Lumen Technologies, Inc. annual report, FY2011

Business context and reporting period

The supplied filing is CenturyLink, Inc.’s Form 10-K for the year ended December 31, 2011, filed February 27, 2012. It is not a filing under the name Lumen Technologies, Inc.; the company’s name and corporate history should be verified when matching this document to the request. The filing includes quarterly data, including fourth-quarter 2011.

CenturyLink provided communications and technology services, including wireline voice, broadband, private-line and wholesale network services, video, and hosting and colocation. The year was transformed by the April 1 acquisition of Qwest and July 15 acquisition of Savvis. Accordingly, reported 2011 results include Qwest and Savvis only from their respective acquisition dates and are not directly comparable with 2010.

Financial and operating metrics

Operating margin was approximately 13.2% in 2011 versus 29.3% in 2010; net margin was approximately 3.7% versus 13.5%. These calculated comparisons are heavily affected by acquisitions, acquisition accounting, and related costs. The company reported $467 million of acquisition-related operating expenses in 2011 and substantial acquired-intangible amortization. Interest expense rose to $1.072 billion from $544 million, mainly because of debt assumed in the Qwest acquisition and debt issued in 2011.

Fourth quarter: Revenue was $4.653 billion, operating income $533 million, net income $109 million, and diluted EPS $0.18. Fourth-quarter 2010 results were $1.722 billion, $486 million, $225 million, and $0.74, respectively; the comparison is not like-for-like because 2011 includes acquired Qwest and Savvis operations.

Operating cash flow less reported capital expenditures and capitalized software was approximately $1.790 billion in 2011 (calculated). The filing reported $1.556 billion of cash dividends paid. Segment margin percentages were 55% overall in 2011 versus 63% in 2010; 2011 margins were 57% for regional markets, 39% for business markets, 69% for wholesale markets, and 21% for Savvis operations. Segment results exclude centrally managed depreciation and amortization and other unassigned expenses.

At year-end, the company had a $496 million working-capital deficit, compared with positive working capital of $132 million a year earlier. It reported $1.423 billion available under its $1.7 billion revolving credit facility and was in compliance with debt covenants. Approximately 95% of long-term debt was fixed-rate. The company had $21.724 billion of goodwill, including preliminary acquisition valuations, and $21.567 billion of scheduled debt principal and capital-lease obligations in the contractual-obligations table.

Material changes versus the prior period

• Revenue more than doubled, principally because Qwest contributed $8.2 billion and Savvis $483 million after acquisition; Legacy CenturyLink revenue declined $380 million, or 5.4%.
• Net income fell $375 million and diluted EPS fell $2.06. The filing attributes the earnings decline to acquisition, severance and integration expenses, acquired-asset depreciation and amortization, lower legacy-business results, and a substantially larger weighted-average share count following acquisition-related share issuance.
• Access lines were 14.584 million and broadband subscribers 5.554 million at year-end, up sharply from 2010 due primarily to Qwest. Legacy CenturyLink access lines declined 6.75% year over year.
• Debt increased $14.508 billion, largely from Qwest debt and financing for Savvis. Goodwill, customer relationships, and property and equipment also increased materially with the acquisitions.
• Operating cash flow rose by $2.156 billion, largely reflecting acquired businesses; investing outflows increased with acquisition payments and capital spending.

Outlook, risks, contingencies, and unusual items

• Management estimated 2012 capital expenditures of $2.7 billion to $2.9 billion and projected Legacy CenturyLink access-line losses of 5.9% to 6.6%. It expected fiber investment, including fiber to cellular towers, to be similar to 2011.
• Management expected to reduce consolidated debt by $800 million to $1.3 billion by the end of 2012, subject to circumstances and market conditions, and expected to continue refinancing maturing debt. It planned to maintain an annual dividend of $2.90 per share, subject to board discretion.
• Management estimated Qwest transaction and integration operating costs at approximately $800 million to $1 billion, including amounts already incurred, plus approximately $200 million of integration capital expenditures. Integration timing, costs, and expected synergies remained uncertain.
• The FCC’s October 2011 Connect America and Intercarrier Compensation Reform order was expected to accelerate reductions in wholesale switched-access revenue, while potentially creating offsets through universal-service and retail revenues. Implementation proceedings and legal challenges left the ultimate impact unclear.
• Significant risks include intense competition and wireline customer losses; high debt and refinancing needs; pension and post-retirement obligations; acquisition integration and preliminary purchase accounting; potential goodwill impairment; and regulatory and energy costs. Pension plans were underfunded by $1.782 billion and post-retirement plans by $3.237 billion at year-end. Pension contributions were $587 million in 2011; management expected less than $50 million in 2012 and approximately $500 million in 2013, based on then-current assumptions.
• Qwest-related KPNQwest litigation included claims of approximately €4.2 billion (about $5.4 billion at the stated exchange rate) and a separate claim of approximately €219 million (about $284 million). The company had not accrued liabilities for these matters because losses were not then reasonably estimable; outcomes could materially affect finances. Other proceedings included fiber rights-of-way class actions, for which the company had accrued an amount it considered probable and not material.
• Qwest and Savvis acquisition-date fair values remained preliminary at year-end; final determinations were expected by the first and second quarters of 2012, respectively. The filing reported no goodwill impairment, but regional and wholesale reporting-unit fair values had been close to carrying values in the September assessment.
• The filing reported $6.2 billion of federal net operating losses, subject to ownership-change limitations, and management expected to use substantially all by 2015 depending on future earnings and tax circumstances. No 2011 extraordinary item was reported; the $136 million after-tax extraordinary gain in 2009 related to discontinuing regulatory accounting.

KPMG issued an unqualified opinion on the consolidated financial statements and internal control over financial reporting; management also concluded controls were effective at December 31, 2011.

Important facts for investors to verify

• Confirm issuer identity and whether CenturyLink’s 2011 filing is the intended document for the Lumen Technologies request.
• Separate acquired-business contributions from organic trends, particularly the 5.4% decline in Legacy CenturyLink revenue and continuing access-line losses.
• Review debt maturities, refinancing progress, covenant headroom, and the assumptions behind the stated 2012 debt-reduction target and dividend plans.
• Track final Qwest and Savvis purchase-price allocations, acquired intangible amortization, integration spending, and realized synergies.
• Assess the FCC reform’s realized effect on switched-access revenue and any offsetting universal-service or retail revenues.
• Monitor pension funding, the projected 2013 contribution, the KPNQwest and other litigation, and goodwill valuation sensitivities.