UNIT - Lumen: An Interesting Play On Survival

Summary

• We had a hold rating on Lumen on our last coverage.
• The stock decline has pushed it to a low enough level that we think a speculative bet can be made.
• We like the idea of betting on survival but through the equity this time as opposed to the bonds.

When we last covered Lumen Technologies, Inc. ( LUMN ) we stressed that the bonds were screaming in pain and the probability of even a single share repurchase, let alone a huge buyback, were abysmal. We reserved our bullish rating for the bonds and decided to stay out of the equity, again. Specifically we said,

Another large asset sale at 10-11X EBITDA multiples could send the bonds 20-30% higher, especially if that coincided with the end of the Fed's hiking cycle. That 30% is also what we would see as the upside in the common equity over the next year, albeit with far more risk. Hence, we maintain a buy rating on the bonds and are keeping the common stock on a hold.

Source: No Dividends Or Buybacks For You

The idea to not be seduced by LUMN worked and the stock has underperformed the S&P 500 ( SPY ) once more.

We tell you why we are now making a pivot and taking a bullish stance even on the common equity.

Reason 1: No More Dividend Groupies

LUMN has been a value trap for a long time. The declining revenue stream was married to an unwieldly debt structure. The combination meant that the only hook for investors was the dividend. Thanks to a constantly falling stock price, that yield remained high, even after dividend cuts. Pre-2022, where the era of ZIRP (Zero-Interest-Rate-Policy) was central to the Fed mandate, investors were constantly drawn to these plays. If they held LUMN all the way down, these investors got a total return of negative 70% with dividends reinvested over the last decade.

That is quite the return and even the much criticized value traps of AT&T Inc. ( T ) and Verizon Communications Inc. ( VZ ) have offered a far smoother ride. We believe that the last part of decline is the capitulation signal as the last of the dividend chasers made an exit. You can see this by the speed of the drop as if someone yelled "Fire!" in a crowded theater.

Alongside tax loss selling, we believe LUMN experienced the worst of all worlds and is ready for some upside.

Reason 2: Valuation Is Extremely Compelling

If we step back from the view of valuing this solely from the dividends, the firm is quite attractively priced. Some of this is obviously a correct action by the market. A copper wire telecommunications company with slowly declining revenues, trying to transition to a new era would have to be cheap. A change of guard at the top with a new CEO (Kate Johnson) coming in also confuses investors. She likely has a heavy growth mindset considering her employment history so investors hoping for a rapid liquidation also probably hit the road after the dividend cut. But what we are left with here is a firm trading at close to 4.0X normalized earnings. Granted that those earnings will contract in 2023, but even post divestitures, LUMN should maintain healthy profits.

From an EBITDA point of view, the EBITDA should have a run-rate of close to $6 billion. That compares with the market capitalization of close to that.

Yes, there is the debt which would be about $20 billion post divestitures. All in, we are looking at a 4.5X EV to EBITDA. Yes, we get the declining aspect of revenues but unless management is willfully blowing the money out the front door, we don't see how 3-5% annual EBITDA declines in perpetuity on the base business make this worth just a 4.5X multiple.

While not an apples-to-apples comparison, we believe it is instructive to look at Uniti Group Inc. ( UNIT ) here for a valuation perspective. Some may call UNIT a rent collector, but the fact remains that if Windstream does not pay rent, UNIT is worth a soft zero. Considering that 80% of its EBITDA comes from Windstream and Windstream keeps repeatedly challenging how much rent it would like to pay, UNIT is a telecommunications operator by proxy. Even that firm trades at 7.1X EV to EBITDA.

2.5X turns of EBITDA would equate to LUMN more than tripling from here. So, while we think there are risks here and any sensible investor would, we believe we have a good setup for upside.

Reason 3: Implied Volatility Gives Us A Gift

While the stock should land up being worth more, we would not bet on that as a likely outcome in the short term. But fortunately, the very high implied volatility present in the stock doesn't require us to be right about significant amounts of upside to make money. In fact, we can make money even with the status quo. A $5 strike Covered Call for January 2024 has a rather pleasant outcome, as long as the stock stays over $5.00. You are essentially making 27% annualized returns, even if the stock declines 8% from here.

The even longer dated options provide an equally interesting outcome. For the ones expiring on January 17, 2025, you are not getting double the premium, but your annual returns are about as strong.

The reason is that your net cash outlay drops and that is of course the base/denominator from where your returns are calculated. Note that in the calculator above returns are shown as simple interest (no compounding effect) for periods beyond a year.

Verdict

The bonds still look appealing for investors betting on the viability of the firm, but we think the covered calls are looking interesting as well.

From a 50,000-foot view, a firm retaining $1.00 of dividend per share per year should be worth $1.00 more per share per year, all other things being equal.

Instead, we have a stock price that cratered and LUMN is far cheaper despite retaining that cash. The 3 reasons above have convinced us that we can play LUMN equity a bit on the long side, as long as we use covered calls and keep position sized appropriately for the risk.

For further details see: