Level 3 Communications in one sentence:
Level 3 Communications, Inc., together with its subsidiaries, operates as a facilities-based provider of a range of integrated communications services primarily in North America, Latin America, and Europe.
The Internet Content Value Chain:
On Durable Competitive Advantage
Lower unit cost faster than you lower unit prices. That has been for 10 years our mantra, through scope, scale, innovation, lower unit costs, faster than unit prices grow, then you create a Netflix, or an environment for a Netflix, or an HBO GO, or an MLB.com, or an NFL.com for gaming, which is a huge phenomenon that rarely gets talked about in proportion to its size.
All of these things are network delivered, cloud-based services. And we feel more strongly than ever that if you could innovate, increase your scope, increase your scale, drop unit costs, it is a price elastic commodity and it is going to respond to lowering prices. We do think it is a mistake for those who I kind of refer to as the [scarce bit] people. There is only so much spectrum, there is only so much bandwidth, we want to raise prices.
I think that is a flawed strategy. The key is to innovate, drop unit costs faster than you drop unit prices, but drop unit prices.
[…]
…so, we have spent three years in an effort to analyze the US addressable market. We have a database. It took us a long time to put it together. We have 3.8 million buildings in it. That is about 13 billion to 14 billion of recurring revenue a month in those buildings.
You know who is in there, you know the number of employees, the type of business by SIC code. You can make a pretty rationale estimate of the spend and it is about 13 billion, 14 billion per month in the US alone. If you say, and we can do this in the database show me the buildings based on an algorithm that has revenue, net ex, Opex, show me the buildings that have been greater than a 70% IRR. That is opportunity. You don’t have to do anything more. We don’t have to enter a brand-new business.
We don’t have to hire a bunch of folks to get into cloud services. We don’t have to invent anything. We have to get better and better at deploying capital in metros. We have three continents to do it on. So to answer your question, we are focusing a great deal of effort with some of our best executives to analyze, manage and deploy capital in the metro on all three continents.
And I would like to think that we could use a greater fraction of free cash in that effort because the returns are so high.
James Crowe @ Morgan Stanley Technology, Media & Telecom Conference (Febuary, 2013)
Level 3 Communications History
Form 8K (feb. 200)
Maximizing NPV Requires Many Complex Trade-Offs Between Tens Of Thousands Of Variables
Dropping Prices – Lowers revenue per unit – But increases number of units sold Increasing transmissions speed (OC-12, OC-48) – Increases capacity – But decreases equipment spacing and number of colors of light Increasing numbers of colors (wave lengths) – increases capacity – But decreases equipment and transmission speed
Shortening network element life – Leverages price performance improvements – But increases absolute capital requirements[…]
o NPV is maximized when price decreases approach technology improvement rates
o Pull less fiber, more often, to leverage technical improvements – Requires multiple conduits
o Deploy new generations of opto-electronics technology very quickly
o Average asset lives are short
o Small improvements compound over time– J. Crowe
“LVLT Sources Scanned from Paper Copies“ – Investor Information Exchange
What is the internet backbone?
The Internet backbone refers to the principal data routes between large, strategically interconnected networks and core routers in the Internet. These data routes are hosted by commercial, government, academic and other high-capacity network centers, the Internet exchange points and network access points, that interchange Internet traffic between the countries, continents and across the oceans of the world. Internet service providers (often Tier 1 networks) participating in the Internet backbone exchange traffic by privately negotiated interconnection agreements, primarily governed by the principle of settlement-free peering.
Industry drivers
Rapid growth in demand
But the most important development of the past year may well be the fundamental changes that are reshaping the communications industry – changes driven by the explosion of demand for online video, gaming, and the streaming of movies and live events. What we are witnessing is nothing short of an information and content revolution, and our industry is being transformed by customer demand for more and more bandwidth and for online delivery of a wide variety of content.
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The explosion of demand for rich content has created unprecedented demand for bandwidth, and
we believe that there is no company in our industry better positioned to benefit than Level 3. We
designed and built our company to fully harness the benefits of Internet technology, beginning with the
construction of the first international communications network to be completely optimized for Internet
Protocol (IP), an accomplishment for which our company was honored as a Computerworld
Smithsonian Laureate and inducted into the Smithsonian Institution. And today, we combine the reach,
reliability and scalability of our IP backbone network with our state of the art content delivery network
(CDN) and our Vyvx Services for Broadcast.We believe that we are now beginning to see the clear implications of our investment in IP
backbone capacity and in our CDN. Our unique assets, our significant operating leverage and the
commitment of our employees are becoming apparent in our financial results.
Industry consolidation
At the same time, a world of lightning-fast innovation and precipitous price drops is a world in which the winner takes all. The technology leader has the lowest costs and, therefore, the lowest prices. That brings more traffic, which cuts costs, which reduces prices, which brings more traffic, and so on. “We watched it with Intel and microprocessors,” Crowe says. “We watched it with Dell and computers. Sooner or later, somebody is going to end up with 70, 80, 90 percent of the Internet backbone. How that happens is always tough to describe, but it’ll happen. You can show mathematically that one company will get supernormal market share. It’s a network effect on steroids.”
And Level 3?
He looks at the floor with an aw-shucks smile. “That’s what Level 3 is built to do.”
– “Surviving the Fiber-Optic Fire Sale” by Frank Rose, Wired magazine (2004).
Longleaf
Longleaf Partners (Southeastern Asset Management) is the largest equity holder (they hold debt as well). Following are comments from their quarterly letters regarding Level 3 in chronological order:
2Q 2002
After the close of the quarter, the Partners Fund, together with Berkshire Hathaway, Legg Mason, and Longleaf Partners Small-Cap Fund, completed a private placement in Level 3 convertible notes. Although typically we neither own corporate bonds nor do private placements, this was a compelling opportunity that the Fund’s Öexible policies allowed us to pursue and that we did not want to forego. The ten-year notes position Longleaf ahead of the common equity, pay a 9% cash coupon, and are convertible at any time to common equity at $3.41 per shareÌa price that is under the stock’s current level, and is far below the company’s growing intrinsic value.Level 3 owns the best Ñber telecommunications network in the industry. Importantly, most of its competitors struggle with huge debt levels and further signiÑcant capital expenditure requirements. Many are now in bankruptcy. Customers are universally worried about their service providers’ reliability,
Ñnancial integrity, and ability to provision future needs. Level 3’s superior network infrastructure, its servicing capabilities, and its capital resources position the company to become the clear industry winner. As we said in the press release announcing the placement, “”We invested in Level 3 to take advantage of consolidation opportunities in the telecommunications arena. We believe these opportunities are substantial. Level 3 is uniquely and competitively positioned, and its management team, led by Jim Crowe, is most able.”3Q 2002
Our investees’ competitive advantages improve the probability that the growth in corporate values will be a meaningful part of our future investment returns. Specifically, our newly acquired and unique assets are:
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– the lowest-cost provider of broadband wholesaling (even after competitors’ debts get washed away in bankruptcy) through Level 31Q 2003
Level 3: Purchased Genuity at a price that was immediately value accretive, adding high margin revenues over a uniquely low fixed cost communications system. Stock rose 5%.2Q 2003
All of the stocks in the portfolio rose during the quarter. The largest contributor to performance was Level 3 Communications. In June we converted our bonds into equity, receiving additional shares to compensate for the interest payments we were giving up. The company strengthened its financial position when we agreed to convert and take the net present value of those future interest payments. This stronger balance sheet further improves the quality of the equity which we now own. Because our investment in Level 3 has been extremely successful in the twelve months since we did the private placement, the company is the Fund’s largest holding.3Q 2003
Although Level 3 has been the largest contributor to the Fund’s year-to-date return, the stock declined 19% during the quarter. Our appraised value of the company was unchanged and our corporate partners remain some of the most capable we have seen. Level 3’s revenues fell primarily because of management’s effort to eliminate the unprofitable portion of Genuity’s business (Level 3 acquired Genuity earlier this year.) Our appraisal assumed this run-off, and our expectation for the company’s cash flow growth is unimpaired. Level 3 has also announced a plan to replace its bank debt with bonds to provide a more flexible financial structure to aid in purchasing additional customer revenues to run over Level 3’s fixed cost structure4Q 2003
Level 3, which is the Fund’s largest position, made important strides. In June we exchanged our 9% convertible notes for equity. The company successfully integrated the Genuity business it purchased and restructured debt for a more flexible financial structure. The management team plans to pursue further organic revenue growth as well as larger scale through acquisitions that make financial sense. Level 3 was the third largest contributor to the Partners Fund’s return, and the stock remains undervalued when compared to our appraisal.1Q 2004
Level 3 Communications hurt the Fund’s results. Lower operating cash flow expectations for 2004 precipitated a 29% price drop. The managed modem business will decline because AOL is decreasing its Level 3 business following revisions in AOL’s dial-up growth expectations. In addition, pricing competition in the Internet Protocol segment has remained terrible for longer than anticipated. Although demand for IP traÇc is growing, revenues are flat. On the other hand, transport revenues are rising at a healthy rate. Our appraisal of Level 3 remains well above its price because we believe that beyond 2004 the company will make up in broadband what it loses in dial-up service, will benefit as pricing becomes more rational, and will continue to see massive increases in demand with the growth of newer applications such as voice-over-IP and wireless communications.2Q 2004
Level 3 detracted from the Partners Fund’s return both for the first half and in the last three months. Early in the year the company reduced expectations in its managed modem business because of the decline in AOL’s dial-up traÇc. Price competition continued to neutralize the rapidly growing Internet Protocol (IP) volume. In response to Level 3’s announcements in the first quarter, we reduced our appraisal to reflect lower cash flow in 2004, but our long-term assessment of the company and its prospects remained sanguine. We believe that expanding capacity utilization from both broadband customers and new services such as voice-over-IP will create firmer pricing in the next few years, and that Level 3 is strongly positioned to be a low cost beneficiary.3Q 2004
Level 3 has been the largest detractor from Fund performance, falling 26% in the quarter and over 54% this year. It’s our view no news other than the ongoing short raid precipitated the recent decline. The company’s strong growth in demand for its fiber backbone capacity continues to be offset by stiff price competition. Based on our appraisals the stock is the most undervalued in the portfolio.4Q 2004
After being one of the largest positive contributors to 2003 performance, Level 3 detracted from 2004 results. Level 3 fell 40% for the year despite a 30% fourth quarter rally. We believe the company is the lowest cost and highest service level provider of fiber optic backbone services, but faced two specific challenges in 2004. The managed modem business that serves dial-up customers suffered from a re-sizing of ports by AOL. While broadband usage increased demand for fiber backbone capacity at rates approaching 100%, price competition driven by overcapacity left revenues flat. These two dynamics hurt our appraisal of the business by pushing cash flow growth further into the future, but the stock price fell much more dramatically. We remain large owners of Level 3 because we believe that top line growth is a question of when, not if. Strong broadband demand should continue since only about a fourth of U.S. homes currently have this type of connection. Additional services such as voice over IP and video on demand will further increase capacity utilization. As this combined growth absorbs capacity, prices should stabilize because competitors with older networks cannot justify capital outlays at today’s prices. We believe that Level 3 has the longest staying power while waiting for pricing to turn because:
– Their cost structure is the lowest in the industry.
– The structure of the company’s leverage is formidable with no bank debt, and its first notes not due until 2008. The company recently bought back much of its obligation for 2008 after a successful placement of 2011 notes.
– The company has been adding customers, and incremental revenues have contribution margins of 60%. The potential to buy another, weaker competitor as they did with Genuity offers additional revenue opportunity.
– The management team led by Walter Scott and Jim Crowe has a strong operating and capital allocation history, they have practiced conservative accounting, and they are substantial owners.1Q 2005
Level 3’s performance hurt the Fund’s return during the quarter, falling 39%. The company announced a higher cash burn rate for 2005 than many expected, as well as higher capital expenditures related to growth in new business. Given this growing demand coupled with Level 3’s low cost position among its competitors and the long overdue consolidation occurring among telecommunications service providers, we believe that Level 3’s stock remains undervalued and that its prospects over the next three to five years are compelling. We acted on this belief by participating with six other firms in the private placement of a convertible bond that is due in 2011 and yields 10%. The offering raised $880 million, which will allow Level 3 to maintain over $1 billion in cash reserves throughout the year and to have flexibility to act on opportunities that may arise. The quarter-end portfolio of the Partners Fund does not reflect this purchase, which closed April 4th and reduced cash reserves by 2.5%.3Q 2005
The two primary stocks that have hurt Fund performance for the year, Level 3 and Disney, are actually in better shape today than at the outset of 2005.
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Hints of firmer prices in Level 3’s IP and Transport businesses have begun to show in the most recent quarter’s financials. In addition, Jim Crowe and the company’s competitors have begun to see better pricing. We have not adjusted our appraisal yet, but are encouraged by the positive signs.1Q 2006
Most of the stocks in the Fund rose during the quarter with the largest contributor being Level 3. As the company reported higher operating cash flow for 2005 and increased guidance for 2006, the stock price responded. The financial results reflected our long-held belief that growing demand and industry consolidation eventually would stabilize pricing. Also, the company made a very important acquisition of Wiltel, and announced a smaller but favorable acquisition of Progress Telecom. The stock rose over 80% in the quarter and the convertible bonds purchased last year were up 50%.2Q 2006
Rallies in many holdings that began the year at the lowest P/Vs have driven much of the strong performance in 2006. Although Level 3’s stock fell 14% in the second quarter, both the equity and the convertible bonds have made significant gains this year. The combination of top line growth, increased operating cash flow and several solid acquisitions has generated value appreciation. In spite of the stock’s large rally, the price remains at less than 60% of our appraisal.3Q 2006
The Fund’s strongest performers for the year continued to do well in the third quarter. The combined bond and equity position in Level 3 has made the biggest impact on returns in 2006; the stock was up over 20% in the quarter. Operating cash flow has grown as pricing declines have slowed. The company’s acquisitions have enabled Level 3 to broaden its offerings from wholesale fiber backbone access to direct customer connectivity in many metro areas. Our appraisal has grown, and we believe that given the business’ operating leverage, the pace of value growth will be substantial. As the low-cost producer, Level 3 is also well positioned to make value-additive acquisitions in an industry that needs further consolidation.4Q 2006
Level 3 almost doubled over the last twelve months. Internet usage has grown with ever-increasing video, voice and data demand. Not only has higher capacity utilization slowed price declines, but the acquisitions that Level 3 has made, including Wiltel, Telcove and most recently, Broadwing, have helped consolidate the industry’s overcapacity while expanding Level 3’s direct reach to customers in metro areas. The stock remains well below our appraisal of corporate value, and that appraisal continues to grow at a fast rate.1Q 2007
Level 3 was the largest contributor to the quarter’s results. The company’s competitive strength continued to grow as did its stock price. During the quarter we converted the 2011 notes into equity, receiving the full face value of all remaining interest payments as well as a premium for early conversion. Adept balance sheet management by the company has played an important role in the success of this investment.3Q 2007
After a substantial rally early in 2007, Level 3 declined 20% in the third quarter, making it the largest detractor for both the last three months and the year. The integration of the Broadwing acquisition has been more cumbersome than anticipated, creating longer provisioning times for orders. 2007 revenues have been delayed, but next year’s sales should reflect the built backlog and growing demand. The longer term outlook for the company remains strong.4Q 2007
Level 3 had the largest impact. The company announced that orders were taking longer to provision resulting in revenue growth in the single digits versus the previously estimated mid-teens. We lowered our appraisal to reflect the delayed cash flows and to assume no improvement in the longer provisioning time. The combined third and fourth quarter stock declines made Level 3 the biggest detractor of 2007. The stock trades at a material discount to our conservative assessment of intrinsic value even though the prospects for Level 3’s future are much more certain than in recent years.1Q 2008
The telecom
industry as a whole, and cellular operators in particular, fell. Level 3’s value grew in the quarter in spite of the stock’s 30% decline. The market overlooked the company’s progress in reducing its backlog of new customers and improving provisioning times. This positive news was overshadowed by the announcement of COO Kevin O’Hara’s departure. We are confident that Jim Crowe, the CEO, is the right person to lead the company and grow its value, and we are glad that CFO Sunit Patel, who previously planned to step down, has decided to remain in his role.4Q 2008
Level 3 (“LVLT”) is the low cost provider among the primary internet backbone transport companies as well as a major competitor in direct internet service to businesses within most major metro areas. Unit demand is growing rapidly, especially with increasing movement of voice, data, and video over the internet. We have assumed lower growth in business services over the next year due to the economy. Concerns over slower growth and the company’s debt hammered the stock price, which fell 74% in the quarter. The company bought over half of its debt maturing in the next two years at significant discounts. Level 3 successfully raised $400 million for this purpose, and the Partners Fund was among the investors offered the opportunity to buy 2013 notes with a 15% coupon, convertible at $1.80 per share. LVLT is cash flow positive with depreciation and amortization outstripping capital expenditures. Jim Crowe and Sunit Patel have continued to ably manage the company’s capital structure while growing the business.2Q 2009
Level 3 bought in more of its near-term maturities. The combination of solidifying its ability to meet obligations over the next several years and the general thawing of credit markets has improved investors’ view of the company. The stock rose over 60% in the quarter and has more than doubled this year.3Q 2009
In the quarter Level 3 reported disappointing revenues primarily caused by internet backbone customer deferred spending. As the economy improves and capacity utilization rises, cable operators and other wholesale customers will have to spend to manage growing demand. Level 3 announced a new board member, Rahul Merchant, who has a wealth of experience in the telecommunications and technology industries including being on the Sun board. Although the stock fell 8% in the quarter, it has almost doubled in 2009.2Q 2010
Level 3 declined 33% in the quarter and is one of the largest detractors for 2010. The company reported disappointing results. Changes made in the business over the last year have not yet shown significantly positive revenue results. We believe the company’s additional sales staff and growing productivity will translate into increased contracts and revenues. Additional sales will deliver substantial operating profit improvement because of the company’s high contribution margin.3Q 2010
Level 3 has irreplaceable fiber assets, and demand for bandwidth is growing rapidly with the increasing movement of data and video across multiple platforms. The company’s pace for adding new direct customers has been disappointing. The contribution margin from increasing top line growth is substantial. Translating obvious demand into strong organic revenue growth in the near term will determine success.We are unhappy with Level 3’s operating results and stock price. You can assume that we are neither oblivious nor idle.4Q 2010
Level 3 fell 36% for the year but had a 5% gain in the fourth quarter following news of becoming a primary carrier for Netflix. Because of the 60+% contribution margin from additional revenues, the growing demand for internet video should add meaningful free cash flow over time. The company has been slower to deliver growth than projected, particularly in the metro business. The short-term cost of hiring and training new sales people has impacted costs but not yet revenues. The transition time from orders to revenues in wireless backhaul has expanded because newer products demand more set-up time, and carriers are taking longer to connect. At this point success depends on revenue growth. Major debt maturities are three years away. Given that the cost to build the network was over $25 billion and that today’s enterprise value (debt + equity) is less than $8 billion, the company’s assets are severely discounted with several possible rewarding eventualities. As we said earlier in the year, we are neither oblivious nor idle regarding Level 3’s results and stock performance.1Q 2011
Level(3) rose 50% in the quarter as EBITDA and margins came in higher than expected, and the company indicated that it expects higher top line growth. Subsequent to quarter-end, the company announced it will buy Global Crossing. The transaction will strengthen Level(3)’s balance sheet, further consolidate fiber capacity, and reduce Global Crossing’s operating costs. Although our appraisal reflects current results, if the combination goes as planned, Level(3)’s value could grow dramatically.2Q 2011
The continuation of strong operating results at several core holdings as well as positive reaction to Level(3)’s announced acquisition of Global Crossing helped performance. Level(3)’s 66% second quarter return took the stock’s first half gain to 148%. Combining these two fiber network businesses provides numerous benefits. Level(3)’s debt cost will dramatically decline as its debt/EBITDA ratio falls from over 6 times to 4 times. Global Crossing’s gross margins will rise meaningfully as the company moves much of its U.S. long haul business to Level(3)’s network. Further industry consolidation bodes well for long-term pricing. We also gain astute partners in the board room as Global Crossing’s majority owner, Singapore fund Temasek, will have three board seats and own roughly 25% of the company.3Q 2011
Level(3), which is up 52% year-to-date, has recently completed its acquisition of Global Crossing. The combined telecommunications fiber company will have lower operating and debt costs as well as larger revenue opportunities. The recent 39% stock decline did not reflect any change to the company’s prospects or the underlying value of its fiber assets. In fact, results released in the quarter included record gross and operating cash flow margins, helping the value of the company grow.
Other Sources:
LVLT on Corner of Berkshire and Fairfax forum
“What is wrong with Level 3?” – on Seeking Alpha
A presentation on smartphone and tablet user trends by Mary Meeker of KPCB
Data on the CDN market:
CDN Data: pricing, volume, contracts (video), (pdf) – Dan Rayburn
