CenturyLink's POTS of Gold

 

By JAY PALMER

online.barrons.com

MAY 22, 2010

 

The popularity of DSL is keeping telecom giant CenturyLink relevant

POTS, or plain old telephone service, as it's known to investors and those in the business are hardly in a growth mode. Telephone lines have been around for more than a century and, while there is some churn as consumers switch from one provider to another, the total number of customers is falling -- and is likely to continue declining -- as more people give up conventional lines in favor of cellular or voice-over-Internet systems.

CenturyLink (ticker: CTL), formerly CenturyTel, delivers local and long-distance phone service to 6.9 million customers across 33 states. It is a classic POTS operation, the third-biggest in the business. Yet, for all the industry woes, the company is doing well. It has rising profits, a rich cash flow and a dividend yield of 8.8%, one of the highest among Standard & Poor's 500 stocks. Equally important, there is reason to believe that the shares, now in the low 30s, could pop higher by about 20% in 2011.

"This is clearly a value stock," says John Apruzzese, a partner in Evercore Wealth Management. "It may be counterintuitive, especially given that industry revenues are falling and are expected to continue falling, but CenturyLink's stock has considerable appeal."

ONE REASON IS SIMPLE: In a shrinking, very fragmented industry long ripe for serious consolidation, CenturyLink has become a textbook consolidator. Its management team, considered one of the strongest in the telecom industry, has been buying rivals, cutting their costs and pumping out strong profits from them.

Over the past 18 years, the company has made 12 major acquisitions, including a $11.9 billion deal last year for Kansas-based Embarq; it paid less than $2,000 for each of that company's 5.8 million access lines. Now, it is acquiring Qwest in a $22 billion all-stock purchase expected to win regulatory approval next year. The pact values Qwest at $2,200 per line or roughly five times 2010 estimated enterprise value divided by Ebitda -- earnings before interest, taxes, depreciation and amortization, a measure of cash flow. (Enterprise value is stock-market value, plus net debt.)Both deals look like bargains, given the average $3,000 per line paid in POTS sales over the past five years.

The integration of Embarq is well under way, and CenturyLink management has become very good at wringing synergies from mergers. In each quarter since the acquisition closed last summer, CenturyLink has raised its cost-savings target, exceeding market expectations. It is now set to realize annual operating efficiencies from Embarq of at least $300 million in 2010 and more than $375 million in 2011.

SOME WORRY THAT CENTURYLINK  has taken on too much, buying Qwest before the Embarq synergies have been achieved. Given the company's track record, that may be worrying too much. Certainly, the payoff from the Qwest deal lies further off, but cost-cutting will pad the company's bottom line. Expectations are that at least 7.5% of Qwest's operating costs can be eliminated through efficiencies and, if past history holds, that is likely to prove a minimum. Moreover, given that Qwest's operations are weighted towards the West Coast and CenturyLink's to the East, there could be greater-than-usual gains from a new ability to create national customer offerings.

"Deals like Embarq and Qwest ultimately deliver considerable savings and synergies," says Glen Post, CenturyLink's president and CEO. "Integration of acquisitions is a core competency of ours. In the end, we are positioned much better to compete to scale, something crucial in this industry."

Given the old adage that it's hard to cost-cut your way to success, it's a good thing CenturyLink has one more string to its bow. Though voice services are a shrinking business for telecoms, the same isn't true for data -- which, though generally associated with cable, can also be carried over land lines. Using a dial-up modem to get that data is painfully slow and technologically outmoded. But digital subscriber lines -- a generic name for a family of technologies that carry digital data over phone lines -- is still a growth business.

In theory, DSL has a big disadvantage, compared with cable: slower Internet-connection speeds. But that isn't always the case, in part because cable users in a local area share the same "pipe," and speeds slow when lots of people are connected at the same time. Against that, DSL has two advantages. It generally (if not always) costs less, and it remains the only reasonably priced decent Internet connection for those without cable.

According to the Telecommunications Industry Association, cable has a lead in total subscribers -- but over the past few years, subscriber growth for both technologies has been virtually the same. Given that forecasts point to further large increases in the number of high-speed data subscribers over the next five years, and given that to all intents and purposes DSL can offer the same services as cable, digital subscriber lines probably will continue to proliferate. The $7.2 billion government-spending stimulus on high-speed Internet will aid growth.

CenturyLink is pushing data services hard. In the first quarter, it recorded a record 70,000 DSL net-adds -- gains where the fees charged flow more or less directly to the bottom line. Over the course of the year, the company is expected to sign more than 200,000 new DSL customers.

"THE METRICS AREN'T THE SAME  for DSL and cable, but, when you get right down to it, the two technologies are very competitive. And CenturyLink is in a good position to grow this business and data revenue," says Evercore's Apruzzese. "Right now, the company is selling data services to just over 30% of subscribers. I see this going to 37% this year, and well over 40% by the end of 2011."  Explains Post: "Data will grow larger and larger. It's where the future is."

In the current year, the Embarq acquisition probably will boost CenturyLink voice revenue 35%, to about $2.7 billion. Data revenue probably will rise almost 60%, to $1.9 billion, while sales of network access to businesses will climb 25%, to $1.4 billion. Overall, this will boost sales 40%, to about $7 billion.

For all that, earnings will be down, perhaps dropping to $3.35 a share from $3.50 in '09. That reflects the rise in the number of outstanding shares after acquisitions. Generally, earnings per share is considered a poor measure of performance for POTS companies. Better measures are either Ebitda or net income, both of which are expected to jump more than 40% in 2010.

THE BOTTOM LINE:  CenturyLink's rising profits, rich cash flow, strong management and 8.8% dividend yield give it appeal. The shares could pop higher by about 20% in 2011.

That is fueling growth in the company's free cash flow, or cash on hand that is theoretically available for payouts to stakeholders. CenturyLink's free cash flow is projected to rise from $460 million last year to more than $700 million this year, boosting per-share cash flow from $5.10 to about $5.25. This money funds not only acquisitions and capital spending, but also CenturyLink's $2.90 dividend, up from $2.80 last year.

Though CenturyLink is clearly a cash cow and an interest play, the stock also holds potential for capital appreciation. Timothy Horan, an analyst with Oppenheimer, says that the shares historically have been stuck in a narrow range whenever a big acquisition is pending. However, in the 12 months following the close of a deal, CenturyLink shares typically rise an average of 19%.

If history repeats, that would have a sweet ring for investors after the Qwest transaction is completed.