Level 3 Communications Case Study Pre-Reading
Introduction
Level 3 Communications, Inc. (“Level 3”) is a $4 billion international communications and information services company headquartered in Broomfield, Colorado.The company is a member of the Fortune 500 and NASDAQ100.Level 3operates one of the largest communications and Internet backbones in the world.
In October 2004, Level 3 launched a major refinancing through a combination of transactions. The transactions closed in early December with debt and equity analysts citing this as a positive step for the company and its investors. The pages that follow provide background on the company and context around the market environment the company faced at the time of the transactions.
The questions at the end are designed to provoke thought on how the company could meet its capital structure objectives.
Company History
Level 3 was founded in 1985 as Kiewit Diversified Group Inc., a wholly-owned subsidiary of Peter Kiewit Sons', Inc. (PKS), a 114-year-old construction, mining, information services and communications company headquartered in Omaha, Nebraska. Kiewit Diversified was originally created to hold PKS' non-construction business assets. On March 31, 1998, PKS announced the separation of its communication/information services business, establishing Level 3 as an independent corporation. The following day, Level 3 common stock began trading on the Nasdaq National Market under the symbol LVLT.
The Level 3 Network
Level 3 set built the first international network in the world to be continuously upgradeable and fully optimized for Internet Protocol. The network was constructed with multiple conduits, enabling Level 3 to deploy new generations of optical fiber and equipment far more quickly and economically than its competitors – a critical capability in an era of rapid technological change. Completed in 2001, Level 3’snetwork today operates as one of the world’s newest and most advanced telecommunications platforms.
Level 3’s network spans 23,000 intercity (long-haul) route miles and delivers services to customers in major markets across the United States and Europe. It serves a substantial number of the world’s largest and most sophisticated communications companies, including inter-exchange carriers, local phone companies, European PTTs, cable operators, ISPs, wireless companies, content providers, and media and entertainment companies. In addition, Level 3 operates multi-conduit metropolitan networks in36 cities in Europe and North America.The companyalso has more than 70 data centers across the U.S. and Europe providing state of the art technical spacewhere its customers can gain direct connectivity to the Level 3 network and the public Internet.This combination of long-haul, local and colocation infrastructure gives Level 3 a strategic advantage over competitors who cannot offer an end-to-end solution.
Technological Leadership
Level 3 is widely recognized for its culture of technology innovation and leadership. The company has played a key role in helping to lead the global communications industry through a true revolution – the shift away from the legacy circuit-based technologies that have been in place for the past century to new Internet Protocol (IP) technologies.
Level 3 engineers and scientists include some of the industry’s most notable network architects and developers. They are responsible for innovations in many of the most important areas of IP-based communications, including softswitch networking, Multi-Protocol Label Switching, bandwidth provisioning, and network optimization.
The Smithsonian Institution has recognized the Level 3 Network as an important component of the ongoing revolution in communications and information technology. In April 2000, the Smithsonian cited Level 3 as a Computerworld Laureate for its historic achievement in creating a new kind of network infrastructure. The Smithsonian noted that Level 3 is changing communications at a fundamental level – and “helping to stimulate the biggest change in communications technology in 100 years."
In February 2003, Level 3 acquired Genuity, another technology pioneer. As part of its former parent company GTE, the Internet business that would later become Genuity was called BBN (Bolt, Beranek, and Newman). BBN built the original Internet, invented the e-mail protocol and "@" symbol, and in 1971, sent the world's first e-mail message.
Beyond advanced voice, video, and data services, Level 3 envisions IP technology becoming the foundation for a wide variety of communications companies that specialize in audio, video, and collaborative services for both businesses and consumers.
Today, Level 3 stands as an acknowledged leader in the communications industry, and continues to aggressively develop and deploy new technologies and processes, pushing the boundaries as one of the key players in the technology revolution.
Products and Services
Level 3 offers a wide range of communications services over its broadband fiber optic network including:
•Internet Protocol (IP) services
•Managed modem dial-up services
•Broadband transport
•Voice over IP (VoIP) services
•Private packet-switched services
•DSL Aggregation
•Colocation
•Metropolitan and intercity dark fiber
The company is one of the largest providers of wholesale dial-up service to Internet Service Providers (ISPs) in North America. Through its ISP customers, Level 3’s dial-up infrastructure is accessible to approximately 90% of the U.S. population. When a typical Internet user at home dials the Internet using a modem in the U.S., there is a fifty percent chance that their call is being completed within a Level 3 data center.
Level 3 is also the primary provider of Internet connectivity for millions of broadband subscribers through its cable and DSL partners.
The world’s largest telecom carriers all use Level 3 services, as do the 10 largest U.S. Internet Service Providers, the largest cable companies, content providers and the 10 largest European telecom carriers. Based on the amount of Internet traffic on Level 3’s IP backbone, Level 3 is among the largest Internet carriers in the world.
State of the Industry
The Telecommunications industry has experienced a “perfect storm” over the past four years. Technological advancements and the effects of regulatory changes have dramatically shifted the competitive landscape. These are the industry dynamics that Level 3 was formed to capitalize on, but many in the industry were ill-prepared to respond. Furthermore, the overly optimistic growth projections and inexpensive, readily available capital that helped inflate and ultimately burst the Dot-com bubble led to the construction of numerous long haul broadband networks and resulted in excess supply of communications capacity. This overcapacity ultimately contributed to irrational pricing by financially distressed players. With financial distress camenumerous bankruptcies, accounting improprieties and indictments of several industry executives that have shaken investors’ and customers’ confidence in the industry.
During this period, price compression for wholesale telecommunications services was rampant, with prices declining between 25%-50% per annum depending on the service. Oversupply remained a problem as weaker players restructured through the bankruptcy process or were rescued by financial buyers, thus delaying a long anticipated industry consolidation.
The industry environment remained challenging during the summer of 2004 but there began to be anecdotal evidence that pricing trends were improving. It was becoming clear throughout the industry that IP was the preferred underlying technology for voice and data services.However, one of the key remaining questionsin the industry was when traffic growth would be sufficient to offset pricing declines and translate into revenue and cash flow growth.
2004 Financial Performance
Level3 was not immune to the challenges in the communications industry over the past few years. With increased broadband penetration, the company’s mature managed modem business was beginning to decline. While this shift was expected and will be long-term positive for Level 3, the near term impact was a reduction in revenue. On February 5, 2004, Level 3 announced fourth quarter and full year 2003 earnings and provided guidance that it expected communications revenue to decline by a high-single digit percentage in 2004 versus 2003. A portion of this decline was related to a notice from the company’s largest managed modem customer, AOL, that it would reduce its purchases of dial-up capacity. Level 3 estimated a year-over-year reduction of $100-$150 million in managed modem related revenues due to AOL’s reduction and other factors.
“Meaningful revenue growth will be difficult to achieve, in our view. With its managed modem business (16% of total revs, +30% of telecom revs) under pressure, LVLT’s topline growth is dependent on its wholesale data business. However, our analysis suggests revenue growth will be difficult to achieve given (1) intense pricing pressure limits expansion of total market size. (2) strong competition makes share gain challenging.”
James D. Breen, Jr. CFA
Thomas Weisel Partners
January 20, 2004
Over the past several years Level 3 hasshown improvement inConsolidated Adjusted OIBDA[1] and OIBDA margindue to increased revenue, acquired revenue and cost containment. In July 2004, the company reaffirmed that projected 2004 Consolidated Adjusted OIBDA, excluding termination and settlement revenue, would be consistent with 2003. However, due to higher than expected network expenses, transaction expenses, and accelerated integrations, Communications Adjusted OIBDA margins for the full year 2004 would be in the mid-20 percent range, a reduction versus previously issued projections.
Notes:
**In 2003, the company completed its acquisition of Genuity. Results reflect the combined companies’ operations.
“Valuation rich, in our view. LVLT currently trades at 13.9x EBITDA, well above peer group average of 3-4x.”
James D. Breen, Jr. CFA
Thomas Weisel Partners
January 20, 2004
In February 2004, Level 3 also reported guidance that Consolidated Free Cash Flow[2] was expected to decline by $40 million to $60 million in 2004 vs. 2003.
Subsequently, due to increased capital expenditures associated with traffic growth and new customer contracts, increased integration expenses associated with acquisition activity, and lower-than-expected cash payments from IRU sales, the company adjusted its full year Consolidated Free Cash Flow guidance from negative $180-$200 million to negative $280-$310 million on its third quarter earnings call in October 2004.
“We reiterate our Sector Underperformer (Spec) rating. LVLT continues to burn cash and near term visibility is low. In addition, price declines in IP and managed modem are not expected to stabilize until the industry rationalizes. At 13x our ‘05E EBITDA, we believe the stock remains expensive.”
Timothy Horan, CFA
CIBC World Markets
October 28, 2004
Despite the historical negative free cash flow, Level 3 maintained a large cash balance of $850 million as of June 30, 2004.
2004 Securities Performance
The performance of Level 3’s common stock over the course of 2004 reflected the analysts’ sentiment. Analystsdoubted Level 3’s ability to grow revenues in the continually changing and challenging industry environment. From January 2004 through September 2004 Level 3’s stock price declined over 50% from $5.70 to $2.59.
The short interest chart below illustrates the total amount of LVLT shares that had been sold short and not yet been repurchased to close out short positions. Short interest in LVLT increased dramatically during2004 and by the end of the third quarter represented approximately 16% of the company’s total shares outstanding.
Level 3’s bonds also traded off over the first three quarters of the 2004, from a yield of approximately 10% at the beginning of the year, to a yield of approximately 20% bythe third quarter.
Capital Structure
As Level 3’s business plan continued to identify, adapt and take advantage of the changing industry environment, the company also continued to monitor the capital markets looking for opportunities to improve its financial position.
Along with the industry downturn, Level 3’s bonds had been downgraded and in November 2004, the company’s senior unsecured bonds were rated CC by Standard & Poor’s.
Level 3's Credit RatingStandard and Poor's
CC / Nov-04
CCC / Aug-02
CCC+ / Jan-02
B- / Oct-01
B- / Jun-01
B / Apr-98
As of September 30, 2004, Level 3 had approximately $5.27 billion of consolidated debt outstanding with a Debt to Adjusted OIBDA ratio of 11x for the trailing four quarters. Of the total debt, $500 million was issued at a subsidiary level and therefore was structurally senior to the parent company debt.
Although there were no significant debt maturities until 2008, a significant amount - $2.37 billion was scheduled to mature in that year.
Strategy
Level 3’s management team had always given thought to the maturity tower in 2008. Beginning in early 2004, Level 3’s bankers began approaching the management team with suggestions that Level 3 could raise money in the convertible and senior secured debt markets. With this guidance from the bankers, management saw an opportunity to issue debt to refinance a portion of the 2008 maturities.
Problem
How should Level 3 execute on the opportunity to refinance its 2008 debt maturity tower?
Key Considerations
- How would debt be retired/refinanced?
- What securities should Level 3 issue to fund the refinance?
- How could Level 3 achieve successful execution in reaching its objective?
1
[1] Consolidated Adjusted OIBDA is defined as operating income from the consolidated condensed statements of operations, plus depreciation and amortization plus non-cash impairment charges plus non-cash stock compensation expense.
[2] Consolidated Free Cash Flow is defined as net cash provided by (used in) operating activities less capital expenditures offset by release of capital expenditure accruals as disclosed in the consolidated statements of cash flows. Management believes that Consolidated Free Cash Flow is a relevant metric to provide to investors, as it is an indicator of the company’s ability to generate cash to service its debt. Consolidated Free Cash Flow excludes cash used for acquisitions or principal repayments.