3 Big Risks CenturyLink Investors Need to Watch

By Billy Duberstein Markets Fool.com

CenturyLink Communications, Inc. (NYSE: CTL) reported lackluster earnings on Feb. 8, with revenue, adjusted EPS, and free cash flow all falling year over year, missing analyst estimates.The stock still looks appealing, however, as it is not terribly expensive, trading at only 11.2 times forward EPS (per guidance) and at a slight discount to book value.

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Moreover, management painted a bullish picture for 2017 as the company forecast better growth prospects for its strategic services division and streamlined Ethernet offering. Moreover, the company believes its impending acquisition of Level 3 Communications, Inc. (NYSE: LVLT), will bolster its position with enterprise customers, along with providing nearly $1 billion in synergies.

Still, there are risks to consider when looking at CenturyLink as a value investment. Let's take a look at a few of them.

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Dividend

Many CenturyLink shareholders no doubt own it for its hefty dividend, which comes in at $2.16 per share annually, yielding roughly 8.8% at the current stock price. In its earnings report, the company guided for adjusted EPS of $2.10-$2.30 for 2017, with the low end coming in below the dividend payout.

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While this guidance does suggest CentruyLink is more likely to cover its dividend than not, the company did miss its 2016 guidance by posting $2.45 in adjusted earnings per share versus its initial guidance of $2.50-$2.70. While the company could cover the dividend even if earnings fall short, this could either require the assumption of more debt, which is already relatively high at nearly $20 billion, or the lowering of capital expenditures, which may harm future revenues and earnings.

Moreover, this non-GAAP EPS measure excludes various costs that the company believes are non-recurring, so even these EPS numbers may be a tad rosier than they actually are. Per the company annual report, non-GAAP EPS, "exclude[s] the after-tax impact of special items, the non-cash after-tax impact of the amortization of certain intangible assets related to major acquisitions since mid-2009, and the non-cash after-tax impact to interest expense relating to the assignment of fair value to the outstanding debt assumed in connection with those acquisitions."

While these adjustments may be warranted, one always must be wary when a company posts wide divergences between GAAP earnings (which were only $0.08 in the quarter) and adjusted earnings, which came in at $0.54. In particular, the company has been acquisitive in its past, so acquisition-related costs may not be as "one-time" as the company indicates.

Competition

CenturyLink has highly profitable yet declining legacy copper/wireline businesses, which it is trying to replace with "strategic" businesses in MPLS (multiprotocol label switching) and Ethernet products, as well as other advanced fiber-based networking solutions.

The problem here is that the strong secular trend of high-speed bandwidth and cloud computing has attracted many competitors. From the company's 2015 annual report:

...we face competition in Ethernet based services in the wholesale market from cable companies and fiber based CLEC [competitive local exchange carrier] providers. We anticipate continued pricing pressure for our colocation services as vendors continue to expand their enterprise colocation operations. In recent years, our competitors, as well as several large, diversified technology companies, have made substantial investments in cloud computing, which has intensified competitive pressures. This expansion in competitive cloud computing offerings has led to increased pricing pressure and competition for enterprise customers, and we expect these trends to continue. The demand for new technology has also increased the number of competitors offering strategic services similar to ours. Price compression from each of these above-mentioned competitive pressures has negatively impacted the operating margins of our strategic services and we expect this trend to continue.

In short, CenturyLink is having a hard time transitioning from the age in which it was a high-margin incumbent with high barriers to entry, to a new world of increased competition and rapid technological change.

Level 3 acquisition

It is well-known that many large mergers turn out to be value-destructive. However, it looks as though CenturyLink needs its pending acquisition of Level 3 Communications more than ever, even with the projected increase in debt and shares to be issued.

Level 3 also reported last week, and while the company reported flat revenues, it was able to grow its adjusted EBITDA 11% and free cash flow 72% for the full year -- a starkcontrast to CenturyLink,.

The companies also forecast almost a billion dollars in post-acquisition synergies, which would allow the combined entity to earn better margins without raising prices for customers. Moreover, Level 3 has $10 billion in net operating losses that CenturyLink could use to offset its taxes, giving it further relief on the dividend coverage front mentioned earlier.

Thus, it seems vitally important to CenturyLink that it close on the Level 3 deal. And while the current administration and FCC chair seem very business-friendly,closing such a large acquisition in the telecom space is never a sure thing. Should the government block the Level 3 acquisition for any reason, or should either CenturyLink or Level 3 shareholders vote down the transaction, CenturyLink and its 8.8% yield could be in a tough spot.

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Billy Duberstein owns shares of Level 3 Communications. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.