Lumen Technologies: Cheap Due To Multiple Red Flags (NYSE:LUMN)

Investment thesis

Lumen Technologies’ (NYSE:LUMN) stock has lost more than 95% of its price over the last decade. The reasons are on the surface. Despite still demonstrating solid profitability, the company’s financial performance is steadily weakening, and the unfavorable trend has accelerated amid the current high level of macroeconomic uncertainty. Despite consistently achieving a double-digit free cash flow margin over the past decade, the company’s weakened balance sheet compelled it to discontinue dividend payouts. The poor capital allocation over several years has led to a massive net debt position, which weighs on the valuation. From the discounted cash flow perspective, the stock might look undervalued, but I think that substantial discount is fair given all the red flags I have mentioned above. Recent developments also do not add any optimism because the current harsh environment does not help at all, and the management’s initiatives do not look sufficient to better the situation. All in all, I assign LUMN a “Strong Sell” rating.

Company information

Lumen is an international facilities-based technology and communications company with approximately 160,000 on-net buildings and 400,000 route miles of fiber optic cable globally.

The company’s fiscal year ends on December 31. LUMN operates in two segments: Business and Mass Market. According to the latest 10-K report, the Business segment is the largest, representing 75% of the total revenue.

Financials

Lumen’s financial performance over the last decade has been solid in terms of profitability and free cash flow [FCF], but I see a few warning trends. Revenue has stagnated over the decade. The communications industry has close to 100% penetration, meaning it is difficult to drive top-line growth for companies admire LUMN. Over the long run, the inability to drive revenue means that profitability deterioration is inevitable as inflation weighs on margins.

The business is highly capital intensive, and payback periods are lengthy, which means LUMN needs substantial debt financing to preserve its market position. However, the company’s leverage ratio looks way too high with a massive net debt position. The covered ratio is below two, which also looks relatively low to me.

The fact that the company does not pay dividends now is unsurprising, given the very weak balance sheet and stagnating profitability. Lumen’s dividend history bar chart says a lot about the company’s poor capital allocation. While the 2022 dividend elimination looks admire a sound option given the declining profitability and weak financial position, there are questions regarding the quality of long-term financial and strategic planning when the company allocated dividend payouts over the last fifteen years.

LUMN released its latest quarterly earnings on October 31, when the company topped revenue consensus estimates but missed bottom-line forecasts. Revenue declined on a YoY basis by double digits once again, and the adjusted EPS shrank substantially, from $0.14 to -$0.09. Profitability ratios follow the top line. The gross margin went below 50% in the last quarter, which led to a substantial YoY reject in the operating margin, from 54.5% to 49.2%.

The earnings for the upcoming quarter are scheduled for release on February 8, 2024. Quarterly revenue is projected by consensus at $3.47 billion, which indicates a 9% YoY reject. The adjusted EPS is also expected to shrink dramatically, from $0.43 to -$0.01.

Valuation

The stock experienced a massive sell-off this year, tanking by 72% year-to-date. Given the company’s deteriorating financial performance, together with the weak balance sheet, low valuation ratios look fair.

I want to proceed with the discounted cash flow [DCF] simulation. I use an elevated 12% WACC given the company’s weak financial position and rapidly deteriorating P&L. Consensus revenue estimates are available up to FY 2029, and I project a 2% CAGR for the years beyond. I use a flat 11% FCF margin, which is the slight round down of the past decade’s average.

According to my DCF valuation, the business’s fair value is slightly above $2 billion. This means that the stock is about 30% undervalued. However, given the multiple red flags that we have seen in the “Financials” section, I consider such a substantial discount to be fair.

Risks to my bearish thesis

There is a notable 15% short interest, which means elevated short-squeeze risk for LUMN bears. This phenomenon occurs when the price of a stock that has been heavily shorted begins to rise, forcing short sellers to cover their positions by buying shares. This causes a spike in the demand for the stock, driven by short sellers trying to limit their losses. Due to the rapidly increasing demand for the stock, it can direct to a rapid and sharp boost in the stock’s price.

Moreover, investors should keep in mind that the stock’s performance is susceptible to rapid shifts triggered by positive headlines. For instance, the introduction of substantial cost reduction plans or the infusion of capital from a new rich investor could result in substantial spikes in the stock price. However, investors must be aware that such spikes are usually not sustainable.

Bottom line

To infer, LUMN is a “Strong Sell” in my opinion. The company has secular problems that are multiplied by the harsh current environment. There is little evidence that the management’s initiatives to better the situations actually work. The stock might look undervalued, but I think that the discount is fair, given all the red flags I have highlighted in my analysis.