CenturyLink (CTL +0.99%) has become a battleground stock among income investors. On one hand, the company's outsized dividend attracts yield-hungry investors. On the other, bearish investors cite increased pressure as more consumers cancel their landline telephone connections and cut the cord. Eventually, they argue, the company will be forced to cut its massive dividend and the share price will plummet.
For the most part, Mr. Market agrees with the bears as these concerns have weighed heavily on the stock price: Over the last five years, shares are down approximately 50%. The upside is that shares currently yield 11.7%, which is nearly 10 times the yield of the greater S&P 500. But what does the future look like?
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The bearish argument for CenturyLink tends to focus on residential consumers, often comparing the company to Frontier Communications and Windstream Holdings, both of which had to cut their dividends and have seen their stocks plummet afterward. However, these bears are wrong on two accounts, and it's possible shrewd investors can take advantage of their misconceptions.
CenturyLink isn't Windstream or Frontier
The death of residential cable and legacy phone lines is an easy argument, but it's not as applicable to CenturyLink as Frontier and Windstream. CenturyLink is now more tethered to enterprise clients (businesses). As of last quarter, which includes the Level 3 acquisition, residential consumers comprised only 23% of total revenue, down from 33% last year. Additionally, the bulk of consumer-based revenue is now in broadband, a growth area for the company.
At approximately two-thirds of CenturyLink's revenue haul, the business segment is more important to investors. Although it's slightly disconcerting that pro forma (incorporating Level 3) business revenue decreased 1% over the prior year, management's free cash flow guidance is encouraging as this metric is the most important measure for dividend sustainability.
Management expects free cash flow of $3.25 billion at the midpoint, which is more than adequate to service the estimated $2.3 billion in dividends. While it's important to note that this figure includes net operating loss carry-forwards, reducing taxes paid for the next several years, the recently enacted Tax Cuts and Jobs Act will significantly lower tax bills afterward.
Fellow Fool Billy Duberstein did an in-depth workup using estimates from both companies, and also came to the conclusion CenturyLink can service its dividend, although his margin of safety was lower, most likely due to lower synergy assumptions.
Dividend cuts are not as negative as you may think
Let me be clear, I do not think CenturyLink's dividend is at risk anytime soon. However, even if I'm wrong, that does not mean CenturyLink investors will be subject to negative returns. A study from Morgan Stanley shows that from the 10 years ended March 2016, companies that were expected to cut their dividend underperformed both the market and their sector. However, those that eventually did go on to cut their dividend saw their shares outperform both benchmarks in each of the 6-month, 12-month, and 24-month periods following the cut.
The hypothesis is that the company's dividend cut affords it the capital to service debt, take on more-profitable projects, etc., which attracts a new class of investor. Additionally, the initial sell-off and the prior period of underperformance often result in cheap valuations, all other factors equal. As a hypothetical, CenturyLink could cut its dividend in half, saving approximately $1.15 billion in cash annually and eliminate most doubts that it can service its dividend going forward. And at 5.9%, CenturyLink would still be one of the larger yielders in the S&P 500.
Notable exceptions to this study's conclusion are Windstream and Frontier, which have both underperformed after cutting their dividends due to deteriorating fundamentals. As earlier stated, CenturyLink is not in the same position due to its business-focused operations.
I think the upshot is that this will not occur, but dividend cuts aren't necessarily a negative. While I think it's a folly to say that the stock is going to turn into a growth juggernaut, it appears the company will continue to service its dividend for the foreseeable future while posting minimal capital gains -- and with a near 12% yield, that's likely enough for most income-focused investors.
