This Dividend Just Got Safer

Investors do love their dividends. But the cruel truth of the dividend investing game is: The higher the dividend yield, the more risky it is. As many novice investors find out, it's easy to get lured in by a juicy yield, only to have the company's operating metrics deteriorate, followed by a very painful dividend cut.

So when CenturyLink (LUMN 2.21%) stock sold off after its recent earnings report, its dividend yield shot up to 11.4%, by virtue of the stock price going down. With a yield over 11%, the market is saying that hefty payout is in danger of being cut. However, CenturyLink just declared a $0.54 quarterly dividend (in line with previous payments). Moreover, on its recent third-quarter earnings call, management said that the dividend will be even safer than first thought -- at least this year.

Is management to be believed, or is that yield too good to be true?

Image source: Getty Images.

Revenue, profits go in opposite directions

What spooked investors is CenturyLink's continuing revenue declines. In the third quarter, these declines occurred across basically all business lines -- not just copper-based voice landlines, which are known to be a declining business.

Data source: CenturyLink Q3 2018 presentation.

It's not hard to see why CenturyLink's stock sold off. Even though it's cheap by many metrics, that top line reveals a declining business across all segments -- even the potential growth drivers like IP and data services. Add in a high debt load of $36 billion, and the situation looks dire.

New CEO Jeff Storey, who was installed by activist investor Keith Meister, tried to reassure investors that at least some of these declines are intentional. He said in the conference call with analysts:

If it's a low-margin CPE [customer premise equipment] and then we're having to implement it and do other things and not generating a good return, it's distracting our organization and it's not giving us anything, so we'll stop it ... same thing is true for low-margin contracts ... there are also lower-margin products and things that are not in our strategy going forward, things around maybe IT consulting services and some of those other types of products that are not network-centric.

The company is deliberately exiting some unprofitable contracts in an effort to streamline the organization after CenturyLink acquired Level 3 Communications in a huge merger of equals last year.

Is the strategy working?

While no one likes to see revenue declining, Storey's strategy does appear to be working. In the quarter, CenturyLink's adjusted EBITDA figure grew to 6.9%, and EBITDA margin expanded from 35.5% to 39.3%. Free cash flow nearly doubled year over year, from $600 million to $1.16 billion.

These savings have come from $790 million in annualized synergies that the company has already achieved since closing on Level 3 last fall; its target is $850 million by the end of the year.

Additional savings to come

In addition to operating synergies, CenturyLink also lowered its capital expenditure plans for the rest of the year to between $3.15 billion and $3.25 billion, which is estimated to increase 2018 free cash flow to between $4.0 billion and $4.2 billion, up from a previous guidance range of $3.6 billion to $3.8 billion.

That's more than enough to cover the $2.3 billion in scheduled dividend payouts.

The question I'd have, however, is whether the company is cutting necessary network investments just to maintain the dividend in the near term. Explaining the capex cut this year, Storey said:

... we put in place a capital governance process comprised of senior leaders of the company, to ensure all investments are in line with business and financial objectives. The financial rigor and discipline led to several decisions to redirect investments. One example is our decision to minimize investment in our copper-based plant for the Consumer business. However, we are ramping up investments in our fiber footprint for Consumer to complement our microtargeting strategy. These changes in capital investment strategy led to some air pockets in spending, as some projects ramp down and others ramp up.

Skeptics abound, but I'm sticking with Storey

Investing in CenturyLink's tough turnaround is a bet on Storey's ability to allocate capital wisely and transform the business. While some decisions might make one quarter's financials look ugly, if they're in the long-term best interests of the company (such as cutting unprofitable contracts), they should benefit CenturyLink shareholders over the long run. With margins improving, I'm willing to give management the benefit of the doubt as it executes its plans.