Level 3 Communications (LVLT) released its fourth-quarter and full-year results on Feb. 12. The market was not pleased with results or comments relating to forward growth, and pummeled the stock on heavy volume. Shares closed down 13.6%.
Given the guidance, it's reasonable to expect the company to show positive FCF (free cash flow) for the full year, but it was far below expectations going into its earnings report. It should be noted that LVLT was FCF positive in 2009 before sinking back into negative territory.
So what's wrong with LVLT? The answer becomes apparent with an understanding of LVLT's turbulent past and the factors that lead to the creation of LVLT -- not only financial, but how it envisioned the future along with the road taken. Is the company at an inflection point, or is the past a harbinger of the future? The discussion below includes:
Level 3 emerged within the Kiewit Diversified Group Inc. (KDG), a wholly owned subsidiary of Peter Kiewit Sons, Inc. In 1998, KDG changed its name to Level 3 Communications, Inc. On April 1, 1998, Level 3 common stock started trading on the Nasdaq under the symbol LVLT.
Level 3 raised $14 billion, constructed 19,600 route miles, and built the world's first continuously upgradeable network optimized for internet protocol. Level 3 Communications was founded on the principles of the "Silicon Economics." The CEO laid out four keys to Level 3's strategy and one critical success-based assumption from the Silicon Economics model.
The four keys for success:
- Bandwidth price-performance improvement rates will exceed Moore's law
- Bandwidth demand is strongly price elastic
- The combination of rapidly dropping prices and increasing demand ("Silicon Economics") is a key dynamic in the communications industry
- Silicon economics is disrupting the traditional, vertically integrated communications industry
The Silicon Economics model projections:
- Rapid decrease in unit cost and unit price caused by market based technology improvement
- Unit demand grows much faster than unit price declines
The concept seemed simple enough; in the 1998 annual report "To Our Stockholders," management said the following in terms of "The Right Question":
The question that is often asked is, 'With so many companies building networks, is there going to be a glut of bandwidth or capacity?' If you locked in today's price for bandwidth, there might be a glut -- but that's the wrong question. The question should be, 'At what price for bandwidth is there a glut?' We and others believe that as you drop the price of communicating, demand increases even faster. At the right price you can't have too much bandwidth.
In early 2000 the market was becoming concerned a bandwidth glut was occurring. LVLT was adamant there was no glut and soothed investor concerns in a special supplement to the 2000 annual report "Is There a Bandwidth Glut, or Not?":
Is there a bandwidth glut? No. We believe the more important question is this 'Is there enough bandwidth at the right price?' As Level 3 continues to upgrade its network as technology continues to improve, the company will have the ability to continue to drive down the cost of moving information. As the cost and resulting price of moving information drop, we believe that demand will increase. Level 3 believes that for every one percent that price drops, demand will increase even faster -- a dynamic we have witnessed in other high tech industries like computing.
LVLT became a Wall Street darling, the stock soaring to a split adjusted $1,980 on March 10, 2000, (boasting a market cap of $44 billion) but problems loomed large. The Internet bubble burst and companies with massive debt and no earnings started to collapse. Some of LVLT's competitors declared bankruptcy then emerged as stronger competitors via strengthen balance sheets.
Businesses pulled back on spending and it was becoming obvious there was a bandwidth capacity glut caused by a serious overinvestment in long-haul network capacity leading to extreme price declines that fueled bankruptcies. More devastating was that not only was management's premise of "The Right Question" wrong but "Silicon Economics" did not produce the revenue increases needed to thrive in an environment of continued price decreases. As a result of debt approaching a crushing $8 billion, no earnings, or positive free cash flow, LVLT went into survival mode. The Asian assets were sold. They increased top line growth with the acquisition of Genuity in 2003. Over the next few years, and through a major industry downturn, Level 3 pursued a strategy that focused on both the balance sheet and investing for a much hoped for industry rebound.
Beginning with the late-2005 acquisition of WilTel, Level 3 has established itself as an industry consolidator. During 2006, the company went on to acquire Progress Telecom, ICG, TelCove and Looking Glass Networks. In 2007, Level 3 acquired Broadwing, the Content Delivery Network services business of SAVVIS, Inc. and Servecast. It looked as if the company was turning the corner but underneath the company was experiencing major problems absorbing acquisitions such as:
- Experiencing an increase in the time it took to activate service for customers, hurting revenue growth
- The company was taking longer to resolve customer network service issues
- The company didn't have adequate provisioning capability to convert orders to revenue
- The company lacked adequate internal controls
As the problems became public the stock plunged to about $20 (split adjusted), then on March 10, 2008, Kevin O'Hara, president, COO and co-founder, resigned. Jeff Storey was brought in as president and COO. The problems were fixed but not without cost. LVLT's revenue declined at a time it could least afford it.
Finally LVLT announced on April 11, 2011, that it would acquire Global Crossing. A deal that would add 1.3 billion shares (pre-split). As a result of financial engineering and acquisitions, LVLT avoided the fate of many competitors -- bankruptcy -- but at a cost of massive stock dilution and a stock price that slipped under $1 ($15-split adjusted). They received notice from Nasdaq on Nov. 3, 2010, stating if compliance with the Minimum Bid Price Rule could not be demonstrated by May 2, 2011, the company's common stock would be subject to delisting. The stock rose above the minimum threshold but the company authorized a reverse split that the board could impose if necessary.
LVLT completed the acquisition of Global Crossing on Oct. 4, 2011, and announced plans to transfer the listing of its common stock to the New York Stock Exchange, which occurred on Oct. 20, 2011. In conjunction with listing on NYSE, the company affected a 1-for-15 reverse stock split of the Level 3 common stock.
A complete set of updated detailed financial data and projections reflected below is found here. As a result of being founded on a faulty premise in "Silicon Economics," a term rarely heard today, dilution and integration missteps destroyed shareholder value as the company struggled to find their way. While revenue and EBITDA have grown over the years, mainly from acquisitions described earlier, per share metrics have trended down for the last decade due to massive dilution:
Management stated their goal is to grow core network services (CNS) revenues at a sequential quarterly rate of 2% per James Crowe, CEO on the Q2 2010 conference call:
And we've said our goal is to get back to the same level of quarterly increase in revenues that we saw prior to the financial crisis, and that was at least 2% a quarter. At that kind of rate, we'll see nice margin expansion, and that's what our clear goal is.
Not an impressive growth rate but enough to eventually grow into their balance sheet (think debt) over time and become FCF positive on a sustained basis, which is the expectation for 2013. Unfortunately they have yet to gain any overall traction over the last several quarters so the 2% goal continues to be elusive as shown in the graph below.
LVLT "Re-categorized" 2012 CNS data reflected below to match how they intend to categorize revenue going forward. Simply put they revised 2012 CNS revenue about $33 million, moving revenue out of CNS into the lower margin Wholesale Voice Services. The Q1/13 projection is from the earnings release: "For the first quarter 2013, we expect to see a slight decline in CNS revenue on a sequential basis."
Due to the re-categorized revenue we can no longer compare forward results to 2011, but the re-categorized 2012 Enterprise CNS revenue appears to be a bright spot among the other categories:
Unfortunately, due to the negative CNS guidance the Enterprise revenue may decline in Q1.
Although FCF is expected to be positive for the year (if they can marginally grow revenue) expect Q1 to be negative since FCF use is heavy in the first quarter, due to working capital uses including annual bonus payments, prepayments, maintenance contracts, property and payroll tax payments.
What's wrong with LVLT? Is a change in leadership long overdue? The answer lies in its history discussed earlier -- i.e., the original premise LVLT was founded on was faulty. Price declines fueled by technological improvements and the massive fiber build out lead to massive growth in bandwidth usage. Unfortunately LVLT was built on a critically important vision; the relationship between elasticity of demand and the firm's total revenue. Simply put, management based their strategy that price declines would lead to strong revenue growth that never materialized and there is little evidence 2013 will be any different. It's not clear if management currently believes Silicon Economics remains critical to their future success. They have not publicly presented a new long term strategy other than the two percent sequential growth goal to drive other metrics.
In fairness, it did not matter who the CEO was since the original business premise was flawed from the start and still is. However, the mega CEO compensation awards are perplexing considering other issues along the way, but that's a story for another day.
Management is aiming for 2% sequential growth, but has yet to establish a track record that inspires confidence. They have already said Q1 will be down from Q4. The negativity is reflected in the stock price, but upside is limited until management can produce stronger results. All this assumes dilution can be reined in going forward.
Further industry consolidation could possibly lead to stronger elasticity of demand or at the very least improved pricing. In the near term, we see no catalysts to sustain upward stock price momentum other than hope they reach the milestone of sustained mid- to upper-single-digit annual revenue growth.
Of course, hope is not a strategy and hope that management can accomplish sustained revenue growth at some future point is all LVLT investors have to hang on to at this point.
Disclosure: I am long LVLT.