Lumen Technologies: The Market Has Lost Its Mind, Buy The Drop (NYSE:LUMN) (2024)

The market increasingly appears to lose confidence in telecom Lumen Technologies (NYSE:LUMN). Shares of Lumen fell into a new down-trend after the company presented results for the fourth-quarter in February and lowered its free cash flow forecast from around $2.0B to just $200M, in the best-case scenario. Additionally, the market has been negatively impacted by a string of high profile bank failures lately that has created new uncertainty for investors. The possibility of new rate increases also weighed on Lumen's market valuation, as investor refocus on the company's unhedged variable-rate debt. However, I believe Lumen's valuation has fallen so significantly, that I am changing my outlook/rating from hold to buy!

Three negative catalysts in the last few months

Lumen can hardly be described as a successful investment, I must admit. I recommended Lumen before -- the last time at $5.40 on January 10, 2023 -- but I later changed my recommendation to hold as the telecom unexpectedly lowered is free cash flow forecast.

The first blow came in Q4'22 when the company suspended its dividend and by doing that eliminated the most important justification for dividend investors to own the stock. Then, Lumen bombed with its free cash flow forecast for FY 2023 which called for just $0-200M in free cash flow, meaning, in the low-case scenario, investors are only going to see break-even free cash flow this year.

The third negative catalyst was dealt to Lumen's investor base just recently, in early March. Due to Lumen's declining market cap and trading volume, the S&P Dow Jones Indexes announced that, effective March 20, 2023, Fair Isaac would replace the telecom in the S&P 500 thereby reducing Lumen's stock visibility.

Lumen's stock will be moved to the less-followed and less-important S&P 600 small-cap index on Monday which means funds that replicate the S&P 500 no longer have a reason to own Lumen's shares. In other words, both dividend investors and funds that track the S&P 500 had good reasons to ditch Lumen.

Interest rate risk and variable-rate debt exposure come back into focus

Despite a string of bank failures, the Fed is expected to push forward with new rate hikes next week, which reignited fears over Lumen's variable-rate debt exposure.

At the end of FY 2022, Lumen had $20.41B in long term financial debt, after current maturities are subtracted. Therefore, Lumen reduced its long term debt by $7.0B last year, showing a decline of approximately 26%. The debt pay-down was facilitated by a couple of asset sales that raised cash and helped the company unburden is balance sheet. Included in Lumen's remaining financial obligations, however, are $7.8B worth of floating rate debt which, as of December 31, 2022, was mostly senior secured debt.

The problem the market sees with Lumen is that the floating rate portion of the company's debt is unhedged, meaning new rate increases on the part of the Fed are posing a profit risk for Lumen. A 100-basis point increase in rates would mean that Lumen could see a $78M increase in interest rate payments, on an annualized basis. However, I believe the market overreacts to Lumen's variable-rate debt exposure: with $4.6-4.8B in adjusted EBITDA expected for FY 2023, a $78M pre-tax increase in interest rate payments -- assuming a 100 bps rate increase -- is hardly going to push Lumen out of business.

I believe Lumen’s exposure to unhedged variable-rate debt was, at least in part, a key reason why the stock made new lows lately.

Lumen’s valuation is now so low, I have to change my outlook on its shares

There comes a point when a stock all of a sudden becomes so cheap that one has to re-evaluate a previous hold recommendation. I down-graded Lumen after Q4'22 earnings due to Lumen's free cash flow guidance for FY 2023, although the company is still seeing solid momentum with its broadband subscriber business. But due to a number of factors including a resurging focus on Lumen’s variable-rate debt and the announced reshuffling of the S&P 500 index, Lumen's valuation has become so cheap that the potential upside widely outweighs any incremental downside risk, in my opinion. After all, Lumen is now just about a $2 stock.

Lumen is currently valued at a forward P/E ratio of less than 7.4 X which translates to an earnings yield of 13.5%. Other telecoms also have seen their valuations decrease, but not as rapidly as Lumen.

Risks with Lumen

Interest rates could go up way more than 100 bps in 2023, if inflation proves stickier than initially expected. The market also widely expects a 25 bps raise this month which could reignite fears over Lumen's variable debt which I believe are misguided. What would change my mind about Lumen is if the telecom were to guide for negative free cash flow in FY 2023 or saw slowing momentum in its broadband subscriber growth.

Final thoughts

I have negotiated with myself a lot last week and asked myself the question whether or not it makes sense to double down on Lumen at this point or not. The stock sits at just $2.48 now, a year ago it was at $11, so to a certain extent I believe the market has lost its mind. In my opinion, the market’s concerns about both the current deposit issues in the financial system as well as the possibility of further rate hikes are not Lumen-specific issues. Weighing the pros and cons, I have come to the conclusion that the potential reward seriously exceeds the additional downside risk. With Lumen trading at a P/E ratio of 7.4X, I believe the risk profile has seriously improved since my hold recommendation!

The Asian Investor