Sunday, July 26, 2009

CenturyTel: Is Its Dividend Safe?

- CenturyTel is a communications-service company with operations in 25 states, but is concentrated in five.
- CenturyTel has been an acquirer for at least nine years now. That strategy has not led to it becoming a growth company.
- As of about a year ago, CenturyTel's management acknowledged such by raising the quarterly per-share dividend from 6.8 cents to 70 cents.
- Recently, CenturyTel has merged with Embarq in an all-share deal; the combined entity will be known as CenturyLink. CenturyTel's total shares outstanding will nearly triple.
- At Friday's closing price, CenturyTel's yield is 9.16%. This yield indicates a market judgment that the dividend may be cut, or at least is not safe.
- In examining the question, I use conservative estimates of operations cash flow and a pessimistic estimate of needed capital expenditures.
- I do not predict that its dividend will be cut, but I conclude that its post-merger free-cash-flow margin of safety is insufficient to consider its dividend safe. Management may have to scramble to meet the dividend in '09.
- The task of keeping the dividend at the same rate will not be impeded by debt-maturity obligations in 2009, but may in 2010. Management might be able to refinance the $500 million in debt due, but they might not. If not, then the obligation to repay the principal will cut into any free-cash-flow accretion from the merger (as well as any economic-recovery benefit) as of next year.


Before the Embarq merger, CenturyTel presented the image of a company aiming to change its ways. Unusually for a telephone company, its payout ratio was paltry until mid-2008. Its 2007 payout ratio was only 7%; its 2000 payout ratio was 11.7%. During the last decade, it showed a real appetite for growth through acquisitions.

Ostensibly, CenturyTel does look like a real grower. Its 1999-2008 continuing-operations EPS growth, as derived from logarithmic regression, clocks in at 19.30%. This rate is well above its 10-year return on equity, which is only 12.54%. The disparity between the two figures suggests something other than operational performance is fueling that growth.

In 2002, CenturyTel restructured, and reclassified part of its earlier net income as being from discontinued operations. That restructring resulted from an overly ambitious acquisition spree in 2000 colliding with 2001-2's hard times. That lowering of 1999-2001's contunuing-operations EPSs added to its growth rate, even if subtracting a $2.91 per share extraordinary gain in 2002 lowered that rate somewhat. Subsequent to the rationalization, EPS growth has been boosted by share buybacks. The EPS growth rate from 2003 to 2008 was +11%, while the growth rate in net income was -0.958%. To be fair, the latter growth rate does reflect a 40.7% drop in net income from 2007 to 2008. However, EPS growth from 2003 to 2007 was 13%, while net income growth was only 4.69%.

As of the most current earnings report, for Q1 '09, CenturyTel's payout ratio is 82.2%. Its yield is 9.16%: the following discussion will explain why.

What Century's been up to is illustrated by the following pair of facts: its shareholders equity is $31.52 per share, slightly higher than Friday's closing price of $30.58, but its book value is less than zero. The company has $4.105 billion in goodwill on its books, which makes up 50.6% of its total assets as of March 31st. Goodwill as a percentage of fixed assets net of depreciation, has grown steadily from 76% in 1999 to 138% in 2008. Raw goodwill has grown 6.62% per year, as also derived by logarithmic regression.

This spurt, as you may have guessed, is the result of acquisitions. Perhaps surprisingly, those sprees were not done with debt after 2000. CenturyTel's debt-equity ratio hit its peak in 2000, at 1.71, but declined steadily later in the decade. It hit its nadir in 2005, at 0.733. The ratio has crawled up since then, but it only topped 1 in 2008. As of March 31st, it has gone back below 1.

Instead, the financing has largely come from CenturyTel's cash flow. The reason for the company's low payout ratio, until about a year ago, should be evident.

The jacking-up of its per-share quarterly dividend in mid-'08, from 6.8 cents per quarter to 70 cents, would seem to signal the company's resolve to turn a new leaf. As mentioned above, only a large share buyback campaign kept CenturyTel's EPS growth rate in the double digits. Had the company not reduced its average-diluted total shares outstanding from almost 150 million in 2003 to 103 million in 2008, its EPS growth would have been in the low single digits from 2003 to '07...and slightly less than zero from 2003 to '08.

Despite the large payout ratio in earnings terms, the current dividend seems sustainable on a free cash flow basis. If CenturyTel were to leave its total shares outstanding at the current level, its annual dividend commitment would be about $281 million at the current rate. From 2003 to 2008, its free cash flow has never been below $500 million per year. The difference between the two figures would leave a comfortable cushion to sustain the dividend payment, had there been no substantial change coming. Despite the company's EPS falling fron 80 to 68 cents from 1Q '08 to 1Q '09, cash from operating activites barely budged in that timeframe; free cash flow was up slightly. Basic free cash flow analysis shows a fairly well-covered dividend.

Until the merger with Embarq is factored in.

An interesting aspect of the merger is that it conforms to a practice well known in Canadian market lore: it was a reverse takeover. A "reverse takeover" is an all-stock merger where the shareholders of the target company wind up holding a majority of the new entity's shares. The share issuance dilutes the holders of the acquirer to a minority position. That's what's going to happen when CenturyTel and Embarq formally become CenturyLink. CenturyTel will have to issue close to 200 million additional shares, and Embarq shareholders will end up with about 66% of CenturyLink. To borrow a term from Canadian securities regulation, this counts as a "material change."

But will it change the safety of the dividend?

CenturyLink's total shares outstanding will be about 300 million once the two companies are financially conjoined. As mentioned above, CenturyTel's current per-share payout is 70 cents per quarter. It makes for $2.80 per share per year, and would make for $840 million per year with 300 million shares outstanding. CenturyTel's 2008 free cash flow was $566.483 million. Embarq's was $1.062 billion. Both together make for about $1,628 million, or almost double the requirement for a hypothetical dividend at the current rate. Embarq's free cash flow actually increased from 1Q '08 to 1Q '09, from $408 million to $526 million. This increase was mostly due to reducing capital expenditures, but operations cash flow also rose $11 million in that timeframe.

Combined, Embarq's and CenturyTel's free cash flows for 1Q '09 are more than $710 million. Paying out 70 cents per share on 300 million shares would cost $210 million. There would have been a large free-cash-flow cushion had CenturyLink been in existence as of the beginning of this year and paid the same dividend as CenturyTel does now.

Management expects the merger to be accretive to cash flow in 2010. This expectation may be based upon keeping capital expenditures on a tight leash. Both companies have reduced theirs recently. As of the end of 2008, CenturyTel's capital expenditure ratio, as a percentage of fixed assets net of depreciation, was 9.9%; Embarq's was 9.25%, Both are unusually low for each respective company. Had the two entities been combined at the end of '08 by the pooling-of-interests method, their net fixed assets would have been about $10.307 billion. Combined capital expenditures would have been about $973 million. The capital expenditure to fixed-asset ratio would have been 9.44%, lower than CenturyTel's ratio as a standalone company.

Let's assume that a capex crisis pushes the ratio up to 20%, which is somewhat higher than CenturyTel's highest ratio over the last ten years. [In 1999, it was 18.0%.] If combined net fixed assets remained the same, instead of declining slightly due to more accumulated depreciation, then a 20% capex-to-net-fixed-asset ratio would require capex spending of $2.061 billion.

Let's further assume that 2009 combined cash flow from operations is the same as 2008's. Since both companies' first quarter operations cash flows are larger for 2009 than 2008, this assumption seems a reasonable one. For 2008, Embarq's was $1.748 billion. CenturyTel's was $853 million. The two together make for $2.601 billion. Assuming a 20% capex-to-net-fixed-assets ratio, CenturyLink's 2009 free cash flow would be $540 million. This amount would not be enough to cover the $840 million annual dividend payout for 300 million shares.

If I'm more conservative, I can assume that Embarq's cash flow contribution was equal to its lowest operations cash flow in the last three years: 2007's $1.624 billion. [CenturyTel's 2008 operations cash flow was well below 2007's $1.029 billion, and only slightly above 2006's $840.72 million.] Then, combined operations cash flows would be $2.477 billion. Hypothetical free cash flow shrinks to $416 million. That's less than half of the annual dividend requirement for 300 million shares. In order for free cash flow to be above the new dividend requirement, assuming that combined operations cash flow will indeed be $2.477 billion, then capex spending cannot rise to more than 15.8% of net fixed assets. CenturyTel's real ratio was above that level in 1999 and 2001. In order for free cash flow to be double the dividend requirement under the operation-cash-flow condition just above, the capex-to-net-fixed-assets rate will have to be an unrealistically low 7.7%.


Given that hypothetical calculation, I would have to conclude that CenturyTel's dividend is not safe. I'm not predicting that it will be cut; I actually believe that the new CenturyLink won't do so. CenturyTel's already under a bit of a cloud for expanding too much already, and the CEO has publicly promised not to make any more acquisitions until 2010 at the earliest. The company's shift in dividend policy a year ago suggests that management realized, or was persuaded to realize, that growth in CenturyTel's size did not add all that much value to CenturyTel's shares. Going ahead with the Embarq merger is not the type of behavior we'd expect from reformed empire-builders, though.

On the other hand, CenturyTel's management did bend with that change in dividend policy. I think they will avoid the backslider reputation that would be earned if they did cut the dividend.

Saying that the dividend won't be cut, however, is not the same thing as saying it's safe. If "safe" means requiring free cash flow to be double the dividend payout with respect to a conservative estimate of CenturyLink's combined operations cash flow, a cushion that's more or less in line with CenturyTel's recent free cash flow as compared with a $280 million dividend requirement, then CenturyTel's $2.80 per share annual dividend is not safe. The current yield of 9.17% has a risk premium built in, and I think there should be one. Thankfully for the company, it has no material debt-repayment obligation in 2009 - but it will have to retire or refund about $500 million in debt in 2010 and a combined total of $1.315 billion in revolving credit facilities in 2011. Any free cash flow accretion in 2010 will bump into, at a minimum, the $500 million obligation for that year.

[Once again, I have to remind everyone that I'm not licensed to dispense investment advice in my home jurisdiction of Ontario.]

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