Business context and reporting period
The supplied Form 10-Q is filed by CenturyLink, Inc., not under the name Lumen Technologies, Inc. It covers the quarter and six months ended June 30, 2017; the filing was signed August 4, 2017. CenturyLink provided communications services to residential and business customers and reported Enterprise and Consumer segments.
The company had agreed to acquire Level 3 Communications in a cash-and-stock transaction, then expected to close by the end of Q3 2017, subject to regulatory approvals and other conditions. It sold its data-center and colocation business on May 1, 2017.
Financial and operating metrics
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Revenue | $4.090B | $4.398B | $8.299B | $8.799B |
| Operating income | $367M | $647M | $998M | $1.335B |
| Net income | $17M | $196M | $180M | $432M |
| Diluted EPS | $0.03 | $0.36 | $0.33 | $0.80 |
| Operating cash flow | — | $1.742B | $2.601B | |
| Capital expenditures and capitalized software | — | $1.610B | $1.264B |
- Q2 revenue declined 7%; first-half revenue declined 6%. Operating margin was approximately 9.0% in Q2 versus 14.7% a year earlier; first-half operating margin was approximately 12.0% versus 15.2%.
- Q2 Enterprise segment revenue was $2.215B and segment income $930M (42% margin); Consumer revenue was $1.402B and segment income $810M (58% margin). Both segments’ income fell year over year.
- At June 30, cash and cash equivalents were $342M, with $6.015B of restricted cash primarily representing Level 3 financing held in escrow. The company reported $2B of undrawn capacity on its existing revolving facility and no borrowings under it.
- Balance-sheet debt was $25.077B, including current maturities, compared with $19.688B at December 31, 2016. Long-term debt excluding current maturities was $24.881B. The company also expected to assume approximately $11B of Level 3 debt at acquisition closing.
- Quarterly dividends declared were $0.54 per share; $590M of dividends were paid during the first half. Stockholders’ equity was $13.086B at June 30, down from $13.399B at year-end.
Material changes versus the prior comparable period
- Revenue declines reflected continuing contraction in legacy voice and private-line services, customer losses, and competitive price pressure. Legacy-services revenue fell 10% in both Q2 and the first half.
- The data-center and colocation sale reduced colocation revenue by approximately $100M in the comparable Q2 and first-half periods. Excluding that effect, strategic-services revenue also declined modestly, with broadband subscriber losses, lower video revenue, Ethernet price reductions and lower managed-hosting volumes partly offset by demand for MPLS and cloud hosting.
- Access lines fell 6% year over year to 10.733M; broadband subscribers fell 2% to 5.868M. Employees declined 7% to 39,800.
- First-half operating cash flow fell $859M, primarily due to lower earnings, higher cash taxes, working-capital changes and the divested business. Investing cash use was partly offset by $1.473B of sale proceeds; financing cash flow included the escrowed acquisition borrowing.
- Q2 net income included a $119M loss associated with the data-center sale and failed-sale-leaseback accounting. Management estimated that the failed-sale-leaseback treatment reduced net income by $101M in Q2 and the first half, including a $117M additional sale loss, partly offset by tax effects. These estimates were preliminary.
Outlook, management commentary and risks
- Management estimated 2017 access-line losses of 4.5%–6.5%, and approximately $1B of capital investment in the second half, excluding additional Level 3 capital expenditures. It expected cash income taxes related to 2017 of $400M–$500M, excluding the estimated $65M tax impact of the data-center sale and any Level 3 effects.
- Management expected a voluntary $100M qualified-pension-plan contribution in Q3 2017. The company expected to maintain its $0.54 quarterly dividend, but emphasized that the Board may change or discontinue dividends.
- Following the Level 3 acquisition, management expected substantially higher debt, interest expense, capital expenditures and quarterly dividends; it also anticipated material transaction and integration costs and said post-closing cash outflows were possible. The acquisition financing was subject to funding conditions, and the filing warned that it might not be available when needed.
- Credit agencies had placed CenturyLink’s ratings on negative watch or review for downgrade following the acquisition announcement. Management noted risks from increased leverage, refinancing needs, floating-rate debt, covenant restrictions and the possibility of reduced access to capital markets.
- Other key risks include ongoing competition and technology-driven substitution, regulatory and access-charge disputes, CAF Phase 2 infrastructure obligations, pension and retiree-benefit funding, and litigation. In June, consumer and shareholder actions and a Minnesota Attorney General suit alleged improper sales and billing practices; the Board formed a special committee to investigate. The investigation was in its early stages.
- Management stated that disclosure controls were effective as of June 30, 2017, and that no material change in internal control over financial reporting occurred during the quarter.
Important facts for investors to verify
- Confirm the Level 3 acquisition’s closing status, final financing, assumed debt, regulatory conditions and realized integration costs and benefits.
- Assess whether operating cash flow can support capital investment, debt service, pension and retiree obligations, and dividends as legacy revenue continues to decline.
- Review the final accounting and cash-tax effects of the data-center sale and failed-sale-leaseback; reported restricted cash is not equivalent to freely available liquidity.
- Track developments in the sales-and-billing investigation and related litigation, as well as access-charge and Missouri tax disputes; outcomes and potential exposure are uncertain.
- Check subsequent credit-rating changes, debt covenant headroom, and the impact of acquisition borrowing and variable interest rates.