LUMN DCF Projections: Growth to Outperform Market Expectations

Lumen Technologies has had the honour of being perceived as one of the slowest and most debt-laden companies in the field through 2018 to 2019, contributing to its valuation drop. However, this perception is due to change with recent developments and we find it a great value buy with a compelling growth story. Our projections give a LUMN DCF target price of $14.69.

Update (11/2/2021): LUMN has hit price targets much earlier than expected without fundamental changes in the company outlook due to volatility caused by GME spiking. We have re-entered the position at lower prices.

Setting the stage

Lumen Technologies has traditionally been part of the wired communication carriers industry, which has been in decline as the use of low-bandwidth copper wiring is no longer viable as competition from wireless providers is fierce. Companies in this industry have been established for a long period of time and across many mergers and acquisitions tend to have businesses in the industries further down the supply chain as well, protecting them from the fallout. Such companies would be players like Verizon and AT&T. Providers have also invested in high-bandwidth fibre-optic networks to improve internet speed and reliability.

Lumen’s share price has fallen more than 50% in the last five years due to a perfect storm of weak company financials and perceived headwinds due to global trends, creating significant negative sentiment around the stock.

Key complaints cited by retail investors include:

1. Dividend cut in 2019 from $0.54 to $0.25

2. Company is significantly leveraged

3. Unlike its peers with wireless businesses, Lumen does not APPEAR to have business segments that can directly ride the 5G hype

As a result, at the time this article was written, the market price implies a growth rate of -4.17% each year in unlevered free cash flow.

A recovering financial position

The company’s financial position has hit a bottom in the near term and the likely trajectory from now, with the aid of management, is up.

• The company is targeting a lower leverage ratio of 2.75 to 3.25 times net debt to adjusted EBITDA by early 2022
• Its financial profile is actively improving as time passes, and it is already nearing or has a better financial position than some of its comparable companies

This, and the presently low interest rates, will allow the company to improve its debt profile and tap into the technological growth spurt that the telecommunications industry is experiencing. And this growth is not just in 5G like many people expect, as we will explain shortly.

A Primer on Fibre, Edge Computing, and 5G

Something investors commonly misunderstand is that rather than being slow and stagnant companies that are only good for their dividends, telecommunication companies are today central to a set of revolutionary technological advancements that include but are not limited to 5G. And it all begins with their fibre networks.

5G has opened an entire can of worms that goes far beyond ‘better wireless speed’.

5G improves speed by increasing spectral efficacy. Edge computing, on the other hand, reduces latency by shortening the time required for data processing by doing calculations closer to the application – a smart object (for example, a smart oil rig that runs the program gathering the data and doing calculations). When combined, edge and 5G can help to achieve round-trip latency below 10 milliseconds. And for this all to work, fibre networks are required as 5G relies on many small cells to bring it to the point for last mile wireless access (the final distance between the radio tower and households/offices).

All three technologies working together ensure the reliability of 5G for more advanced applications such as artificial reality and autonomous driving machine learning AI requiring low margin of error, creating the network of the future and likely giving rise to more industries; they are expected to grow in tandem.

Lumen hits the ground running in Edge Computing

Given the context above, even without a wireless business, Lumen is absolutely poised to take advantage of the 5G boom. In fact, we believe that Lumen will be able to capture a significant portion of the edge computing market's ~27% CAGR between now and 2025.

Here's why:

1. Experience with wireline and a large existing fibre network gives Lumen easy entry into the edge computing market

2. Lumen’s Edge Compute service has started offering 6 nodes as of Dec 2020, it has built more than 100 edge compute locations across the U.S. and secured a partnership with VMWare to grow its edge computing business

3. Lumen is expected to boost their connectivity business, reduce latency for customers and attract corporations that do not have the economies of scale to deploy their own edge computing solutions, boosting its Enterprise and SME segments.

Potential Upside in Rural Communities

There is a large addressable market in the rural communities of U.S. and Europe.

The large social benefit of a widespread internet is driving governmental support towards adding FTTH to rural areas. High speed internet access is seen as crucial for connecting people to the education, health care and jobs they need.

The Federal Communications Commission voted early 2020 to approve a $20.4 billion fund designed to ensure that residents in rural areas of the US have access to broadband internet connections, with the subsidy available to broadband providers. Local governors have already started rolling out broadband infrastructure projects, and Lumen has shown interest. A recent example would be its acceptance of a grant to expand its services to 5 counties in North Carolina.

Adoption by rural households has only just begun; Cartesian estimates that only 30.1% of households have been passed over by fibre networks as of 2018 and even less are connected. It projects that at least 23 million more households will be connected by 2024 --  easy pickings for Lumen which has substantial experience setting up wireline connections and bringing them to offices and homes.

This can be attributed to the debt structure of telco companies discouraging them from investing in rural areas in the past. However, the movement to provide services in rural areas has been ignited by subsidies and renewed incentive to expand fibre networks due to technological advancement.

Increasing Product Prices Stem Bleed

Lumen’s strategy of aggressively investing in fibre to drive higher average revenue per broadband customer to offset legacy voice and video declines, and bundling weaker products (e.g., voice) with stronger ones to encourage consumer loyalty is simple and not uncommon but it is working.

The past 11 quarters have seen a downtrend in subscriber declines and uptrend in average revenue per user, which we expect to continue and counteract the drop in voice and other legacy services.

Besides, Lumen’s ARPU is in line with its larger counterparts, and even though it has significantly lower subscriber growth compared to companies like Comcast at the moment, this will be manageable with the current rate of ARPU increase.

Segment Data

You may see a list of the company's five segments, each split into four parts, along with their projections below. The trends are derived from company annual report notes and the theses above.

In Summary...

Lumen is a telecoms company at the centre of a revolutionary technological advancement with its wireline technology and is poised to profit from the 5G rollout, whether it has a wireless business or not. It has growth upside from various channels such as rural households and its rising ARPU, and its debt profile is steadily improving. Even if we completely ignore its dividend yield rate as a reason to buy the stock (which is over 10% as of today!) it is still an amazing play.

For dividend-based investors who are worried about dividend cuts, from a long-term investment point of view and given the technological opportunities on the horizon, paradoxically the stock might even be a stronger buy if dividends are void to save equity for Lumen's technological advancement as this will accelerate its growth.