2023-09-27 12:00:37 ET
Summary
- Lumen Technologies is trading at multi-decade lows and it appears as if the market is pricing it for imminent bankruptcy.
- Real risk of bankruptcy before 2027 maturities is extremely low.
- Lumen has a turnaround plan focused on investing in fiber networks and next-generation business solutions to return to growth.
- The market is undervaluing the common and overestimating the chances of failure, creating a favorable risk/reward for the brave.
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Lumen Technologies ( LUMN ) is a telecommunications company that is currently trading at multi-decade lows and it appears as if the market is pricing it for imminent bankruptcy. With a new management being committed to a multi-year turnaround strategy to return back to organic growth, I believe that at current prices LUMN offers an asymmetric risk/reward opportunity. In this article, I want to investigate the current situation and try to show why equity and bond prices might not accurately reflect the company's real risks.
Why is the market pricing Lumen for bankruptcy?
With a debt stack of over $19B, a net interest expense of over $1B yearly and declining top-line and bottom-line numbers, the long-term future looks bleak for this highly-levered company. The company is currently investing billions into a turnaround plan to return to growth, leaving little to no cash to prematurely pay down debt, let alone distribute to shareholders.
With the majority of both business revenue (~55%) and mass market revenue (~80%) still coming from rapidly-declining legacy services like copper-based broadband or voice and a lack of substantial cost savings from the company, the market is projecting a deteriorating situation for the years to come. Even when adjusting top-line decline by past divestitures, the company's legacy services are still showing double-digit declines Y/Y. When factoring in the smaller chunk of growing business the company has, overall decline still sits at mid single-digits.
Y/Y Revenue Bridge (Lumen 2Q23 Earnings Presentation)
Due to some unfortunate timings regarding debt maturities, the company is facing a disproportionate amount of debt maturities until 2030. While proceeds from a divestiture of Lumen's EMEA business (scheduled to close end 2023/beginning 2024) are earmarked for their $1.6B 2025 maturities, there is a big $9.4B debt tower coming up in 2027 the market is worried about.
Lumen Maturity Profile (Lumen Investor Day)
The price of the company's common has been in a downtrend for almost 10 years now, with a rapid downfall starting in about August 2022, when the common was still trading at over $11, to now, where the common is trading at just $1.40. A tough macroeconomic situation and high-interest rates are not kind to highly-levered and cash-intensive businesses.
10Y Price Chart (Seeking Alpha)
Macroeconomic factors combined with other above mentioned fundamental problems and risks also lead to a rapid decline in Lumen's bond prices with bonds yielding a rough average of around 30% currently.
While the company's bond and equity prices are declining due to fundamental issues of the company, the low bond and equity prices themselves further put stress on the company's ability to refinance their debt, creating an unpleasant downward spiral.
Lumen's turnaround plan
On their Investor Day in June 2023, the company presented their turnaround plan to reposition the company for growth. Seemingly, the market did not buy into the company's story and the common dropped another 26% just from Lumen's Investor Day to today. In short, Lumen wants to return to growth by investing into their fiber network, providing high-quality business services and actively combating customer churn by onboarding legacy customers onto their next-generation solutions. Lumen projected further pain until the end of 2024 while they invest time and capital into their repositioning. However, the company projects a return to growth in 2025, well before the dreaded 2027 debt maturities.
Lumen Outlook (Lumen Investor Day)
Mass market
On the mass market side, the main driver to recapture market share for the company will be fiber penetration. While their fiber buildout is highly capital intensive, it can provide a long-term annuity stream for the company with high barriers of entry for competition.
Looking at the numbers, the company states a high of $1.5k of average cost per fiber location enablement. Even though the company projects a long-term penetration of their fiber locations at 40%, I will base my assumptions on current numbers of ~25% as per their Q2 2023 release. Even though the company mentions a current $75 intake ARPU for most customers we will use the ARPU of $60 mentioned in their Investor Day for our calculations. Based on the numbers above, we can assume that only every 4th fiber location will convert to an actual mass market fiber customer, meaning the company is investing $1.5k × 4 = $6k to convert a new fiber customer at an annual price of $60 × 12 = $720. With a projected EBITDA-Margin of 53% for their mass market business, the company is making an estimated 6.36% annual EBITDA on their fiber buildout. Since we used the high-end of their cost estimation and the low-end of penetration and ARPU, this number should be considered a near worst-case scenario. The estimate could probably be adjusted to the upside after, if the next earnings results show better numbers.
Even though my rough estimations for annual EBITDA from their fiber buildout show a return that is likely too low to justify the capital invested, especially at current refinancing costs, at scale the EBITDA-Margin will increase and penetration can likely be improved. If we assume for example that in the long term the company's projected penetration of 40% is accurate, the estimated annual EBITDA on their fiber buildout will increase to over 10%. At their Investor Day presentation management talked about a ramp-up in mass market marketing activity. It remains to be seen whether they can improve fiber penetration that way.
The market is basically writing off all this invested CAPEX. I believe there is considerable opportunity here for Lumen to establish a high-return annuity stream with their fiber business, improving their chance of refinancing their debt and in the long-term even return capital to shareholders.
Lumen's Q2 2023 release shows that they are on schedule with their fiber buildout having added 130k fiber locations Q/Q. Even though penetration of added locations in Q2 was slightly below their average, I assume there is some ramp-up cost and time needed for penetration. Both top-line and bottom-line mass market projections of the company, so far, seem accurate, leading to return to growth towards the end of 2025.
Lumen Mass Market Outlook (Lumen Investor Day)
Business segment
The business side is by far the larger chunk of the company's overall top-line and bottom-line. In a recent Analyst Call the CFO, Chris Stansbury, says the following:
The enterprise business is one of high margins, the need for innovation, quicker product turnover and as a result, quicker paybacks and higher returns.
The consumer business is one of build it and they will come.
On the mass market side, the company can simply use their existing expertise and infrastructure and use capital to get fiber into the ground which will convert to paying customers relatively quickly. However, on the business side they need to innovate to grow. At the same time the business side is providing higher returns, while the mass markets side is providing a low, but steady, stream of annuities. The higher returns on the business side also come with higher risk of not capturing market share from business clients.
With Lumen's CEO, Kate Johnson, being Ex-President Microsoft US and shifting towards a "play to win" instead of "playing not to lose" , the management team seems confident in their ability to "disrupt" the industry and does not shy away from investing large amounts of capital into their business segment repositioning.
Since the company's new CEO took over, Lumen has announced several high-profile partnerships and innovative products. The company is "innovating for growth" which shows in their security work with Black Lotus Labs , 400G Offering , ExaSwitch and NAAS . Partnering with the likes of Microsoft and Google , management seems to utilize their industry connections well. Looking at their new products, the company is far from an old-fashioned legacy network provider.
The results from these investments are still to be seen. The 400G offering for instance, was only able to account for $25M of annualized revenue after 6 months of operations. It is not clear how successful some of the other solutions are.
While the next few earnings releases will have to confirm the projections, I believe these vertical expansions are a natural next step for a telecom company. Services higher up in the stack than pure bandwidth naturally come with higher margins and a better growth outlook. In my opinion, the chances that Lumen's current investments into growth initiatives will be more successful than the market's prices for the companies common might suggest, are significant.
Lumen Business Segment Outlook (Lumen Investor Day)
What to look out for
The next coming quarters are going to be very significant for the company. Mainly, they will show the market whether the company can continue to hit their objectives and projections for their turnaround plan or fall behind them.
I remain bullish on the common, as long as the company can stay above their low-end estimations for Revenue and Adj. EBIDTA while not exceeding their upper-end estimations for CAPEX.
On the Mass Market side I am closely looking at them staying on-track with their new enablements and also increasing penetration. ARPU should not decrease in any of the upcoming quarters. On the Business side it is important to see, whether their new growth initiatives can generate revenue and if any of their new products can catch on and become real contributors to their top-line.
Even though there is still a great margin of safety at current prices, a failure to keep up with their projections over the next few quarters could shift my position to hold or sell, depending on the severity of the failure.
Conclusion
The market is apparently pricing both the company's bonds and the common for imminent bankruptcy. However, looking at the debt maturities, there does not seem to be a big risk of bankruptcy until at least 2027, when the big debt tower is due. While declining top-line and bottom-line numbers do put pressure on the company, the ability to pay their interest expense even with the current high interest rates does not seem to be threatened. The company also still has enough cash left to invest into their turnaround plan.
Even though I personally would like to see more cost-discipline and more opportunistic behaviour when it comes to decreasing CAPEX to buy back discounted debt, the new management so far seems to be doing exactly what they set out to do. While especially on their business segment it still remains to be seen how successful their investments into growth initiatives will be in the end, it is too early to write off all the CAPEX put into these growth initiatives.
With a TTM EV/Sales of 1.37 and EV/EBITDA of 4.14 there seems to be an asymmetric risk/reward opportunity at current prices of around $1.4. If you see even a small chance of management being able to successfully pull of the repositioning strategy in the next 4 years, the common is a cheap option to purchase with a high upside.
Especially the fiber buildout likely has a market value close to what Lumen spent on it in CAPEX. Combined with the remaining value of Lumen's legacy infrastructure and business, even in the very worst case scenario of bankruptcy or forced reorganization the common might still not look at a full loss.
I still want to be clear however, that there is a real risk of bankruptcy and total loss of capital. While I personally think the odds of this bet are on my side, any such bet can fire back at any time. Even before the 2027 maturities management could opt for a voluntary reorganization, potentially severely diluting shareholders. With no share purchases (besides grants) by insiders at these prices, some market participant might further be discouraged of trying to catch the falling knife.
For further details see:
Lumen: Favorable Risk/Reward