LEVEL 3 COMMUNICATIONS INC LVLT
October 11, 2011 - 6:37pm EST by
biv930
2011 2012
Price: 1.70 EPS nm nm
Shares Out. (in M): 3,103 P/E nm nm
Market Cap (in $M): 5,275 P/FCF nm 12.3x
Net Debt (in $M): 8,625 EBIT 1,777 2,174
TEV ($): 12,295 TEV/EBIT 6.9x 5.7x

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Description

(Note:  EBIT #s above are actually EBITDA #s) 
Thesis:  LVLT is a turnaround story that has also made a transformational acquisition, both of which should drive significant improvements in fundamentals over the next few years.   There is also optionality on a super upside case driven by further industry consolidation, continued acceleration in bandwidth demand and revenue synergies from the GLBC merger. 10yrs+ of over-capacity, intense competition, massive pricing pressures, high operational/financial leverage, and low returns on capital has resulted in investor hardwiring.  Investors/sell-side hate this stock and are over-looking the impact of the turnaround/acquisition on the underlying fundamentals.   

LVLT will earn approximately $.30/share in FCF in 2013 vs street expectations of ~$.10/share.  LVLT trades at ~6x our estimate for 2013E FCF and should grow FCF at 25% annually for several yrs after (and trades at ~5.5x our estimate for 2013E EBITDA).  It also trades at ~25-30% of reproduction value although it would be incredibly difficult to reproduce their network today.  We expect upside of ~2-3x over the next few years.

Path to Profitability:  LVLT is able to generate revenue growth of ~6% per year and 60% incremental EBITDA margins on that growth.  Leverage multiples decline from 6-7x to <3.5x, they generate ~$350m in opex savings and ~$200m in interest expense savings over the next couple of years.   LVLT earns ~$2.2b in EBITDA and ~$900m in FCF in 2013 vs consensus expectations of ~$1.6b and ~$300m, respectively.  Consensus #s are based on the few analysts who have updated their models for the merger True consensus is actually lower than the above #s as most analysts haven't even updated their models for pro-forma #s including the synergies. 

Phases of Investment:  There are 4 phases to this investment.  We have high conviction in the first 2 phases below and all of the #s in this memo are based on those phases.   We think there is a reasonable probability that LVLT moves into phase 3 and 4 and will be tracking that closely.

1) Phase 1: The Turnaround - Next Few Quarters                                                                                                                                                                                                                       a. QoQ CNS revenue growth has accelerated to ~2% in the latest quarter. They are able to sustain this growth trend moving forward. This drives revenues/ebitda to come in ahead of expectations for 2011/early 2012 and investors begin to realize that LVLT has worked through their historical integration issues. Management credibility improves.

2) Phase 2: Transformational Acquisition - 2012/2013                                                                                                                                                                                                             a. The deal with GLBC closes and investors begin to give LVLT credit for merger cost synergies of ~$500m+. LVLT executes on merger synergies (ie cost/interest expense) while maintaining 6%+ top line growth driving a FCF inflection point in 2012. LVLT generates ~$.30/share in FCF in 2013 vs consensus expectations of ~$.10/share

3) Phase 3: Transition to Horse
a. The combination of LVLTs network and GLBCs sales team allows them to accelerate enterprise revenue growth. The combined company has <5% share of their addressable enterprise TAM. LVLT also has a competitive advantage in its CDN business which has significant tailwinds. Revenue growth accelerates from 6% to 10%+ and LVLT generates $.50/share in FCF in 2014.

4) Phase 4: Reproduction Economics                                                                                                                                                                                                                                             a. Through consolidation, continued rapid demand growth and increasing utilization rates, pricing declines decelerate in LVLTs wholesale business. ROICs expand to 10-15% after-tax as it is extremely difficult to reproduce LVLTs network. LVLT trades at 1-1.5x reproduction value or $11-17/share.

Bear Case:

1) Bad Business that is Super Levered: The fiber optic industry has suffered from massive over-supply since the internet boom in 2000. Since then, there has been significant pricing pressure and returns on capital have been almost non-existent. LVLT currently has 6-7x turns of EBITDA in net debt. Macroeconomic weakness and continued pricing pressures could push them into bankruptcy.

2) Operational Issues: LVLT tried to integrate 6 acquisitions in 2007 and it was an operational disaster. Provisioning times increased by 2-3x, customer service deteriorated and churn increased. The business is still a mess today and management has no credibility.

3) Risk with GLBC Merger: LVLT didn't execute on their previous acquisitions and they are unlikely to execute with GLBC. There is no reason to believe it's any different this time.

4) Expensive Valuation: LVLT trades at 8-9x EBITDA (no credit for synergies) for a crappy business that is over-levered, unlikely to generate FCF and has real risk of going bankrupt.

Our View:

1) Operational Issues Fixed/Revenue Growth Accelerating: LVLT suffered from several operational issues when trying to integrate 6 companies in 2007. They brought in a new COO (Jeff Storey) in late 2008 who is highly regarded in the industry and our research indicates that they had fully worked through their integration issues by mid-2010 and churn, provisioning and customer service are now back to industry leading levels and continue to improve. This has caused core revenue growth to accelerate to a run rate of ~7-8% annual growth.

2) Transformational Acquisition: The merger with GLBC is transformational as it will improve LVLT's competitive position in the enterprise market, allow LVLT to achieve global reach, deleverage the balance sheet and improve FCF generation which will allow LVLT to invest in additional growth prospects. Our research indicates that company projections of $300m in opex savings are likely low and they will also generate $200m+ in interest expense savings due to the improving credit profile (most of this already locked in).

3) Business Fundamentals Improving/Significant Deleveraging: The industry has experienced massive consolidation and continued rapid growth in bandwidth demand has also driven increasing utilization rates. As a result, pricing declines have decelerated on many routes and have even turned positive on some select routes. Even before the GLBC merger, LVLT had acquired several companies that allowed it to create one of the deepest networks in the US with significant reach. This has allowed LVLT to compete for business that is less commoditized where they are only running up against a couple major competitors. Post GLBC, LVLTs fundamentals will improve further and the synergies will help deleverage the balance sheet and drive FCF generation, reducing the severity risk. LVLT will look like a dramatically different company within 2yrs.

4) Limited Integration Risk: Integration risk is low as they are primarily integrating a long haul network in the US which is significantly easier than integrating metro assets. The international assets are largely in regions where LVLT has no presence so integration isnt a problem there. In addition, a chunk of the long haul fiber that GLBC has in the US was leased from Genuity which is a long haul network that LVLT purchased and already integrated back in the early 00s. The integration problems in 07 were a result of LVLT trying to integrate 6 companies (many metro assets) at the same time and then compounding those issues by cutting headcount very quickly and losing human capital that was necessary for network management at several small companies that had weak systems in place. The dynamics are very different today.

5) Cheap Valuation: LVLT is a company that hasn't generated sustainable FCF for over a decade. The perception of the company will change dramatically in the next couple of years as they reach a FCF inflection point which will also allow them to accelerate revenue growth as they can invest in additional growth opportunities. Our research indicates that LVLTs growth has been constrained partly due to lack of capital to invest in new projects. LVLT trades at ~6x 2013E FCF which is ~3x consensus expectations and should be able to grow FCF at 25%+ past 2013.

Recent Signposts:
1) Churn has been improving for the past few quarter
2) QoQ CNS revenue growth turned positive in 2Q 10 for the first time post the credit crisis/integration issues and they have maintained positive top line growth since then
3) Time to provision new business has returned to industry standard levels and continues to improve
4) LVLT announced the acquisition of GLBC with significant cost savings and possible revenue synergies
5) The market price of LVLTs debt implies ~200bps+ of interest expense savings and they have already begun to refinance their debt
6) LVLT has already closed the GLBC deal (ahead of expected) and is doing a reverse stock split as a low single digit stock price usually falls off the radar of many funds

 

Catalyst

1) Continued QoQ growth rates of ~2%
2) FCF inflection point over the next 12 months
3) Higher than expected synergy flow through
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