Lumen Technologies (LUMN, Financial) is one of the largest communications infrastructure providers in the United States and plays an integral role in making up the backbone of the entire internet, transporting data around the world with a wide-reaching network that has few rivals. The problem is that its rivals are massive companies like AT&T (T, Financial) and Verizon (VZ, Financial).
Even though it’s not the leader in this space, the increasing relevance of the connected world does ensure the value of Lumen's network and business model. More importantly, with the stock down 55% since summer 2022, meaning the stock could be undervalued in my view.
Lumen is in a transformational period
Why is Lumen down so much? Here’s what happened. Management eliminated the company’s dividend, likely causing those dividend-focused investors to sell their shares. There wasn't much other reason to own the stock before, as it was in a long-term decline. The company is selling assets and redirecting resources towards growth, but it still does a good job of producing cash.
In October, it sold off its ILEC (incumbent local exchange carrier) across 20 states to the Brightspeed unit of Apollo Global (APO, Financial). An incumbent local exchange carrier is a telecom company that was typically the first to provide local service in a given area. It usually owns the existing copper wire infrastructure and provides telephone services over it. The ILEC is often an affiliate of the regional bell operating company (RBOC) and, while selling it to focus on new technologies makes sense, the cash flow Lumen loses hurts.
Divesting its older assets is supposed to allow Lumen to sharpen its enterprise focus and support its Quantum Fiber deployment plan to drive growth on the Lumen Platform. Lumen does retain its ILEC assets in 16 states where it plans to continue to invest in Quantum Fiber rolling out that to more communities.
In November, the company entered into an exclusive agreement to sell its EMEA (Europe, Middle East and Africa) business to Colt for $1.8 billion. The transaction implies an 11x sales multiple and the terms enable Lumen to continue to serve multinational enterprise customers through a strategic partnership with Colt. This deal along with the sale of ILEC has raised nearly $10 billion to focus on its core business, which is no longer strictly telecom services.
The bad news
Pivoting is hard. Following its 2017 merger with Level 3 Communications, about 70% of its revenue now comes from enterprise customers, where it provides communication services on a global holistic scale rather than requiring its customers to buy them piecemeal, plus its extensive fiber network limits the number of competitors who can actually replicate its services.
While the depth of these services could lead to cost advantages or higher switching costs, the legacy business also continues to weigh on its return on invested capital, which has run at mid-single digits since the merger, not to mention the massive amount of debt Lumen has on its books. Total debt is now just shy of $26 billion. This debt hampers Lumen’s growth, especially with its fiber business seeing strong momentum. This debt could take a decade to pay down.
The good news
The company still generates a great deal of profit, and a revised allocation strategy will help it be flexible and spur growth. At least, that’s the plan. The board eliminated the annual dividend and authorized a two-year $1.5 billion share buy back program instead.
This will boost earnings per share and investor ownership with the leftover cash used to further reduce its debt. By the end of 2023, Lumen’s shares outstanding should be down to 900 million with net income at $1.4 billion. Furthermore, Lumen’s gross margin is 56%, return on equity sits at 17% and the net margin is at 11%. These are all more than respectable numbers for a company in a transition phase.
Lumen is undervalued by Mr. Market
Looking at the landscape for telecom companies, many are trading with single-digit price-earnings ratios, but Lumen presents a unique opportunity for growth.
By cutting its dividend, the company can invest that money in expanding its product portfolio and services, leveraging its vast network infrastructure and investing in new technologies like edge cloud, Internet of Things (IoT) solutions and protecting customers against the rising frequency and severity of Distributed Denial of Service (DDOS) attacks. Long-term, this could continue to drive top and bottom line results as well as push retained earnings and ultimately book value much higher.
Aside from the debt, a big reason why Lumen’s price-earnings ratio is so low at 2.58 is because it has used cash flow to pay out dividends that are no longer there and investors have to rely on a company that hasn’t grown revenue at all in the last decade to finally jump start growth. It’s a big ask. However, Lumen has done a good job in the efficiency category, squeezing out higher profits despite sales being flat since since 2012. If it is successful, the earnings could rise considerably.
Takeaway
With the above in mind, I believe that if it is unsuccessful after a few years of trying to grow revenue profitably, Lumen could just reinstate the dividend at its previous rate and reward investors. The bottom line is, when a company with this level of financial consistency and durability can be found trading at such incredibly low prices, it's a rare opportunity.
