Published by Nicholas McCullum on March 27th, 2017
Joel Greenblatt is one of the most famous investors of all time.
As the portfolio manager and co-Chief Investment Officer of Gotham Asset Management, Greenblatt oversees a ~$15 billion portfolio of long/short equity investments.
Fortunately, we can piggyback off of Greenblatt’s success (and substantial research budget) by analyzing his 13F filings with the U.S. Securities & Exchange Commission. These filings describe the holdings of Gotham’s portfolio on a quarterly basis.
One of Greenblatt’s more intriguing holdings is CenturyLink, Inc. (CTL)
Gotham Asset Management holds 835,718 shares of CenturyLink with an aggregate market value of $20 million. Further, CenturyLink is Joel Greenblatt’s highest-yielding stock.
This article will analyze CenturyLink in detail.
CenturyLink is a telecommunications and IT services company headquartered in Louisiana. The company can trace its roots to a predecessor company known as Oak Ridge Telephone Co., which was sold for $500 in 1930 and had 75 paid subscribers.
Today’s CenturyLink is a much larger entity, with a market capitalization of $12 billion. The company reports earnings in two segments – Business and Consumer.
CenturyLink’s Business segment is the largest, generating $2.5 billion (64%) of fourth quarter revenues. It also has more inherent operational diversity than the Consumer segment.
More details about CenturyLink’s Business segment can be seen below.
Source: CenturyLink Fourth Quarter Investor Presentation, slide 12
CenturyLink’s Consumer segment is dominated by two subsegments: Broadband services and Legacy voice services. It is a smaller part of CenturyLink’s overall business, contributing $1.4 billion (36%) of fourth quarter revenues.
More details about CenturyLink’s consumer segment can be seen below.
Source: CenturyLink Fourth Quarter Investor Presentation, slide 13
Current Events: Level 3 Communications Merger
On October 31, 2016, CenturyLink announced a merger with Level 3 Communications (LVLT) in a cash-and-stock deal that is valued at $34 billion (including the assumption of debt). The implied valuation in this transaction is ~12.0x Level 3’s trailing-twelve-months EBITDA.
Considering that CenturyLink’s current market capitalization is just over $12 billion, this is a huge transaction for this company. It is also the largest acquisition in CenturyLink’s corporate history.
The deal is lucrative for the shareholders of Level 3 Communications. Each shareholder receives $26.50 per share in cash, as well as 1.4286 shares of CenturyLink for every share of Level 3 Communications. The deal had an implied value of $66.50 at the time of the announcement, which represented a 42% premium over the prevailing market value of Level 3 Communications stock.
More details about the acquisition can be seen below.
After the merger, CenturyLink shareholders will own 51% of the combined company and Level 3 Communications shareholders will own the remaining 49%.
The qualitative benefits of the merger are substantial. The combined entity will benefit from a much larger network, which is visualized below.
The pro-forma entity will also have a clean balance sheet, with a net leverage ratio of less than 3.7x. The company is also expected to maintain the current CenturyLink annual dividend payout of $2.16 per share, which is a yield of 9.5% based on CTL’s current market price of $22.76.
Further, the pro-forma CenturyLink will benefit from $10 billion of Level 3’s net operating losses (NOLs) which can be used as a tax credit against future operating earnings. Management expects to use less than $2 billion per year of these tax credits, which helps spread out the benefit of this one-time financial occurrence.
The board of directors of both CenturyLink and Level 3 Communications voted unanimously in favor of the transaction. Quotes from the chief executives from each firm can be seen below.
Many of the near-term growth prospects for CenturyLink are centered on the pending merger with Level 3 Communications.
The merger will substantially increase the size of the pro-forma company’s fiber network. Moreover, the new CenturyLink will have the second highest number of global enterprise customers behind AT&T (T). Since CenturyLink’s Business segment is already its largest, it appears that the company is playing to its strengths.
Many of Level 3 Communications’ current global enterprise customers are high-quality businesses. Consider the company’s top three revenue generators:
After the merger, the new CenturyLink will be able to leverage these relationships and potentially cross-sell services to increase the company’s top line.
CenturyLink will also benefit from a much larger number of on-network buildings after the merger is complete. The pro-forma company is estimated to have 75,000 on-network buildings, which is an increase of 75% from today’s figure.
Many of these added buildings are in regions that CenturyLink had no exposure to previously, which benefits the long-term expansion prospects of the newly formed company.
As long as CenturyLink’s management can successfully execute on this transition, then the company’s growth prospects appear robust for the foreseeable future.
Competitive Advantage & Recession Performance
As a telecommunications company, CenturyLink benefits from some of the highest barriers to entry of any industry. The telecommunications industry is capital-intensive and highly regulated, both of which discourage new competitors from entering the market.
However, CenturyLink’s competitive advantage is not as strong as the larger telecoms like Verizon and AT&T.
The company seems to be recession-resistant. CenturyLink performed well during the Great Recession of 2007-2009.
- 2006: $3.07 of adjusted earnings-per-share
- 2007: $3.13 of adjusted earnings-per-share (2.0% increase)
- 2008: $3.37 of adjusted earnings-per-share (7.7% increase)
- 2009: $3.46 of adjusted earnings-per-share (2.7% increase)
- 2010: $3.41 of adjusted earnings-per-share (1.4% decrease)
CenturyLink emerged virtually unscathed during the financial crisis. The stock appears to perform well during more general economic recessions.
Valuation & Expected Total Returns
Total returns for CenturyLink shareholders will come from changes in valuation multiples, current dividend yield, and earnings-per-share growth.
CenturyLink reported 2016 adjusted earnings-per-share of $2.45. The most recent closing price of $22.76 represents a 9.3x multiple of 2016’s adjusted earnings. CenturyLink is trading at a very attractive valuation right now, likely because of underwhelming business performance and the uncertainty surrounding the merger with Level 3 Communications.
The valuation situation is similar on a forward-looking basis. Management’s guidance for fiscal 2017 was underwhelming, as they expect adjusted earnings-per-share of $2.10-$2.30. Taking the midpoint of this range ($2.20), and CenturyLink is trading at 10.3x 2017’s expected adjusted earnings-per-share.
The following chart compares CenturyLink’s current valuation to its historical averages.
Source: Value Line
CenturyLink is currently trading at a price-to-earnings ratio that hasn’t been seen since the financial crisis. If the merger with Level 3 Communications goes according to plan, then the market will likely assign a higher premium to this stock and its shareholders will be rewarded by an expansion in the price-to-earnings ratio.
CenturyLink currently pays a quarterly dividend of $0.54 per share – or $2.16 per year. With the stock’s current price sitting at $22.76, CenturyLink has a very high dividend yield of 9.5%. Investors that buy right now can ‘lock-in’ this substantial return as long as the company does not cut their dividend.
Turning to earnings-per-share growth, CenturyLink’s track record has been less than fantastic. The company’s per-share net income has actually decreased over the past decade from $3.07 in 2006 to $2.45 in 2016.
Looking ahead, I would conservatively estimate that CenturyLink can grow their bottom line by at least 2% over the long run, assuming management can successfully execute on the merger with Level 3 Communications.
This gives investors total returns composed of:
- 9.5% dividend yield
- 2% earnings-per-share growth
For total returns of ~11.5% before the effect of valuation expansion.
Right now, CenturyLink currently has a dividend yield of 9.5%. This might be a red flag for some investors, as ‘chasing yield’ is one of the surefire ways to consistently lose money with dividend stocks.
However, chasing yield is a bad thing on average. There have certainly been great investments in the past that had high dividend yields and delivered great total returns.
The key differentiator is valuation. The only way a high dividend yield is sustainable is if the company is trading at an almost unreasonably low valuation.
Fortunately, this is the case with CenturyLink. Since the company is priced at 9.3x 2016’s adjusted earnings-per-share, a 9.5% dividend yield is possible without an exceedingly high payout ratio.
Based on 2016’s adjusted earnings-per-share of $2.45, CenturyLink pays out 88% of their earnings as dividends. While this is on the high side for the stock market in general, it is not unreasonable for a telecommunications company. For context, AT&T’s payout ratio is ~90% and Verizon’s payout ratio is ~70% according to Yahoo! Finance.
An 88% payout ratio does not leave a significant margin of error if earnings decline. Further, CenturyLink cut its dividend in 2013. These factors together lead me to believe that CenturyLink might not be the safest stock for income investors, particularly if the company encounters any obstacles in the integration of Level 3 Communications.
From a quantitative perspective, CenturyLink looks like an appealing investment right now. The company pays a healthy 9.5% dividend and trades at a rock-bottom valuation of 9.3x 2016’s adjusted earnings-per-share.
The qualitative aspects of CenturyLink are not as appealing. This stock is shrouded in uncertainty. Much of the company’s near-term growth prospects are hinged on the completion (and successful execution) of the merger with Level 3 Communications.
As such, I would advise having a thorough understanding of the merger and the risks associated with it before initiating a stake in CenturyLink.