Lumen: Extreme Undervaluation Despite Strong Free Cash Flows (NYSE:LUMN)

Shares of Lumen (NYSE:LUMN) have languished since the telecommunications company reported third-quarter earnings and informed the market that it would no longer pay a dividend in November. Although the market has had more than enough time to deal with Lumen’s changing dividend and investment priorities, Lumen’s shares continue to suffer from considerable negative sentiment overhang. While investors have to accept that they won’t receive a dividend for the foreseeable future, Lumen could easily double its valuation without becoming overvalued. I added to my Lumen investment in January and consider the risk profile extremely favorable right now!

Misallocation of capital and Lumen’s course correction

At the beginning of November, Lumen informed the market that it was no longer paying shareholders a dividend and that it instead will be using its free cash flow for investments in its accelerating fiber business, debt repayments and opportunistic stock buybacks when market conditions are favorable. While I often come out against stock buybacks (because I prefer dividend payments over unpredictable share repurchases), I believe management made the right decision here.

The key reason for this is that the company’s balance sheet is in urgent need of repair and 2023 could be the year in which Lumen can make great progress. Lumen carries a significant net financial debt position on its balance sheet and as of September 30, 2022 had to service $25B.

Lumen’s significant financial debt saps the company’s growth potential, especially in the fiber business which is seeing strong momentum right now.

Before Lumen suspended its dividend in November, the company paid a $0.25 per-share dividend each quarter which cost the company approximately $1.0B annually. Returning so much of its free cash flow to shareholders while the balance sheet is burdened by so much financial debt is a misallocation of capital that the company is now finally correcting.

Lumen sold some of its incumbent local exchange carrier assets in FY 2022 and the company expects to apply a large portion of its $7.5B proceeds to its debt balance which means the company is going to see a deleveraged balance sheet in FY 2023. Going forward, Lumen could decide to sell even more assets to bring down its debt to a more manageable level and apply a larger portion of its free cash flow — which in the past was used to fund the dividend payment — to debt repayments. The result is likely going to be a much healthier balance sheet which could help remove some of the negative sentiment that has been created for Lumen’s stock in FY 2022.

Lumen’s valuation reflects deep free cash flow value

Lumen projected $2.2-2.4B in free cash flow for FY 2022, which is an enormous amount for a company that currently achieves a market cap of only $5.65B. In FY 2022, due to timing issues with the sale of non-core assets, Lumen raised its free cash flow forecast from $2.0-2.2B to $2.2-2.4B and lowered its CapEx forecast by $200M to $3.0-3.2B.

With $2.2-2.4B in free cash flow expected in FY 2022, the telecommunication company’s equity is valued at 2.5 X free cash flow with seems like a truly ridiculous multiplier factor. Since Lumen already sold some of its incumbent local exchange carrier assets to Brightspeed last year and may decide to sell even more assets in the future, the telecom is looking at compressing free cash flow in the future.

But even if Lumen’s free cash flow would decline to, say $1.0B annually, due to further asset sales, then the firm’s stock would still be valued at only 5.7 X free cash flow which isn’t exactly a high multiplier factor either. The key point here is that I believe investors have become way too pessimistic about Lumen’s free cash flow prospects and valuation in the context of the dividend suspension.

Lumen’s free cash flow yield currently stands at a 44.8% which indicates that the Lumen is significantly undervalued relative to other telecom investments.

Risks with Lumen

Lumen’s biggest risk, as I see it, relates to the firm’s balance sheet which is overleveraged and must be fixed, the sooner the better. If Lumen can repay 30-40% of its debt and bring its leverage ratio down in the next 2-3 years, then Lumen has material revaluation potential. If Lumen fails to restructure its balance sheet, investors may continue to perceive Lumen to be a restructuring play and apply an unreasonably large valuation discount to the telecom.

Final thoughts

Lumen is currently valued and perceived as a restructuring play that needs to fix its balance sheet and reroute its free cash flow to correct past mistakes regarding capital allocation. Since the company has cash coming in from recent asset sales and a larger portion of free cash flow could be applied to Lumen’s debt balance in the foreseeable future, the telecom is set to see a substantial improvement in its leverage ratio in 2023. As the telecom’s balance sheet gets successively deleveraged, investors may be more willing to correct Lumen’s silly valuation based off of free cash flow. I consider the risk profile to be extremely favorable here and I see Lumen perform very well in 2023!