This report contains substantially new material. Subsequent edition will have new or revised material Highlighted. LVLT updated for 4Q04 results
Overview
Level 3 is a facilities- based communications and information services company headquartered in Colorado. The company offers a wide range of communications services over its approximately 23,000 mile broadband fiber optic network including Internet Protocol (IP) services, broadband transport, colocation services, and patented Softswitch-based managed modem and voice services. It has a global Internet protocol (IP) network connecting 200 cities in the U S and over a dozen in Europe. It is building an international advanced IP based network in several phases over the next few years.
Level 3 has invested over $12 billion in a state of the art network since 1997. Its growth, however, is more through strategic acquisitions than organic growth. Many of its peers from the telephony boom years have gone into bankruptcy. Larger rivals, AT&T and MCI, have agreed to be acquired. Pricing remains competitive and demand has been weak. Level 3 Communications, Inc. has terminated its stockholder rights plan, commonly referred to as a “poison pill.” Analysts think this could be viewed as a sign that Level 3 is up for sale and wants to attract bidders.
Rank within Industry 65 of 69
Key Positive Arguments / Key Negative ArgumentsStrong, innovative management team / Over leveraged, have to sell assets to reduce debt.
Growth in wholesale VoIP and infrastructure revenue, VoIP grew 100% sequentially, offsets deterioration in other products going into 2006 / Will lose vast majority of DSL aggregation revenue in 2005 when Verizon contract ends
Building International Advanced IP based network / Very competitive and uncertain environment
Long haul market achieving more rational structure / Continued negative free cash flow, greater cash burn dashes hope for FCF breakeven over next couple of years
Signs of improvement in enterprise spending on network / Slack demand
Telecommunications industry coming out of doldrums / Heavy customer concentration: top 10 contribute 59% of Communications services revenue
Migration to higher margin broadband from dial-up, Positioned in narrow band and broad band / Continued high pressure on Managed Modems, the high margin product line
Expects to win incremental federal transport contracts; transport pricing stability a top priority / Value of long distance networks is highly uncertain because of industry overcapacity.
Expected to become less aggressive on pricing and more focused on profitability / With additional acquisitions in the sector, the need for a standalone Level 3 Communications continues to decline at an alarming rate.
Focusing on new revenue streams / Debt for equity swaps pressures EPS
Expect continued voice revenue growth / Pricing environment remains weak and it may take another round of bankruptcies before the industry rationalizes hence, credibility may be deteriorating.
Elimination of ‘poison pill’ could attract bidders / Growth products carry lower margin
Strategic acquisitions could add more growth at reasonable cost
Sales
Please see the spreadsheet LVLT.xls for further details and estimates.
4Q:04 / 2004A / 2005E / 2006EZacks Est. LVLT Sales(M) / $1055 / $3172 / $3526 / $3647
High Estimate / $1055 / $3172 / $3697 / $3787
Low Estimate / $1055 / $3172 / $3485 / $3121
One analyst (CIBC) points consolidated revenue grew 6.8% YOY to $ 1.1 billion in the fourth quarter, 7% better than analyst’s forecast. Excluding the one time termination revenue of $100 million from the termination of a dark fiber contract with McLeod USA, revenue would have been $955 million, down 3.0% YOY, as core communications revenue declined 4.3% from the year ago period. Information services revenue of $ 547 million was down 3.2% YOY and was 4% higher than expected due to normal seasonality. The analyst continues to like Level 3’s strategy of horizontal segmentation and remains impressed by the company’s strong management team. However, he is concerned over negative growth.
The company is optimistic on new service trends notes one analyst (Legg Mason), but remains cautious on broader competitive, industry wide trends. The analyst shares this caution, reading the upside as driven primarily by timing of the AOL modem turn downs, one time reciprocal compensation, and early termination benefits rather than insight/confidence about the trends of recurring revenue.
According to analyst (Thomas Weisel), LVLT is entering a new growth phase and expects near-term major contract wins in VoIP, a firming of the colocation market and a slight demand increase for its broadband products. He thinks these will begin to offset AOL dial-up attrition.
Others (Merrill Lynch, Fulcrum) agree that revenue growth will be a challenge. Analysts have treated the $4 million property tax as a one time event, adjusting the ongoing revenue accordingly. Some analysts see the $10 million reciprocal comp number as 50% ongoing. Analyst (Fulcrum) saw this as a credibility issue and treats it as a warning.
New Products
Level 3 launched several new products targeting voice opportunities and signed several new contracts to support VoIP rollouts. Its new services target both consumer and business customers and it has signed contracts with VoIP retailers, cable companies, RBOCs, long distance companies, and value added resellers.
As the world’s third largest Tier I Internet backbone combined with a large aggregation business for DSL and cable broadband, LVLT provides the network core critical to the “IP” in VoIP.
Although it has discontinued its (3) Tone Centrex product, one analyst (Bear Stearns) expects the consumer market to drive overall voice growth in 2005. However he expects revenue pressure from declining dial-IP, the elimination of $125M in DSL aggregation revenue from Verizon, and lower reciprocal compensation to impact the top line in 2005.
Information Services
Information Services delivered $547 million in revenue 4Q:04 and $17.4 million in OBIDA. Growth was attributed to stronger IT spending as well as seasonality since the second and fourth quarters are usually strong for the Software Spectrum business. While positive, one analyst (Legg Mason) considers these operations immaterial to LVLT’s valuation.
In previous quarters, analysts noted the potential sale of the information services business while
management stated that Information Services remains a strategic asset as computer networks move more from local area architecture to grid architecture and LVLT could service the application requirements of this future network. One analyst (Merrill Lynch) feels these will barely contribute unless the market develops. The sale of Information Services was not discussed in 4Q:04 releases.
Communications
Communication revenue for the 4Q04 was $482 million versus $423 million for the previous quarter. Total communications revenue for the 4Q consisted of $459 million of communications services revenue and $23 million of reciprocal compensation revenue, compared to $345 million and $78 million in the third quarter. Included in the communications services revenue was $103 million and $1 million of termination revenue for the fourth & third quarters, respectively. The increase in termination revenue was due to the previously announced dark fiber contract termination with McLeod USA.
Communications services revenue excluding termination revenue increased by $12 million quarter over quarter primarily due to an increase in voice and transport and infrastructure revenue, partially offset by a decline in managed modem revenue.
Offsetting the declines will be the expected growth in VoIP and IP/VPN applications. VoIP, which was broken out separately for the first time grew 100% sequentially to $24MM, or 7% of service revenue and 5% of total Communications group revenue.
Federal government contracts were an area of revenue growth. Level (3) management thinks this will be a future source of revenue growth and has decided to increase its government targeted sales efforts. Analysts expect rapid government growth to help offset AOL disconnect revenue and which, when combined with next generation revenue, will dwarf the AOL revenue.
The top 10 customers 4Q:04 based on communication services revenue are 360 Networks, AOL, AT&T, Cingular, EDS, EarthLink, Microsoft, Savvis, SBC, United Online, Time Warner and Verizon. They contributed about 56% of communications services revenue, flat from the prior quarter, notes one analyst (CIBC).
Transport/Collocation
Transport and infrastructure revenue was $122 million (up 7% from 3Q04), accounting for approximately 34% of core communications revenue. Soft switch services was $124 million (up 5% from 3Q04), excluding reciprocal comp, representing 35% of core communications revenue, and IP and data services was $104 million (down 2% from 3Q04), or 29%of core communications revenue, notes one analyst (CIBC).
VoIP:
VoIP provides significant volume opportunity. Level 3 is in the process of aggressively growing its voice over Internet protocol (VoIP) business, focusing on the delivery of VoIP infrastructure solutions for other carriers and service providers seeking to add voice onto their existing product offerings. Recent deployments by large enterprises coupled with voice over cable launches by most major MSOs signify that the market has accepted the technology and early adoptions being followed by mass market deployments. Though terms of each deal vary, typically management has guided to approximately $5-$7 per subscriber per month when delivering VoIP infrastructure to other carriers. This represents a sizable revenue opportunity that potentially converts Level 3’s model from pure Internet and fiber optic infrastructure into the $150 plus billion voice market in the U.S and Europe.
LVLT signed 20 new distributors for its business oriented VoIP product and saw its VoIP revenue grow 32% sequentially and its minutes grew by 45%. LVLT now has over 60 channel partners reselling voice, IP and data services. LVLT signed contracts for VoIP services with seven communications companies although revenue generation from these agreements is not expected for a few quarters. It takes them 3 to 6 months to generate revenue.
LVLT has signed contracts with major systems integrators (IBM, CSC, EDS) to provide IP-VPN services to large enterprise customers. LVLT envisions winning voice traffic and transport contracts from large enterprises following initial customer penetration with the IP VPN offering.
Reciprocal Compensation
As the RBOCs breathe a sigh of relief over FCC pricing changes on reciprocal compensation, this revenue stream becomes increasingly less significant for Level 3. Analyst (Fulcrum) assumes no termination revenue, and that reciprocal compensation revenue is cut in half (although it could approach zero at just about any time with a stroke of a pen by the FCC).
IP Services:
IP services revenue of $104 million was down 2% sequentially. Guidance was single digit YOY percentage decline in communications revenue in 2005, driven by further dial up attrition and the end to the DSL aggregation contract with Verizon.
Operations and Structure:
Management believes that Consolidated Adjusted OIBDA and Communications Adjusted OIBDA Margins are relevant and useful metrics to provide to investors, as they are an important part of the company’s internal reporting and are indicators of profitability and operating performance, especially in a capital-intensive industry such as telecommunications. Management also uses Consolidated Adjusted OIBDA and Communication’s Adjusted OIBDA margins, to compare the company’s performance to that of its competitors.
The company acquired the network assets of 360networks in March 2005. One analyst (Thomas Weisel) views this positively as it eliminates another capacity provider and brings a previously top-ten customer to Level 3, mitigating credit exposure. It also brings as a customer Deutsche Telecom, who was 360network’s top customer. Additionally it eliminates the potential of 4 fibers under long term lease of going to other competitors.
Capex:
Capex for the quarter was $86 MM, slightly lower than analyst’s expectations. Capex/sales for the quarter were 18%, down sequentially from 20%.
Consolidated Cash Flow & Liquidity:
During the 4Q04, unlevered cash flow was positive $20 million, versus negative $15 million during the third quarter. Consolidated free cash flow for the fourth quarter was lower than projected due to an early payment of $16 million in accrued interest expense associated with the company’s tender offer in the fourth quarter and higher than expected working capital needs related to accounts payable and accounts receivable in LVLT’s communications business. For the full year 2004, unlevered cash flow decreased to $64 million from $237 million in 2003, and consolidated free cash flow decreased to negative $344 million in 2004.
The loss of high margin dial-IP revenue from AOL, as well as the loss of DSL revenue from Verizon will hurt 2005 cash flow more than anticipated. One analyst (Bear Sterns) expects Level 3 will replace much of its lost dial-IP revenue with new voice, IP and transport revenue, but at lower margins.
On February 22, 2005, Level 3 Communications, Inc. announced that it has terminated its stockholder rights plan, commonly referred to as a “poison pill.” Although analysts have been quite negative on LVLT, many now think the company's termination of a "poison pill" plan could be viewed as a sign that Level 3 is up for sale and wants to attract bidders. One analyst (Fulcrum) however thinks the removal of the poison pill is just window dressing as he thinks no one would be foolish enough to buy Level 3.
Also on February 22, 2005 the company said it would sell $880 million in convertible notes, giving Level 3 more financial flexibility and easing concerns about the company running out of cash.