When Lumen Technologies (NYSE:LUMN) suspended their dividends in favor of share buybacks back in November 2022, the reaction from the market was both swift and brutal with their share price instantly plunging more than 10% on the news and thus far since, continuing to remain under further selling pressure. Even though this is a very disappointing end to the year, I feel it is actually a win-win for income investors when considering the flow on impacts of their new shareholder returns policy in the medium to long term.
Throughout the last few years, their high single-digit to low double-digit dividend yield has often caught the attention of many income investors, although concerns regarding its safety have always persisted and were often debated. Regardless of whether sitting in the bull or bear camp, alas, many investors were caught off guard when their dividends were not simply cut but rather, suspended in favor of share buybacks, as per the commentary from management included below.
“Earlier today, we announced that we are eliminating our dividend and instituting an up to $1.5 billion two year share buyback program.”
-Lumen Technologies Q3 2022 Conference Call.
Whether you love or hate this choice, management feels share buybacks will provide a better path to create value for shareholders and are seemingly intent upon completing their $1.5b program across the next two years, thereby amounting to $750m per annum. Despite leaving their shareholders without cash flowing directly into their pockets, thankfully, reinstating their dividends is still not off the table forever, as per the commentary from management included below.
“Returning value to shareholders is a key priority for Lumen, and we believe the dividend is an appropriate value delivery mechanism. But we’ve also said that our Board regularly reviews whether that approach remains aligned to the current circumstances.”
-Lumen Technologies Q3 2022 Conference Call (previously linked).
Anyone who is familiar with my articles over the years may recall that I often criticize companies focusing upon share buybacks over dividends and whilst yes, I always prefer dividends, I still see situations where by the latter creates value or provides a tangible benefit. Most of the time when criticizing share buybacks, they are being conducted by oil and gas or coal companies, which is different in this situation, face highly cyclical financial performance that risks seeing more being conducted at cyclical highs and less at lows, thereby going against the old adage of buy low, sell high. Plus, they also face an uncertain long-term future in this age of clean energy and thus because share buybacks are effectively an investment back into the existing operations of the company, this creates uncertainty surrounding their medium to long-term tangible benefits.
Thankfully in this situation, neither of these problems are too relevant and thus as a result, I do not view their share buybacks as a necessarily bad choice for shareholder returns, despite my love of dividends. Regardless of whether they ever reinstate their dividends, thankfully they have plenty of free cash flow to execute their current share buyback program.
Thanks to their steady cash flow performance, they have consistently generated free cash flow every year in recent history with an average of $3,149b during 2019-2021. Even with their softer operating cash flow during the first nine months of 2022, they still generated free cash flow of $1,711b and thus in theory, they could actually afford to complete their entire $1.5b share buyback program in less than one year, meaning that its current $750m per annum rate is easily affordable. Apart from raising the prospects of a faster rate in the future, this also very importantly means there is a large margin of safety, which in turn, removes most doubts of whether their share buyback program will be completed within two years. Since they are burdened with a very large $24,986b pile of net debt, it is not surprising that they are throttling down their share buybacks well beneath their free cash flow to facilitate deleveraging, which in turn provides benefits itself.
Future Share Price & Potential Dividends
When assessing valuations, I normally opt for a discounted cash flow valuation that makes use of their dividend payments but obviously, their lack of dividends makes this approach impossible. While their free cash flow could instead be utilized as commonly practiced within the finance industry, given it is being directed towards deleveraging and share buybacks, these clouds have true intrinsic value in my eyes because a material portion does not land in the pockets of shareholders. As a result, this time I will instead utilize an approach that provides very conservative valuations by exploring the flow on impacts of their share buybacks.
Upon the end of the third quarter of 2022, their outstanding share count was 1,034,758,000 and given their current share price of $5.30, this sees a market capitalization of approximately $5.5b. If their share price was to hypothetically remain static, their $750m per annum of share buybacks would remove all of their shares in slightly more than seven years.
Needless to explain, such an outcome is impossible and thus, one way or another, something is going to have to give. Considering the very large margin of safety between their free cash flow and share buyback program, these are not likely to be reduced, thereby putting upwards pressure on their share price as their outstanding share count plunges. In theory, their share price should at least scale higher proportionally with their lower outstanding share count, which keeps their market capitalization static and stands to deliver very desirable returns.
When reviewing the results of this scenario, the benefits of their share buybacks are easy to see after implementing their existing $1.5b two-year program with their potential share price rising to $7.00. This would represent an increase of almost one-third above their current share price, thereby providing a compounded annual return of almost 15%. After this point, it remains uncertain whether share buybacks would continue taking precedence over dividends but if this were the case, they would obviously continue seeing this same compounded annual return perpetually into future years with their potential share price accounting for $10.63 after five years.
Even though a capital gain of 15% per annum is not necessarily the highest return ever, it nonetheless would likely surpass much of the market and thus is still very desirable, especially considering it results from a very conservative scenario whereby their market capitalization remains unchanged. Plus, this is happening in conjunction with deleveraging because as previously discussed, they are throttling down their share buybacks to help address their very large pile of net debt.
Since their share price is already down slightly over 50% year to date, it seems safe to say their current market capitalization is anything but high nor influenced by exorbitant expectations. If anything, their share price could even recover in the short-term after plunging almost 30% since their dividend suspension but for right now, this potential for a quick payoff will be ignored to instead focus on their fundamental medium to long-term potential. Obviously, if their share prices were to recover, thereby lifting their market capitalization in tandem, it would reduce the effectiveness of their share buybacks compared to this scenario, although this is not necessarily a negative with investors enjoying even larger capital gains. Apart from pushing their share price higher in the medium to long-term, their share buybacks also stand to dramatically increase their future dividend potential.
When reviewing these results, it shows that if their dividends are reinstated after two years and thus after implementing their existing share buyback program, their former circa $1b per annum of dividend payments could fund annual dividends of $1.28 per share. Apart from providing a massive 24% dividend yield on current cost, this would also represent an impressive 28% increase over their former annual dividends of $1.00 per share. If they were to reinstate their dividends at this point, I would expect their share price to recover dramatically, far surpassing the very conservative potential $7.00 estimated earlier as investors rushed to grab this massive source of income.
As it stands right now, it remains uncertain whether management will reinstate their dividends in two years or not. Whilst uncertainty is normally the enemy of investors, thankfully their future dividend potential continues to climb ever higher if they renew their share buyback program, even assuming they only maintain its easily affordable $750m per annum rate and thus, it reduces the pain of an extra -long wait.
If looking back at these results, their future dividend potential under this scenario ultimately sees their annual dividends reaching $1.94 per share by the fifth year whilst still only costing the same $1b per annum, thereby seeing an insanely high 37% yield on current cost. Similar to earlier, this assumes their market capitalization remains static and whilst yes, a rally would reduce the effectiveness of their share buybacks and thus reduce their future dividend potential, once again, a higher share price is hardly worthy of a complaint.
Income investors are still hurting from the loss of their former high single-digit dividend yield but thankfully, not all hope is lost as reinstating their dividends in the future remains on the table once their $1.5b share buyback program is completed in two years. Unless their share price recovers significantly, which is already a good outcome, this stands to boost their future dividend potential of an impressive 28% and therefore represents a win for income investors. Even if this is not forthcoming and their market capitalization remains static at its depressed level, their share buybacks can still deliver a very desirable 15% compounded annual return, thereby making for a win-win, which means that I believe a strong buy rating is appropriate, despite my love of steady and reliable dividends.
Notes: Unless specified otherwise, all figures in this article were taken from Lumen Technologies’ SEC Filingsall calculated figures were performed by the author.