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This Dividend Stock Yields 9.6% and Has Room for Dividend Growth

By Adam Levine-Weinberg - Nov 29, 2020 at 9:38AM

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Dividend stocks with high yields and low payout ratios are worth investigating.

In early 2019, CenturyLink -- now known as Lumen Technologies ( LUMN 0.65% ) -- slashed its quarterly dividend by 54%, from $0.54 per share to $0.25 per share. Clearly, investors weren't pleased. Lumen stock has lost more than a quarter of its value since the dividend cut was announced.

Despite this rocky history, Lumen still has a very high dividend yield. Moreover, the dividend isn't just safe -- there's plenty of room to increase the payout starting in a year or two. That makes Lumen Technologies an attractive dividend stock.

A visualization of a telecom network over a city

Image source: Getty Images.

High yield and low payout ratio

Stocks with 9%-plus yields are pretty rare in today's market. Typically, a dividend stock's yield only rises to that level if the company is having trouble covering its payouts. To put it another way, high yields are frequently associated with a high probability of future dividend cuts.

That isn't the case for Lumen, though. Lumen's $0.25 per share quarterly dividend costs it $1.1 billion annually. Meanwhile, the company has been generating about $3 billion of annual free cash flow, although there is some volatility based on the timing of capital spending and cash restructuring costs. This puts Lumen's dividend payout ratio (as a percentage of free cash flow) well below 40%. While investors have varying philosophies about appropriate payout ratios, most agree that payout ratios below 50% are ideal for dividend stocks.

The deleveraging plan is working

CenturyLink reduced its dividend last year with the explicit goal of paying down debt at an accelerated pace. In addition to making the company safer for investors, management expected to reap massive interest cost savings from reducing the company's total debt burden and refinancing higher-cost debt to take advantage of low interest rates.

The company has made huge progress during 2020. It has refinanced billions of dollars of debt at lower rates while devoting the majority of its free cash flow to debt reduction. As a result, interest expense fell to $409 million last quarter from $496 million a year earlier. Lumen projects that net cash interest payments will come in between $1.62 billion and $1.65 billion this year, down from $2.13 billion in 2018.

Interest expense will continue falling rapidly over the next year or two. Just this week, Lumen issued $1 billion of unsecured debt at a 4.5% interest rate, allowing it to redeem $775 million of higher-cost debt. Furthermore, the company has $3.7 billion of debt maturing between now and March 2022. It should be able to repay the vast majority of this debt from free cash flow, saving over $200 million of interest expense annually.

Lumen is on track to get net debt within its target range of 2.75 to 3.25 times adjusted EBITDA by sometime in 2022. Once that happens, the company will likely modify its capital allocation plan -- with a strong possibility of dividend increases.

A solid core business makes this a great dividend stock

Lumen's revenue has been falling in recent years, putting modest pressure on its earnings. That's probably why this dividend stock carries such a low valuation and high yield: investors fear that Lumen is a declining business.

However, while some parts of the business are in secular decline (such as landline phone service and DSL internet), the company's revenue base is steadily shifting toward high-speed fiber-based communications services. As a result, Lumen's revenue is gradually stabilizing. The need to transmit large quantities of information quickly will only grow in the years ahead, providing the foundation for a return to long-term revenue and earnings growth.

In a few years, Lumen will likely become a cash taxpayer again, negatively impacting free cash flow. However, further reductions in interest expense, lower restructuring spending, and (eventually) EBITDA growth should offset this extra cash tax burden. That means Lumen could continue generating $3 billion or more of annual free cash flow.

Once Lumen reaches its leverage target, it will be able to increase its payout ratio and thereby grow its dividend. It will also have plenty of excess cash that it could use for acquisitions or share buybacks, enabling further dividend growth. Between its sky-high yield and solid prospects for future payout increases, Lumen Technologies is a compelling dividend stock.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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$12.37 (0.65%) $0.08

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