Qwest Communication (Q) reported a quarterly profit that was better than expected, as net income was up 37% from last year primarily due to significant cost cutting measures.  On a per share basis, last year the company made 8 cents per share, which is what the Street had expected, but the actual EPS was up to 12 cents per share.  The company had warned that revenue would be modestly lower than estimates of $3.25 billion, the reported total was consistent with that at $3.17 billion.  The stock is up about 5% through half of the trading day, partially because the overall market is up and also because of the earnings beat.  However, we have some real concerns with Qwest’s performance in the quarter.

First of all, perhaps the biggest difference between Qwest and its larger rivals AT&T (T), Verizon (VZ) and to a lesser extent Sprint (S), is that Qwest is more dependent on their wire-line telephone business and internet services.  Qwest’s competitors have more diverse offerings from both cell phone service to television service.  Qwest is in the process of transitioning its formerly stand alone wireless service to Verizon, and they do not have their own television service.  So, Qwest has been greatly effected by the downturn in the housing market and the economy in general, as people are shedding the extra and often redundant home phone service.  The total number of lines was down 10% in the quarter to 11.2 million.  Granted, some of this decline was by Qwest’s own volition as they dropped service to some of their unprofitable customers, but 10% decline in one of your main revenue streams is important to note.  In addition, Qwest was only able to add 42,000 internet subscribers which was below what analysts had expected.

Cutting costs was certainly the highlight of the quarter as the company was able to generate an impressive $339 million in free cash flow.  From a valuation standpoint, Qwest still looks pretty attractive as the current price-to-cash flow is 1.97x, whereas the historically normal range for this company is 2.94x to 7.48x.  Similarly, price-to-sales over the past ten years has normally ranged between .58x and 1.35x, the current valuation metric stands at .47x.  The dividend remains intact at a hefty yield of 8.5%, but unless there is a further increase in earnings that could be in danger.

So, there are the basics of the argument and to be honest I do not know whether Qwest is a bargain or a value trap.  The fundamentals suggest you are getting a stock that is quite attractive and with a nice yield to boot.  However, much of the fundamental strength comes from cost cutting and certainly not growth, and the historical ranges are based on an era where the hard-wired phone was not in decline.  By our methodology, we believe Qwest in Undervalued and could reach as high as $5 per share, but then again there are doubts about the sustainability of profits when there are no more costs to cut.  Thoughts?