can be seen below. This was projected to increase further but is expected to stabilise after the merger synergies have been realised around 60%. The advantage to CTL of LVLT’s business is an enhancement, due to its free cash-flow plus the expense synergies and the NOLs, to CTL’s ability to pay its $2.16 dividend (which represents a 9.4% yield at its current share price) at a more sustainable payout rate.

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For LVLT shareholders, like me, the value of the deal all depends upon CTL’s share price at closing. I doubt I’ll keep much of the CTL shares after the deal closes as CTL’s post merger doesn’t excite me anywhere as much as a standalone LVLT although it is an issue that I am still trying to get my head around.

As per the post’s title, I’m confused but content about events with LVLT.

Level3 hiccup

I have posted on one of my major holdings Level 3 (ticker LVLT), a facilities-based provider of a range of integrated telecommunications services, many times before, most recently here. One of the features of LVLT is its volatility and the past weeks have proven no exception. LVLT broke below $50 in late June to $47 before being buoyed to above $56 by a unsubstantiated rumour that the firm was “reviewing strategic alternatives to maximize holder value, including outright sale or large buyback”. After the quarterly report on the 27th of July when LVLT reported disappointing revenues but beat on the bottom line, the stock is now down below $50 again without any news from the firm on buybacks or M&A.

The revenue figures, particularly the increase in CNS monthly churn to 1.2%, was disappointing with the loss in accounts been driven by SME enterprise customers. One possible reason for the lack of focus was the temporary absence of the CEO due to a heart issue earlier in the year. As the chart below shows, LVLT does have form with revenue dips after initial successful M&A integration. Many, including me, thought that the current management was more on top of the issue this time around.

click to enlargeLevel3 Operating History 2005 to 2017e

Despite this disappointment, the revenue impact is likely to more contained this time around and I believe the case for LVLT in the longer term remains strong. I have reduced my revenue estimates in the graph above but the free cashflow that LVLT’s business is throwing off makes the bull case. My PV cash-flow analysis still has a price target of over $65, which represents a 2018 EV/EBITDA multiple of slightly below 10. Although the multiple is high compared to the incumbent US telcom giants, I think it is warranted given the quality of LVLT’s assets in an ever data hungry economy. The current favourable, albeit political, regulatory trends (net neutrality and the ban on lock-up agreements) are another plus factor.

I estimate that the FCF generated by LVLT could, in the absence of any M&A, mean the firm could afford $1 billion of buybacks in 2017, rising by $250 million a year thereafter. An aggressive buyback programme over a five year period, 2017 to 2021, could amount to approx $7.5 billion or approx 30% of current share count at an average price of $65.

In terms of M&A, management are obviously keen although they did emphasis the need for discipline. An interesting response to an analyst question on the Q2 call that any potential M&A fiber targets for LVLT trade at higher EV/EBITDA multiples was as follows:

“So as we look at M&A, and you mentioned fiber companies, we look at fiber companies post-synergies and believe that we are very good at acquiring and capturing synergies and moving networks together, combining networks, and creating value for shareholders through that. So I don’t feel that the M&A environment is necessarily constrained.”

One of the firms that the analyst was possibly referring to is Zayo, who interestingly just hired LVLT’s long time CTO Jack Waters. Zayo currently trade at over 10 times its 2017 projected EBITDA compared to LVLT currently at a 2017 multiple in the low 9s. Obviously a premium would be needed in any M&A so the synergies would have to be meaningful (in Zayo’s case with a 50% plus EBITDA margin, the synergies would likely have to be mainly in the capex line). COLT telecom is another potential M&A target as Fidelity’s self imposed M&A embargo runs out after 2016 (see this post).

A significant attraction however is for LVLT itself to become a target. One of the US cable firms, most likely Comcast, is touted as a potential to beef up their enterprise offerings to compete with the incumbents. Other potential candidates include the ever data hungry technology firms such as Google or Microsoft who may wish to own significant fiber assets and reduce their dependence on telecoms such as Verizon who are increasingly looking like competitors.

As ever with LVLT, the ride is never boring, but hopefully not ever ending….