Level 3 Beats Earnings Consensus, Lures Warren Buffett

Wholesale carriers that during the late `90s hey day raised a mountain of cash in public equity and high-yield bonds began their descent into insolvency last year after Silicon Valley’s dot com hotshots packed their bags.

Faced with mounting debt payments and increasing skepticism about the viability of the wholesale carrier model following the demise of Internet startups, competitive local exchange carriers and other communications companies, 360Networks Corp. (, Global Crossing Ltd. (, and Williams Communications Group Inc. ( have filed for bankruptcy protection during the last 13 months.

When Williams Communications deviated in April to the bankruptcy court for relief from its creditors, analysts examined whether the carrier’s debt-laden rival, Level 3 Communications Inc. (, would suffer the same fate.

In its 2002 guidance, Level 3 had told Wall Street one-quarter of its recurring revenue base was at risk and noted it could violate a revenue-based covenant as early as the second quarter. Level 3 allayed those fears by focusing on the 300 largest bandwidth consumers around the world and acquiring two software resellers that generated a combined $2.4 billion in annual revenue last year.

Last month, the company raised $500 million in convertible notes through Berkshire Hathaway Inc. (, Longleaf Partners Funds ( and Legg Mason Inc. (

Level 3 CEO Jim Crowe has said he is interested in buying distressed assets. The company has made a bid for a portion of Global Crossing: its Frontier operations, consisting of the former Rochester Telephone Co., a provider of telecom services to corporations, according to The Wall Street Journal.

“We believe the opportunity before Level 3 remains quite significant,” said spokesman Paul Lonnegren. “We have fewer competitors and a strengthening customer base. Our business plan remains fully funded to free cash flow positive.”

Still, many financial analysts assert the company’s long-term prospects are weak. They cite sluggish growth in the global broadband market and long-term debt payments that total nearly $6.5 billion. Level 3 posted a second-quarter net loss of $156 million and EBITDA of $76 million, which exceeds some analyst estimates.

“Although we are moderately encouraged by (Level 3’s) efforts to improve its liquidity and reduce capital expenditures with $6 billion in debt and below investment grade credit quality, liquidity remains a concern,” according to a Standard & Poor’s ( stock report issued a week before Level 3 posted its earnings. Level 3 “still remains focused on telecommunications customers that are similarly reducing their budgets. With a highly leveraged balance sheet, poor industry fundamentals and sizable fixed costs, profitability is likely still a few years away.”

S&P, which rates the stock a hold, is not the only skeptic. Brokerage firms, including Goldman Sachs (, Merrill Lynch ( and Bear Stearns (, warned Level 3 poses risks despite meeting or exceeding analyst estimates and luring Berkshire Hathaway’s Warren Buffett, a billionaire who traditionally has avoided dumping funds in high-tech companies.

Merrill Lynch, which reiterated a reduce/sell rating in an equity report, said the carrier might have difficulty meeting minimum revenue covenants by the end of next year. Moreover, the brokerage firm suspects Level 3 “will struggle” to generate sufficient earnings by 2005 to pay for $800 million in annual capital expenditures and interest expenses. The task will become increasingly difficult as the company’s long-term debt matures between 2005 and 2010, analysts said.

Poor visibility and customer credit concerns outweigh Level 3’s operational improvements, Bear Stearns analysts said in an equity report. Level 3 posted a total of 1,600 communications customers in the second quarter, down from 1,775 companies last quarter. Bear Stearns rates the stock neutral.

“Although management has improved the company’s operational performance and has shown resourcefulness in meeting debt covenants Level 3 continues to be dependent on the difficult wholesale telecommunications market for the majority of its operating cash flow,” the analysts said. “The timing and magnitude of a sustained macro recovery remains uncertain, a global acceleration in broadband adoption triggering profound and lasting demand for broadband is unlikely in the near-term and the company still wrestles with $6.5 billion in debt.”

Wholesale price wars could resurface if the likes of 360Networks and Williams Communications emerge from bankruptcy court with little debt. 360Networks submitted reorganization plans July 18, to the bankruptcy courts outlining a plan that would allow the company to emerge from creditor protection with approximately $215 million in debt and more than $50 million of cash on hand. Williams Communications also is close to submitting a reorganization plan, according to recent media reports. Theoretically, Level 3 could be at a disadvantage if its bankrupt peers emerge with little debt and undercut the carrier on price. Lonnegren declined comment.

In the meantime the wholesale telecom market shows no signs of near-term recovery, analysts said.

Level 3 “is in a no-growth environment with increasingly limited visibility, in our view,” Goldman Sachs analysts said in an equity report. “There is still no evidence of a demand pickup and (Level 3’s) exposure to churn of at-risk customers will continue to overshadow new customer wins.”

On the other hand, Level 3 could move to acquire the assets of distressed companies for pennies on the dollar. Level 3 ended the second quarter with $1.55 billion in cash and equivalents, positioning the company to buy the distressed assets of such bankrupt carriers as XO Communications Inc. (, WorldCom Inc. ( and Global Crossing, according to Kaufman Bros. ( The brokerage firm, which rates the stock a buy, said the company could bid for WorldCom UUNET’s dial-up wholesale business.

“Industry consolidation could help Level 3 load its network, eliminate the specter of future irrational competition, gain market share and enjoy abnormal returns over the next few years by pricing on the margin based on substantial networks available for pennies on the dollar,” Kaufman Bros. stated in an equity report.

Level 3 posted gross margins that exceeded 70 percent in the second quarter. “I think that is a strong (testimony) to the efficiency of our network and operations,” Lonnegren said.

Shares of Level 3 closed Monday at $5.78 on the Nasdaq National Market (, and shares were trading down by about 2.7 percent shortly after the market opened today.

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