Lumen Technologies, Inc. quarterly report, Q2 FY2011

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CenturyLink, Inc. — 2011 Q2 Form 10-Q

Issuer and period: The filing is for CenturyLink, Inc., for the quarter ended June 30, 2011—not an issuer identified as Lumen Technologies in the filing. Financial statements are unaudited. Qwest results are included from its April 1, 2011 acquisition date, making reported comparisons with 2010 uneven.

Business context and reporting period

CenturyLink provided communications services across 37 states, including voice, broadband, network access, hosting and data services. At quarter-end it reported approximately 15.1 million access lines and 5.4 million broadband subscribers. Following the Qwest acquisition, it reported regional, business and wholesale markets segments. Savvis was acquired on July 15, 2011, after quarter-end.

Financial performance and liquidity

  • Revenue: Q2 revenue was $4.406 billion, versus $1.772 billion in Q2 2010; first-half revenue was $6.102 billion, versus $3.572 billion. Qwest contributed $2.746 billion of Q2 revenue after intercompany eliminations. Excluding Qwest, revenue declined 6.3% for Q2 and 6.0% for the first half, mainly due to legacy-service declines.
  • Profit and EPS: Q2 operating income was $459 million versus $523 million; net income was $102 million versus $238 million; diluted EPS was $0.17 versus $0.79. First-half operating income was $923 million versus $1.068 billion; net income was $313 million versus $491 million; diluted EPS was $0.69 versus $1.63. Higher acquisition, integration, severance, depreciation and interest costs contributed to lower earnings.
  • Comparable pro forma results: Management’s unaudited pro forma six-month figures, assuming Qwest had been acquired on January 1, show 2011 revenue of $8.887 billion and net income of $386 million, versus $9.335 billion and $428 million in 2010. These are illustrative, not reported GAAP results.
  • Margins: Total segment margin was 56% in Q2 and 58% for the first half, versus 64% in each 2010 period. Segment margins exclude depreciation and amortization, interest and certain centralized costs; Qwest’s inclusion affects comparability.
  • Cash flow and investment: First-half operating cash flow was $2.018 billion, versus $881 million. Property, plant, equipment and capitalized-software spending was $790 million, versus $362 million. Cash at quarter-end was $2.546 billion, up from $173 million at year-end, including Qwest cash and debt proceeds; the balance was held partly to fund the subsequent Savvis acquisition.
  • Debt and liquidity: Total debt, including current maturities, was $21.344 billion, versus $7.328 billion at December 31, 2010. Current assets were $5.007 billion and current liabilities $5.064 billion, producing negative working capital of $57 million. The $1.7 billion revolving credit facility had $1.639 billion available; the company reported compliance with debt covenants.
  • Dividends: The declared quarterly dividend remained $0.725 per share ($1.45 for the first half). Management expected to continue an annual $2.90 dividend, subject to board discretion.

Material changes and unusual items

  • Qwest was acquired for estimated consideration of $12.273 billion, primarily CenturyLink shares. Preliminary acquisition accounting recorded $10.005 billion of goodwill; fair-value estimates and useful lives remained subject to finalization.
  • Qwest added substantial debt and benefit obligations. At acquisition, preliminary unfunded Qwest pension and postretirement liabilities were $479 million and $2.516 billion, respectively. Qwest debt had stated principal of $11.598 billion and weighted-average contractual interest of 7.63%.
  • CenturyLink estimated $800 million–$1.0 billion of Qwest transaction and integration operating expenses and approximately $200 million of integration capital costs. The MD&A listed acquisition-related expenses of $240 million in Q2 and $261 million for the first half in SG&A, plus $26 million and $40 million, respectively, in cost of services.
  • Qwest contributed $823 million of post-acquisition Q2 depreciation and amortization, which management said was about $200 million higher than anticipated due to preliminary intangible-asset valuations.
  • On July 15, 2011, CenturyLink completed the Savvis acquisition. The filing describes $1.732 billion in cash and 14.313 million CenturyLink shares issued to Savvis stockholders, plus $547 million to retire certain Savvis debt and accrued interest. Savvis results are excluded from the quarter.
  • Expense classifications and segment reporting were revised; prior-period amounts were reclassified. The filing states these presentation changes did not affect total operating expenses or net income.

Outlook, risks and contingencies

  • Management estimated 2011 capital expenditures of $2.35 billion–$2.5 billion and anticipated continued investment in broadband and fiber, including fiber to cell sites. It forecast incumbent-market access-line losses of 7.0%–7.5% in 2011 and anticipated similar losses in Qwest markets.
  • Management expected Qwest pension contributions of $300 million–$350 million in 2012; Legacy CenturyLink pension contributions were estimated at $180 million–$200 million annually for 2012–2014. Future amounts depend on plan performance, rates, demographics and funding rules.
  • One credit-rating agency had changed its outlook to negative. Management noted that a downgrade could follow if leverage was not reduced while maintaining free cash flow over the next 12–18 months. Debt maturities included approximately $1.5 billion of Qwest debt in the following 12 months, which the company expected mostly to refinance.
  • Key risks include executing multiple integrations (Embarq, Qwest and Savvis), realizing anticipated savings, customer or employee losses, access-line declines, competition and pricing pressure, regulatory changes, pension funding, refinancing access, and restrictions on use of Qwest tax losses under Section 382.
  • Qwest-related litigation included KPNQwest claims seeking approximately €4.2 billion (about $6.1 billion at the stated exchange rate) and separate claims of approximately €219 million (about $320 million). Other contingencies included fiber-right-of-way class actions and a CenturyLink claim for approximately $34 million in access charges; no liability had been accrued for the latter matters. Outcomes and financial effects were uncertain.
  • Interest-rate sensitivity: approximately 96% of debt was fixed rate. A hypothetical 100-basis-point rate increase was estimated to reduce debt fair value by $1.081 billion; a 100-basis-point LIBOR increase was estimated to reduce annual pretax earnings by about $8 million.

Important facts for investors to verify

  • Compare underlying performance using the filing’s Qwest pro forma figures and its acquisition-adjusted revenue discussion; reported year-over-year results are not like-for-like.
  • Track final Qwest purchase-price allocations, goodwill and intangible-asset lives, which could change future amortization and reported earnings.
  • Assess integration costs against realized synergies, including the $800 million–$1.0 billion operating-cost estimate and $200 million integration-capital estimate.
  • Review debt maturities, refinancing terms, credit-rating outlook, liquidity after the Savvis purchase, and the sustainability of the dividend alongside planned capital spending and pension funding.
  • Monitor access-line trends, strategic-service growth, pension contributions, Section 382 limits on tax-loss use, and material litigation developments.