It's easy to see why so many investors are bearish on Telecom giant CenturyLink Inc. (LUMN 9.16%). Its legacy business is expected to continue shrinking, and it has paid out more in dividends than it has earned in profits for years. Oh, and there's even more. Its success is almost entirely reliant on something few companies ever get right: successfully integrating a major acquisition while also delivering cost savings and growth.
Based on those things alone, no wonder more than 8% of its shares -- worth $2.1 billion in market value -- were sold short at last report. It's only a matter of time before the ax falls and CenturyLink's dividend gets cut, right?
Not so fast. It's more secure than the metrics make it appear, and count me in the minority of vocal investors who expect the dividend to survive for the long term. Let's take a closer look at why that's the case.
What about the payout ratio?
This is as good a place as any to start. Yes, CenturyLink's payout ratio, which measures the portion of earnings it takes to "pay" the dividend, has looked horrible for years:
But here's the rub: GAAP earnings aren't a cash flow metric. There are often a lot of things in the earnings number that aren't cash. Dividends, however, are almost always paid out in cash (with rare stock-funded dividend exceptions). When we look at CenturyLink's cash payout ratio, things look much better:
The cash payout ratio did spike last year around the time of the merger with Level 3 Communications, but in recent quarters, as the two companies have steadily integrated their operations, the portion of its cash flows used to pay the dividend has fallen back well below 100%.
Don't get me wrong: GAAP results still matter, but they aren't the only -- or even most important -- measures to use, particularly when it comes to cash flow analysis.
Can CenturyLink keep the cash coming?
This is the main question to answer when it comes to the dividend sustainability. And there are plenty of people, including my fool.com colleague Anders Bylund, who say CenturyLink's cash flows won't be sustainable.
He makes a good point with regard to the roughly $10 billion in net operating loss carry-forwards that came along with CenturyLink's acquisition of Level 3 Communications. The company is already benefiting, since it can use these carry-forwards to reduce its income tax bill for the next few years, which does temporarily -- one could say artificially -- increase cash flows.
But what about when those NOL carry-forwards are all used up? The lower corporate tax rates implemented at the beginning of 2018 are one thing that will make a difference, as fool.com colleague (and fellow bull) Jamal Carnette described.
But that's not all; it's becoming apparent the company is getting the Level 3 merger right. Last quarter, management said the integration has already delivered $675 million in combined savings, well on the way to the target of $850 million in annualized reductions.
Between lower corporate taxes and delivering on promised cost savings from the merger, CenturyLink's future cash flows look as if they'll be more than sufficient to continue supporting the dividend.
This year, management expects to generate $3.6 billion to $3.8 billion in free cash flow, leaving it with $1.3 billion to $1.5 billion after paying the dividend and spending 16% of revenue on capital expenditures.
Already working on debt reduction
Long-term debt jumped to $37.3 billion following the Level 3 acquisition, and at $2.25 billion this year, it costs the company nearly as much as it will pay in dividends. It's imperative that the company address that debt, particularly since rising interest rates will only increase the cost of servicing this debt.
There's excellent news on that front. The company recently announced it was calling for redemption of $1.34 billion in debt that costs between 7% and 7.5% in yearly interest. That will cut interest expense by at least $95 million on an annualized basis once it's fully paid off. CenturyLink said it would use existing cash (it had $700 million at quarter's end) and its revolving credit facility to redeem this debt, so it won't immediately wipe out all the interest expense, though the 4.9% rate on that facility is lower.
Business results are better than you think
The one unknown right now is how much growth CenturyLink will be able to deliver. In the second quarter, revenues actually declined 2.3%, raising some concerns.
However, there continues to be growing demand for data services. IP and data services increased 2.3%, and I.T. and managed services was up 5.2%. The growth in these segments wasn't enough to offset the 8% decline in voice-related services and 1.9% decline in transportation and infrastructure revenues. But these growth segments are more profitable, and that's already offsetting -- and then some -- lost revenue from declining voice-related businesses. CenturyLink's adjusted EBITDA margin was 38.5% in the second quarter, up from 35.7% year over year.
So far, the Level 3 merger is delivering as promised, with cost cuts and tax benefits paying off to help keep cash flows strong in the short term, while growth of higher-margin services and debt reduction should help support it over the longer term.
There are no promises that things will keep going swimmingly; frankly, they've gone almost perfectly since the Level 3 merger was closed. But as we have seen so far, CenturyLink's plan is working, and its cash flows are on track to be substantial enough not just to support the dividend but also to generate a meaningful margin of safety in the years ahead.