Level 3 Communications, Inc. (NASDAQ:LVLT)
Morgan Stanley Technology, Media & Telecom Conference Call
February 26, 2013 7:25 pm ET
James Crowe – Chief Executive Officer
Okay. Good afternoon everybody. It is my great pleasure to welcome Jim Crowe, CEO of Level 3. I’m going to ask Jim to make some opening remarks. Before that please note that all important disclosures, including personal holding disclosures and Morgan Stanley disclosures, appear at the Morgan Stanley public website, www.morganstanley.com/researchdisclosures or at the registration desk.
Jim, over to you.
Well, good afternoon. I’m going to take just a minute or two and provide some context, and I will start with an assertion. Our business has become a whole lot easier to understand over the last couple or three years ago – versus a couple or three years ago. Back then, those of you who followed us remembered we had revenues that were going down, revenues that were coming up. We have completed a number of acquisitions, so there was a lot of dust and smoke in the air.
Today what matters is top line growth. Below that level our margins, gross margins, EBITDA margins have been seasoned for several years. They are constant at 80% incremental gross, 60% incremental EBITDA. We have actually outperformed that because of synergies, but that is a good trendline relationship and we are at about 12% of capital.
So you would decide on the top line growth that makes sense, our cash flow production is a mathematical output of that – of that growth rate. So what determines top line growth? A number of core varying headcount. We have about 1000 and they each produce 8000 to 8500, something in that kind of range. So the logical question is why don’t we just double our sales force, double our sales.
There are two answers. First, we really like 80% gross margins. We like them financially and strategically. Financial is obvious. Strategically, the more you buy access from companies whose customers you want to take away, the local incumbents, the more difficulty you are going to have. They obviously don’t want to co-operate in helping you take their customers and if you are buying a vital feedstock, access, sooner or later you won’t be happy with the outcome.
So the conclusion is we have to have enough on-net market to support whatever is our sales force and produce 80% gross margins. That is an effort we started a couple of years ago adding buildings, which is really the way you manage that gross margin. We need to maintain a ratio roughly, where 60% of our revenue is on that with 100% gross margins, 40% off-net, with 50% gross margins, and we wouldn’t mind if more and more were on that.
It is a big effort digging up the streets of San Francisco or New York or Sao Paulo or London. It takes a lot of careful planning and management, but we have got the process going and we expect to add more and more buildings. The other limiting matter, which we have a lot of experience in and we’re getting better and better is the factory. We roughly add 10,000 orders each month, or turn them out. Each order has roughly 40 process steps. That is 400,000 process steps each month.
It is a big workflow management process. It is where we have spent a great deal of our time, our energy, our chief operating officer, Jeff Storey, his passion is process. We have shown remarkable improvement over the last two, three years. Of course we merge with Global, whenever you merge two fairly equal size companies there is going to be some surprises, good and bad, fluctuations quarter-to-quarter, but our ability to predictably meet our customers promises – the promises we make to customers is central to how many sales people we have.
We sell it and can’t turn it up, predictably that does no one any good. So maintaining 80% gross margins, predictably turning up service at huge volume that is what we are focused on. We have plenty of addressable market, plenty of customers, who want to buy from us, 64% of our revenues in the last quarter were enterprise. That grew 8% in constant currency. We want to see that continue, and we feel very good about watching the progression towards our goal, which is to grow 2% sequentially.
We say that to keep everybody co-ordinated, adding addressable market and in the factory when we hit 2% we will set some other goal. So that is where we are at.
Great. Okay, well, let us start with then Global Crossing, you are well into the integration now. You achieved a lot of synergies during 2012. What is left to do there and how do you think in particular, I guess going beyond the cost and Capex synergies, but cross selling the various networks and products.
We have got a common product catalogue that is a set of services. We are operating as one company globally. Processes and systems are largely integrated. We still have some work to do. For instance in Latin America, we’re not on the same ERP system we are in the rest of the world. That is all planned out. So I would say organizationally in process and system and in product we’re initially integrated.
There is lot of opportunity to improve that integration. The product catalogue still can be simplified. We have more products with more descriptors than we eventually want. That simplification will improve our process throughput. We have a lot of effort going around on process simplification. We took out several hundred individual applications last year. We have more to go that is eliminating redundant applications and processes.
Financially, where we [said], maybe a bit ahead. We are comfortable that we achieved the 300 million of synergy and 40 million of Capex savings. And we believe and hope we can do better than the projected 45% of the 300 that comes from network expense. Historically we found lots of opportunities to groom circuits for several years after we have finished, meaning we have 400 access suppliers, and we buy 2.5 billion of access globally. And we think there is a long-term opportunity to improve that.
We have seen a lot of that prior to the global transaction where we had higher margins in the ones I described to you mostly because we took a lot of expense out of the network. We also hoped, but did not announce that we would see a significant improvement in our credit quality and that is a greatly lowered cost of debt. That has been the case as you are well aware.
Our cost of borrowing today is several hundred basis points below what the blended average of Global and Level 3 was. As debt comes up and we have opportunity just to refinance, I think we can see 100 million to 200 million, some of that is already in place, but we said 100 million to 200 million of additional cash flow from interest savings.
So you talked about your goal of 2% sequential CNS growth, I think your guidance was in Q1 we will see some headwinds, you have obviously got a little bit of UK government coming out and so forth. But talk us through 2013, and how you see that accelerating through the balance of the year and how close are we to actually seeing that 2% on a consistent basis?
So, a bit of history. In 2010, we were wrapping up the process improvements and the operational improvements that were necessary from all of the integration and some acquisitions we made in ’06 and then integrated in ’07. In ’10, we said we were confident that we would see growth accelerate and move into the 2% range. That is exactly what happened in 2011, we went from 1% plus to 2.6% through the course of the year in constant currency basis.
So we have done it before. We now need to do it at a bigger scale. Directly to your question, as I said we don’t lack for addressable market. The key is enough on-net to get the margin production, and making sure that the work flow enables us to meet our promises to our customers about dates, when we offer them service, or when we turn their service up.
Last year we saw a steady progression to 1.8% in constant currency terms in the fourth quarter. As you said, we have announced that finally a number of contracts we said would go away that were quite large, anchored by UK government contracts, we think will finally go away in the first quarter.
Now the good news is we have gotten a lot of cash from those contracts, but they will go away, and it will affect us. In many ways it would have been nice if they had simply disappeared earlier. Our ability to predict that isn’t perfect. That is a customer decision. So we think it will affect the first quarter.
We have also said that without exception, look at what happened in 2012, the comparable second-quarter to second, third quarter to third, fourth to fourth, we expect to be better.
So, exiting this year you should be better or close to that 2% number?
Okay, and then if we take it then, you obviously did a nice job of summarizing your operating leverage that you have, and you still got significant financial leverage, I think in that context your EBITDA guidance of low double-digit seemed quite conservative, and you just put up sort of high teens number for 2012. Obviously, you are investing in some of the sales force. You do have some of these headwinds. So help us think through why we are not necessarily seeing with still some synergies going through not more of that flowing going through to the EBITDA line this year, and…
One overarching comment, looking through the quarterly fluctuations we still expect to see very strong top line and EBITDA growth rate. EBITDA if you just rough work the math grows at about twice the rate CNS, core network services, grow. It is just a function of the operating leverage. So 5%, 6% CNS growth, low double-digit EBITDA growth.
The reason that we have projected that kind of EBITDA growth is as we have said – we fell a bit short. For the whole year our revenue was very close to our target, but in the fourth quarter we fell a bit short for a variety of reasons that were explained on our conference call.
That kind of run rate affects the following year, and then the issue in the first quarter. That pretty much explains if you work through the numbers the shortfall in EBITDA. But I want to make it clear if you look over time that top line growth, EBITDA growth, and cash flow growth, I think you are going to – you will see performance that is certainly better than any of the larger wireline businesses, and if you look at our enterprise growth, which is now 64% of our global revenue. That is a 8% growth constant currency last year and we can accelerate that. That is better I think than almost any other comparable you’ll find.
Then if I’m right in thinking, your management team, a lot of your senior management team is compensated on – at least in part on EBITDA performance.
All of our management is compensated with the exception of me, and the reason I’m compensated heavily based on stock price performance. And that is just to make sure that we have the – I am the anchor to windward to make sure we don’t take actions where we make EBITDA guidance, but don’t invest in the future, and the board is obviously focused pretty heavily. I don’t worry about it a lot because we have a management team that is pretty much oriented towards long-term.
But we could in any quarter or year, we could make almost any EBITDA, reasonable EBITDA target you want just by cutting back on expenses, roughly 60% or more of our operating expense is about new sales, new marketing, future, and we wouldn’t be happy nor would investors be happy if we don’t have the right balance between current performance and longer term investment.
So, let us dig under the revenue a little bit further, I think one of the themes we’ve really heard in the last couple of days is just the – it feels like something that you have been talking about for years, but the sort of data velocity is just continuing to grow at a very rapid pace, whether it is fiber to the tower with all of the LTE deployments that are going on, whether it is Netflix, and everybody watching House of Cards in one weekend, download session, but we’re really – that future has sort of arrived. It is here today. What are you seeing on your network in terms of traffic, and how do you think about that over the next couple of years and sort of pricing trends around that?
As you understand, when we talk about the network there are layers to the network, and they are interchangeable. You can buy waves, you can buy private lines. You can buy virtual private networks. You can buy IP transit, you can buy CDM, and depending on your size, your scale as a customer, those are fungible to a large extent.
We believe we have a pretty large sample size at each of those layers, certainly we are not the largest company in the industry, but for IP optical services I think we have a bigger share than any of our competitors. And I think third-party estimates would confirm that at the IP layer for instance, most would say we have roughly a quarter, let me put it this way, because there are so many overlapping networks, one out of every four [bits] of global IP traffic traverses our network.
So it is a big sample size. For antitrust authorities it is a hotly competitive business. We have no concentration. Lots of people are in that business. But we do have a big view in the traffic, and roughly our own internal work confirms the excellent work Cisco did in their Visual Networking Index. The future is dominated by broadband individuals. Now I use that word carefully, I don’t mean individuals at their home, individuals at the home and individuals at the office. There is a sea change going on where individuals make selections of the devices, bring your own device, by which they conduct business and by which they conduct their personal affairs.
That is just exploding, wireless and broadband to the home. Broadband to the home is growing, according to Cisco, and again we would roughly agree with this at 40%, 45% a year. That is 80% of today’s incremental demand.
Wireless broadband is a few percent, but growing at over 100%. Business is yet to accelerate. It is roughly the balance, 16%, 18% growing at 20% a year, and business still hasn’t adopted a lot of visual interaction, a lot of supply chain management through visual communications, communications with their customers through visual interaction. That is coming.
So the punch line of all of this is we think for the foreseeable future those who create applications and content will move much more quickly than the rather slow-moving wired and wireless communications providers through which that content and application flows. I think that means pricing for bandwidth in its various forms. Wireless is a great example. It is going to tend to be higher, because you are in a constrained environment. Look at your wireless billing. See what is happening to it.
I think that creates huge opportunities for those in the business, like us who believe the key is not simply to raise unit prices. It is to lower unit prices faster – 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.
Would you say the pricing environment is fairly rational right now?
For 90% of what we sell pricing is plus or minus 10%. The closer you get to the fiber and the closer you get to the Metro and the customer the more you get above zero. So for metro fiber, for infrastructure, data centre services, co-location, up in actual real terms. You get to the centre of the network, it tends to decline, for monthly billed stuff, maybe 10% a year.
For usage-based high speed IP, stabilized high-speed IP, it kind of goes up and down. It depends on whether certain suppliers get frisky or not. It depends on what whether somebody is trying to take temporary share. But that is at the margin.
As part of your guidance, you projected free cash flow generation in 2013, but I think there was some caveats around working capital and around interest rate swaps, so maybe you can just clarify what the expectation should be for?
I don’t think it was around working capital. It was around that interest rate swap and whether we chose to settle it or not settle it. I want to be careful here. You know, a slight change in payables versus receivables, a particular bill that shows up on December 31 and gets paid versus January 1 can have a fairly big movement.
I think what I would hope in the way we investors would focus on, and what we certainly look at, look at 2012, then’11 and ’10, in 2012 we used 165 million of cash. So we had negative free cash flow of 165 million. If you look at our guidance, in 2013 we expect to be above the positive line. That is 165 plus swing. We expect that kind of leverage or more to continue. You have got a pretty good model. You can plug the numbers in, run rate and trend line. You get 3% or 4% top line growth, to generate not to far in the future hundreds of millions of a 3, 4-year period of free cash, if you can get above the 5%, 6% range, you can get up into the 1 billion to 2 billion.
That is a good trend line. And I think you can see it if you look to the kind of one quarter here, one quarter there.
Okay. We got time for some questions from the audience. At the back there.
Hi Jim. A couple of years out, let us say you are fortunate enough to generate free cash flow, and let us go 4 years out, how would you expect to use that cash to be used to pay down debt, dividends, buy back shares, what do you think you are going to be thinking if you are fortunate to be in that position?
So, it is a question fundamentally for the board, but I will give you one board member’s view. If you look at Simon’s model, and pick your own range of top line, I mean, this pension, try to pick a point estimate 2, 3 years out is just not useful. There is a cone of probability. But pick your number. We generate a fair amount of cash.
I said earlier that we want to invest in metro facilities to assure we have enough addressable market to maintain 80% gross margins. That is hard money to spend as I explained. We do not believe we can spend effectively as much as we will generate if we meet the kind of growth rates even at the low conservative end of a range. So that means we have got extra cash. That is a good thing.
You all know the various ways in which you can deploy extra cash. We hope – they depend on tax laws, on changes, and preferential return of capital to shareholders. It depends on other opportunities to deploy capital and high return efforts. So I would simply say look at our chief financial officer and his team, look at what they have been able to do over the last five or six or seven years.
From my perspective they have been wonderful at managing the balance sheet and cash flow in times of stress. It was only three or four years ago, lots of folks said, Level 3 is going to go bankrupt. I expect that they will bring that same skill to how we deploy our capital, and will do it on behalf of the shareholders. Hopefully I appropriately dodged being too specific around your question.
Personally, I would – 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.
Jim, you talked about the Constellation product that they have introduced, I am just wondering competitively what you think about that product, and if you think Level 3 needs to move in that direction from a product standpoint.
I heard everything.Everything What is the product?
The Constellation product being more of a customer front-end platform.
I can’t hear.
Yes, it is the Constellation platform that TW is rolling out.
Bandwidth on demand. I have a long relationship with many of the people at TW Telecom. We work together, and I have a great admiration for them. I don’t – I bought the product. I don’t know the state of development. In general, we believe the market is looking for VPNs, which by definition are scalable.
We see this over and over again. Logical carving pipes out of the Internet with higher service levels, greater security, which is a huge issue, where we are spending a lot of time and energy. It seems to us it makes a lot of sense. I wish TW the best of luck. It is a job though to establish a new protocol, a new kind of service. I hope – we wish them well, but the standards are around Ethernet and IP VPNs, and that is where we are putting a lot of our time and energy and it is responsible for the 8%, small party enterprise growth last year and we think it will accelerate.
The number of global corporations that say, I have got 20 or 40 or 60 production locations I need to tie together, I can’t deal with 400 different suppliers in a supply chain.
We would like to have a common platform with common service level agreements et cetera is startling and that is where we are focusing our time.
Unfortunately we’re out of time. Jim, thank you very much. We appreciate it.
Thank you very much.
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