Sunday, August 2, 2009

Qwest Communications: Risky Turnaround

Qwest Communications was one of those companies whose financials imploded after the dot-com crash. That implosion continued until 2002, when it climaxed with a revelation that Qwest had overstated certain items: 2002's loss per share was $10.48. As later losses showed, that climactic loss was more than Qwest taking a bath; they continued until 2005. Not until the next year did Qwest eke out a small profit of 30 cents per share. After getting up to $1.52 in 2007, its EPS slumped back to 32 cents. Quest is the only company in the Low P/E Bin with 10-year average EPS of below zero: -$2.40 per share.

2008 was the year it instituted a regular dividend of 8 cents per quarter. At Friday's closing price of $3.86, the stock's yield is 8.29%. That yield shows that there's not a lot of confidence right now that the dividend will be kept as it is.

So far, this company looks like a plain "avoid" despite the last three years' worth of profits. Nevertheless, the price of Qwest stock is low enough to rate a second look. It's now selling at the same level it was at in 2003-5. In those years, Qwest paid no dividend and reported EPSs of -$0.76, -$1.00, and -$0.41 respectively. Now, though, the company pays a dividend and now has 12-month trailing EPS of +$0.63.

It isn't a value stock, despite the high dividend rate. Quest's book value is negative; during this decade, its earnings before interest and taxes was double its interest payments in 2008 only. The current ratio is well below 1. Its debt was 67.7% of its total assets in 2008, and that was the second-best year of the last four. Only 2007's 63.2% was lower. The debt level and lack of shareholders' equity would make a value investor shy away. $792 million of that debt matures in 2009; as much as $2.168 billion will mature in 2010. $1.265 billion of that figure is for convertible notes that can be redeemed for 100% of maturity value on November 15th of the latter year. The notes have a conversion price of $5.90, and have an interesting feature: if handed in for conversion, the holder will receive cash equal to the principal amount of the notes and enough Qwest shares to cover the overage - if Qwest chooses to send shares; the company has the option to send cash instead. Consequently, the dilution potential of these notes is far less than it may seem...but the cash-draining potential is much larger than it would have been had those notes been ordinary convertibles.

Qwest's earnings-coverage ratio is another metric that would make a value investor think twice, if not reject it outright. Its free cash flow, however, has been double the current dividend payout since 2006. For 2008, the only full year that Qwest did pay a dividend, free cash flow was 2.08 times the dividend requirement.

That's the only argument in favor of the stock as even a speculative value stock. Clearly, Qwest is a turnaround stock with a high dividend. If the 8 cents a quarter isn't cut, then a turnaround-hopeful shareholder will get paid for waiting more than 8% per year at last Friday's price of $3.86. But will the company turn around?

As of the second quarter of 2009, that hope looks iffy. Qwest did manage to post 2Q '09 EPS of 12 cents, which were 20% over 2Q '08's. This gain came from rebates of earlier taxes paid: had taxes in 2Q '09 been equal to those paid in 2Q '08, 2Q '09's EPS would have been only about 5.5 cents per share. The only bright spot in its segment revenue came from business services; Qwest's residential customers are still leaving in droves. Management plans to extend the fibre lines to offer more high-speed download services, which is expected to reduce the rate of cancellation-caused decline. Business service revenue was up, which says something in this economy, but its total income is only 26.2% of total segment income. The company's data and voice traffic wholesale division, which it didn't sell at what it considered to be a reasonable price, contributed more to segment income. Its own revenue dropped faster, on a percentage basis, than consumer-service revenue did.

As a turnaround stock, Qwest is still speculative. Any buyer of the stock that does so in the hopes of better times had better be patient and watchful. The household mass-market division, which contributes the largest share of its segment income, is still declining in terms of revenue and number of customers. The wholesale division, which is the second-largest, is declining at a greater rate in terms of revenue. Only the smallest in terms of income contribution, business and government services, is improving in revenue terms. Although all three segments saw their margins increase, the revenue declines of the two largest suggest that Qwest is being slowly priced out of its respective markets. Margins may have to be sliced in order to regain market share, although the company has announced no plans to do so as of now. If the faster-broadband plan doesn't work as expected, they may have to.

Management's estimates of EBITDA, minus interest payments equal to those of last year, leave a free-cash-flow cushion for the dividend that's higher than double. Last year's cushion was after a reduction of $592 million of debt. That's $200 million less than the company would have to pay off in 2009. In 2008, free cash flow was $1.154 billion; the dividend payout was $556 million. Assuming that free cash flow stays the same in 2009, except for the maturity requirement, it will come in at $954 million. That would lower the cushion to below twice dividend requirement.

As for what will happen to the dividend, I have to admit that I can't call it either way. The current recession is drawing near an end, which should bode for Qwest's fortunes increasing. On the other hand, Qwest may face being priced out of its larger markets. The refinancing obligation is a worry because the company has no standby lines of credit, so it depends upon juggling the cash flow to meet current liabilities. It's going to depend upon refinancings in 2010. 2007's went well, but that was a year when Qwest's earnings were much higher than its current ones are.

I have to conclude that it's too early for Qwest to be dubbed a promising turnaround stock. With the exception of the business segment, it only has potential macro factors going for it right now. That potentiality may be good enough for some, but company-specific factors could reduce any benefits the company sees from a recovery. 2010 is going to be a challenging year, debt-wise. Qwest might not be able to refinance all of its maturing debt that year unless its fortunes spring back to 2007 levels. These obstacles make for a risky turnaround, even at the stock's current low price.

Note: I'm not licensed to act as an investment advisor in my home jurisdiction of Ontario in Canada, nor am I qualified to become licensed as such.

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