Is CenturyLink Destined for Greatness?

Every investor can appreciate a stock that consistently beats the Street without getting ahead of its fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with improving financial metrics that support strong price growth. Let's take a look at what CenturyLink's (LUMN 3.82%) recent results tell us about its potential for future gains.

What the numbers tell you
The graphs you're about to see tell CenturyLink's story, and we'll be grading the quality of that story in several ways.

Growth is important on both top and bottom lines, and an improving profit margin is a great sign that a company's become more efficient over time. Since profits may not always reported at a steady rate, we'll also look at how much CenturyLink's free cash flow has grown in comparison to its net income.

A company that generates more earnings per share over time, regardless of the number of shares outstanding, is heading in the right direction. If CenturyLink's share price has kept pace with its earnings growth, that's another good sign that its stock can move higher.

Is CenturyLink managing its resources well? A company's return on equity should be improving, and its debt-to-equity ratio declining, if it's to earn our approval.

Healthy dividends are always welcome, so we'll also make sure that CenturyLink's dividend payouts are increasing, but at a level that can be sustained by its free cash flow.

By the numbers
Now, let's take a look at CenturyLink's key statistics:

CTL Total Return Price data by YCharts.

Source: YCharts. *Period begins at end of Q3 2009.

CTL Return on Equity data by YCharts.

Source: YCharts. *Period begins at end of Q3 2009.

How we got here and where we're going
Despite impressive revenue and free cash flow growth, CenturyLink's had a hard time matching that growth to its bottom line. When paired with a doubling of outstanding shares, this trend results in weak earnings-related and equity metrics, leaving CenturyLink with a mere two of nine possible passing grades. Can this telecom improve its score with a solid performance in 2013?

It's worth noting that the in the past three years, CenturyLink's made three major acquisitions, which will skew these results somewhat until everything is settled. Thanks to its purchase of Qwest (formerly US West), CenturyLink now owns the assets of the only former Baby Bell that's not currently a part of either AT&T (T -1.21%) or Verizon (VZ -4.67%). While CenturyLink remains far behind the big two in scale, these acquisitions dramatically increased its presence, as evidenced by its impressive three-year revenue growth.

Another acquisition, of data services company SAVVIS, positions CenturyLink in an area of growth that's becoming more and more important to the telecom sector. Data transmission is rapidly becoming the most important service in many people's lives, particularly given the proliferation of voice-over-IP telephony services that replace minutes with megabytes. CenturyLink seems to have done a better job integrating SAVVIS than Level 3 Communications (LVLT) has done with its similar (and similarly timed) pickup of Global Crossing. While CenturyLink's free cash flow has been rising ever since, Level 3's free cash flow has sunk further into negative territory since 2011.

Beyond the acquisitions and the growth potential, many investors have sought out CenturyLink for its high yield. That yield hasn't been boosted much by rising payouts over the last few years, and it's currently sucking up about three-quarters of CenturyLink's free cash flow. If the company's free cash flow levels continue to rise, there will be room for an increase, but it seems unlikely at present.

What CenturyLink does have going for it, though, is that its free cash flow payout ratio has not risen above 1.0 (at which point every dollar of free cash flow would go toward dividend payouts) in the past three years. Contrast that to fellow high-yielding telecoms Windstream (WINMQ) and Frontier Communications (FTR). Frontier spent months with a ratio over 1.0, and was forced to cut back as a result. Windstream's free cash flow payout ratio has been moseying higher for three straight years, and just recently broke over the 1.0 mark. It may remain above that level for a few distributions, but if Frontier's any example, it won't be for too long.

Putting the pieces together
Today, CenturyLink has some of the qualities that make up a great stock, but no stock is truly perfect. Digging deeper can help you uncover the answers you need to make a great buy -- or to stay away from a stock that's going nowhere.