Over the past two years, Lumen Technologies (LUMN +2.87%) has moved aggressively to cut its interest expense by paying down debt and refinancing what it still owes at lower interest rates. This strategy has already had a significant impact, and the company is on track to make more progress in 2021. As a result, it will be freeing up cash flow that could be used to fund dividend growth.
Interest expense has already plunged
In early 2019, Lumen -- then known as CenturyLink -- cut its dividend by more than 50%. This move displeased income investors who had favored the stock for its extremely high yield. However, it enabled the company to start cleaning up its balance sheet.
Over the past two years, Lumen has used the majority of its free cash flow to pay down some of its high-cost debt. Meanwhile, it has capitalized on the current low-interest-rate environment and its improving balance sheet to refinance other high-cost borrowings. As a result, its interest expense declined from nearly $2.2 billion in 2018 to around $1.7 billion in 2020.
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In the third quarter of 2020 -- Lumen's most recently reported quarter -- interest expense fell to $409 million. Furthermore, the company continued its refinancing efforts in the last few months of the year. As a result, it likely entered 2021 with interest expense at an annual run rate of no more than $1.6 billion.
A big year for refinancing and debt reduction
Last week, Lumen's Level 3 Financing subsidiary issued $900 million of sustainability-linked notes due in 2029 at a very favorable 3.75% interest rate. It immediately turned around and issued redemption notices for an equivalent amount of debt due in 2024 that carries a 5.375% coupon. This refinancing will save the company about $15 million a year.
Lumen also has three significant debt maturities between June and December of this year, totaling $2.3 billion. It should be able to pay off those notes using its free cash flow. Getting those off the books will reduce its annual interest expense by another $151 million.
Finally, Lumen has been systematically redeeming the "baby bonds" issued by its Qwest subsidiary, which all carry interest rates in excess of 6%. It redeemed nearly $1 billion of baby bonds last quarter alone, and will be permitted to redeem another $235 million at par as of Feb. 1. An additional $977 million of baby bonds will become eligible for redemption on Sept. 1. Assuming Lumen can refinance this debt at a 4.5% rate (in line with its most recent unsecured debt offering from two months ago), it would save $25 million a year.
Lower interest expense will enable dividend growth
While revenues from some aspects of Lumen's business (like voice service and low-speed DSL) are declining, most of the company's business is very stable. It owns a huge high-speed fiber network that plays a critical role in supporting global communications. With operating income likely to grow (or at least remain flat), lower interest expense should drop straight to the bottom line.
Since its early 2019 dividend cut, Lumen has been paying out less than 40% of its free cash flow to investors. That's a very conservative payout ratio for a stable business. This alone provides ample room for dividend growth once the company reaches its debt-reduction target (likely in the second half of 2022).
As interest expense continues to decline -- and as spending that was delayed due to the pandemic finally hits Lumen's top line -- free cash flow could grow further. That would provide additional support for future dividend increases.
Lumen stock currently yields nearly 9%. That high yield signals that many investors are skeptical of the company's ability to sustain its current dividend payout. In reality, Lumen could be well-positioned to start increasing it again within a couple of years. If so, shareholders could be poised to profit in two ways: from higher dividend payments and from a jump in the share price as investors reevaluate the company's prospects.
