A Dead Canary In The Telecom Mines. Investors Beware.

Miners used to carry caged Canaries for early warning of toxic gas.  The Canaries would keel over from the gas before the miners would.

The Canary here is US Telecom CenturyLink, who recently cut its dividend by 53% while raising 2019 capital expenditures by 16%.  CTL is a $14.5B pipsqueak compared to $225b behemoths like Verizon and AT&T.  But its labored breathing is a dangerous sign across the Telecom complex.

If CTL had cut its dividend and its investment spending, this would just be a run-of-the-mill cash crisis.  What makes CTL’s move remarkable is plowing roughly half its $1.16B dividend cut back into network investment.  That points to a more existential crisis.

For all the talk of a fiber-optic future, huge swathes of CTL’s network are still old copper lines running to homes, small businesses, and even many large-ish businesses.   Most of that copper is mostly depreciated off CTL’s books.  But those assets are still generating cash.

Depreciation lives exist for a reason.  If you are making pots of cash off an asset past its useful accounting life, it’s a pretty good indicator those cash flows are at risk.  At some point, the actual physical assets go past their useful life and need replacing.

The rub is that delaying that replacement spend is lucrative for all concerned.  The cash keeps rolling in.  Investors are happy.  Managements are happy.  Why end the party?  That has been the fairly comfortable position of telcos for the past 20 years.

The responsible choice – replacing the asset – is particularly painful because it generates no incremental return for that incremental investment.  You spend a whole lot of money just to keep the cash flows already coming in.

This painful math is familiar to anyone who’s ever spruced up a rental property.  You might see a small boost in income from the investment, but you are mostly spending to maintain the current income stream.

The Telcos have, instead, taken the slumlord approach.  Just let the asset wither and lower rents to keep the place occupied.  This works until the building is no longer habitable and even low-rent tenants start to leave in droves.

The declining slum model fairly describes much of CTL’s network today.  Declining business and residential revenues providing an increasingly skimpy cover for largely fixed operating costs.  So CenturyLink is cutting it dividend and putting roughly half of that cash towards replacing its asset base.

CTL is the canary in this coal mine because they don’t have a wireless business to hide behind.  Or the media and entertainment assets that AT&T and Verizon have both diversified into.  So CTL can’t hide the rot at its core.  But that same rot affects most developed world telcos.  Deutsche Telekom’s recent capitulation on copper life-extending pipe-dreams in favor of fiber investment stands out in particular.

This explains why most Telcos are quietly embarking on massive new network builds without the fanfare of the dividend cut (yet).  Often blaming government prodding or under the PR cover of building out 5G.  Pulling shiny new fiber an re-starting the clock on a 30-year-depreciation lifespan.

Investors should expect the next 20 years to look very different from the last 20.  Steady spending of incremental capital for little or no incremental revenue.  Not to say the current model of over-earning on depreciated assets is dead forever.  Pencil it in for a return around 2050 to 2070.  But it will be a hard slog to get there from here.

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