Lumen Technologies Stock: Taking the Bear Case (NYSE: LUMN)

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Lumen Technologies (LUMN) is popular with many high yield investors due to its 8.1% dividend yield which is well covered by free cash flow. That said, there are also compelling arguments against the stock, as evidenced by its 10.3% short position:

#1. Lumen Technologies has a history of significant underperformance.

While management’s sales pitch that the stock is significantly undervalued and the company will return to growth in the next few years sounds great, the bottom line is that revenue has been steadily declining. and that the company continued to persistently underperform the broader stock market:

Lumen Technologies Prices and Revenues
Data by YCharts

Despite management’s successful efforts to cut costs, resulting in strong free cash flow generation, revenues continued to decline even on a reduced COVID-19 basis in 2021. This persistent decline is likely the main driver of the management’s decision to reduce its target and increase its commitment to growth investments.

As the CEO admitted during the second quarter earnings call:

I’ll be the first to acknowledge that we’re not yet seeing the pace of growth we expect from these initiatives, but we remain confident in the opportunity and are streamlining our focus and investing more to drive that growth.

What’s more, it’s not just recent poor performance that bothers many investors, but the fact that the company’s legacy under its former CenturyLink name was also poor relative to the broader stock market (SPY) before it changed. the name in LUMN in 2020. :

Return of LUMN against SPY
Data by YCharts

While we don’t necessarily care about past performance, many investors are wary of a company – and management team – with such a poor track record, as it often indicates a business model, management team, or two lower.

#2. LUMN’s 8.1% dividend could be at risk.

Management also announced a dividend cut next year after agreeing to the terms of two major asset sales to Stonepeak and Apollo (APO) when it said their dividend payout ratio “will be under pressure” in due to the free cash flow dilution of the agreement, management’s planned growth investments, loss of synergies due to asset sales and the expected depletion of NOLs due to the low tax base of the assets sold.

For many investors who have suffered a dividend cut in the past, this likely served as the final straw that prompted them to rush into the stock following the earnings call. Given LUMN’s high dividend yield, it attracted a large number of dividend investors and an investor base, and rumors of a dividend cut likely drove many of them out of the stock.

Why We’re Still Bullish on Lumen Stock

While these concerns are certainly valid, we believe they will ultimately not derail the investment thesis for the following reasons:

1) The growth story is subject to change

Management is making a big bet here by selling assets that will prove so dilutive to free cash flow. Given that these assets were sold at a clear premium to Mr. Market’s valuation of the company and are in a much stronger financial position, the chances of LUMN realizing its intrinsic value are quite high. in our opinion.

Additionally, the assets LUMN plans to invest in are among its best and are benefiting from strong tailwinds driven by the rising tide of disruptive technologies. Management expressed overwhelming confidence that its investments in its best fiber assets would yield strong returns, saying:

The jury is out on this one. When we invest in consumer fiber, we’re taking ownership and driving profitable growth. As I mentioned, upon closing of the Apollo transaction, approximately 70% of our remaining mass market footprint will be the type of urban and suburban markets that are best addressable with Quantum Fiber solutions…while we remain strategic and disciplined in our approach, expecting to build faster and at scale in the markets we prioritize for investments in Quantum Fiber.

Additionally, while we expect top line growth to resume after asset sales close next year, we expect net income to grow even stronger. The company is executing cost control well, it expects its fiber investments to generate a high margin, and it is moving towards a fairly aggressive stock buyback capital allocation strategy, which it has already executed with an impressive deployment of $1 billion in cash that has reduced outstanding float by approximately 7% at prices well below management’s (and ours’) estimates of fair value.

As a final potential wildcard, the company could very well be acquired by a larger investor or at the very least a large part of it could be, since its assets are very valuable and very undervalued on the current market. A company with much greater financial resources than LUMN could likely generate significant incremental returns and add significant value to its asset base, similar to what Apollo is about to do with the assets it is on. about to acquire from LUMN and what American Tower (NYSE: AMT) made with assets acquired from Telefonica (NYSE:TEF). Such additional sales would likely prove highly accretive to LUMN shareholders at current valuations.

2) Dividend cut fears are overblown

First, while we’re not excited about a potential dividend cut, it’s not a thesis breaker for us for three reasons:

1. Ultimately, a dividend is simply a capital allocation decision. If management can generate strong shareholder returns through buyouts and growth investments, it should. While we certainly prioritize dividend income at High Yield Investor, we are also focused on generating attractive total returns. We would rather receive a lower dividend yield and generate significant total return outperformance than receive an exorbitant dividend yield with significantly lower long-term underperformance.

2. In addition, we still believe that the dividend yield will be attractive (5% or more relative to the current share price) in the event of a drop in the dividend. Management is committed to paying an attractive dividend, as it stated during the second quarter earnings call:

We have long asserted that we believe that cash return in the form of a dividend is an appropriate capital allocation vehicle in a business such as ours. However, with these transactions, the profile of our business is changing and will change rapidly in the future as we look to investing for growth and further streamlining the portfolio. I realize this will put pressure on our dividend after these transactions close and the further we move forward with our investment program. But for now, we are not faced with this compromise decision, and we will continue to balance the return of cash to shareholders through dividends and buybacks as we accelerate our investments in business and quantum fiber growth.

3. Last but not least, management recently stated that they ultimately have no intention of cutting the dividend. During its third quarter earnings call, management made it clear that maintaining the dividend was one of its top priorities:

…we do not intend to change our dividend, which we believe is sustainable at the $1 per share level. Although our payout ratio will likely increase in the near term as we rationalize our asset portfolio and invest in Quantum and Enterprise opportunities, we expect our focused operations to provide the foundation for revenue growth. 2-3 years from now, what we expect will result in a more normalized dividend payout ratio over time.

The CEO doubled down on this at a recent investor conference, saying:

we do not intend to reduce our dividend. And our Board of Directors believes this is an important part of our shareholder value. Our board and I believe this is sustainable in dollars per share. So we were very comfortable with the dollar per share. We expect payout ratios to increase in the near term as we make this transition to growth, and — but we will also more or less maintain our current leverage ratios, more or less stable through the cycle of investment. We still believe that our ratio of 2.75 to 3.25 times net debt to adjusted EBITDA is the right long-term ratio. But again, we will more or less maintain the current level during the next period of the investment cycle.

3) LUMN stock is very cheap

Yes, the company has a history of serial underperformance. However, it is now extremely undervalued by any measure: its free cash flow yield is in the 1920s, its dividend yield is 8.1%, its EV/EBITDA ratio is significantly lower than its recent asset sales, and its remaining assets are among its most promising for more targeted growth investments.

Key takeaway for investors

LUMN may not have the best sales or management team, but they don’t need to set any records given the safety margin present in the stock right now. There is a large short interest in the stock, likely awaiting a dividend cut. Whether or not this materializes is debatable, but for now management seems focused on maintaining its dividend and its reduction in the number of shares by 7% at the end of 2021 is certainly helping to make the dividend even easier to maintain.

Time will tell if LUMN’s pivot to growth is successful, but the margin of safety is so large here and the remaining assets are on average higher quality than those he sold, so the odds certainly seem to favor the longs versus the shorts.

LUMN is the asymmetrical “heads I win, tails I don’t lose much” type of bet we like to make at High Yield Investor.

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