How Safe Is Lumen Technologies' Massive 10% Dividend Yield?

The last 10 years have been tough for income investors. The decade was bookended by major crises -- the Great Recession and the coronavirus pandemic -- that compelled the Federal Reserve to cut the Fed funds rate to near zero. Other interest rates across the board followed that benchmark downward, which left income investors little choice but to shift toward somewhat riskier investment vehicles like dividend-paying stocks.

Initially lured by the fact that tax rates on qualified dividend income are lower than the rates for interest from corporate bonds, many income investors have found there are quite a few stocks with massive dividend yields at their current share prices. However, companies can cut those payouts with no warning, and when share price moves push yields up toward the double-digit percentage range, that's often a sign the market thinks the payout is at risk.

Investors, then, need to be on the lookout for those diamonds in the rough -- companies with hefty dividend yields that the market fundamentally misunderstands. In my view, Lumen Technologies (LUMN -5.15%) is one of them.

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Lumen's dividend is safe for now

Lumen Technologies is a toxic name for many income investors, and that's understandable considering its history. Lumen was until recently the much-troubled regional telecom CenturyLink. Management changed its name in late 2020 with the explanation that it wanted to focus attention on its higher-growth fiber connectivity operations.

However, the new branding can't alter the fact that CenturyLink sliced its payout by 50% in 2019 after repeatedly assuring investors it would not do so. Many income investors adopt a "once burned, twice shy" approach after dividend cuts. However, Lumen's dividend today is safer than it looks.

The most straightforward argument against Lumen being able to keep making payments to shareholders at current levels is that its dividend payout ratio -- the percentage of net income that's paid out as dividends -- is high at 87%.

However, that's not the best way to measure in this case because dividends are paid out in cash, while net income includes non-cash expenses like depreciation and amortization. Due to its large capital expenditures, Lumen expects its non-cash charges to be approximately $4.8 billion.

Cash flow is supportive and will likely improve

A better metric for estimating this company's ability to pay would be its free-cash-flow dividend payout ratio, which factors out non-cash charges like depreciation and amortization. Free cash flow also accounts for long-term capital expenditures like property and equipment needed to keep the business functioning. Over the last four quarters, the free cash flow payout ratio has been a manageable 39%.

Data sources: Lumen's 10K and 10Qs

There are reasons to believe Lumen Technologies' free cash flow payout ratio can improve.

The simplest reason is the company's debt management strategy. The 2019 dividend cut was not made because the company was at the time unable to sustain its payout, but rather because management wanted to free up cash it could use to retire debt, which had climbed to nearly $40 billion after it acquired telecom Level 3 Communications. Lumen has reduced debt by approximately $2.7 billion in the last three years while taking advantage of lower interest rates to restructure its debt maturity profile. It now has more time before it has to pay back the principal.

The Level 3 acquisition allowed the company to transition away from declining consumer businesses like landline telephony and dial-up internet, and shift toward a focus on next-gen broadband internet and enterprise fiber connectivity. This hasn't been an easy evolution, but there are signs of light at the end of the tunnel, at least with respect to the company's declining top line.

For the third quarter, revenue attributable to Lumen's troubled consumer segment slid 4% year over year, but it was only off by 0.5% compared to the prior quarter. Its declines are starting to taper off. The company's strategy of focusing on high-speed internet upgrades to offset the loss of landline telephone customers is taking hold. Additionally, the Level 3 acquisition is starting to show signs of life; Lumen's Enterprise segment posted a 1% year-over-year gain -- and that was during a period time business spending was significantly impacted.

Lumen Technologies can continue paying its dividend at current levels, and its key operations are looking better. If you're looking for a high-yield turnaround play, put this stock on your watch list before the broader market catches on.