Lumen Technologies, Inc. Q2 FY2021 Earnings Call

Greetings and welcome to Lumen Technologies Second Quarter 2021 Earnings Conference Call. As a reminder, this conference is being recorded, Tuesday, August 3, 2021. It is now my pleasure to turn the conference over to Mike McCormack, Senior Vice President, Investor Relations. Please go ahead, sir.

Thank you, Franz. Good afternoon, everyone, and thank you for joining us for the Lumen Technologies Second Quarter 2021 Earnings Call. Joining on the call today are Jeff Storey, President and Chief Executive Officer; and Neel Dev, Executive Vice President and Chief Financial Officer. Before we begin, I need to call your attention to our safe harbor statement on Slide 2 of our 2Q 2021 presentation, which notes that this conference call may include forward-looking statements subject to certain risks and uncertainties. All forward-looking statements should be considered in conjunction with the cautionary statements on Slide 2 and the risk factors in our SEC filings. We will be referring to certain non-GAAP financial measures reconciled to the most comparable GAAP measures that can be found in our earnings press release. In addition, certain metrics discussed today exclude costs for special items as detailed in our earnings material, all of which can be found in the Investor Relations section of the Lumen website. With that, I'll turn the call over to Jeff.

Good afternoon, everyone, and thank you for joining today's call. It's an exciting day for Lumen, and we have a lot to cover. I'll begin today's call with our recently announced transactions, including the just announced sale of a portion of our legacy local exchange business to Apollo. I'll then ask Neel to review a few second quarter highlights as well as provide a preliminary view of the expected effects of these transactions on Lumen's financial profile. And of course, we'll reserve time for your questions at the end of the call. So let's jump in. Last week, we announced the sale of our Latin American assets to Stonepeak at a value of $2.7 billion, representing an approximately 9x multiple of the Latin American business' 2020 estimated adjusted EBITDA. There are more details about this transaction in the release materials, but the simplest way to think about LATAM is that we will transfer ownership of substantially all our LATAM-based customers and assets to Stonepeak, and are entering into a services agreement with Stonepeak to continue to serve the needs of our enterprise customers based outside the region. Subject to customary regulatory approvals, we expect this transaction to close in the first half of 2022. I'm also pleased to share that we have agreed to sell our legacy local exchange business in 20 states to Apollo for $7.5 billion, representing a multiple of approximately 5.5x our 2020 estimated adjusted EBITDA. In short, with this transaction, we are transferring to Apollo all our legacy local exchange assets in 20 states, along with the consumer, small/medium business, state and local government, education, and wholesale customers served by those assets. Lumen will retain ownership of our non-local exchange fiber assets in those 20 states, including our long-haul fiber and the enterprise CLEC assets. Lumen will also retain our legacy local exchange assets in another 16 states. In the transferred markets, the service needs of Lumen's enterprise and government customers will be met under a network services agreement to be entered into with Apollo. Subject to customary regulatory approvals, we expect this transaction to close in the second half of 2022. I'm very pleased with the valuations we were able to achieve for these two sets of assets. On the whole, our retained markets have significantly higher fiber penetration, population density, enterprise demand, and overall growth opportunity than the transferred assets. We have spoken about the sum of the parts analysis of Lumen. And I believe multiples of 5.5x for these 20 states and 9x for LATAM should shine a bright light on the relative value of our retained business. Don't get me wrong, the 20 states we're selling to Apollo are good markets with quality assets, talented employees, and excellent customers. As we looked at these states, though, we knew that we were unlikely to prioritize investments in these markets ahead of our other opportunities in the Enterprise and Quantum Fiber. After closing of this transaction, approximately 70% of our remaining mass-market footprint is well suited for Quantum Fiber investment. This transaction will allow the transferred assets to get the higher level of investment we know they can sustain, and we are committed to partnering with Apollo to help them realize their vision for these markets. As I mentioned on our Analyst Day back in April, we have worked very hard over the past three years to transform our company, both financially and operationally. We’re committed to driving growth over the Lumen platform and continue to transform the business. These transactions are fully aligned with that strategy, and we believe will drive future growth as we meet the needs of the fourth industrial revolution, for enterprises and consumers alike. Undertaking these transactions allows us to simplify our business, deliver differentiated products to a higher percentage of our customer base, and target our capital investments to drive higher growth and more attractive long-term returns on both the Lumen platform and through our Quantum Fiber investment. Of course, the transactions create pressure as well. While the sale of the consumer assets is expected to have a positive effect on our product mix day one after close and an improved growth profile going forward, the high levels of cash flow these markets generate will be free cash flow dilutive in the near term, even at these strong valuations. Even so, we are confident that these transactions are right for our business over the long term and will improve the growth profile of our company. Neel will cover some of the operational financial impacts, but let me take a moment to speak to the implications of these transactions for our capital allocation strategy. First, we absolutely expect to accelerate the pace of our growth investments in Quantum Fiber. By retaining the 16 states we have, fiber-based consumer and mass market services remain a huge opportunity for us and we have built a differentiated offering with Quantum Fiber, enabling an all-digital customer experience that uniquely positions us among mass-market broadband providers. As Neel will discuss, our Quantum Fiber results are bearing this out as we saw another quarter of net adds for our fiber and higher-speed offerings continuing results from previous quarters. The jury isn't out on this one. When we invest in consumer fiber, we take share and we drive profitable growth. As I mentioned, upon closing the Apollo transaction, approximately 70% of our remaining mass-market footprint will be the sort of urban and suburban markets that are best addressable with Quantum Fiber solutions. We are developing an accelerated build plan, and we'll share those details as they're finalized. What we can tell you today is that while we remain strategic and disciplined in our approach, we expect to build faster and with more scale in the markets that we prioritize for Quantum Fiber investment. We also believe we have a unique opportunity to grow our Enterprise business by leveraging our expansive fiber network to provide essential transport services and further penetrating our on-net buildings, utilizing our edge computing network to move critical workloads closer to the source of data and the use of data and expanding the capabilities of the Lumen platform and enabling greater digital consumption of our services for all of our customers. I'm the first to acknowledge that we're not yet seeing the pace of growth that we expect from these initiatives, but we remain confident in the opportunity and are streamlining our focus and further investing to drive that growth. Second, I expect we will manage our balance sheet to remain more or less leverage-neutral over the next few years as we accelerate investment into our growth initiatives. Longer term, I believe the previously articulated leverage range is the right one for our business. But I'm prepared to allow the time line to achieve that range to extend as we work through this investment cycle. Further, beyond fully investing in the growth of our business, we're mindful of being opportunistic in considering share repurchases. We are not choosing share repurchases over funding growth. Even as we scale the Quantum Fiber build and the Lumen platform investments, we expect to have excess capacity to consider opportunistic share repurchases if we can do so at multiples that will be accretive to long-term share value. To that end, we've also announced today approval by our Board of a $1 billion buyback program. Lastly, the dividend. We have long stated that we believe return of cash in the form of a dividend is an appropriate capital allocation vehicle in a business like ours. However, with these transactions, the profile of our business is changing and will change rapidly going forward as we lean into investing for growth and continuing to rationalize the portfolio. I do realize that will put pressure on our dividend after we close these transactions and the further we get into our investment program. But as of now, we are not faced with that trade-off decision, and we'll continue to balance the return of cash to shareholders through dividends and buybacks while we accelerate our investment in Enterprise and Quantum Fiber growth. Let me provide a small bit of color on my views on the second quarter results. While we worked hard to get these transactions announced, we remain very focused on driving performance in those areas that we believe provide the best opportunity for growing revenue and strong returns. That said, our second quarter revenue trends were sluggish. We've talked about the slow sales in the fourth quarter and the beginning of the first quarter as a result of COVID and delayed decision-making. Since then, we've seen good sales growth sequentially and believe our growth initiatives across the Lumen platform will help us improve our revenue trends as we move forward. Before I turn the call over to Neel, let me offer a few points in summary. We're excited about the two transactions we've announced. We're pleased with the valuations that have also done these transactions to drive investment and operational focus within the remaining business, sticking to the strategy we discussed since launching Lumen and Quantum Fiber last fall. At 5.5x on the ILEC business and 9x adjusted EBITDA on the LATAM business, we believe the valuations highlight and support our view of the sum of the parts for the remaining business. While we already operate one of the world's most extensive and powerful fiber infrastructures, we will continue to invest in growth via the Lumen platform, cloud edge initiatives and to accelerate deployment of Quantum Fiber. We believe the recently announced transactions were executed at excellent valuations, and are aligned to our strategy of streamlining our business to those markets on which we are best able to profitably invest in growth. With that, I'll turn the call over to Neel to provide a few more details on the quarter and some of the expected effects from the announced transactions.

Thank you, Jeff, and good afternoon, everyone. I want to leave ample time for your questions on our announced transactions, so I will briefly review our second quarter results. Let me begin with our financial highlights in our earnings presentation. For the second quarter 2021, we delivered solid adjusted EBITDA and expanded margins year-over-year. Cash flow remains very robust, providing the opportunity to ramp investment in our key growth areas in the second half of the year. However, given our spending in the first half, we are reducing our CapEx guidance to be in the range of $3.2 billion to $3.5 billion. And accordingly, we are adjusting our free cash flow expectation to $3.1 billion to $3.3 billion for the full year 2021. As Jeff mentioned, our Board has approved a $1 billion share buyback program over 2 years, with which we will be opportunistically buying back shares. Turning to second quarter revenue by sales channel. Total revenue in the second quarter declined 5.2% on a year-over-year basis to $4.924 billion. Normalizing for the sale of our correctional facility business in the third quarter of 2020, our revenue would have declined 4.9%. It is important to remember that year-over-year metrics were meaningfully affected by the surge in demand for voice collaboration and conferencing in the second quarter of last year, making comparisons less relevant. From a sequential perspective, total revenue declined by 2.1%, primarily driven by lower sales in the last couple of quarters. Moving to business segment. In the second quarter, total business revenue declined 2% sequentially and 5.2% on a year-over-year basis to $3.522 billion. Normalizing for the sale of the correctional facility business, the decline was 4.9%. Within our business segment, IGAM revenue declined 0.9% sequentially and 2.6% on a year-over-year basis. The year-over-year decline was primarily driven by higher usage in the prior year period related to COVID. Within IGAM, compute and application, IP and data and fiber infrastructure services were flat sequentially driven by improvement in sales and installs. Large enterprise declined 0.6% sequentially and 4.3% on a year-over-year basis. Compute and application services and fiber and infrastructure services both grew sequentially. Mid-market enterprise declined 4.7% sequentially and 9.7% on a year-over-year basis. Sequential performance was impacted by strong nonrecurring revenues we highlighted last quarter. This sales channel was also impacted by the previously noted sale of the correctional facility business. Wholesale declined 2.6% sequentially and 5.5% on a year-over-year basis. As a reminder, the first quarter of this year benefited from carrier settlements. Our overall business segment revenue performance continued to be impacted by delayed decision-making by enterprise customers in the current environment. While year-over-year comparisons this quarter were affected by the pandemic-related surge in voice services last year, we are seeing stabilization in sequential trends. Moving to business segment revenues by product categories. Compute and application services for the enterprise channels grew sequentially and was flat year-over-year. We expect compute and application services, which includes cloud edge and our newer Lumen platform offerings, to provide additional growth with increased market traction. IP and data services for enterprise channels declined both sequentially and year-over-year as increased demand for IP and work-from-home solutions were offset by continued delayed decision-making for enterprise hybrid network deployments. Fiber infrastructure services for enterprise channels grew year-over-year. Sequential performance was impacted by strength in nonrecurring revenues for equipment and professional services in our mid-market channel last quarter. Voice and other services in the wholesale channel continue to be managed for cash, with legacy voice declines in line with our expectations, but year-over-year comparisons were impacted by higher COVID-related usage in the year-ago quarter that I just mentioned. As with the first quarter, market conditions in the second quarter remained challenging. As Jeff mentioned, we are not pleased with our revenue performance year-to-date, and have a solid plan to improve our revenue trajectory as the economy reopens and our new initiatives take hold. Turning to mass markets, second quarter 2021 revenue declined 2.2% sequentially. During the quarter, we added 31,000 Quantum Fiber customers, reaching a total of 746,000. Our mass markets fiber broadband revenue grew 30% year-over-year this quarter. Fiber-based broadband revenue now represents 17% of mass market's broadband revenues compared to 13% in the year-ago quarter. Turning to adjusted EBITDA. For the second quarter of 2021, adjusted EBITDA was $2.109 billion compared to $2.135 billion in the year-ago quarter. We expanded adjusted EBITDA margins during the quarter, growing 170 basis points year-over-year to 42.8%. As we continue to direct incremental operating expense investments towards key growth areas of the company, we were able to more than offset those investments with our ongoing focus on operational transformation savings. Capital expenditures for the second quarter of 2021 were $646 million. As we have mentioned, a significant portion of our capital is success based. And with the lengthening sales cycles, we were able to calibrate our capital spending to the current environment. As previously mentioned, we have adjusted our CapEx expectations lower for the full year, with an expectation that the second half spending will be higher than the first half as we start to ramp our mass market investments, and business decision-making accelerates. In the second quarter of 2021, the company generated free cash flow of $1.044 billion, and we have adjusted our full year 2021 guidance for free cash flow as a result of lower capital spending year-to-date. During the second quarter, we continued to make progress on our deleveraging initiatives by reducing net debt by more than $700 million. We issued $1 billion of lower coupon debt during the second quarter to refinance more than $1.2 billion of debt. On a year-over-year basis, we have reduced net debt by $2.3 billion. Moving to the financial outlook for 2021. Other than the previously mentioned capital expenditures and resulting free cash flow changes, all other guidance metrics remain unchanged. We remain confident in our adjusted EBITDA target of $8.4 billion to $8.6 billion. Moving on to our announced transactions, both today with Apollo for part of our ILEC footprint and last week with Stonepeak for our LATAM business, I would like to provide you with some high-level financial impacts that should help inform your modeling as you look past the expected closings in 2022. With respect to the LATAM divestiture, we estimate our 2020 revenue related to the transaction at approximately $800 million; estimated adjusted EBITDA, a little over $300 million, and capital expenditures of about $200 million. The estimated adjusted EBITDA includes costs to operate the business on a stand-alone basis and also elimination of non-cash revenues and resulting EBITDA consistent with the proposed sale. These impacts predominantly affect our IGAM channel. In terms of the ILEC transaction, we estimate our 2020 revenue related to the divested assets at approximately $2.5 billion; estimated adjusted EBITDA of $1.4 billion; and CapEx of about $400 million, excluding CAF. Similar to LATAM, these estimates include revenue and costs to operate the business on a stand-alone basis. As far as revenue associated with this transaction, about 70% of the revenue is mass markets, and the remainder roughly split between wholesale and enterprise channels. In terms of the product mix, about 50% of the revenue is for voice and other product category, and the remainder are largely mass market broadband revenues. As with any carve-out, we do expect some dis-synergies, but we are also confident that we can address those with our focus on cost transformation initiatives. Upon the closing of both transactions, Lumen's NOLs will be substantially utilized, and we will become a cash taxpayer. As Jeff mentioned, we will manage our debt profile to ensure that the transactions are leverage-neutral. And our long-term target leverage of 2.75 to 3.25 net debt to adjusted EBITDA remains unchanged. In summary, we have made significant progress this quarter in optimizing our business with a clear focus on positioning Lumen to capitalize on the growth opportunities. We expect business segment trends to improve, driven by our Lumen platform initiatives as enterprise decision-making accelerates. And we are very excited about the investment and growth opportunity in our mass markets fiber business. With that, we'll open it up for your questions.

Our first question comes from Phil Cusick with JPMorgan.

I have a couple of questions today. First, could you provide some insight into the revenue and EBITDA performance of the U.S. business, as well as the locations that have been retained and sold? Additionally, what has been the growth trajectory for each of these segments?

So Phil, we have also shared a map detailing the ILEC asset sales transaction, indicating which operations we are selling. Please note that we're not selling the entire states, just the ILEC operations within them, while retaining the CLEC and IXC networks. This encompasses about 20 states. The transaction involves not just our mass markets revenue but also includes ILEC access revenue for wholesale and enterprise, totaling approximately $2.5 billion in revenue and $1.4 billion in EBITDA. Regarding the growth profile you mentioned, 50% of that revenue comes from voice and other services, which is experiencing a decline similar to the overall trend in mass markets. However, less than 10% of our fiber revenues originate from this category, as it mainly pertains to rural areas. An additional point of interest is that about 60% of our CAF II subsidy and units are located in the areas we're selling. Nevertheless, broadband revenues in those states have remained relatively stable due to the current competitive landscape, and we expect this to change in the future. Overall, that summarizes the mix and the footprint.

And if I can, one more. It sounds like buybacks at this point are more of an option or consideration than a plan. Can you just expand on what opportunistic means and how that fits into the leverage plan?

Yes, I'll begin, and then Neel can add his thoughts. Our Board has approved $1 billion in buybacks. This means that if we identify a good opportunity to purchase our stock at perceived undervalued prices, we will proceed with that. We've discussed various aspects of our business, and we believe these transactions demonstrate that the overall value of our components is quite strong.

Yes. And in terms of your question, Phil, on leverage. Like Jeff mentioned, we expect to be largely leverage-neutral. And as we look forward, the key thing to highlight there is that we're going through an investment cycle. So we do plan to scale up our investment in the remaining 16 states. We've proven out our model with the micro-targeting approach. And as Jeff highlighted, we're moving more from a micro-targeting to really scale up our investment with a market-based approach. And so as we go through this investment cycle, simple way to think about it is we're directing more of our operating cash flow towards investment versus paying down debt. But we haven't changed our long term.

Our next question is from the line of Eric Luebchow with Wells Fargo.

You mentioned that the payout ratio might be under pressure during this investment cycle. Could you discuss what the pro forma payout ratio looks like and what your comfort level is for the next couple of years? Additionally, how will you decide whether to maintain the dividend or possibly reduce it in favor of increased investment?

So Eric, I think Jeff summarized it well. We've just completed the transaction, and we do plan on increasing our investments. I'd like to make a few broader comments regarding the factors we're considering. One is that the company's capitalization will look very different by the time we close the transaction and shortly thereafter. We are reducing our debt and we intend to buy back shares, which is something to keep in mind. Jeff also mentioned that we are continuing to rationalize the portfolio, so we'll be active on that front. Regarding incremental growth capital, it's a matter of timing and scaling. We want to increase our efforts, but we also want to do this responsibly to avoid stranded capital, ensuring that we are effectively investing where it matters. There are various factors we're navigating, so I can't provide a specific payout number at this time. However, we understand that as we grow, as Jeff mentioned, it will put pressure on the payout ratio. We're not at that point yet, but I wanted to mention it. Additionally, this pressure arises from our investments in areas that have demonstrated good returns, which overall will be beneficial for our shareholders.

And the only thing that I'll add is that we have the benefit of a strong balance sheet and we continue to invest in growth, and also, return cash to shareholders through dividend and share buybacks. And so we view that as a strength for us and will be part of our balanced approach to capital allocation moving forward.

And just maybe one more on the fiber expansion in consumer fiber. You have 2.4 million fiber-enabled homes today. I know you've said in the past, you still think you're underpenetrated. I mean how meaningful do you think that business can become? I mean where are you seeing opportunities where returns or penetration levels you can get are attractive? Maybe you could just expand a little bit on where you plan to take that business in the next few years.

Sure. We'll provide more information in future quarters about our plans. We've analyzed this business and have been focusing on micro-targeting as Neel mentioned, which has led to successful growth in our penetration. We see significant opportunities ahead. In the 16 states we've retained, there are over 20 million homes, with about 70% considered urban or suburban, translating to around 15 million homes. We believe these present excellent opportunities for fiber investment. Our intention is to ramp up our plans and scale our efforts because, based on our experience over the past couple of years, we've effectively invested in fiber and expanded in those areas.

Our next question is from Simon Flannery with Morgan Stanley.

Great. On the CIO and the enterprise spending, I think last quarter, you talked about expecting a resumption or an increase in delayed decision-making improving in the second half. Is that still your expectation? Have you sort of seen a pickup in activity here? Or when do you think that's going to really become more meaningful in terms of accelerated bookings? And then coming back to the deal flow, help us with timing here because you actually took your CapEx guidance down even though you're highlighting higher CapEx. Is the CapEx contingent on closing these deals? Or will you start that more aggressively in the near term? And sort of the same with the buyback, is that tied to the deal close? So could you start that imminently?

Okay, I'll address all three of your questions. Neel, please chime in if I miss something or if my response is incomplete. Regarding enterprise spending, we noticed a slowdown in the fourth quarter and the early part of the first quarter, but we have seen improvement since then. Sales are improving sequentially. However, the Delta variant is affecting how our customers are returning to work, and we are also adapting to the challenges. We are confident that sales cycles will improve and that we will reach our sales expectations, although there are still some factors that may pose challenges. In terms of capital expenditure, it's more closely linked to the first question than to deal flow. When we experience slowdowns in sales and purchasing cycles, our capital investment decreases. Our capital spending is strongly tied to our growth, and we haven't spent as much in the first couple of quarters as we initially anticipated. We do expect that to improve, leading to higher capital utilization in the second half of the year as sales grow and we drive revenue growth. Finally, regarding buybacks and their relation to deal closures, the answer is no; they are not tied to closing deals. Our Board has authorized $1 billion for buybacks, which is based on market evaluation and timing opportunities.

Yes. That's what I was going to add, Simon. I think the underrun that Jeff highlighted is really related to the current environment and the enterprise business, and that's what we manage on a success-based basis. But we haven't slowed down on Quantum, and we are looking to accelerate that second half of this year and going into next year. And that's not contingent on the deal. But with these things, it takes a while because there is this actual physical deployment, so permitting, etc., but we're scaling up.

The next question is from Batya Levi with UBS.

With all the pieces on the financials that you helped us with, I think dividend payout would look more close to 70%, 75% without really leaning into CapEx. So can you please provide a bit more color why you would like to maintain the dividend at these levels now and not maybe accelerate the buyback beyond what you have announced? And just a couple of follow-ups. On the taxes, would the NOL cover most of the taxes? Or will there be some leakage? And if you can also talk about how much has subsidies these assets that you're selling we're receiving?

So Batya, regarding the dividend, I would refer you back to Jeff's comments. Essentially, if you consider the timing of the deals, the LATAM sale is expected in the first half of next year and the ILEC asset sale in the second half. We anticipate that the ILEC asset sale will take about 12 months, but it could take longer. There is quite a bit of uncertainty related to timing and approvals. As I mentioned, there are several factors to consider moving forward concerning our company's capitalization and growth capital. Therefore, we believe it is a bit premature to make any declarations about the dividend. Jeff and the Board will be very thoughtful in their decision-making process. We also recognize that the calculations you're considering are similar to what others will also be doing, and there will be trade-offs between growth capital and the dividend allocation. However, this is not a decision that needs to be made today. As for your question about the NOL, there are many variables affecting that as well. It depends on the timing of the deals and the taxable income generated in our core business. Additionally, we will need to consider tax regulations at the time we close the deals. Given our NOL balance, these assets have a low tax basis, meaning we will utilize all of the NOL. We will incur some cash taxes by the time we finalize the deals, and we will become a cash taxpayer afterward.

Our next question is from Brett Feldman with Goldman Sachs.

You obviously underwent a strategic review of the consumer business a few years ago and chose not to proceed. One of the questions you might receive is what has changed? Was it simply about finding the right partner, or is there something else that enabled you to move forward? You've also conducted a substantial review of your asset portfolio based on the transactions you announced. Is that process still ongoing, or do you believe these transactions will lead you to the asset base you desire? Additionally, we have received numerous questions on this call regarding your approach to increasing investment in fiber in mass markets. What about in the business sector? If you have excess capital, are there opportunities to further develop the business market as well?

Sure. I want to summarize your questions. Nothing has changed. A couple of years ago, I mentioned that we were open-minded and focused on making smart decisions for our shareholders, aiming for good returns on our investments and sensible divestitures. We've partnered with Apollo because we believe they are the right fit for this opportunity, and now is the ideal time to collaborate with them. They plan to invest significantly in these markets to foster growth and create a strong business. We'll work closely with Apollo as they will play a key role in serving our Lumen customers across the 20 states tied to the ILEC assets they'll be managing. We've committed to being thoughtful and flexible, and our recent transactions exemplify this approach. Moving forward, we will remain open-minded about our assets and how to optimize them for maximum shareholder value, continually exploring acquisitions and divestitures that align with our business evolution. This ties into your question regarding business growth. We've discussed our Lumen platform, which we view as a significant growth driver for the enterprise segment. We continue to emphasize edge cloud and edge computing capabilities for our customers. Our partnerships with companies like Zoom, VMware, and IBM allow us to combine our strengths and deliver more value to our clients. We are committed to amplifying growth for our enterprise customers, enhancing our efforts to penetrate buildings effectively and lighting new ones as part of our routine operations.

Our next question is from Frank Louthan with Raymond James.

When you look out at the ILEC operation that you're retaining, what do you think you can build to those customers per home passed? And it looks like you've got a little over 10% of the addressable locations with fiber. What's the overall broadband penetration? And what percentage of those homes ultimately do you think you can target to build fiber?

So, I'll let Neel answer the second question about how many homes and all of that. And I'm not 100% sure I have the first question right, Frank, but I'm going to answer the question as I heard it, which is what do I think we can build to those customers. I think we can build a great product set that we can deliver in a digitally consumed way. If you look at our fiber-based Quantum Fiber new customer experience, I think our NPS is like positive 74, which I would put up against anybody, anywhere. And so, I think that what we're building for them is a great product, is a highly secure, robust product that can be consumed digitally and through very ease of use for our customers, so we'll continue to deliver that. And then, Neel?

Yes. I think Jeff mentioned this earlier. If you consider the footprint we have, about 15 million of the 21 million homes are in urban and suburban areas, and we believe most of these are addressable. We are doing further analysis on this and will provide updates in future quarters. We believe a significant portion of these homes is addressable. Regarding our cost structure, I won't provide a specific figure, but we believe we have a very competitive cost structure compared to the public companies we've analyzed. In terms of market penetration in areas where we have established a presence, we observe a penetration rate of 40% to 50% for fiber-enabled homes. Additionally, we enjoy high EBITDA margins, as we are investing heavily in self-service capabilities, not just for installation for new customers, but also in how we support customers over time.

Okay. I apologize. My first question was really more on the cost per home passed. I probably didn't phrase it very well. Any insight there on what you think you can build in those states that you're keeping?

Yes. I won't provide an exact figure, but we believe we have a significant cost advantage in the states we are focused on. When considering all our lines of business for building infrastructure, including state and local governments, federal governments, enterprise customers, small and medium businesses, and consumer customers, we feel we can construct at a highly competitive price point, and we will continue to prioritize this.

And Frank, we do have a separate slide deck on the website, which can help you get to a sort of an enablement percentage. If you look at that slide, we can follow up as well.

Our next question is from David Barden with Bank of America.

I have a couple of questions regarding the Apollo deal. When you break down the segments, you have direct costs along with historically reported segment EBITDA, as well as a significant amount of corporate overhead costs. Are the EBITDA numbers for the divested properties based on the NSA you mentioned negotiating with both counterparties, Neel? Do you anticipate that they will fully reimburse you for the allocations to these entities so that your net position remains neutral? Also, how has that NSA been formalized? My second question is for you, Jeff. You spoke about cash flow dilution. When I add up the figures, it seems the Latin American segment is at negative $100 million in EBITDA minus CapEx. The ILEC is at $1.1 billion, bringing the total to $1.2 billion. Tax implications as a full taxpayer could lead to a negative $800 million. As a full cash taxpayer, that might add another $700 million, totaling about $1.5 billion. Losing CAF II could add another $100 million, bringing it to $1.6 billion. You would save some money from the debt, potentially around $10 billion with 5% interest, which after taxes would be about $350 million. This could bring you to a negative $1.25 billion on a pro forma basis. Are there any other factors, Neel, that we should consider as we model what Lumen looks like in 2023?

Yes. On your first question, I would say it's EBITDA on a stand-alone basis. So, it's really a direct cost to run the business. And then there's the NSA MSA netting out of that. So, at a high level, our 2020 EBITDA, like I mentioned, was $1.4 billion, that will be the impact to Lumen going forward. So that's the simple way of thinking about it. And in terms of the math that you're doing. Yes, those are the numbers that we provided. Obviously, like I mentioned a couple of times before, you have to make some assumptions in terms of the capitalization of the company going forward. And keep in mind, there's also CapEx for CAF II that's going to fall off. So, over the last 3 years or so, we've been averaging $300 million or so. So that will fall off as well. Now we're ramping up other investments, but that's another data point to keep in mind.

Our next question is from Nick Del Deo with MoffettNathanson.

First, a quick question for Neel. Do the revenue, EBITDA, and CapEx metrics you mentioned for the divested ILEC assets include or exclude CAF II? You indicated they were from 2020; I’m curious if those will decrease further in '21.

Yes, those figures are from 2020 but do not include CAF II. As for the CAF II subsidy, that will be settled by the time the deal is finalized.

Those are solid numbers that won't decrease. Regarding the buyback plan, is it wise to buy back stock considering your leverage, which is nearly 4x when adjusted for CAF II, the growth trajectory of the business, potential cash flow dilution from the deal, and upcoming cash taxes? Historically, you have operated the business — and even Level 3 before — in a fairly conservative financial manner, and it appears that there may be a shift in philosophy occurring.

I don't know if it's a philosophical change. We look at how do we return the best value to shareholders. And we believe that dividend is an important part of that. We believe growth is certainly an important part of that. But we also believe that there are times when it's appropriate to use a repurchase program. And our Board has decided that now is an appropriate time for us to authorize one. And then we will continue to look at the market. We'll look at our other opportunities to invest, and we'll make those decisions opportunistically.

Yes. The only thing I would add is that the key word is opportunistic. If we believe our equity is undervalued, then that represents an opportunistic investment from our perspective.

Our next question is from Ana Goshko with Bank of America.

So two questions. So first, I just wanted to clarify the planned use of proceeds, and then I had a second question on leverage. So the total sale price is $10.2 billion, $1.4 billion of that is assumed debt. I think people are assuming that's that EMBARQ fund due in 36. If you can just confirm that. But then that leaves $8.8 billion of cash proceeds, assuming that's all shielded from taxes. Is that all going to debt paydown? Or is that still TBD? Is some of that potentially earmarked for the fiber investment and/or potentially other share buyback.

So Ana, the $1.4 billion is the EMBARQ notes. And then if you think about leverage, our objective is to stay leverage-neutral. So if I look at kind of our leverage this quarter, based on LTM, we're roughly around 3.5x. If you adjust for CAF, we're probably 3.7x. So even with the deals and our investments, we expect to stay roughly in that ZIP code as we go through the investment cycle. So that's the objective.

Okay. So then you could dial up or dial down the amount of debt that you'll repay because your target really is to maintain kind of neutral leverage at this point. Is that fair?

Yes, that's right.

Okay. Your leverage target has been 2.75x to 3.25x, which is based on a business that heavily relies on the ILEC assets that are considered lower in value. Now that you are shifting towards a potentially higher-valued business, should this leverage target be reconsidered? On a debt-to-value basis, you might believe you can manage and sustain a higher leverage level.

Yes. That's a good question, and that's why we're comfortable staying leverage-neutral over the next few years as we go through the investment cycle. So to your point, if you were to look at the ILEC assets that we're selling, on a stand-alone basis, you could argue that that business would have a much lower leverage without an investment commitment or profile. So we could have argued to pay down a lot less debt with that transaction. But we're staying where we are and comfortable with that as we go through the investment cycle. Yes. We just closed the transaction today. We have had some conversations with them, and we will reach out to ensure that those conversations continue.

And with that, our last question is from James Ratcliffe with Evercore ISI.

I want to follow up on the deleveraging topic to clarify my understanding. The transaction should clearly lead to deleveraging. Based on the numbers you've shared, you're facing a $1.7 billion loss in EBITDA while reducing net debt by around $10 billion. Are you suggesting that the investments will significantly boost ongoing EBITDA due to the associated costs? Or will the free cash flow likely be negative? I'm trying to grasp how this doesn’t qualify as a deleveraging transaction. Additionally, do you have any insights on how potential digital discrimination legislation might affect your ability to deploy fiber efficiently within your existing footprint?

I'll take the first question, and Jeff can address the second part. Our comment about being leverage-neutral is straightforward, so please don't overinterpret it. We're not suggesting it's a forward-looking guidance on EBITDA or cash flow. What we're saying is that as we progress through the investment cycle, the net debt to EBITDA ratio will remain roughly leverage-neutral following the deal closure. This takes into account the organic performance of the business, deal proceeds, and so on. Currently, we stand at about 3.5 times; adjusting for CAF, we are at 3.7 times. So, you can expect us to manage our ratio in that range as we advance through the investment cycle.

When it comes to digital discrimination, I can speak for Lumen and also highlight that Apollo is investing in these 20 states to expand fiber and sell broadband services to homes in those areas. Lumen is doing the same by investing in fiber and aiming to increase the penetration of high-speed broadband services for our customers. This is part of our investment strategy and what we believe is beneficial for the communities we serve. We will continue to collaborate with the government to participate in any programs aimed at bridging the digital divide. Looking at our remaining states, about 70% are urban or suburban, which presents a significant opportunity for us, especially with our high percentage of multiple dwelling units. This allows us to extend broadband to a wide customer base. Thank you for your questions, and I will conclude here. I appreciate everyone joining the call on such short notice. We are excited about the two transactions we've announced. Our company profile is rapidly evolving as we invest in the business and adjust our portfolio, maintaining a 5.5x multiple on the ILEC business and adjusted EBITDA in the LATAM business. These valuations reinforce our belief in the value of the remaining business. We're satisfied with these valuations and have undertaken these transactions to enhance investment and operational focus within the remaining segments. With a robust balance sheet, we continue to invest in growth and return cash to shareholders through dividends and share buybacks. I'm very pleased with the transformation we've achieved over the past few years and look forward to the growth opportunities ahead. Thank you once again for participating in this call; we greatly appreciate it. Operator, that concludes the call.

Thank you. We would like to thank everyone for your participation and for using Lumen Technologies' service today. This does conclude the conference call. We ask that you please disconnect your lines. Have a great day, everyone.