Description

Level 3 (LVLT) Bonds – Very Low Risk and a 25+% annualized Return for 6-8 years.

What is one of Bill Miller’s largest holdings in the Legg Mason Value Trust? What “tech play” is Warren Buffett rumored to own? The answer is Level 3 Communications. Buffett is thought to own the bonds and Bill Miller has both the stock and bonds. Let’s examine why both these successful “value” managers have such big stakes in an industry that’s on its knees at present.

Level 3 is a global provider of bandwidth and related services primarily to the networking/telecommunications industry. Level 3 was formed to develop and operate a global IP network offering the lowest cost per bit transported of any network in the world. I believe that the Level 3 is misunderstood by the market and thus its bonds offer very high annualized returns for 6-8 years while being a very safe play. It is these characteristics that have attracted Miller and Buffett.
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The company IPO’ed in early-1998 and stock hit a high of $130/share at the peak of the Nasdaq frenzy in Q12000 – sporting a market cap of about $46 Billion. Today the shares are 97% off their high – changing hands at about $4.50.

Its customers include Microsoft, AOL Time Warner, Yahoo, France Telecom etc. Their business model is like Intel. “Design Wins” are more critical than present revenues as once they get in the door, they can substantially expand. Level 3 has been consistenly getting terrific design wins.

The company took a hit on its receivables and future recurring revenues when the dot coms crashed. Initially it was a big beneficiary of the surge in bandwidth needed by the dot coms. However, the original business model was never based on the dot coms. They showed up and turbo charged the growth engine for a while. Level 3’s business model rests on five core assumptions. They are:

1. Internet Protocol (IP) will be the dominant means of transporting voice and data long term.

2. The most efficient means of transporting this information will be optics-optics for a long time.

3. “Lighting” all the dark optics that’s been laid will take about $500 Billion is investment in equipment. At the current rate of equipment expenditure, this will take over a decade.

4. It will be far cheaper and more efficient even for facilities based service providers to outsource their optic-optic links and capacity to companies like Level 3.

5. Regardless of the fate of the dotcoms, data traffic will continue to grow at very high rates for the next decade and longer.

Prior to fund management, I spent 5 years designing and marketing high-speed data networks for Tellabs. I agree 100% with all of Level 3’s assumptions being valid.

The state of the capital markets has meant that most of their competitors will be out of business because they are not nearly as well financed as Level 3. The dot com crash and weak economy has meant that there is a glut of bandwidth at present. This is depressing prices and profitability temporarily. Level 3 estimates that this inventory glut will be cleared in a few months.

More interesting (and far less risky) than Level 3 stock are its bonds. The company issued about $8 Billion in various debt and convertible debt instruments over the last four years. These bonds are now sporting annualized yields of 25-30%. Level 3 is a very well financed company. The stock and bonds are trading assuming the company is a bankruptcy candidate. Nothing could be further from the truth.

Here is the listing of its debt by seniority as of 12/31/01 (in thousands)


Bank Debt: $1,125 ,000
Mortgages: $232,000

Secured Subtotal: $1,357,000

9.125% 2008 Sr. Notes $1,430,000
11% 2008 Sr. Notes $442,000
10.5% 2008 Sr. Notes $583,000
10.75% 2008 Euro Sr. Notes $307,000
12.875% 2010 Sr. Notes $386,000
11.25% 2010 Euro Sr. Notes $93,000
11.25% 2010 Sr. Notes $129,000

Senior Unsecured Subtotal $3,370,000

Convertible Sub. Notes 6% 2010 $728,000
Convertible Sub. Notes 6% 2009 $612,000

Subordinated Unsecured Subtotal $1,340,000

TOTAL DEBT $6,067,000

On the liquidity side, the company has $1.5 Billion in cash and securities and $650K in unused credit facilities for total availability of $2.1 Billion. The nature of Level 3’s business is high upfront fixed costs to build out the network and then they sit and collect revenue as the pipes get used. Level 3 spent over $10 Billion building a state of the art fiber-optic IP network around the country, Europe and Asia including high-speed trans-Atlantic fiber-optic links.

Their network buildout is complete. Over 80+% of new capex going forward is tied to revenue. Their revenue history is:

1998: $392 Million
1999: $515 Million
2000: $1.2 Billion
2001: $1.5 Billion

Their free cash flow (after all capex) for the last three years is:

1999: ($2.9 Billion)
2000: ($4.4 Billion)
2001: ($2.1 Billion)

This year they expect well under $1 Billion in negative cash flow and next year well under $500 Million before Level 3 expects to become cash flow positive by 2004. It expects to use its cushion of $2+ Billion conservatively over the next three years until it turns cash-flow positive. In light of the dot-com crash and adverse capital markets, the company has turned very conservative on its capital outlays. Here is an excerpt from a 2/25/02 press release:

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“As of the end of fourth quarter 2001, Level 3 had available liquidity of approximately $2.1 billion, consisting of $1.5 billion in cash and marketable securities and $650 million under its undrawn and available revolving credit facility. These amounts exclude any proceeds from the sale of non-strategic assets, such as the proposed Commonwealth Telephone transaction described below.
Since the end of 2001, Level 3 has completed a number of strategic transactions, including the sale of its Asian operations to Reach Ltd. As a result of this sale, the company expects to save approximately $300 million through free cash flow breakeven. Additionally, Level 3 has closed the acquisition of McLeodUSA's wholesale Internet dial access business.
Level 3 has also recently announced or completed certain financial transactions to further strengthen its balance sheet and funding position. On February 8, 2002, the company announced its plan to sell approximately 2.75 million shares of Commonwealth Telephone in an underwritten public offering. Additionally, during the first quarter, Level 3 has retired approximately $195 million face amount of debt securities, approximately half through debt for equity swaps and the balance using excess cash to repurchase debt. Including these transactions, Level 3 has retired approximately $2.1 billion face amount of debt over the past six months on what the company believes are attractive terms.
"Taking into account all recent transactions and events," said James Q. Crowe, CEO of Level 3, "we believe that Level 3 remains fully funded to free cash flow breakeven with a substantial cushion in accordance with our business plan, even if our current rate of sales does not improve over time."

Analysts are projecting that Level 3 will have about a $500 Million shortfall of cash eventually. They get these projections by reducing revenue numbers but assuming no reduction in capital expenses etc. The company vehemently disagrees with these projections. Their perspective is that they will edit expenses to be in line with revenues as they have already done.

So we have two schools of thought on Level 3. The company says they have no problem (even if business does not improve) and analysts think they’ll crash and burn like all the other bandwidth providers. Who is right? Who should be believed?

This is where the “DNA of Level 3” becomes critical. It is this DNA structure that gives me comfort on the bonds. Level 3 Communications originated in 1985 as Kiewit Diversified Group (KDG), a subsidiary of Peter Kiewit Sons’, Inc. In 1997, the company embarked on the plan to build an advanced worldwide fiber optic network. In 1998, KDG sold off its non-telecom assets and renamed itself Level 3. Walter Scott, Jr. is the Chairman of Level 3. He is the CEO of Peter Kiewit and sits on the Berkshire Hathaway board.

Charlie Munger and Warren Buffett have the highest regard for Walter and respect his business abilities. It is rumored that Berkshire Hathaway has bought about $350 Million of the Level 3 bonds recently (Barron’s, July 16, 2001, Page 15). I would not be surprised to find truth in the rumors. Buffett loves to buy distressed bonds that have a very high probability of being paid in full. He has known the Kiewit folks for 40+ years.

Walter Scott Jr. is on Berkshire Hathaway’s board. Even the skeptics acknowledge that Level 3 has the best management team in the industry. I don’t think its possible that Buffett would have anyone with an ethos problem on his board. If Walter Scott Jr. is the high ethos guy I think he is, then there is NO WAY he’d let a CEO of his company lie or set false expectations about their financial position. On every conference call Jim Crowe has repeatedly mentioned that they are funded to cash-flow break-even with a substantial cushion even if business does not improve.

I spent about three hours listening to the entire Q&A web cast with the CEO of Level 3 at their recent annual meeting. I walked away with the highest regard for the CEO, Jim Crowe. I’d strong recommend listening to the web cast (its on www.level3.com). The meeting was run virtually identical to the Berkshire meeting and Jim is a huge Buffett fan and has adopted Buffett’s shareholder orientation. He has no stock options or restricted stock etc. He bought all his shares at the time the company was renamed.

The 5000+ employees of Level 3 only have Outperformance Stock Options (OSOs) which only kick in if the stock outperforms the S&P 500.

Walter Scott, Jr. recently added to his 35 Million shares by buying shares from Jim Crowe (who had borrowed money to buy the shares). He also recently infused $50 Million into RCN – which is a Level 3 unit.

Level 3 has several bonds to choose from. All have YTM in the 25-35% range. I believe that they’ll be paid bin full at maturity. Once the company achieves cash flow break-even, then paying the bonds is not difficult.

Catalyst

The bonds may start moving up next week after Level 3 holds their Q1 call and revises their financial projections. Long Term the bonds will move up once the street sees evidence that they are right. As all the marginal players go away, revenues and profits improve and free cash flow is achieved even sooner.