Lumen Technologies, Inc. (NYSE:LUMN) is a textbook example of a contrarian investment based on valuation, financial strength, and profitability. Not all these factors are in favor of LUMN stock, but at least two of them are positive factors investors should weigh in on.
There are the geopolitical risks and rising U.S. interest rates expectations that could come later in March. A shift to safety would favor high-dividend stocks.
LUMN is a high-dividend stock with a 5Y Monthly Beta of 1.01. So, in economic theory, it should move almost in perfect tandem with the broader U.S. stock market. The S&P 500 has losses of nearly 11% year-to-date and shares of Lumen Technologies have losses of approximately 15% in 2022. So, they have underperformed the S&P 500 by a margin.
Shares of Lumen Technologies have a strong bullish case and unfortunately, a strong bearish case, as well. It is time to play with numbers and start with the good news first.
LUMN Stock: A Value Play With a Compelling Story
The best way to start is to focus on the forward dividend and yield of $1.00, or 9.36%. An annual dividend of $1.00 in a stock with a price of $100 does not mean a lot, but in a stock with a price around $10, such as LUMN, is too tempting to pass up on.
Lumen Technologies has stated that it plans to maintain the $1.00 per share dividend. So, we can use the zero-growth dividend discount model to estimate a valuation of LUMN stock. In a zero-growth dividend discount model, the intrinsic value of the stock is calculated by dividing the annual dividend by the required rate of return.
We know the annual dividend is $1.00, so we must find the required rate of return. What is the required rate of return (RRR)? “The required rate of return is the minimum return an investor will accept for owning a company’s stock, to compensate them for a given level of risk.”
Using the capital asset pricing model (CAPM), we can calculate the required rate of return for LUMN stock as follows: RRR = Risk-free rate of return + Beta X (Market rate of return – Risk-free rate of return).
The input for the market rate of return can be taken to be 10.5%, which is the “historic annualized average return” for the S&P 500 “since its 1957 inception through 2021.”
The risk-free rate is the 30-year U.S. treasury bond yield, which was was 2.35% on Mar. 11 at the time of writing.
Now that we have gathered all the data, we can plug in the numbers. We have RRR = 2.35% + 1.01 (10.5%-2.35%) or 10.58%.
Therefore, the zero-growth dividend discount model gives us an intrinsic price of 1.0/0.1058, or $9.45 for LUMN stock. But don’t get too excited because that does not make LUMN stock a value play. It is overvalued by 13%.
Now, onto the compelling story.
When analyzing stocks, you may look at ratios and key metrics. However, you must add information together, analyze it and then make a solid argument. It seems that shares of LUMN are now overvalued. Based on the expectations of rising U.S. interest rates, the bond yields should rise and bond prices should fall. Rising bond yields will make the valuation of LUMN stock worse, as it will increase the required rate of return.
If we use another discounted cash flow method, such as free cash flows, then Lumen Technologies shows a free cash flow trend that is volatile, yet it is positive. In 2021, it grew by 28.84% to $3.6 billion. Add in the element of share repurchases the firm is considering, and things could be building a bull case now.
LUMN Stock: The Bearish Story
For the past three consecutive years, Lumen Technologies has had a declining revenue growth. In 2019, 2020 and 2021 the revenue growth was negative 8.47%, negative 3.48% and negative 4.95%, respectively. The company has a high level of debt. On a trailing twelve month basis, the debt-to-equity (D/E) ratio stood at 2.48 at the end of the most recent quarter. This D/E ratio is high even though the company reduced net debt by approximately $1.5 billion in 2021.
High debt and declining revenue growth are building a bearish scenario.
What is my opinion on LUMN stock? The high debt and loss of momentum in sales growth worries me. At the same time, high inflation erodes the power of the dividend that does not grow. As you may guess, if the stock price falls below $9.45, things change. If that happened, the stock would be more attractive given its risks.
Be patient now and monitor LUMN stock for its high dividend yield, but do not rush to buy it yet.
On the date of publication, Stavros Georgiadis, CFA did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.