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A Sour Valentine from CenturyLink

By Roger Conrad on February 15, 2013

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What were they thinking?! On Thursday, Feb. 14, CenturyLink’s (NYSE: CTL) management shocked its investors with a 26 percent dividend cut and plans to buy back $2 billion in stock. Oddly enough, its fourth-quarter earnings report was otherwise largely free of surprises.

The resulting selloff erased some $6 billion in market value by lunchtime, followed by a generally flat performance, with share prices ending the day down 22.6 percent from the previous day’s close. Downgrades by six of the 24 analysts covering the stock fueled the downside momentum. And adding insult to injury, Fitch cut the company’s credit rating to BB+, or junk status.

Standard & Poor’s already rates the company sub-investment grade, and Moody’s may join it in the coming days with its own cut–due to the large capital outlay needed for $2 billion in share repurchases. For those still holding CenturyLink, the bigger question is whether this is the bottom or merely a prelude to something much worse.

Certainly, the knives are out for the company after this move. One of the stock’s numerous short sellers was quoted predicting further dividend cuts and a drop to $15 per share. Wall Street analysts, meanwhile, have been falling over themselves to slash their 12-month price targets, though only two of the dozen forecasts are below CenturyLink’s current price–and both are only at 30.

Selling has been further exacerbated by the fact that for the past couple of years wireline companies have been treacherous plays for dividend investors. Smaller fare such as Alaska Communications Systems Group (NSDQ: ALSK) and Otelco (NYSE: OTT) have lost more than 90 percent of their value by completely eliminating dividends.

Frontier Communications Corp (NYSE: FTR) cut its payout by considerably less, but still lost more than half its value. Even sector companies that have held firm on dividends–Consolidated Communications Holdings (NSDQ: CNSL) and Windstream Corp (NYSE: WIN)–have been subjected to waves of selling and wild volatility.

But what sets CenturyLink apart from other dividend cutters in its industry is that its latest move appears to have been entirely unforced. In fact, fourth-quarter results demonstrated management is successfully executing on plans to stabilize revenue after a multi-year string of aggressive acquisitions.

Cash-Heavy Model

Wireline companies like CenturyLink enjoy massive cash flows from traditional telephone assets that have been paid for many times over. The catch is Americans are rapidly switching to broadband communications, and cutting the old connections in the process.

The upshot is wireline companies have plenty of cash now to pay dividends, pay off debt, buy back stock, make acquisitions and expand networks. But their long-term survival depends on converting their basic phone customers to their suite of broadband services.

Those that fail to do so will lose their business to competition from cable television and wireless companies. And sooner or later, they’ll have to cut dividends or worse. The latter may in fact soon be the case for Otelco, which is coming to the end of its grace period for suspending the interest portion of its income deposit securities.

CenturyLink’s goal has been to reach revenue stability in 2014. On that score, fourth-quarter results were certainly a step in the right direction, with revenue dropping at a 1.7 percent annualized pace versus the prior year’s 3.8 percent decline and a 5.6 percent drop in 2010.

That’s due entirely to progress converting basic phone customers to broadband, such as high-bandwidth data and Internet-based television. And management now projects annualized revenue declines of just 0.5 percent to 1.5 percent for 2013, while sticking to its forecast for stability in 2014.

Add in the fact that broadband services are generally higher margin than plain old telephone service (POTS), and you’ve got the case for an increasingly profitable company. Meanwhile, there’s considerable upside as well from such initiatives as fiber-to-the-tower, which vastly improves the fidelity of rural wireless communications, among other things.

The company completed 4,500 fiber “builds” in 2012 and now operates some 14,700 nationwide. It’s also investing heavily in cloud computing, again taking advantage of less competition in its sparsely populated territory. The company’s television penetration is now at 11 percent of passed homes.

That sounds very much like a formula for sustaining dividends over the long haul. And fourth-quarter free cash flow–operating cash flow less all capital expenditures–came in at $610 million, enough to cover the old 72.5 cents per share rate by a solid 1.81-to-1 margin.

So why cut? Paraphrasing from CEO Glen Post, III from the fourth-quarter conference call this week, the company decided during 2013 budget discussions that maintaining an investment-grade credit rating would require slashing investment in the business and cutting the lion’s share of the dividend–in order to “use 100 percent of free cash flow to repay debt.”

But management was unwilling to do this. So it elected to maintain capital spending to stabilize future revenue and cut the dividend “to a level that would be closer to the payout ratio that we have historically maintained.”

The $2 billion stock buyback–equal to about 10 percent of current market value–was intended to ease the pain. For 2013, management forecast $3 billion to $3.2 billion in free cash flow, part of which will presumably be put toward the stock buyback. And it projected a worst-case payout ratio of 60 percent of free cash flow, when it becomes a full-cash taxpayer in 2015.

Confusing Premises

If that sounds like a confusing plan, you’re not alone. In fact, the mixed messages here undoubtedly helped spur the selling momentum.

During the conference call’s Q&A session, one analyst asked why the company didn’t just leave the dividend rate alone and buy back less stock. Post’s answer basically implied that higher taxes in 2015 made continuing the current rate akin to a “one-time” dividend that would have to eventually be cut anyway, and that retiring shares would be accretive to shareholders now.

In his follow-up, however, he seemed to deny that 2015 was a significant factor in making the decision. Rather, he repeated the company was acting “from a position of strength.”

In fairness, that appears to be true, if for no other reason than this move was not forced, but rather a choice. And now that the stock price has adjusted downward for the lower dividend, CenturyLink appears stable with more cash available to do what it sees fit.

Restoring investors’ faith, however, may be a lot more problematic. And until disaffected shareholders are convinced management made the right move, the stock’s unlikely to reclaim its old heights.

The most important lesson income investors should draw from this is to adhere to the rules of diversification. CenturyLink’s move isn’t anything anyone could have predicted from numbers alone. In fact, I suspect you would have needed a seat on the board to comprehend what was going on inside management’s minds.

Obviously, it would have been better not to hold this stock when this announcement was made. But before this happened, Street opinion was overwhelmingly bullish on CenturyLink. By the time anyone realized something was wrong, the damage was done. And there’s never any point selling into this kind of downward momentum, particularly when the underlying company is in no danger of imminent bankruptcy.

When a portfolio is properly diversified, there’s only so much damage a single stock can wreak. In an economy where austerity is just starting to bite, any company can stumble.

By spreading your investments across a number of names and sectors, as well as rebalancing your portfolio regularly, you’ll avoid the damage from the few stocks that do blow up in 2013. And this will keep you in the game for the gains and dividend flows from the stocks that don’t, which are almost always the vast majority of companies.

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