Lumen Technologies, Inc. (LUMN) Earnings Call Transcript & Summary

All right. Good morning, everyone. Thanks for joining us for our last day of the Wells Fargo TMT Summit. I'm Eric Luebchow. I'm really pleased to be joined by Lumen's CFO, Chris Stansbury. Thanks for joining us.

Great to be here.

So Chris, I know you joined back in April, and we have a new CEO, Kate. Kate Johnson, who started in early November. So maybe if you could talk about, generally speaking, you expect under Kate's leaderships in terms of strategic priorities, any change of direction? I know it's early days and you don't want to speak on Kate's behalf, but any color you could give us would be great.

Yes, sure. I mean, really, and it's why I came to Lumen. I think there's a great growth opportunity. We've got a lot of work to do. But when you look at where the business sits today, the gift that we have that is the strength of our network and how we can monetize that as we go forward, that's really where the company's focus is going to be, where Kate's focus is going to be. And when she came into Lumen, she came in with a strong knowledge of Lumen's business. When she was at Microsoft, she had a lot of interaction with Lumen, so she knows it well. And more importantly, she knows how to take a business that isn't growing to growth. And so she saw things, I guess, in a way that was very consistent with what I saw in terms of the opportunity, and that's why she's here. So she's hard at work. I think you'll hear more from her in the New Year, but there's a lot of energy in the building, a lot of change underway. And I think that's all going to be positive.

That's great. So obviously, you had a big announcement on your last earnings call around capital allocation. Electing to eliminate the dividend, which I'm sure was not an easy decision. But as you -- maybe you could walk us through some of the moving parts of your business that led you to that decision? Between the asset sales that have already closed, ones that are pending, the Quantum Fiber investment and anything else that kind of led you to that being the most prudent decision for shareholders?

Yes, sure. And you're right, it was not an easy decision. I mean, the reason we're all here obviously is to return capital to shareholders. But our view on that is how do we best do that now and in the future? And when the 20-state ILEC sale was announced over a year ago, the company did say at the time that when the deal closed that they relook at capital allocation priorities, and that's exactly what we did. There was extensive conversation with the Board leading up to the close of that deal. Kate was involved in that before she joined, so that she knew what was coming and had input to that decision. And really, what it all boiled down to is we've got a commitment on Quantum Fiber, and that opportunity is real. We've got an enterprise business that in large enterprise and public sector is performing well, but that also requires capital. And really, over the next 4 to 5 years, we're in investment mode while we position the company for long-term strength and returning capital to shareholders. In the short term, there's really two levers. The first is with the stock price, where it was before we made the decision, I would say that the market wasn't really fully rewarding the value of that dividend because of concerns over its sustainability. And so converting that to a buyback, the $1.5 billion over the next couple of years, allows us -- or the next 1.5 years rather, allows us to more aggressively return capital when the stock is at good prices and manage that guardrail of leverage that's so important. And so that flexibility is important, but we think buying stock at today's values is the right move given current market conditions.

So on the buyback, the $1.5 billion, so really nothing other than trying to keep leverage, as you said, relatively leverage neutral in the 4x below -- or range or below, I believe? Nothing preventing you from being more aggressive on the front end of the buyback window if you think the stock is dislocated?

It's really -- again, I don't want to get too much into timing. I would say that I think in the past when we've done buybacks, we were very aggressive about doing it all and doing it quickly. I think this has got a more measured approach around it. The Board is informed. We've put a structure around how we can buy, at what prices and what trading volumes. But the leverage factor is an important factor. We know that equity investors are harmed if we start to threaten debt ratings and we're not going to do that either. So it's going to be a dynamic process. I think is the best way to say it. As we look at coming quarters, what the investment looks like in terms of uses of cash, how that's going to impact leverage versus when the EBITDA comes from those investments and where the stock price is at that moment. So it's not a simple rule that we're going to follow. We're going to look at all those variables, and make sure that we do the right thing at the right time.

Okay. Fair enough. So just stepping back a little bit, kind of a broader business macro outlook. I think on your last earnings call, you've talked about some slower decision-making from large enterprise customers. So maybe you could talk about your sales funnel of opportunities. Is it really just timing, getting people to go through their internal approvals, and you see a good sales funnel of opportunity? Maybe you could just talk generally about that, and whether you've seen that change at all with some of the macroeconomic volatility that we're going through right now.

Yes. The funnel to date remains strong, so I think that's a really good sign. Decisions are taking a little longer. There's more layers to go through. I mean, it's happening at Lumen. There's things that I'm requiring to approve that I didn't require to approve 6 months ago. So I think that's normal. We're not seeing any change in cancellation behaviors, and I think that's another real positive. So I mean, look. When you get right down to it, the core of what we're selling in the enterprise space is really important to the operations of any companies that are buying those services. So I don't think it's about doing it on the cheap; I think it's just people are being a little more purposeful in how they approach the approval process. And so just taking a little more time.

Yes, yes. That makes sense. So you've resegmented the enterprise or business segment into Grow, Nurture and Harvest, the three buckets. And as you look toward that path in the next 2 to 3 years of returning to revenue growth, maybe you could talk about the Grow bucket first? I mean obviously, I know aspirationally, you need that to grow faster. I think it was around 1% on a pro forma basis this past quarter. So what are kind of some of the steps you're taking to incentivize your sales force to attack that funnel of opportunities?

Yes. And it's -- I'll go a couple of places there. So yes, the growth wasn't great in the quarter. Obviously, I think the economic environment has impacted that somewhat. There was a normalizing factor, something that was, in last year, a benefit that we had that didn't continue this year as well as the contract that ended. So that had an impact of probably 150 basis points, but still not where we want to be, to your point. So a few things. The low-hanging fruit as we go into next year, sales comp has been changed to incent more around the Growth bucket and less around Nurture and Harvest, so I think that's a change in the right direction. But most importantly, what you're going to see us do as a company is become far more kind of customer-in rather than product-out focused under Kate's leadership. And so we do have great product in those buckets, but a more specific customer focus on the problems they're trying to solve, whether that be by vertical or just more broadly, that's how we get the growth bucket to grow faster. So you'll continue to see us make moves in that direction. I also think you'll see us continue to seek to bring product to market that customers need for problems that -- problem solving that are focused more on the service layer around the network. And that's what's going to exist in that growth bucket as we go forward. So it's going to continue to evolve, but that is, I would say, the vast majority of Kate's focus right now is how do we do exactly that.

That makes sense. So thinking about the Nurture and the Harvest bucket, I know in the quarter, I think the Nurture bucket actually declined at a slightly higher rate. So maybe you could talk about as you think about those segments, largely managing them for cash and to be kind of NPV positive over time. What are you -- how should we think about the relative directions of those buckets as well?

Yes. So the -- if I start with the Harvest bucket, I think the reason why Harvest performed as well as it did is because you started to see re-rate activity, yes. So when we broke the buckets apart, which I know seems like a long time ago, but it was really not all that long ago, it's as we exited the second quarter, we put a dedicated team focused on that business really around how do we make sure we're maximizing revenue and then also how do we get cost out. The easier, if you will, not that it's easy, but a piece to approach was the revenue side. And so they've done a lot of work around re-rates. That started to hit. We'll see some of that actually in that thought process transition into the Nurture bucket as we go forward, so more to come on that. And on the cost side, they'll get at later. But it really is about maximizing the cash flow from those businesses. And quite frankly, we're being very precise internally around cash flow is cash flow. I'm less concerned about EBITDA if a product is requiring CapEx and not generating any free cash flow, and it's more of a distraction for the organization. So you're going to see us continue to make decisions around product lines as we go forward to make sure that we're not spending time and energy on products that really aren't generating anything for us over the long run, and we'll spend more time on those products that are generating cash and where we can start to migrate customers up the stack from, say, a Harvest voice TDM product to say, VoiP. So those are the kinds of things we'll be focused on.

And as we think about the bucketing, is there any evidence of kind of cannibalization across any of the products in terms of, I think, one that has been talked about for years is people migrating from MPLS to SD-WAN, that has any material impact on your ability to get to kind of consolidated revenue growth in the next few years?

Yes. I mean, it's a great question, right? And let me -- just within the walls of Lumen, give you, I think, an example. If you think about the consumer business for a second, when you think about Quantum Fiber, that whole mindset about, hey, cannibalization is bad, is exactly why we have roughly 10% copper penetration in the markets where we are and why we're out doing Quantum today. That mindset cannot influence the way we think about the enterprise segment. So my view on cannibalization is cannibalization is good as long as we're the ones doing it. It's not somebody else doing it to us in the form of share loss. Because ultimately, the world is going where the world is going. And if we can be part of a solution that takes a customer and moves them to next-gen technologies and brings more services to them and allows us to manage the NPV of that customer more efficiently, then we'll do that all day long. Now how that plays out in terms of the shifts between buckets, that's a little harder to model. I think we'll definitely be back to the market with more around that as we get a little more thinking behind the moves that we'll make next year. But that is a definite mind shift change within the company, which is we can't -- we absolutely cannot sit on our hands and say, cannibalization is bad. Let's try to preserve this dying asset because it's going to die, so.

And I think, as you've said as well, the gross margin contributions across the buckets are relatively consistent, which I think may have surprised some people who always thought that some of the legacy telecom products always had super high margins. So it sounds like we shouldn't see a big margin impact even if things do shift.

No, and I think that's right. I mean, that's one of the reasons why we provided a little color on that last quarter, and it's just part of the march we've been on to give more visibility into what's going on inside the business because those shifts are not harmful over the long run. If anything, they're beneficial. We have to manage it appropriately, and I think that's the key thing that we're focused on right now.

Yes. Fair enough. So I definitely wanted to talk about Quantum Fiber, fiber to the home has been a big topic of discussion at this conference. So you've called out a variety of labor, supply chain, permitting challenges as part of your Quantum Fiber build. And I know aspirationally in the past, you've talked about wanting to get to a run rate of building out 1.5 million to 2 million locations on an annual basis, so maybe you could talk about the pathway or anything on the timing to get there? And whether you see some light at the end of the tunnel on working through some of these supply chain challenges?

Yes. So when I came in to Lumen, my biggest concern is that we -- I didn't want us just to be focused on number of enablements and cost per enablement, right? We need to be focused on good enablements, right? Enablements that allow us to generate solid penetration as we go forward. So there's no point in building fiber if a customer doesn't want that fiber, right? And so we have gone through extensive work to make sure that those are the kinds of enablements we're building. So that's a real thing. I think there's been very good thinking that's been done on that. And then yes, that is -- you layer on top of that some of the issues we've had on the supply chain side, and that's where we are today. So I'm not ready to give a time frame on when we get to necessarily those larger numbers. I do think that the scaling of the factory, if you will, is moving in the right direction, but it's not going to be quick. It's -- when you look out in terms of engineering and permitting. At any point in time when you're having that discussion, you're really talking about something that's going to take place in 9 months. And so I think we're doing the right things, but I think it's going to be a little while until we see that really start to ramp.

Yes, yes. Understood. And has the current environment in terms of inflation and obviously, higher interest rates today, made you reevaluate at all? Whether 12 million, which is kind of the addressable market you've talked about in the past, does that still make sense? Or higher cost of capital raising the hurdle rates at which you look at certain markets?

Yes. So if you look at the cost per enablement, it's definitely a little higher right now. I don't think that changes the outlook for the product. Again, it's a three variable model, if we oversimplify it. It's the cost per enablement, it's your penetration rate and it's the ARPU. The only thing we know for sure right now is the cost per enablement. We don't know where the penetration of the ARPU is going to go. What we do know is that the penetration is ramping very nicely to our 40% expectation. If we can do better than that because, again, we're building in a smarter way where customers want that product, then that will raise the level at which we can spend on the front end, right? But the returns are looking good, so that's not a limiting factor today in our outlook. I also would say that even with our focus on making sure we're building the right enablements, these are growing markets. And they're definitely -- we're in Western markets, there's definitely a shift west. I think that will continue to create future opportunity that we can't really measure today. But as building continues and population shift, that's in our favor.

Fair enough. And one of those variables, ARPU, I think your ARPU is around $60 or so on fiber. And I would imagine that there's an opportunity for that to scale over time. We all see some of the exploding bundles that the cable operators have that could maybe give you some opportunity. I mean, is the plan to start at kind of a lower price to gain share? And then as you get scale, you can start to grow ARPU a little more aggressively?

I would say yes. I mean, the reality is that we wanted to bring simplified pricing to the market. We want to be easy to do business with, that's why the NPS scores are so strong. And largely, as we go forward, it becomes -- and when we build out enablements, it becomes a self-service product because the hardware that we're putting in the home allows scalability on the speeds that you're able to connect to. So all of that's really good. But until we get to scale, it doesn't make sense to do a ton of marketing, right? It makes more sense to have a sharper price point to create the penetration than it does trying to blast the market with marketing when you don't have the enablements built that would support that. So that's really the near-term thinking. But yes, I do think given the quality of the product and the ability to do marketing behind that as we get to scale, that probably gives us more tailwinds than headwinds.

Have you noticed any type of competitive response at all from the cable companies in your markets where you're starting to build in terms of pricing? Or have they been relatively rational so far?

It's been relatively rational. And again, I'm sure we're going to see activity at some point. But the reality is that the capabilities of that product, cable can't meet. And again, we've already announced a symmetrical 8-gig product not because we think there's huge demand for that today, but that's a statement. And it's a statement about how future proof this network is as we build it out and the scalability of that, and competition can't touch it. And at some point, the consumer will make those decisions based off their needs.

Yes. Fair enough. So last month, you gave some -- a few guideposts on some items on your 2023 outlook. So maybe you could kind of walk us through a couple of the main points from the 2023 outlook and the moving parts there?

Yes. So obviously, we're not ready to give guidance yet. Kate's been here for just a few weeks. She's hard at work getting us aligned around where we go next year. So more to come on that in the new year and you'll -- I guess I mentioned earlier, you'll hear more from her in the New Year. But what we wanted to do was provide some clarity given all the moving pieces with the divestitures and whatnot. So setting aside EMEA for a second, because we don't expect that to close until late in '23, we talked about a roughly $1.4 billion reduction down in EBITDA for the impact of the assets that have been divested that were included in '22. So if you take our expectations for this year, which are at the low end of guidance, you adjust the $1.4 billion, that gives you a stepping off point. We also said there were some near-term challenges around dis-synergies associated with those divestitures. We're hard at work on that. I've got a team working on how we can aggressively take out other costs. And my comments earlier on the product portfolio would be part of that as well. We talked about CapEx being in about the same neighborhood that we guided this year. But that actually, in real terms, is about a 10% increase in capital spending because the businesses that we divested had CapEx associated with them. So that allows us to go invest in some of the areas that Kate is going to want to focus on. We will be a cash taxpayer next year, so 26% is the effective rate. We say that equates to about $300 million to $400 million. And our average interest rate on our debt is about 5.75%, and our net debt after we pay a tax bill associated with the divestitures is going to be in the roughly $20.5 billion range next year. So those are...

Yes, that's helpful. And maybe just given the moving -- the volatility in the fixed rate or the fixed income market, you could talk about managing kind of the floating rate exposure in your market and then how you're going to balance that against your desire to repurchase stock, and whether you'll need to fund any of that with incremental debt?

Yes. So the -- if you look at where leverage is today, so we're kind of [ 37 ], [ 38 ], I think using leverage to buy back stock is not really in the cards today. Our fixed floating mix is roughly 60-40 today, and that's manageable. We're not -- I don't say we're not concerned, but we're not overly concerned that there's any major risk associated with the floating rate exposure that we have today. And if you look at how the debt is balanced out over the coming years, we don't feel any pressing need to make any major adjustments there. Although opportunistically, we'll take advantage of the markets when that exists. So that's where we are on that. I feel good about 1/3 of our debt being gone. Again, obviously, leverage hasn't changed a lot. But we're over time simplifying our debt structure, and I think that's a positive as well.

So on the CapEx front as well, you've provided some disclosures around Quantum Fiber around $1 billion of CapEx this year, around $500 million of maintenance CapEx. I think enterprise CapEx for some of us is a little bit more of a little black box at Lumen. So maybe you could talk about ways that you're seeking to be more capital efficient on the enterprise side going forward to help offset some of the ramp in Quantum Fiber, for instance?

Yes. It's -- the enterprise number is always the toughest number to forecast because the biggest piece of that is success-based. So we've made a number of announcements this year around public sector wins, right. DoD, USDA, USPS, order security. Every one of those projects has capital associated with it. So at the beginning of the year, we don't know if we're going to win a contract or not. We don't know if we do, we don't know when it's going to start. But the capital that goes into those projects is largely what sits in that roughly $1.5 billion that we've talked about. There are other things, though, that we will be investing in to improve the front end. So we've done some work around our digital marketplace. We've got a lot more work to do to be more customer-friendly, again, with that customer-first mindset that Kate brings to Lumen. And so there will be work around digitizing the selling motion, digitizing more back office so we can get at the dis-synergies. So that's in there as well.

That was helpful. And maybe you could walk us through some of the dis-synergies? I think some investors were a little confused around the moving pieces there. Obviously, one of those pieces is cost transformation that I think you can probably accelerate a little more now that you've closed on the two transactions, and then there were a couple of other dis-synergy buckets as well. Maybe you could talk about how those are trending and how we should think about those this year?

Really, the biggest dis-synergy at a high level is you've got a corporate overhead structure that is very difficult to change even though the business has gotten smaller, right? I can't make my SEC reporting team smaller. I can't make IR smaller. And so those things are real. The things that we can focus on, though, it gets back to the digitization efforts. There's a lot of manual work we do today, so we're in a situation where we've got to do an ERP upgrade because the product we're running on is getting old. But that opens a door to allow us to collapse 20-odd ERPs into one. That's an example of how we get to systemic cost change over time to help offset the dis-synergies that exist. So it's not necessarily saying this group is a dis-synergy. I got to figure out how to make it smaller. We'll do that where we can, but we also can't break anything. It's more about how do we look for ways to drive efficiency elsewhere in the organization, and I think there's ample opportunity to do that.

Got you. So do you think over time, as we look at kind of your consolidated EBITDA margins pro forma, there's an opportunity for those to scale as you work through some of these different transactions?

There's moving pieces. So I would say, longer term, yes. But near term, let's not lose sight of the fact that the 20-state ILEC sale was some of our highest EBITDA margin products, so there will be a step down. So on a pro forma basis, we will be lower going forward than we have in the past. But off of that base, yes. With dis-synergies with more of a focus on service layers that customers want to solve their problems, I think that's an opportunity.

Fair enough. So there have been some recent reports on you maybe exploring additional asset divestitures. And I know you won't comment on anything specific, but maybe you could generally talk about how you think about additional divestiture opportunities as another source of funds? And then related to that, obviously, you had a pretty nice multiple on the EMEA business. But anything you see from infrastructure funds, private capital, their willingness and demand for some of the assets in your portfolio?

Yes. I would say that from a geographic standpoint, there's not much that's left by the time we're done EMEA. There's maybe one or two things that we would look at. And again, the reason that we did what we did around LatAm and EMEA, we got great valuation for it. But those businesses needed capital, right? They needed capital to drive scale. And in Lumen's operations, they were generating very little free cash flow. So they needed more capital than we could afford to put in it. And frankly, it was a distraction given the task at hand on what we needed to do in North America. By divesting of those assets, we set them up for success in terms of scale. And we have cross relationships with each other where we can sell each other's network to meet needs for our global customers on both sides of those transactions. So it's a win-win in that regard, and yes, the EMEA deal, we got another great multiple. I would say it goes more to my comment earlier in our conversation around product. And I don't want to get specific about product, but we're getting very focused about a product-by-product look and say, okay, why do we do this? This doesn't generate any free cash flow. We got people working on it. We've got utilities exposure, because we got to keep things turned on. We've got maintenance exposure. So you get into all those hidden costs that ultimately hit the P&L, but may not be getting allocated correctly or anything else. And so we can, I think, do a better job of saying if that's not generating free cash flow and it's not part of our future success, then let's have a really challenging question as to why we're doing it. And if there's a buyer for it, great. If there's not a buyer for it, then how do we manage the exit of that business.

That's great. I think we have time for just one more, Chris. So One of the other big industry events happening right now, the broadband maps are out for the infrastructure build, the $42.5 billion BEAD program. And I'm sure you have teams evaluating it, but how do you think about some of the government subsidy opportunities to maybe attack parts of your ILEC footprint with fiber over time?

We'll obviously look at all of those. It's going to be a very competitive process though, and so in our modeling, we're not counting on any of that. So I don't want to set a false expectation that then we don't deliver on. But to the extent that there's something that's economically viable for us to bid on and help use those funds to improve service to those areas, we'll absolutely do it.

Okay. Well, I think we're just out of time now. So Chris, I appreciate you joining us and making the trip out to Vegas.

Great. Thanks a lot.

Thank you.