2017 was a year to forget for CenturyLink (NYSE:LUMN). The telco posted four straight earnings misses, struggled with declining consumer and enterprise revenues, and was slammed by lawsuits regarding fraudulent billing practices. Some investors also questioned the benefits of its acquisition of Level 3 Communications, which closed in early November.
CenturyLink's stock fell nearly 30% this year, and it could still struggle in 2018. Let's examine the main bullet points which investors should keep an eye on.
Integrating Level 3
CenturyLink's $34 billion takeover of Level 3 makes it the second largest fiber provider in the US after AT&T (NYSE:T). The combined company now reaches over 350 metropolitan areas with more than 100,000 fiber-lit, on-net buildings -- including 10,000 in the EMEA (Europe, Middle East, and Africa) and Latin America.
The Level 3 acquisition transforms CenturyLink in two main ways. First, it becomes more of a networking company than a phone company, with about 75% of its core revenues coming from enterprise customers. It offers a wide variety of connectivity solutions with Amazon Web Services (AWS), the biggest cloud infrastructure platform in the world.
Second, it will widen its moat against AT&T and Verizon (NYSE:VZ) with a broader portfolio of network solutions and IT services for enterprises, small businesses, government agencies, retailers, and consumers.
During last quarter's conference call, CEO Glen Post stated that the Level 3 integration was "well under way and on track with our expectations," and that the sales teams would be "fully integrated in the first quarter of 2018."
Post also said that the two companies' migration onto a single ERP (enterprise resource planning) system should occur in the second quarter. But there are plenty of other systems and processes to integrate, which Post expects to complete within "approximately three years."
CenturyLink expects the deal to be accretive to its free cash flow within the first year, and generate $975 million in annual run rate cash synergies. But it will initially weigh down its earnings. That's why analysts expect the company's revenue to rise 34% next year (which starts on Jan. 1), but its earnings to drop 27% on acquisition-related expenses.
Defending its dividend
CenturyLink's declining earnings raise serious concerns about its forward dividend yield of 12%. That dividend consumed a whopping 373% of its earnings and 254% of its free cash flow over the past 12 months. It previously slashed its dividend in 2013, and hasn't raised it ever since.
By comparison, AT&T and Verizon respectively spent 93% and 59% of their earnings on dividends over the past 12 months.
During last quarter's conference call, Post stated that the expected synergies and tax savings from the merger with would "enhance our adjusted free cash flow generation and lower our dividend payout ratio." He also stated that CenturyLink could "continue to pay the dividend, while investing in growth and in our network, and as we de-lever our balance sheet."
CenturyLink generated about $462 million in free cash flow over the past 12 months, so generating almost a billion dollars in annual cash synergies could significantly reduce its cash dividend payout ratio. However, this also assumes that CenturyLink doesn't get hit by acquisition indigestion.
Getting its debt levels under control
CenturyLink's debt levels are also getting uncomfortably high. The company finished last quarter with $24.9 billion in long-term debt, up from $18.2 billion at the end of 2016. That gives it a net debt to adjusted EBITDA ratio of 4.2 on a pro forma basis (excluding acquisition-related expenses) over the past 12 months, which exceeds its own target leverage range of 3 to 4.
Last quarter, CFO Sunit Patel stated that CenturyLink was "confident" that it could "drive down" its leverage ratio every year, but that could be tough as the company simultaneously integrates Level 3, expands its network services, and tries to protect its dividend.
More insider buying
On the bright side, CenturyLink's insiders seem confident that 2018 will be a much brighter year. Over the past 12 months, insiders purchased 5.87 million shares on the open market but only sold about 664,000 shares.
The key takeaways
I personally wouldn't buy CenturyLink at these levels since there's simply too much uncertainty about the Level 3 integration, its dividend, and its debt levels. Its 12% yield looks tempting, but I'd rather own AT&T or Verizon for their 4%-5% yields and sleep better at night.