Shares of internet service provider CenturyLink (NYSE:CTL) are plumbing fresh lows after reporting a solid conclusion to 2018 and slow but steadily improving profitability. The real news, though, was the surprising -- but also not-so-surprising -- announcement that the annual dividend is being cut from $2.16 per share to $1.00 per share. While the previous yield was a ridiculous 14%, management had indicated it was on solid footing. The new yield is still a generous 7.7% as of this writing, and CenturyLink has new plans for that cash going forward. Is the new payday amount sustainable? The short answer is yes, but there are question marks surrounding the why.

First, a review of 2018

After CenturyLink's takeover of Level 3 Communications in 2017, investors may have been hoping for better sales results. That didn't transpire this year as the telecom's legacy services continue to slide. The good news, though, is that the company completed its cost-cutting initiatives post-Level 3 merger a couple of years ahead of schedule, providing a big boost to free cash flow (money left over after basic operations and capital expenditures are paid for).

Metric

Full-Year 2018

Adjusted Full-Year 2017*

Change (YOY)

Revenue

$23.44 billion

$24.13 billion

(3%)

Cost of services and products

$10.86 billion

$11.50 billion

(6%)

SG&A expenses

$4.17 billion

$4.72 billion

(12%)

Capital expenditures

$3.18 billion

$4.23 billion

(25%)

Free cash flow

$3.86 billion

$1.57 billion

146%

Total dividends paid

$2.31 billion

$1.45 billion

59%

Data source: CenturyLink. *Adjustments to account for the Level 3 acquisition. YOY = year over year. 

Because of the aggressive cost-cutting associated with the integration of Level 3, CenturyLink's tenuous-looking dividend actually seemed like a safe bet -- even though total dividends paid out ballooned because of the extra shares CenturyLink issued to help pay for the acquisition. The dividend payout ate up about 60% of free cash flow last year.

Management said it expects free cash flow to drop to between $3.1 billion to $3.4 billion in 2019, in large part due to increased capital expenditures (purchase of property and equipment) of $3.5 to $3.8 billion -- thus the surprise from some investors that the payout got a haircut, as the $2.16 per share a year would have put dividends paid at roughly $2.3 billion in total: still well within the free-cash-flow guidance. With the payday dropping to just $1.00 a share and $1.08 billion in total consideration, the payout ratio to cash flow will be around 30%. Long story short, the new dividend yield is easily sustainable assuming nothing drastically deviates from CenturyLink's expectations.

Check out the latest CenturyLink earnings call transcript.

The back of an internet modem with an ethernet connection cable plugged into it

Image source: Getty Images.

The call with management gets intense, and personal

But the question remains: Why make the cut if it was still doable? David Barden, an analyst at Bank of America, asked for more details on the earnings call:

Let me push back a little bit and say that I think that pretty much everyone that bought the stock from early December -- when Neel [Dev, the chief financial officer] was at the conference talking about a comfort level in the low 70s payout ratio range -- bought the stock because of the dividend, and now that you've cut the dividend, you're gonna create an incremental billion dollars of cash flow per year over a three-year time frame, that's $6 billion of cash flow, but you only have $3.6 billion of debt over that time frame maturing, all of which trades above par, all of which has a yield that's several hundred basis points below where the new equity yield is gonna be. What is the reason -- how do you create value for your equity holders by creating this incremental cash flow for which there doesn't really seem to be a lot of immediate uses that are higher and better than returning it to the shareholders, either through maintaining the dividend or the stock buyback program? 

Fair question. Where will that cash go? We'll have to wait and see, as the answer given was somewhat vague. However, it would seem that debt reduction and investment back into the business will be priorities. That could be a good move as total long-term debt sat at $35.4 billion, and cash and equivalents were $488 million at the end of 2018.

Additionally, CenturyLink also took an impairment charge (a writedown on a business's value) of $2.73 billion on the "consumer business segment" in the fourth quarter. That underscores the pressure CenturyLink has been under as the way households communicate has rapidly changed the last decade. More pressure is on the way with the initial launch of 5G mobile networks, like Verizon's 5G Home, which is meant to be a replacement for traditional broadband internet service.

Thus, while the timing of the dividend drop may come as a surprise, the payout reduction CenturyLink just enacted makes sense. If the internet service provider is to remain a healthy and viable company over the long term, it needs cash to shore up its balance sheet and to reinvest back into new and improved internet services. The good news is, with a 7.7% yield, it still looks like a pretty good income-generating stock.