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We previously warned investors that a dividend cut was likely imminent for Lumen Technologies (NYSE:LUMN), stating:
We recently contacted the company with a list of questions and in a recent note that we shared with members of High Yield Investor… we discussed our takeaways from that discussion… [LUMN] appears to be keeping the option open – if not outright planning – to cut the dividend… While we do think a dividend cut is already priced in, to some extent, it is still very possible that the stock will get hit further if the dividend gets slashed.
As a result, we sold the remainder of our position at $8 per share in early October (after having sold a sizable portion of it at a profit back in May). It did not take long for us to be grateful for that decision, as LUMN confirmed our thesis by eliminating its dividend along with Q3 results, sending the stock crashing by 18% today.
In this article, we will break down the Q3 earnings release, share our outlook for the company moving forward, and explain why we are still not buying despite the massively discounted share price.
LUMN Q3 Results
LUMN’s Q3 results were more of the same disappointing results, with the outgoing CEO even admitting that they are seeing no material uptick in demand for the company’s products despite his years of promising growth and sinking billions of dollars into “growth” investments. The weakness, combined with macro headwinds, were summed up well in the following statement on the earnings call:
Supply chains are strained with labor is the key headwind, and we are all facing the impacts of inflation… That said, we expect to end the year towards the low end of our adjusted EBITDA guidance range… We estimate that our full year 2022 EBITDA will be impacted by approximately $100 million related to inflationary pressures.
Revenues declined by double digits year-over-year, showing little to no sign of reaching the top line growth that management has repeatedly claimed – and still maintains – is its top priority. Its International and Global Accounts segment saw revenue plunge 16.9% year-over-year, Large Enterprise fell 10.4%, Mid-Market Enterprise declined by 4.6%, and its largest segment – Mass Markets – was down by 14.9%. The only segment to see anything resembling growth was the Wholesale business, with 1.2% year-over-year growth.
Free cash flow plummeted from $1.072 billion in the year-ago quarter to $620 million in Q3 2022, reflecting just how precipitous the decline in earnings power has been.
If there was one bright spot from the earnings report, it was the announced exclusive arrangement for the proposed sale of the company’s EMEA business to Colt for $1.8 billion. Given that LUMN will be receiving an 11x multiple for the business (which is roughly twice the current multiple that the market is assigning for LUMN’s entire business), it appears to be a meaningful way to unlock value for shareholders. Management expects the sale to close in about a year, assuming the necessary regulatory approvals are received.
LUMN Outlook
While the company is clearly struggling to stop the bleeding on its top and bottom lines and just eliminated its dividend, it does continue to make progress on selling off large chunks of its business at fairly attractive valuations. Does the latest crash in the stock price make LUMN worth buying right now?
For us at High Yield Investor, that is a big no, for a couple reasons.
First and foremost, LUMN no longer pays a dividend at all, which is a requirement for us as income investors.
Second, while management’s proclamation that they will be instituting an “up to $1.5 billion two-year share buyback program” sounds good, especially in the wake of asset sales at a vastly superior valuation to what the stock is trading at today after the latest selloff, buybacks are a far less dependable form of capital return than a dividend is. This is particularly important in the case of LUMN because it is infamous for failing to generate attractive returns on invested capital. Without the added discipline required for allocating a sizable chunk of cash each quarter towards paying the dividend, LUMN management is freed up to procrastinate on and potentially not even fully buy back the $1.5 billion buyback program. Instead, they may sink that cash into “growth” projects that generate outcomes tragically similar to LUMN’s “growth” investments of the past many years.
Third, management has misled shareholders all along about its capital allocation priorities, and we have reason to believe – based on the company’s own commentary during its latest earnings call – that it is still not being fully transparent with them. Just read the CEO’s own words from just one year ago on the Q3 2021 earnings call and then contrast them with what he said on this year’s Q3 earnings call:
we have no plans to modify our dividend, which we believe is sustainable at the $1 per share level. Although our payout ratio will likely rise in the near-term as we streamline our asset portfolio and invest in the Quantum and Enterprise opportunities, we expect our focused operations to provide the underpinnings for top-line growth in 2 years to 3 years, which we expect will drive a more normalized dividend payout ratio over time.
Our board believes the return of cash in the form of a dividend is an important part of our value proposition and we are focused on supporting our dividend, even as we make the investments necessary to reach our growth objectives. As I mentioned on our last earnings call, and as you can see in priority 3, we will manage our balance sheet to remain more or less leverage neutral over the next few years.
Management was so adamant about the sustainability of its $1 per share dividend that it even listed it in its slide deck as one of its top priorities. Now on the Q3 2022 earnings call, the CEO said this:
When we announced the $7.5 billion ILEC transaction last year, we specifically said that the Board would assess our capital allocation policy in the wake of that transaction. The transaction completed on October 3rd, and today’s announcement reflects the output of that assessment. We believe that the current market value of our shares dictates that the long-term value creation is better realized through share repurchases rather than the payment of a dividend.
As I said, we have authorized an up to $1.5 billion two year program, and believe it is more attractive to retire shares at today’s prices than to pay dividends at today’s yields. We have long supported the dividend as a good vehicle for value delivery, but at today’s stock price, that is no longer the case. We expect to opportunistically repurchase shares over the life of the program.
This does not seem to match. On last year’s Q3 earnings call, the company had already announced the ILEC transaction and specifically said that it was committed to supporting its $1 per share dividend through its asset sales and investments in its growth cycle. Nowhere in there did they ever say that at a certain share price they would consider eliminating the dividend in favor of buybacks. Regardless of how you or we may feel about the prospect of using cash for buybacks as opposed to dividends at various stock prices, management is clearly not being fully honest about its past communication to shareholders.
However, management’s lack of forthrightness in its communication with shareholders did not stop there, it also contradicted itself within the same earnings call. When speaking about the benefit of the dividend cut, LUMN said:
The benefits of reallocating capital from the dividend are significant for our growth plans, our balance sheet, and our ability to use our free cash to unlock longer-term value through share repurchases.
First and foremost, our new policy should remove any questions you may have about the capacity to invest in the growth of our business. Growth has always been and will continue to be our key imperative and this decision makes our ability to fund that growth clearer than ever.
In other words, eliminating the dividend gives them the cash they need to ensure that they achieve their topline growth goal. However, later on in the earnings call when put on the defensive by analyst questions regarding capital allocation, the CEO implied that it really wasn’t about that, but rather just about favoring buy backs over dividends:
it’s not a sign that there’s any greater weakness or inability to fund our business. It’s just we don’t think that’s the best way to return value to shareholders. And as part of our assessment coming out of the Apollo transaction, we just believe that it’s better to buy back shares.
So, which is it? Will the savings from the dividend being eliminated be used exclusively for buy backs, or will they also be used for growth investments and potentially even debt reduction? It appears obvious to us from management’s prepared remarks and from looking at the reality of the business fundamentals that LUMN knows it needs to sink even more cash into the business and balance sheet in order to keep leverage under control and try to turn its rapidly sinking revenues around. However, they did not want to fully admit that their growth strategy is not working as well as they hoped, so they threw in the optional buyback program as a bone to the market in order to try to keep investors and analysts at bay.
Finally, LUMN continues to push out its projected growth timeline. During the 2021 Q3 earnings call LUMN made a big deal about how their CEO for the first time provided a timeline to achieving topline growth. It was two to three years. However, during this earnings call – exactly one year later – management again kicked the growth can down the road, despite announcing still further non-core asset sales that should have, if anything, accelerated the topline growth timeline. The projected return to topline growth is apparently still “two to three years” away according to an answer provided to an analyst on the earnings call:
I still think we’re two to three years away from total growth.
Investor Takeaway
The only good thing happening at LUMN is that it is selling off its assets at pretty attractive valuations. However, its repeated failure to deliver attractive returns on retained cash flows makes those asset sales seem like a total waste. The top and bottom lines continue to plummet and now the dividend – one of the few attractive things about this company and something that management had repeatedly promised shareholders was a “top priority” – is gone. The stock price is cratering with no bottom in sight, and we think this is fully justified given how untrustworthy and incompetent management has proven to be.
With management going against their previous assertions regarding the dividend, contradicting themselves during the earnings call about the extent of their commitment to using the retained cash from eliminating the dividend for buybacks, and then quietly and indirectly admitting that they are falling behind on their previous return-to-topline-growth timeline, there is little to like or trust in here.
While we do not think LUMN is a Sell due to its dirt-cheap valuation right now, we also do not think it is a Buy, especially when there are so many other attractively priced opportunities with far better business models and management teams in today’s marketplace. We are glad we sold when we did and we have no plans of buying back in.
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