Login | December 17, 2018

'Free cash flow' explained and investing in CenturyLink

MALCOLM BERKO
Taking Stock

Published: October 11, 2018

Dear Mr. Berko: In 2011, I asked you about investing in CenturyLink because I needed the income. You wrote me: "Don't buy that junk. It has nowhere to go but down." It was $38, and the $2.90 dividend was yielding 7.4 percent. Certificates of deposit then were paying less than 1 percent, so I bought the stock at $38. It's now about $23. Management cut the dividend by 74 cents, to $2.16, though it yields a fantastic 9.5 percent. My stockbroker wants me to buy 1,000 more shares and says the dividend's safe because the free cash flow is twice as much as the dividend. Please explain what free cash flow is so I can understand it. My broker says that a high free cash flow guarantees the dividend, but his and my accountant's explanations are Greek to me. Should I buy more CenturyLink or hold what I have? -- TL, Jonesboro, Ark.

Dear TL: Think of free cash flow as something as simple as a Rubik's Cube in three dimensions. If your broker or accountant can't explain this in terms you understand, I doubt I can. I'll give it a go; however, my explanation may be a few fries short of a Happy Meal.

Free cash flow is the cold green cash remaining after a company pays for operating costs and capital expenditures, such as buildings and equipment. FCF can be used to pay dividends, reduce debt, buy jewelry for an intimate friend, expand facilities, repurchase stock or bribe a member of Congress. Now, pour yourself a glass of warm milk and find a quiet place in the house. You'll need CenturyLink's (CTL-$23) income statement, its balance sheet, a pencil and a clean sheet of paper. Time to sit, focus and concentrate.

First locate net income. Add back the charges for depreciation and amortization. And you may have to make an additional adjustment for changes in working capital. You do this by subtracting current liabilities from current assets. Then you need to subtract capital expenditures, or spending on plants and equipment, from net income. The formula is: net income plus depreciation/amortization minus change in working capital minus capital expenditures equals free cash flow. It may seem confusing to add back depreciation/amortization, seeing as it accounts for capital spending. However, the reason we add it back is that FCF measures money that's being spent now, not money that was spent in the past. This year, CTL expects to earn $1.80 a share on revenues of $24 billion, with FCF of $3.45 a share. This year's FCF is sufficient to pay the $2.16 dividend and retire about $400 million in debt. CTL's FCF after dividends in 2018 should come in at about $1 billion.

CTL has modest investment appeal. The shares are up over 50 percent from the low of $15 it skirted last March. Because of a healthy cash flow, the 9.5 percent dividend appears safe, but the recent increase in stock price mitigates CTL's potential capital appreciation. Frankly, I'm surprised that the Royal Bank of Canada and Jefferies have "buy" ratings on the stock. Their optimistic opinions may have more to do with CTL's $24 billion acquisition of Level 3 Communications last October and the fact that Level 3's CEO, Jeffrey Storey, is now the CEO of CTL. Various activist investors who believed CTL had a weak management team are as pleased as pashas.

Level 3 Communications is an $8 billion-revenue international communications company that has transit networks in 46 states, South America, Europe and Asia. Anchored by extensive fiber networks and connected by undersea facilities, its global services platform features deep metro assets that reach over 500 markets in 60 countries. It also has the highest-ranked connectivity degrees on the internet. I don't like the stock, but the acquisition of Level 3 keeps CTL's dividend safe for a couple of years. And Morningstar's $22 "fair value" estimate has certainly proved to be near-fetched.

Please address your financial questions to Malcolm Berko, P.O. Box 8303, Largo, FL 33775, or email him at mjberko@yahoo.com. To find out more about Malcolm Berko and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate website at www.creators.com.


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