On Wednesday afternoon, Lumen Technologies (LUMN -6.20%) reported disappointing earnings results for the second quarter of 2022. Adjusted earnings per share (EPS) plunged 27% to $0.35, falling well short of the analyst consensus of $0.46.
Lumen stock fell as much as 6% on Thursday following the earnings miss, though it recovered somewhat to end the day down 3%. If anything, this decline represents a buying opportunity, as the telecom company has continued to make good progress on its strategic plan in recent months.
Cost pressures hit earnings
In the second quarter, Lumen's revenue trajectory improved modestly. While the top line is still falling, revenue declined 3.4% year over year on an organic basis, compared to a 5.5% decline in the first quarter. Excluding a one-time adjustment related to the CAF II federal subsidy program (which ended last year), revenue was flat compared to the first quarter.
However, Lumen's costs increased sequentially across all line items. Most significantly, cost of services and products increased by $73 million relative to Q1. By contrast, in recent quarters, Lumen had typically offset its top-line pressure with cost reductions.
The net result was that Lumen's adjusted EBITDA margin (excluding CAF II) fell to 39.3% last quarter, after consistently ranging between 41% and 42% over the previous four quarters. This caused adjusted EBITDA to decline to $1.81 billion from $1.91 billion a quarter earlier and $1.99 billion in Q2 2021. Inflation was the main culprit, as Lumen experienced rising energy and labor costs last quarter.
Pre-tax income declined at an even faster pace, partly due to a $16 million foreign currency loss and a $137 million loss on an investment recorded in the second quarter.
Guidance looking shaky
Lumen executives say they are redoubling their cost-cutting efforts in the current inflationary environment. Thus, despite the drop in its adjusted EBITDA margin last quarter, Lumen maintained its full-year guidance, which calls for $6.9 billion to $7.1 billion of adjusted EBITDA and $2 billion to $2.2 billion of free cash flow.
Nevertheless, CEO Jeff Storey acknowledged that labor cost increases have "put pressure" on the company's EBITDA outlook. In short, Lumen is likely to post full-year results toward the low end of its guidance range, and there is a meaningful risk that Lumen will fall short of its full-year target altogether.
Lumen's long-term strategy remains on target
While Lumen faces near-term earnings headwinds, its long-term transformation plan is on track. On Aug. 1, the company closed the $2.7 billion sale of its Latin American business to Stonepeak. And Lumen is set to sell its traditional telecom operations in 20 states to Apollo Global later this year.
These divestitures will give Lumen a sizable cash windfall, enabling it to pay down a good chunk of its debt load, which stood at $29.4 billion at the end of last quarter.
The extra cash will also help Lumen fund aggressive investments in its Quantum Fiber mass markets business over the next few years. Despite permitting delays and supply chain issues, Lumen expects to make fiber internet services available at nearly 1 million new addresses this year. That will expand Quantum Fiber availability by roughly 35% to 40%.
Image source: Getty Images.
Lumen plans to accelerate the pace of fiber deployments further in 2023, and it holds a long-term goal of making Quantum Fiber available at 12 million-plus locations, with 40%-plus penetration. Meanwhile, Quantum Fiber just began offering multi-gigabit services at higher price points. As a result, the Quantum Fiber business is poised for rapid growth over the next five years, supporting a big improvement in Lumen's overall revenue and profit trajectory.
A bargain for long-term investors
Lumen stock could remain volatile as the company continues through its transition into a fiber-focused business. However, as declining legacy services become a smaller proportion of its revenue mix and the Quantum Fiber segment's footprint grows, Lumen should be able to stabilize its revenue by the end of 2023 and return to growth thereafter.
The combination of an improved revenue trajectory and ongoing cost-cutting efforts will support a return to long-term earnings and cash flow growth. By contrast, Lumen stock is currently priced for terminal decline.
This points to substantial upside for investors who buy the stock now and wait for the market to catch on to Lumen's long-term potential. In the meantime, Lumen shareholders are getting paid handsomely for their patience: Lumen stock currently yields 9.4%.
