Lumen Technologies: Why I Don’t Buy Its Turnaround Plan (NYSE:LUMN)

LUMN inventory: quant rankings are so unfavorable for good causes

A couple of 12 months in the past, I wrote a couple of articles on Lumen Applied sciences (NYSE:LUMN) inventory (see the chart beneath) to warning potential traders concerning the risks lurking behind a budget valuation and excessive yield. At the moment, the inventory was buying and selling round $1.80 per share and an FY1 P/E of 4.6x. Regardless of such overwhelmed down costs and valuation ratios, my prime considerations at the moment had been twofold:

I’m involved about LUMN’s outlook for each the highest and backside traces forward. LUMN is affected by a excessive leverage ratio and structural underinvestment.

I went on so as to add:

As a result of lack of progress potential, the inventory is definitely extra expensively valued than its friends akin to Verizon for my part regardless of its dramatic worth corrections.

Quick ahead to now, the inventory’s worth corrected for an additional ~30% as seen within the chart above, hovering round a file low. So as to add insult to damage, the correction was in opposition to a terrific development of the broader market (the S&P 500 gained about 23%). Verizon (VZ) gained much more when it comes to complete returns with a worth appreciation of 19% and a dividend yield of about 7%.

In opposition to this backdrop, the thesis of this text is to elucidate why I see the danger/reward ratio has turn out to be even much less favorable for LUMN. Regardless of the close to record-low costs, fundamentals have already deteriorated. Within the the rest of this text, I’ll make my argument in two steps. First, I’ll argue that the present funding thesis in LUMN is essentially a wager on its turnaround plan. And second, I’ll argue why I see the chances in opposition to LUMN on this turnaround plan.

The broader market sentiment appears to echo my above thesis. For instance, the chart beneath exhibits the Wall Avenue rankings and Searching for Alpha’s quant rankings on the inventory. Based mostly on the chart, LUMN has a promote score from each Wall Avenue analysts with a rating of two.45 and a good decrease Quant score of 1.89. Trying on the issue grades nearer, the one brilliant spot is the valuation grade, which is a robust A+. In any other case, the grades paint a really pessimistic image. For instance, profitability will get a weak D+ grade, however the progress and revisions grades are even worse with each being Fs.

Subsequent, I’ll look at the valuation extra intently. You will notice it get an A+ grade largely due to its topline-oriented metrics, and I’ll clarify why I strongly counsel in opposition to the reliance on such metrics on this case.

LUMN inventory: a more in-depth take a look at valuation

The chart beneath summarizes LUMN inventory’s valuation grade. As seen, bottom-line oriented ratios such because the P/E ratios (even on non-GAAP foundation) are usually not significant (“NM”) due to the shortage of revenue. As such, traders must depend on topline-oriented valuation metrics akin to EV/gross sales ratios. Right here, the numbers are certainly enticing. For instance, its EV/Gross sales (“TTM”) ratio has a B+ grade with a price of 1.32x, which is considerably decrease than the sector median of 1.92x and its 5-year common of 1.90x.

Nonetheless, I’m typically in opposition to the reliance on topline-oriented metrics, particularly when A) the corporate has no web earnings (properly, if it does, we received’t want topline-oriented metrics to begin with), and B) when the corporate is extremely leveraged. And subsequent I’ll clarify that I’m involved about LUMN on each fronts.

First, LUMN is unlikely to have any optimistic web earnings for years to come back. The following chart beneath exhibits the consensus EPS estimates for LUMN within the subsequent few years. As you’ll be able to see from the chart, analysts count on LUMN to be unprofitable within the subsequent three years. To wit, the consensus EPS estimates level to a lack of -$0.14 in fiscal 12 months 2024 and count on the loss to additional worsen to -$0.19 for fiscal 12 months 2025 and -$0.15 for fiscal 12 months 2026. A small revenue of $0.15 is predicted for the fiscal 12 months 2027, and the implied P/E can be 8.6x, not low-cost in any respect for my part.

Moreover, I’m very skeptical of a forecast that’s 4 years out given the massive uncertainties surrounding the enterprise. Any bullish LUMN thesis is now a wager on its turnaround plan in my thoughts. Certainly, the corporate has plans to reinvent itself. It has reclassified its reporting construction for higher transparency, because it merged its world accounts and huge enterprises into one channel. It additionally moved the general public arm into its personal sector. One in every of its most beneficial property for my part is its fiber broadband section. And its administration does plan to deal with additional constructing out the Quantum Fiber. Trying additional out, there are different initiatives that intention at cloudifying its community to turn out to be a digital firm.

Nonetheless, all of this implies heavy investments for years to come back. On the identical time, this almost certainly will even require new govt hires and spending on automation. Even when the plan works – a giant if for my part – I count on a pressure on its efficiency within the strategy of years earlier than the initiative can bear fruit.

Within the meantime, I’m not that positive if the assets or time are on LUMN’s facet. The corporate’s stability sheet could be very stretched to begin with as proven within the chart beneath. Truly, LUMN is way extra leveraged in comparison with AT&T (T), a peer that’s usually cited for its heavy debt burden.

The declining working earnings and persisting excessive borrowing charges additional compound the problems. As aforementioned, I don’t count on the corporate to indicate a significant web revenue for years. Even when it comes to working earnings, the image is kind of regarding as proven in its earnings assertion beneath. Its working earnings declined sharply from about $3.3B in 2022 to solely about $746M TTM, whereas the curiosity bills have been hovering over $1B. After servicing its money owed, there’s not a lot natural earnings – if any – left for the corporate to finance the initiatives.

Different dangers and closing ideas

By way of upside dangers, I see two main ones beneath present circumstances. The primary one includes the profitable execution of its cost-cutting plan. LUMN goals to attain substantial annualized price financial savings within the subsequent two to 3 years. If that is profitable, it might make its natural earnings higher than my projection above and supply extra assets for its turnaround plan. Second, I additionally agree with LUMN’s general turnaround technique. General, the technique is to deal with improvements in Community-as-a-Service (“NaaS”), enterprise-to-cloud connectivity by ExaSwtich, in addition to new safety choices (i.e., Lumen Defender). I agree that these are the correct strikes and will get pleasure from a secular tailwind. I simply doubt it has the assets to execute it and/or in a means that’s aggressive to its friends.

To conclude, traders needs to be cautious about LUMN’s seemingly overwhelmed down worth and low-cost valuation (when it comes to topline-driven metrics). Contemplating that unfavorable EPS is predicted for the subsequent few years, the valuation shouldn’t be low-cost in any respect for my part. The upside right here is essentially a wager on its turnaround plan. As defined in an earlier article analyzing the turnaround prospects of Medical Properties Belief,

Turnarounds do occur now and again, however not practically as usually as many traders suppose. The various profitable turnaround tales we learn are largely the outcomes of survivor bias. For each profitable story we learn, there are a lot of unsuccessful tales untold. And for the turnaround to work, it all the time takes time and assets.

In LUMN’s case, I don’t see both issue on its facet given the issues above.