Description

Level 3 bank debt (roughly 83c) yielding 12% unlevered (or north of 20% levered 2-1) represents a favorable return for a claim that appears to be clearly worth par intrinisicly (covered 3-4 times) and is secured and there is likely to get post petition interest in bankruptcy filing.

This is a name that has been written up here before, but I have not agreed with the long recommendation on any of the securities in the capital structure until recently. As this name has been extensively discussed before, I’ll skip the introductory remarks and get to the heart of the matter.

What has changed…

The event that has changed my view on this company has being their acquisition of Genuity, which I think will return greater than a 100% IRR.

I cannot, at this point, guarantee that the company will be able to handle it entire debt structure (roughly $6 billion), but feel confident that the bank debt is a par claim and feel that one is more than adequately compensated for the risk.

Level 3 has roughly $1.125 billion in bank debt outstanding, with the potential to grow to $1.275 billion when fully drawn. This is a senior, secured facility with coupons in the LIBOR + 325-450 range depending on the tranche, and 3.5-4.5 average time to maturity, yielding roughly 12% to maturity.

These securities are supported by the following:

1) The facilities require the company to maintain minimum cash balances of $400-500 M, which on the low end equate to 31c on the fully drawn facility. (Note also the 3Q02 cash balance was roughly $1.5 billion)

2) A non-core software resale business that is generating $60ish million in EBITDA with minimal cap ex. I place a rough valuation of 350-450 on this business or another 30ish cents of value of the fully drawn facility. This was the business they acquired in part to meet revenue based covenants in a prior iteration of bank loan.

3) The core communication business which I feel will be on a EBITDA run rate of $550-650 million with capital requirements in the 250-350 range once they have integrated the GENU acquisition. I’ll let every one pick their own multiple for this business, but I fell that this is several billion. I will elaborate further on this below

My view on the company is more pessimistic than many of the bulls on this name and my recommendation discounts the following pessimistic points.

- I feel the company has large working capital “hole” that they will need to paid down. This is not a fraud or anything, but most likely outstanding payables from their construction build.
- Managed modem, their largest business, serves dial up ISPs who are facing flat to declining subscribers and are pushing for price concessions from providers like Level 3.
- A significant revenue source ($120 million estimated for 2003) is reciprocal compensation, which is being phased out and is 100% margin revenue.

Despite these points, I feel the company remains in a strong liquidity position, which should last them until the 2007-2008 time frame when they face serious amortization of the other outstanding debt. I also feel that the company’s claim that the will be FCF+ in 2Q04 including cap ex, interest, and debt amortization is in the range.

Genuity acquisition

Level 3 bought in bankruptcy the majority of Genuity’s business for about $130 million, which was an absolute steal, but somewhat of a fluke. Level 3’s main motivation was roughly $660 in run rate revenues, which they plan to migrate to their network for a small incremental cost. As a result, they will be able to increase the GM on this business from 30ish % to 64% based upon their implied guidance. There will be a further opportunity to increase this to the 80% range 2-3 years out when they migrate further portions of the traffic to their network when certain contractual obligations roll off that they were required to assume as a part of the deal. In addition they will be severely cutting out large portions of the SG&A costs. The company has been somewhat coy here, but based upon the announced reduction in fiber miles (6x), pops (7x), data centers (4x), and hints at headcount reduction (5x), I predict that they will be able to cut 2/3 of the Genuity SG&A from $120 million a quarter to $35-45 million a quarter. The net result is that, once integrated, the Genuity business will contribute an incremental EBITDA of 200-300 with modest incremental cap ex (25-75 million guess). If these numbers come to pass, they will earn a handsome return of their $130 million investment together with the $50 million they will burn bringing these assets to breakeven.

It’s worth noting that I think that it was somewhat of a fluke acquisition that probably won’t be repeated on this scale. There reason LVLT was able to buy these assets this favorable results from three unusual factors/influences. 1) GENU was burning cash so rapidly (75c for every $1 of revenue) that the creditor were very focused on an lighting quick close, rather than price and none of the other reasonable bidders could credibly close as quickly as LVLT did. 2) The buyer had to be competitive in managed modem to be able to turnaround the GENU assets. With WCOM in ch11 and Quest unable to close quickly, this left LVLT nearly alone 3) They had to have the resources to make a sizable acquisition, which eliminated many of the smaller managed modem competitors. These factors collectively explain why in competitive markets, LVLT was able to earn a 100% return on the investment, which came as a surprise to me.

Should LVLT file for Ch11, the return on the bank debt investment would be less favorable, but still more than adequate. My assumption is that as a senior secured creditor with ample asset protection, they will receive post petition interest. What will change in ch11 is the time that par is repaid. Depending on timing of filing and time in bankruptcy this could either increase or decrease the average time to maturity of the bank loans. Most likely is that it will extend by 2 years the maturity, decreasing the YTM to the 10% range unlevered and the high teens levered 2-1, which I feel is good for a security is amply covered by the intrinsic value of the business and has 60c of easy value in the minimum cash balance and non core businesses.

disclosure: may own these securities professionally

Catalyst

- Positive financial results over the next few quarters from the GENU acquistion

- turning FCF+ in 2Q04

- debt amortization will return capital