Lumen Technologies, Inc. (NYSE:LUMN) RBC Capital Markets Global Technology, Internet, Media & Telecom Conference November 15, 2022 4:45 PM ET
Company Participants
Christopher Stansbury – Executive Vice President and Chief Financial Officer
Conference Call Participants
Bora Lee – RBC Capital Markets
A – Christopher Stansbury
Thanks. It’s good to be here.
Question-and-Answer Session
Q – Bora Lee
Alright. Well, hopefully, that’s working. So before recently decided to eliminate the dividend, can you talk about how it came to the decision to eliminate versus reduce the dividend? And why now?
Christopher Stansbury
Sure. So the Board, over a year ago and the company, more broadly announced that they were going to be selling 20-state ILEC business to Apollo. And when that deal closed, they would relook at capital allocation priorities, and that’s exactly what they did. So the deal closed in early October. At that time, we were also looking at the EMEA business, and we’ve reached an arrangement with Colt for that business to transfer. And so when we look at both of those pieces, the Board felt, with obviously management support, that now is the right time.
When you look at the decision of do you cut or do you eliminate, I mean, really, when you look at overall valuations today, we felt that retiring shares was a better way to return capital than to pay a dividend at today’s yields. And so that’s really why the decision was made the way it was. If you look at bond yields and where they are and what an appropriate dividend yield would have to be, it just made more sense to eliminate and do the repurchasing.
Bora Lee
SO here we go. All right, so we saw the 8-K that you filed this morning with some details about pro forma net debt, EBITDA, some financial impacts and partial 2023 guidance. Can you — let’s take a few minutes to run through some of these piece parts. If we could start with net debt, you recently closed on LATAM, the ILEC business, the 20-state ILEC business and now you’ll have EMEA towards the end of next year, if I remember correctly. So what are the expected tax implications?
Christopher Stansbury
Yes. So in the sale of the 20-state ILEC business and the sale of the LATAM business, we’re estimating a tax bill in the $900 million to $1 billion range. That was contemplated in the announcements we made about the net cash proceeds from those businesses. So at the end of Q3, we gave a pro forma guide that said that when you take into consideration the cash on the balance sheet, that our net debt was about $19.4 billion. So the way to think about it is that when that tax bill is paid, which will be split between the first quarter and second quarter next year, our debt — our net debt will be more in the $20.4 billion or so range. So that’s what addresses the ILEC sale to Apollo and the LATAM sale.
When you look at the EMEA arrangement, that’s a very attractive arrangement when you look at valuations, so we’re looking at a deal that’s at about 11 times EBITDA on a business that today, because the CapEx profile generates free cash flow that’s in the tens of millions. But the transaction, when you break it down, a $1.8 billion transaction, by the time we keep leverage neutral and we pay the tax bill, they’ll be about $600 million to $800 million remaining that we can then use for investment in growth or debt repayment or buybacks.
Bora Lee
And is there any impact on your pension obligations from these transactions?
Christopher Stansbury
No. In fact, with the 20-state ILEC sale, we actually transferred about $2.5 billion of the pension obligation. Right now, based off of our most recent work, we’re about 90% funded on our pension and don’t see any need to be making any investments in those in the next couple of years. I think the unfunded piece is in the $500 million to $600 million range.
Bora Lee
Okay. So on the third quarter earnings call, you announced the sale of EMEA. And we come back into EBITDA based on the valuation multiple that you just provided. But can you walk us through the details from the 8-K on free cash flow, EBITDA margins and revenue contribution?
Christopher Stansbury
Yes. When you think about how we kind of model the business going forward, there’s obviously been a lot of change in the underlying business as we refocus and pivot ourselves towards growth. So what we said is that this year, we expect to be at the lower end of our EBITDA guidance, given some of the headwinds on inflation.
We said that in this year, there was about $1.4 billion of impact from those transactions and also some CAF II funding from the reserve releases that we had in the books. So that kind of gets you to a starting point for next year. We’ve also said that our go-forward tax rate is in the 26% range, and that’s cash taxes and accrual. It’s about — they’re about the same. We’ve said that we’d have about $20.4 billion of debt at 5.75%. So given those numbers, you can kind of back in we said the tax bill would be about $300 million to $400 million on that 26%.
So you can kind of back in to a starting point, there are some near-term headwinds, right? We’re all dealing with inflation. We’re doing what we can on re-rate. So we expect more inflationary impact for the full-year next year than this year. We’re trying to see how much of that we can offset. There’s obviously a natural decline in the business that we’re focusing on altering that trajectory, but that’s not going to happen overnight.
And then there’s some dissynergies from the two deals that closed where, corporate overhead, we can’t reduce on a one-for-one basis with the EBITDA reduction. So that focus is really around automation and how do we take out cost going forward with that. So that won’t come right away. So I would say something less than that starting off point, but we’ve got to look at all those other variables as we look to next year, with our new COO arrival, Kate Johnson, we’ve got some work to do before we can give that guidance.
Bora Lee
And can you discuss the net proceeds from the EMEA transaction once it closes? And how do you plan to actually use those proceeds?
Christopher Stansbury
Yes. So as I said a few minutes ago, we got about $600 million to $800 million of net proceeds after we pay the tax bill and after we keep leverage relatively neutral. If you look at our new capital allocation priorities much more streamlined, the number one objective is growth and the things that we need to do to drive growth to ultimately drive returns for the shareholder, right? That’s the focus here. So we’ll make sure that we’ve fully funded those first.
From there, it’s going to be a trade-off really between keeping leverage in the, kind of, mid to high-3% range. We don’t want to go above 4% and then opportunistically buying back stock where we think the stock is trading below fair market value. And we will rely on outside parties to help provide those parameters to us. And then we’ve got a disciplined approach about how we would buy, but it’s going to be a dynamic process. It’s not one in front of the other. It’s going to depend on time and place and where the stock is and where leverage is. So I would expect that with that $600 million to $800 million of proceeds, that it will follow that same motion in terms of how we deploy that capital.
Bora Lee
So I guess, first of all, was that — can you shed any — can you provide any additional detail on the sales process for EMEA? Was that competitive?
Christopher Stansbury
It was a competitive process. I mean really, when you look at the things we’ve done, particularly in EMEA and Latin America, there, you had two businesses that needed ongoing investment that didn’t generate a lot of extra free cash flow. And the reality is they both need to drive scale and focus. So we did a competitive process. We came up with a decision and the arrangement with Colt. One of us in EMEA had to get bigger to drive that scale. And in this case, it’s going to be Colt.
But the really important thing for us is they sell global solutions to their European customers. We sell global solutions to our North American customers. And with this transaction, we end up with a network in EMEA that’s much stronger. It’s going to be more focused. It’s going to have the scale that it needs to reinvest. And so that ultimately benefits our customers, our network in North America and benefit their customers so —
Bora Lee
Do you think being a strategic buyer was positive for you within this process?
Christopher Stansbury
In terms of an alternative? Yes.
Bora Lee
Versus the [Multiple Speakers]
Christopher Stansbury
No, I think the way this worked out is actually better for both. I mean, really, Lumen’s core focus is the North American market. I think we’ve done very well in large enterprise, and those trends continue to improve, and we’ve done particularly well in public sector. So as we go forward, having a more focused portfolio, both geographically and from a product standpoint, I think, allows us to solve the bigger customer problems that are going to drive value.
Bora Lee
In the 8-K, you also provided some information about the 2023 outlook. How should we be thinking about free cash flow?
Christopher Stansbury
Yes. It’s early yet. I mean really, the reason why we gave the color around next year is, again, with so much change, we wanted to make sure that people were modeling directionally correctly. We gave some color on CapEx, because with the change in the dividend policy, I think there were questions around, hey, are we going to be spending a lot more? And so we gave that number to provide a little more clarity there.
I think what’s important is, is that in 2022, when we did the guide, we guided between $3 billion and $3.2 billion. We’re going to spend a little less than that this year, which we just updated. But when we say $3 billion to $3.2 billion next year, they’re actually not the same number, because in 2022, some of that spend was on the two businesses that we just sold. And so that actually gives us approximately $300 million to $400 million more that can be put to other uses.
So in next year, you’re going to see a greater focus on the digitization of Lumen. And I would say, that’s both back office and front office. So back to the dissynergies that I talked about, as the EBITDA base gets smaller and we can’t take out OpEx at the same rate, we’ve really got to focus on how we automate more of our back-office functions, right? So I think about finance, and I think about many, many ERPs going to few as an example, you’ll see us invest there.
On the selling motion, we’ve done a lot around marketplace and whatnot. But truly kind of end-to-end focus on how we think about the selling motion and how we deploy products to customers, that will be an investment area for us under Kate’s leadership as we go forward as well. So that’s, I think, how you’ll see us repurpose that CapEx spend next year.
Bora Lee
So in terms of EBITDA for next year, I appreciate the details you provided on the third quarter call regarding setting the 2022 jumping off point. So if I take the low-end of the guide for 2022 we moved $1.4 billion, we’re starting at about $5.5 billion. What are the other piece parts that we should consider in modeling out 2023 EBITDA?
Christopher Stansbury
Yes, I want to be careful here because, obviously, we’re not in a position to give guidance yet. And part of it is we just don’t know, right? Where there is a lot of things we’re looking at. We’re looking at what is the annualized impact of inflation going to be and how much of that can we offset with re-rate activity. We’ve got the dissynergies, which we previously said are in the neighborhood of a couple of $200 million. And some of that we experienced this year because we didn’t have a full year of those two assets that we sold, but we’ve got to annualize that.
There’s the near-term run rate decline in the business, which I think will impact things. And then it will come down to where do we want to invest more to drive growth, where do we want to pull back, what other cost savings can we get if we look at some of our structural cost. So all those things we’ve got to look at before we give guidance for next year.
Bora Lee
So in terms of capital allocation, you announced a two-year $1.5 billion share repurchase program. You recently completed a tender offer, been kind of busy. You have some additional capital after the completion of the EMEA divestiture. How are you thinking about your capital allocation priorities amongst organic growth, inorganic growth, share buybacks, dividends?
Christopher Stansbury
Yes. The key thing is we have a tremendous opportunity to drive growth at Lumen on top of what is a fantastic network, all right? When I look at the public sector success, I think that’s a bellwether for the quality of what our services sit on top of, right? When DoD signs a contract, it’s not simply a price conversation. It’s really about security. It’s about performance. And so when you look at our ability to bring complex solutions to customers, I think that’s where we excel, and we can do a lot more.
So the key is, as we go forward, we’ve already disclosed that we’ve got a product portfolio approach to how we manage the business. We’ve got growth, nurture and harvest in terms of how we categorize our portfolio, and we’ve got different resource constraints around those and where we will invest and whatnot. But I think where you’re going to see tremendous focus is on how we get that growth bucket to grow faster. And I would say that, that is a product that is driven by a customer problem that we’re solving rather than product looking for a home. So more focus on the end customer and their problems. And you’ll see investment around that motion and how we can accelerate the growth portfolio. So that’s dollar number one. And ultimately, that leads to long-term stability and growth in EBITDA that will benefit the shareholders.
The second and third, again, in conjunction with each other, are really the leverage and the buybacks, and we’ll do that dynamically. If leverage is starting to creep up, then maybe we’ll focus a little more on leverage at that point. If leverage is in good shape, and we think that the stock is trading below fair market value, then maybe buybacks take priority in that quarter. So it’s going to be something that we do, as I said, dynamically to make sure that we’re balancing both a strong balance sheet, as well as the ability to return capital to shareholders at good value.
Bora Lee
On M&A, how are you thinking about currently? Is there anything that you’d be interested in divesting possibly? Or I don’t know, even acquiring potentially?
Christopher Stansbury
Yes. I mean, I think we’re getting close to the point where the big chunks of assets that we feel are less strategic are being addressed with the EMEA arrangement. From a product standpoint, we’ve already started some of that when we went through that categorization. So for example, there were products that I want to get specific on. But that we were investing in, whether that’s CapEx or OpEx, a year ago that sit in the harvest bucket today that won’t get that, kind of, investment. So we’ve started it.
I think the question is, are there assets in that bucket that we can realize good value by selling? And if there are? If there’s a market for that where somebody is going to pay for, then we’d be interesting in selling it. If there’s not, then we’re going to continue to manage those businesses for cash. So it really is the NPV analysis of sell versus keep as it relates to any more pruning.
As it relates to acquisition, certainly. I mean, I think we have to continue to look at our portfolio. And again, back to that guidepost of what problem are we trying to solve for the customer. And if there’s an asset that we think is important in terms of that delivery, then we need to look at those things. So I would think as we go forward, you’ll see us look at those build versus buy decisions as we go from here. So the key message I would give you is that I think the big pruning has been done. Maybe there’s some fine-tuning along the way, and now we go from here as we start to inflect on growth.
Bora Lee
Great. So you’ve been at Lumen for fairly eventful seven to eight months.
Christopher Stansbury
Yes.
Bora Lee
What were your main priorities when you joined the company? And have they sort of evolved over time during your tenure?
Christopher Stansbury
Yes. So I mean, look, I’m super excited to be at Lumen. I think that Jeff got us to the point we are today in terms of focus and whatnot. Obviously, some initial investments to help the growth profile of the company. And Kate comes in, I think, with a skill set at an important junction in Lumen’s history to really help accelerate that growth. And I couldn’t be more excited to be working with her and the management team to do that.
So when I came, I mean, I had a few things I had to do. I had to try to learn the business as fast as I could, still doing that, but have picked up quite a bit. There were two deals that needed to be closed. There was the looming question on capital allocation and what we do. There was a huge issue around, gee, how do we disclose the business to investors? Because I coming in saw the same things that investors were seeing. And it was a bit of a black box, particularly around the business segment.
So in the first quarter that I was here, which was our second fiscal quarter of the year, we gave more disclosure around the consumer business. In the second quarter I was here, we gave a lot more disclosure around the business segment. We did a little more of that in the third quarter. And as we go forward, I think there is a few more things we can do. And I think that had a twofold impact. It not only, I think, improve the understanding of our business to the outside world, but it also forced us, I think, necessarily to manage the business in a very different way.
So back to the point I made about we had a portfolio of products and people were fighting over resources and wanting things to support their corner of the world. And the reality is when we looked at it, we can’t be good at everything. We made choices in terms of the life cycle approach. And that really drove a discipline internally around resource allocation. So I think we’ve gotten a lot done. There’s a lot more to do, but it’s exciting. It’s fun.
Bora Lee
So speaking of Kate, she’s been on the job for about a week, I think?
Christopher Stansbury
Yes.
Bora Lee
Any early indications of her strategic priorities? And what’s the next center involvement to-date on major discussions such as EMEA and the dividend?
Christopher Stansbury
Yes. Yes, I would say Kate’s been on the payroll for a little over a week, but she’s definitely been working longer than that. Look, she’s been great in terms of making sure that she understood the implications of the decisions on EMEA, on capital allocation and the decisions we made there. So she’s made herself available to all of that, has done — did a lot of work around onboarding before she walked in the door.
And the reality is, she has experience dealing with women as a customer from her previous roles. So she knew a number of the management team. She knows the business quite well. So her focus has really been on going deeper and just understanding where some of the gaps may be. She is — I think, an exceptional leader with a great track record. And her number one point in a town hall meeting we had last week was her number one job is to bring clarity and focus. And so to do that, she and we together need to bring clarity around what is our North Star, what is it we’re aiming for, and everything will follow from that. So we’re trying to give her a little bit of space to do that and in the next couple of months. And then I think you’ll start to see more for next year as she’s got a little more time under her belt, and we can start to share more of that. But it’s great to have her. It’s super exciting.
Bora Lee
Great. So switching to the business, one comment we heard during the pandemic was that it reminded businesses that they needed to continue to invest into their digital transformation. So some folks, who were called flat, but they ultimately accelerated their efforts during the pandemic. Slightly different circumstances now with perhaps a recession looming, but in the current macro environment, are you seeing any impact on customer decision, time lines or yes/no decisions on projects, scope? And are there any differences of note — to note along the sales channels?
Christopher Stansbury
Not really. I mean the good news is in terms of the big questions that you asked, our cancellation rates increasing, our customers changing the scope or complexity of the projects that we’re engaging with them on, the answer to both of those is no. So those are two really good knows, right?
It is a little more bureaucratic in terms of getting the approval to start proceeding with projects. I think that’s normal in times like this. I think there’s good news, bad news. The good news is, is that we’re in a business fundamentally that our customers need. There’s not — with a fragmentation in the world and the unfortunate situations we see all over the world, there’s not too many company saying, gee, I think I can lean out my security budget next year, right?
The flip side of that is when you look at, kind of, core underlying network services that we sell, that increasingly with competition, it faces more commodity type pressure. So the success and the pathway for Lumen is really that service layer that we should own that relies on the network for its performance. So things like edge compute; things like SASE, which is SD-WAN with Zero Trust security wrapped around it. Those are the pieces a real estate that we should own in the market. And we have had success with those, but it’s how do we accelerate those faster.
And I would say part of that is really the more complex solutions that we bring to market. I mean, one of the pieces of feedback we get from the public sector customers is that our ability to deploy complex solutions rapidly is a significant strength. So I think leveraging that as we go forward is a real opportunity for us.
Bora Lee
So let’s talk about those product buckets that you — those buckets that you actually introduced, so growth harvest and nurture. Can you talk about how you’re envisioning the customer and product life cycles among those buckets?
Christopher Stansbury
Yes. I mean, it really is nothing new in terms of how you would think about something and may be new to Lumen. But — so they’ll start at the harvest bucket. Think about things like legacy voice, right? So you have customers that are still using that product. It’s not a product that’s actively being sold today, because there is other solutions that exist in the marketplace. But that really comes down to there’s great cash generation from those businesses. We aren’t investing to support those anymore, because they are end of life. So it’s really about how do you maximize the NPV of those customers, because that cash is enormously valuable to help fund the things that we’re doing in the growth bucket.
As you move up the stack, and you think about things like nurture, those are products that we continue to sell. Customers still want them. They just want less of them. So think about things like VPN, Ethernet, right? And the move there would be, again, how do we run them efficiently, but also how do we convert customers to say a newer solution. They don’t want VPN anymore. Can SD-WAN fill that void as an example.
And then in the growth bucket, that’s really things like IP and Waves and SD-WAN, all replacing that motion that VPN and Ethernet would have done. So — and I think there’s a lot more we can do in that space, not just on products that meet a customer problem, but also thinking about how we address, say, public sector versus large enterprise versus mid-market. And that selling motion looks different. The underlying products might be called the same things, but obviously, their level of capability and complexity would be different. So there’s a lot that we can do there that I think gives us upside.
Bora Lee
Does that require a different structure with the sales force incentive — I guess, incentives for selling?
Christopher Stansbury
I think there’s some changes that we’ll continue to make. I mean, I’ve never been part of a selling organization that didn’t constantly adjust compensation to make sure that it was up-to-date with what the company was trying to drive towards. But I would say that there’s a definite — there has been a definite focus on mid-markets and how we shore up additional resources there. I think our public sector experience, where we are getting great marks for our ability to deploy, I think we can learn there. If you think about public sector as a vertical, I think there’s a learning in there. So maybe there’s some more focus vertically as we go forward, we don’t know.
So early days, particularly with Kate getting on board, but again, she’s got an experience that she brings that she can leverage. And I think in the coming months, we’ll have a lot more clarity around where we’re going to make more bets and where we’re going to make fewer bets.
Bora Lee
So on the Quantum Fiber side, you provided some helpful KPI stats in the 3Q deck. Can you talk about how that’s been tracking relative to your expectations? And what your current thinking is on the trajectory of the build-out and CapEx spend given the general macro challenges?
Christopher Stansbury
Yes. This is hard stuff, right? But there’s a great economic profile to it. And we’ve learned a lot. I would say that our enablements are going to come in a little below what we would have liked for this year. The cost per enablement is a little higher given the inflationary environment. Does that change the investment thesis over a 30-year product? No, it doesn’t. And we’re very mindful about how we approach that. But the markets that we’re penetrating are dense urban locations, which have great return profiles associated with them.
The key thing in this business, and so back to your question on how I spent my 7.5 months, it’s about getting to scale. And when you think about a motion where you’ve got to engineer locations and how you’re going to reach them, you’ve got to get permitting around that. You’ve got to get labor that puts stuff in the ground. Until you have that pipe fill that scale — it’s very hard to predict when you’re going to have permit approvals and when you need labor in a certain market so that you can make volume commits. And so that’s been the hard part.
The good news is, is that I think we’ve got that motion figured out. There’s been a lot of work and attention focused on it, frankly, to the point where I’ve been involved sitting in rooms for days to understand that better. So as we move into next year, it’s — these are long lead decisions. But I think as we get towards the second half, later into next year, we’ll be at that scale that makes this much more of a steady motion.
Bora Lee
So safe to say that these are a factor — that some of this is actually factors that are under your control, and you may be able to accelerate the build out once those are in place?
Christopher Stansbury
Yes, for sure. I mean there’s no question that, that cost per build is a near-term thing, but is that limiting what we’re doing? Not at all, I mean, I would much rather have a scenario where our teams came in and said, I could double how fast we’re going and make that a problem for me to go figure out how to pay that bill, because that would be a great problem to have, right? So — because that just means we get through this faster, we get to the return part of the journey faster. So that’s not a limitation, it really is getting that factory running so we can get to scale. And I think we’re doing the things we need to do.
Bora Lee
Great. So just to wrap up, after all the moving pieces of the past year and EMEA is completed, how would you summarize the new Lumen to investors?
Christopher Stansbury
Well, again, more to come on that. But certainly, as a starting point, I would say that this isn’t just a legacy telecom company that’s going to play the legacy telecom game. That’s not interesting. This is a company that is focused on the services and the security that customers are looking for in their solutions in the part of the real estate that we should realistically own given the network that we have.
So we have a tremendous foundation in terms of the network asset. We’ve got a tremendous foundation in terms of the EBITDA that asset generates today. And I think the focus on the service layer and the customer problems we’re trying to solve is going to take us to the next level, so.
Bora Lee
Great. Thank you for your time.
Christopher Stansbury
Great. Thanks a lot.
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