Level 3 Communications, Inc. Q2 2009 Earnings Call Transcript

Jul.31.09 | About: Level 3 (LVLT)

Level 3 Communications, Inc. (NYSE:LVLT)

Q2 2009 Earnings Call Transcript

July 30, 2009 10:00 am ET

Executives

Valerie Finberg – VP, IR

Jim Crowe – CEO

Sunit Patel – EVP and CFO

Jeff Storey – President and COO

Analysts

Michael McCormack – JP Morgan

Jason Armstrong – Goldman Sachs

Frank Louthan – Raymond James

Simon Flannery – Morgan Stanley

Michael Rollins – Citi Investment Research

Romeo Reyes – Jefferies

Colby Synesael – Kaufman Brothers

Jonathan Schildkraut – Jefferies

Ana Goshko – Banc of America

David Dixon – FBR Capital Markets

Michael Funk – Banc of America

Murray Arenson – Janco Partners

Operator

Good day and welcome to the Level 3 Communications Incorporated second quarter 2009 earnings conference call. (Operator instructions) At this time I would like to turn the conference over to Valerie Finberg, Vice President of Investor Relations. Please go ahead.

Valerie Finberg

Thank you, Jessica. Good morning everyone, and thank you for joining us for the Level 3 Communications Second Quarter Earnings Call. With us on the call today are Jim Crowe, Chief Executive Officer; Jeff Storey, President and Chief Operating Officer; and Sunit Patel, Executive Vice President and Chief Financial Officer.

Before we get started I wanted to mention that in addition to the press release and financial exhibits, a presentation summarizing our results, which Sunit will be referring to during his remarks, is available on our web site at www.level3.com on the Investor Relations home page. To view this presentation, from the Investor Relations home page click on the link titled 2Q09 earnings presentation.

I also need to cover our safe harbor statement, which can be found on page 2 of our 2Q earnings presentation and that says that information in this call and in the presentation contain financial estimates and other forward-looking statements that are subject to risks and uncertainties. Actual results may vary significantly from those statements. A discussion of factors that may affect future results is contained in Level 3’s filings with the Securities and Exchange Commission.

Also, please note that on today’s call we will be referring to certain non-GAAP financial measures. Reconciliations between the non-GAAP financial measures and the most comparable GAAP financial measures are available in the earnings release, which is posted on our web site, www.level3.com, on the Investor Relations home page.

With that, I’ll turn the call over to Jim.

Jim Crowe

Thanks Valerie. Consistent with our past practice, Sunit will start with a discussion of financial results for the quarter and an outlook for a year. Jeff Storey will discuss operational matters, including segment results and pricing by product. I will provide a brief summary, and we will then open it up for questions. Sunit?

Sunit Patel

Thank you, Jim, and good morning everyone. Before I go into the details, I would like to take a moment to comment just briefly about what we are seeing across the businesses highlighted on page 4 of the presentation, and how we are executing and approaching things if this economic environment.

Certainly the environment continues to be very challenging and as appropriate and we're focused on execution and disciplined cost management. The sequential decline in Core Communications Services revenue was less than half of what we saw in the first quarter. In this environment, strong discipline in managing costs across all levels of the business continues to provide benefit as our comparison of year-over-year results shows.

Both gross margin and adjusted EBITDA margin improved as a percent of revenue compared to the second quarter of 2008 but not sequentially. Our current rate operating expenses declined for the fifth straight quarter. In addition, we completed a number of liability management transactions, which further strengthened our balance sheet and pushed out more of our near-term debt maturities and reduced our interest expense.

While we continue to expect revenue performance to improve over the reminder of 2009, we do not believe the improvement will occur as quickly as we expected a quarter ago, and therefore we’ve updated our outlook for 2009.

Turning to detailed results for the second quarter on Slide 5, Core Communications Services revenue was $877 million this quarter, a 2% sequential decline from its $899 million in the first quarter of 2009, an improvement from the 7% sequential decline in the first quarter of 2009.

On a year-over-year basis, core revenues were down 8% on an as reported basis and down 6% on a constant currency basis.

Core Network Services revenue was $707 million in the second quarter, a decline of 9% compared to a normalized $779 million in the second quarter of 2008.

Wholesale Voice Services revenue was $170 million this quarter compared to $175 million in the second quarter of 2008.

The breakdown of Core Communications Services revenue by market group was $495 million for Wholesale Markets Group or 57% of revenue; $218 million for the Business Markets Group or 25% of revenue; $82 million for Content Markets Group or 9% of revenues and similarly $82 million for Europe, also 9% of revenues.

Jeff will discuss in more detail our performance in each of the customer facing markets, but at a high level, we did see some improvements in sales and churn and moderate declines in revenue.

While the outlook remains uncertain, we do expect revenue performance to continue improving over the balance of the year. We continue to expect volatility in wholesale voice services as we manage for margin contribution versus revenue growth.

Turning to slide six, gross margin was 59.1% this quarter compared to an adjusted 58.3% in the second quarter of 2008 and 59.5% in the first quarter of 2009. The slight sequential decline in gross margin percentage was due to declines in high margin Core Network Services revenue and other revenue, offset by continued network optimization.

Communications SG&A expense, excluding non-cash compensation, restructuring and impairment charges was $311 million during the second quarter of 2009, again reflecting our continued disciplined approach to cost management. This represents a decline of 17% compared to $373 million in the second quarter of 2008, and a decline of 3% from the first quarter of 2009. As expected, we had $6 million in severance costs from headcount actions taken earlier in the quarter.

Turning to Slide 7, consolidated adjusted EBITDA was $229 million in the second quarter of 2009 compared to an adjusted $239 million in the second quarter of 2008, a 4% decline. EBITDA declined as a result of the decrease in Core Communications Services revenue, which was partially offset by network and operating cost improvements.

Despite the decline in EBITDA, communications adjusted EBITDA margin improved from an adjusted 22.7% in the second quarter of 2008 to 24.8% in the second quarter of 2009.

At the bottom of slide seven as you can see capital expenditures increased to $80 million in the second quarter of 2009 compared to $78 million for the first quarter of 2009, but was down compared to $160 million in the second quarter of 2008.

Turning to slide eight, unlevered cash flow improved to $146 million in the second quarter of 2009 compared to $126 million in the second quarter of 2008 and $43 million for the first quarter of 2009. More importantly year-to-date our unlevered cash flow was $189 million for 2009 compared to $105 million for last year.

Consolidated free cash flow was a positive $20 million for the second quarter of 2009, an improvement compared to $4 million for the second quarter of 2008, and negative $82 million for the first quarter of 2009. Year-to-date free cash flow is a negative $62 million compared to negative $156 million last year.

As I noted earlier, we completed several liability management transactions during the quarter. As you can see on slide nine, over the course of second quarter of 2009 we made open market debt repurchases totaling approximately $314 million of principle using approximately $281 million in cash, which excludes accrued and unpaid interest, and also includes an early redemption at par the remaining $13 million of our 11.5% senior notes during 2010.

In addition, in June 2009 we exchanged a combination of approximately $78 million in cash and $200 million of new 7% convertible senior notes during 2015 in exchange for approximately $282 million of debt during 2010.

In May 2009, we announced that we raised an additional $60 million in our senior secured Tranche B term loan adding to the $220 million completed in early April. With the completion of all these transactions, we reduced 2009, 2010, 2011 and 2012 debt by $602 million and importantly lowered the amount of debt due in 2009 and 2010 from $1.1 billion as of late last year to $694 million at year-end 2008 to approximately $223 million at the end of the second quarter of 2009.

With the numerous liability management transactions completed during the quarter we have adjusted our outlook for GAAP interest expense for the full year 2009 to $600 million versus $610 million as previously discussed and $515 million for net cash interest expense versus $525 million as previously discussed.

Depreciation and amortization expense was $228 million in the second quarter of 2009, compared to $234 million in the second quarter of 2008. As previously mentioned, we expect depreciation and amortization to average $225 to $235 million per quarter in 2009.

Based on the factors I discussed earlier, we're updating our business outlook. Our sales and churn did improve in the second quarter, but given our customers’ responses to the challenging economic environment, we're taking a more cautious view for the remainder of the year. We expect our revenue performance to continue to improve over the balance of the year. Our outlook assumes a steady level of sales for the reminder of the year and improving churn rates. By updating our consolidated adjusted EBITDA guidance to $900 million to $950 million, and expect to be free cash flow positive for the reminder of 2009 in the aggregate, but above free cash flow neutral for the full year 2009, obviously subject to minor working capital swings.

While we continue to manage costs tightly, we're starting to increase our sales resources in our enterprise business as we accelerate our relaunch of services in various cities with a more local approach. Early results from the handful of markets we launched in earlier this year are giving us the confidence to launch in additional markets. We expect capital expenditures to remain consist with the quarterly rate of spend for the year so far.

Our liquidity position is strong particularly in light of the significantly lower upcoming debt maturities over the next two years, and the positive free cash flow we expect to generate going forward.

With that I will turn the call over to Jeff.

Jeff Storey

Thank you Sunit and good morning everyone. As Sunit mentioned, the macroeconomic environment continues to create challenges. This quarter we saw many of the same indicators that we discussed during our first quarter call. Our largest customers continue to rationalize their network spend and as they attempt to aggressively manage cost. While this certainly creates a challenge as we overcome the effects of disconnects and rate [ph], it also creates opportunity as we provide scalable network solutions as an alternative to the incumbent.

In general, we saw sales steadily improve, but did not say that the rate of improvement in churn that we expected. Although still not surpassing the effects of churn, quarter-over-quarter sales were up again for most of our segment. Sales in aggregate were up more than 10% quarter-over-quarter. However, lead times closed sales remained long as customers deferred to pass the expansion decisions as strong as possible.

Despite the economic backdrop and the network rationalization by our larger customers, our indications point to a continued increase in fundamental demand for bandwidth. Market expansion for broadband data services, mobile data and video delivered via the Internet are driving strong growth in overall market demand. I would like to take a moment to review what we are seeing in each of customer facing groups, the effects of the economic environment where most evident in our segment serving large service providers, larger entertainment and media customers and large enterprises. These customer segments have not yet returned to their historical buying pattern.

In our Wholesale Markets group the decline in revenue this quarter was greater than we expected. Revenue pressure was primarily from customers continued efforts to reduce the costs. Just as we have been aggressive in grooming our network to reduce expenses as much as possible our wholesale customers continue to optimize their networks for costs as well resulting in disconnect and deferred purchases from Level 3.

While we saw early signs of improvement in March and April, that improvement did not continue for the rest of the quarter. On a positive note, we have seen improved sales and the strengthening sales funnel in the wholesale segment, particularly in wireless, tier 2 cable, and federal government.

As I noted a moment ago, ongoing growth in wireless data is the driver of demand and Level 3 ability to provide a national footprint of metro and intercity transport services combined with our mutual providers status sets us apart from our competitors.

We previously announced federal government awards for the networks enterprise and Yipes contracts as well as our partnerships with systems integrators, who serve the federal government. We are continuing to make traction in the federal segment and had our best sales month ever during the second quarter.

The coastguard contract, which we announced last week is an example of how our capabilities align with government agency needs for data connectivity. We’ve also seen opportunities to support other customers as they pursue broadband stimulus funding. Level 3’s unique position as a middle mile provider with 300 access points in rural and underserved markets acting as on ramps for the Internet are helping us win contracts as providers begin to implement broadband alternatives directly to the rural consumer.

In business markets, we remain convinced we have a good opportunity to increase our market share, particularly in the mid market segments. We define mid market as customers extend from several hundred thousand dollars per month up to several hundred thousand dollars per month. During the second quarter, we launched our local markets initiative in five US markets. In each, we named the general manager responsible for driving revenue growth. We added salespeople and aligned our operations team around the local market to improve our service to customers that are best served on a local or regional basis.

While it is too early to say definitively how things are going, today our experience has been as expected. Sales activity is picking up in each of the five markets and we are optimistic about our prospects.

In the third quarter, we will expand in five additional markets, Philadelphia, Chicago, Miami, New York Metropolitan area, and San Francisco. Having selected the previous markets for the opportunity to learn from a variety of different market types and sizes, the third-quarter expansions are all targeted at tier one markets. We expect to see traction from these initiatives both in reducing disconnects and increasing sales.

It will take a few quarters before results overcome the pressure we have seen in business markets revenue. During the second quarter, in keeping with current economic conditions, disconnects continue to keep pressure on business markets revenue outpacing new installs. In addition, consistent with the rest of the industry, we also saw significant declines in enterprise voice revenues during the quarter.

Among our large enterprise customers, the Financial Services segment has seen nice revenue improvement quarter-over-quarter. Within our Content Markets group, we generally start to see a seasonal pickup in broadcast revenues during the second quarter, however, this quarter broadcast revenues were flat to slightly down quarter-over-quarter. The broadcast industry continues to see soft advertising revenues and is cutting back in all areas, including the number of events they are covering and the level of redundancy in each of them.

Pricing pressure for IP and CDN services also negatively affected the Content Markets group. Despite these pressures, we did see nice growth in gaming and social media segments. In constant currency terms, our European business showed 1% growth compared to the first quarter of 2009, and 20% growth compared to the second quarter of 2008, but in the quarter we expanded into Poland and have already begun to see returns from that investment.

We also saw continued growth from our content customers in Europe, both from our CDN services and our newly launched European divx video transport products. For the full year, we expect to see year-over-year growth at a more moderate rate than in recent years given the economic pressures within the region.

Turning to pricing and demand, as I mentioned previously fundamental demand continues to grow from many of our data services like IP, CDN, metro transport and wavelength services. However, pricing pressures have increased recently for IP services. For both metro and infrastructure services, we continue to see pricing flat to slightly up. With respect to high-speed IP pricing, we have recently seen more aggressive competitive behavior primarily in sales to resellers and media and entertainment companies.

However, we believe we have the best cost structure in the industry and remain well-positioned to compete in this segment. We continue to make progress operationally and have focused on improving our customers’ satisfaction across the full spectrum of the customer experience. While not where we want to be yet, we are making progress from streamlining the coding process to ensuring that end voices are correct, we have broken down the customer experience into a series of initiatives aimed at improving the customer satisfaction across the board.

As we have discussed, our Level 3 local initiative is improving the support and resources available to our mid market customers, and we have several initiatives underway with the goal of making it easier to do business with Level 3 across the company.

In summary, while the economic environment has put greater pressure on revenues than we expected, we are encouraged by the increase in sales and sales activity during the quarter. With our continued improvements in our cost structure and the work that Sunit and his team have done to strengthen the balance sheet, we feel good about our financial position and our ability to invest in new customer opportunities to grow as the economy grows.

We are excited about the changes we are making in the local market and coupled with our focus on the customer experience, we believe we have a significant opportunity.

With that I will turn the call over to Jim.

Jim Crowe

Thanks Jeff. As I have mentioned for the last couple of quarters, given continuing economic uncertainty, we have and will continue to take action and make progress towards three goals. First, we want to make sure our cost structure is appropriate for a wide range of potential revenue growth rates, as is demonstrated by the year-over-year margin improvements discussed by Sunit, we're making clear progress in spite of the challenging environment.

Second, we want to continue to make visible improvements in credit quality through operational improvements and results and appropriate deleveraging transactions. Both the improvements in unlevered cash flow and the significant liability management actions which Sunit described demonstrate the noteworthy progress we continue to make in this regard.

Third, make sure that we are positioned to take advantage of the opportunities that are and will continue to emerge as the longer-term positive fundamentals of our business displace short-term challenges. As Jeff mentioned, we are adding local management, operational and sales resources in metro areas, where we already have substantial fiber-base facilities. This allows us to address the very large market for services purchased by enterprise to make buy decision either regionally or locally. As we continue to invest in effort designed to ensure we combine our very large scale with technical innovation, ensuring that we have the best cost structure for a wide range of optical and IP-based services.

And importantly, as Jeff described, we continue to invest in our customers overall experience with Level 3.

Operators that ends our prepared remarks. Would you please describe the Q&A process.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) And our first question comes from Michael McCormack with JP Morgan.

Michael McCormack - JP Morgan

Hi guys, thanks. Jim can you just give us an update on where we stand on unity whether or not everything you wanted to put in place there is now up and functioning, and then maybe sort of connected to that, when you are looking at the sales pipeline, I know some of this is you know, business decision-making and how long that takes, but can you sort of try to quantify how long it is taking now versus say a year ago to take something out of the pipeline and actually convert its revenue-generating?

Jim Crowe

With respect to your first question with regard to unity, I don't think we -- we're never going to be to a point where we say we are now done and completely satisfied with a static completed set of processes and systems. We are where we thought we would be as we announced I guess at the end of the year, we were flowing well above our targeted two-thirds of new core revenue through unity provisioning.

Jeff has described in a fair amount of detail in previous quarters the kind of work we are doing on network inventory. That is making sure that our data concerning what facilities are there, what are utilized by customers, and what are available for new services is accurate, and that is something any service provider continuously works on. But yes, I think we continue to see the benefits that we expected from unity and I think you'd see it clearly visible in the kind of incremental SG&A it takes us to add a dollar of revenue, which continues to be well within our target. With respect to the sales pipeline, Jeff may wish to add a comment, but mine would be and I think there is we have provided presentations that describe this, there is a waterfall that starts with an identification of a target that can take 30 to 90 days or longer.

Once we have made a sale, it takes us roughly 45 days and there is a broad range on either side of that depending on whether it's some usage-based service we can turn up almost immediately or we have to add a building, and then we just turn up and start billing. It is the first piece that is from opportunity identification to a sale that we have said and would continue to say has stretched out longer than historical levels. I don't have a metric and I think it'll be hard to give you a metric, other than to say we are still not back to historical levels of pipeline conversion. Jeff did you have…

Jeff Storey

No, the only comment I would add on the unity question is that, we need a common platform to design and engineer circuit and services across the network and that's what unity is, but we will be perpetually dissatisfied with the capabilities. We'll always want to add, we'll always want to augment, we will always want to improve the capabilities that it is performing as we expected.

Jim Crowe

I used the term pleased, but never satisfied. Next question.

Michael McCormack - JP Morgan

Thanks guys.

Operator

We'll move next to Jason Armstrong with Goldman Sachs.

Jason Armstrong - Goldman Sachs

Thanks, good morning. Couple of questions, you talked about improvements in the revenue trajectory over the back half of the year and presumably this means that the rate of erosion is less severe than it has been. When can we expect this company get back to revenue growth. Could you just step us through maybe the segments, and little bit of an outlook around expectations, and then secondly in terms of the potential mix shift in revenues Jeff talked about, you know, more of a localized hiring model to sort of penetrate in middle-market enterprise presence, which clearly makes sense. If this takes hold, how should we think about the margin profile that is sort of available in this segment if this is relative to existing margins? Thanks.

Jeff Storey

Yes, I'll take the second one first and come back to the first one. So, as far as the margin profile goes Jason, it is similar to what we have currently, with the retail orders that you might have little more in sales expense but at the same time, you know, pricing to that segment is better also. So from a EBITDA margin contribution or even from a capital intensity perspective, it is the same as some of our other segments.

Jason Armstrong - Goldman Sachs

As you build out this, is there some sort of expectation of near term dilution as you put the full presence in place and then you will scale it overtime and how should we think about that?

Jim Crowe

I think the reason we are taking this action as we as we have said publicly more than once, we have accumulated what we would say is a unique asset through a series of acquisitions and construction over the course of the last three or four years. We have a major presence in dozens of metropolitan areas, and we are leveraging in investment that we and frankly others made in the past. The statistic or the figure of merit that we often point out, and I would repeat again as there are 100,000 enterprise buildings within 500 feet of our network, meaning, we can sell in those buildings and add the building after we successfully sell. So we think we have a success-based model here that leverages a huge capital investment already made. Sunit if you want to -- revenue growth.

Sunit Patel

Yes, and maybe just one little point on this Jason. Keep in mind, I mean, we are in more than 100 markets with metro fiber. So just in five increasing resources, and another five here in the second quarter. So in proportion to the overall business we have, I think yes, the answer is we can add resources to some of these markets without diluting our overall margin at the pace we are going. Back to your revenue growth question, I think you saw the sequential improvement in the revenue decline percentage. We think that will continue. The question on when we return to growth is a trickier one in the sense that it depends on the economy, but certainly is a trajectory we are going on could happen as early as the fourth quarter or a little later, but again it starts to look too far ahead in this economic environment, but well positioned, well leveraged and suddenly you know, what we are seeing in terms of what Jeff is talking about, we feel good about.

Jim Crowe

And I would emphasize something that I'm sure everyone on the call is well aware of, and that is there is more volatility and outlook these days and perhaps in any time in any of our careers. So we just want to keep repeating this is an uncertain environment. We think we are managing through it as well as anyone, but it is uncertain. Next question.

Operator

We will hear now from Raymond James and Frank Louthan.

Frank Louthan - Raymond James

Yes, thank you. Can you give us an idea of what you saw for Internet traffic growth in the quarter, and maybe give us a little more idea on what you are seeing on some of the disconnects on the enterprise side. Is it companies that are just going out of business or more network grooming. Are you seeing some of your larger carriers advancing their own fiber. What exactly are we seeing there?

Jim Crowe

So, let me take the enterprise question first, and then we'll come back to the IP traffic question. When looking at our mid market, which I think I may have defined (inaudible) in the script, mid market we define as customers from several thousand dollars per month from several hundred thousand dollars per month. We see the disconnect falling into three buckets roughly of equal size. One bucket is what we consider good disconnect, where they are going from one type of product to another type of product within our portfolio. Another one about the same size is where we see customers going out of business or scaling back their services, and then the third one is where we see loss to competitors. So it is kind of mixed bag. Obviously, we are focused mostly on the third category.

Jeff Storey

Yes, with respect to IP traffic, as we have said many, many, many times the substitution of products up and down what we think of as the service for protocol stack continues and perhaps accelerates. We don't capture a lot of what really is Internet traffic in a metric, which only describes IP trends, but in -- with all those caveats the quarter-over-quarter growth in North America was 8%, and there is a lot of variability quarter-to-quarter, but that was the growth in units.

Frank Louthan - Raymond James

Okay, great.

Jeff Storey

Next question.

Operator

We will hear next from Simon Flannery with Morgan Stanley.

Simon Flannery - Morgan Stanley

Thanks very much. Good morning. Sunit, capital spending is this a good run rate for the rest of the year. How should we think about that? Also you had nice increase in the deferred revenue balance this quarter. Can you just talk through the drivers of that and is that something you might see more of it as second-half or is that more of one time? Thanks.

Sunit Patel

Yes, I think the -- first of all the answer of the capital spending, yes. That rate, sort of the run rate for the first half of the year is which you will see in the second half of the year. On the deferred revenue, yes we did have some wins in the second quarter. I think you saw the release put out with a large multinational, we signed an agreement. So we have some help from there. The deferred revenue balance generally moves around. So I think we had some benefit in the second quarter.

In the second half of the year it might go down some, but from a working capital perspective in general, obviously we expect working capital to be a source of cash in the second half of the year, just from you know, receivables, payables should more than offset, prepaid should more than offset any change in the deferred revenue balances to give you some sense.

Simon Flannery - Morgan Stanley

Great, thank you.

Jim Crowe

Next question.

Operator

Michael Rollins with Citi Investment Research has our next question.

Michael Rollins - Citi Investment Research

Hi, good morning. Just a question, going back to Business Markets group, in the past you talked about the churn you were seeing in your very small customer segment within that large group. Is that what you are still seeing today or is the churn picking up in other areas of your Business Markets customer base?

Sunit Patel

Well, I mean I think as we said the churn is I don't think has increased per se, just didn't go down as much as we thought in the second quarter but the small, the churn is across-the-board I would say, as far as the very small business customers go, you know, we have largely as I said, if you see it in earlier periods, you know, either sold that base or worked that down a fair bit. I think this is across-the-board. Jeff, can you add to that.

Jeff Storey

I think that's right. I mean, we certainly see a higher percentage of disconnect in the lower customer step, but that is a relatively small piece of the overall pie at this point.

Michael Rollins - Citi Investment Research

But I think -- can also just describe what the foreign currency impact was sequentially in European markets group in the quarter please?

Sunit Patel

I think sequentially we didn't have too much of a change from a foreign currency perspective. I think year-over-year it has been more. So I think the sequential rate is about on a currency basis would be better otherwise.

Michael Rollins - Citi Investment Research

Thank you.

Jim Crowe

Next question.

Operator

We will move now to Jefferies and Romeo Reyes.

Romeo Reyes - Jefferies

Hi, couple of quick questions. A quick follow-up on Simon's question on the deferred revenue, it seems like there was a fair amount of cash that came in from your sales in the second quarter. Can you, you know, talk a little bit more as to you know, maybe whether or not we are going to see a little bit more or less in the second half of the year. Is this kind of an indication of demand for, I mean for services at all, is it a lagging indicator? Can you give us a sense of how are you thinking about IRU demand or is it dark fiber of its lit services. That's a first quick question here, and then secondly with respect to Telefonica and also the multinational carrier, when do we start to see those revenues. I think the -- I'm sorry multinational customer that you got, you said in your 8-K that it was a $140 million of revenues committed over the first four years of the contract, thanks.

Jim Crowe

So, Romeo the -- my definition IRU sales are lumpy and move up and down a fair amount quarter-to-quarter. Over the course of a couple or three years, we think there is a set of market trends that favor us. We've talked a fair amount about this. Large users of services, so think cable, media companies, portals, search engines, social networking sites, new media, run through a lifecycle, if you would, maybe that is the wrong word, a pattern of growth, a start out focused on revenue. At some point, they begin realizing they have a set of data centers or mobile switching centers or tape or head ins and as between those locations it makes sense to go -- to move from a metered by the unit service to something that is more predictable and accommodates their view of growth, which generally are waves or in the very large cases dark fiber.

Outside those areas, there is a similar kind of movement from high level usage-based services down through more fixed by the month services, wavelengths, or private lines. We have found it is to our customers benefit and therefore to our benefit to match up with those kinds of organizations that have that kind of tremendous growth, and provide them with what we think of as a set of lifecycle services. They get built into their businesses. Our facilities are engineered into their capability to serve their customers, and we find that's a great way to match up with our customers for the long term, provide them long-term value.

How any of that plays out in one quarter or two is in normal times difficult to predict since a slippage of one month, one way or another can have a big effect. In these abnormal times, it is even more difficult to pick as carriers and providers struggle with two factors, the need to manage cost aggressively as Jeff described, but an underlying growth in units that continues at high rates and has to be accommodated over whatever is their provisioning period, three, six, nine months. We think cost to board that means companies in this category are running networks harder than we have said that more than once. That is, margin safety is being reduced. That is an opinion on our part, but we have heard it repeated by quite a number of other companies. That has a life to it. So there should be some kind of snap back. When it occurs, we are not going to guess that as too odd.

Jeff Storey

I'd one clarification on Michael Rollins question earlier. Mike, I think I didn't understand your question right. What I meant to say was on a constant currency basis, sequentially as Jeff Storey pointed out, we grew about 1%. That's why I said not much change there, but on a reported basis, we grew about 5% as you can see in our press release. So I just want to clarify that. On a year-over-year basis we were about flat on a reported basis, but up about 20% on a constant currency basis.

Jim Crowe

Okay. Operator next question.

Operator

We will move now to Colby Synesael in Kaufman Brothers.

Colby Synesael - Kaufman Brothers

Great, thank you. I have two questions. The one has to do with, maybe you could just talk about the difference in revenue churn versus customer churn. I think that you must be seeing more revenue churn than you are a customer churn right now. Also, as it relates to the debt, just curious how much more is to do, maybe to ask it a different way. Are you guys simply taking advantage of the current market opportunity or is there an absolute number that you guys are shooting for in terms of reducing you know, called 2009, 2010 debt, thanks.

Jim Crowe

Yes, I'll take that one and then Jeff can talk about the revenue versus customer churn. I think on the debt side, you're right. The markets have continued to rally, and I think as you know, we have always been opportunistic every period, every quarter. We are always looking at ways we can improve our balance sheet profile, and you can continue to expect us to look at that. So, yes, we keep pretty close tabs in the market. So we agree with you the market improved a fair bit. There maybe some opportunity…

Colby Synesael - Kaufman Brothers

So, there will be more -- I mean the types of transactions we saw in the second quarter. I mean there is no reason that you gotten your debt to a certain degree now for 2009 and 2010 in terms of what due, that should stop you, or am I missing that?

Jeff Storey

Yes, I know. I think our position is, we are never satisfied with that and we want to keep improving it. So we just keep close tabs on what's happening in the market and every time we see opportunities we try to take advantage of that into our balance sheet.

Jim Crowe

You might talk about our publicly stated target for debt and high quality.

Jeff Storey

Yes, I mean you know we have our target leverage ratio of being in a debt to EBITDA ratio 3 to 5 times, and you know I think that we are currently at a net debt to EBITDA basis in the fixed zone. So that has been our stated target for the last three or four years. So (inaudible) we can get from various means.

Sunit Patel

When it comes to the mix between revenue churn and customer churn, in the wholesale markets and the content markets and European markets, it is almost exclusively revenue churn as opposed to customer churn. When you look at the very small end of the enterprise market, then it is going to be more heavily weighed to customer churn. Then looking at the broad mid market, it's predominantly again going to be revenue churn with a little bit higher up tick in customer churn.

Jim Crowe

Okay, operator next question.

Operator

We will hear now from Jefferies and Jonathan Schildkraut.

Jonathan Schildkraut - Jefferies

Great, thank you. Just to build on that churn question, I was wondering if you could just tell us about you know, with your standard enterprise customers. I guess what kind of pressure you're getting on repricing of contracts? Additionally, you know, when Sunit we spoke I guess in June, you know, you indicated that some of the churn coming up now had to do with kind of more aged customers that may kind of be living out of their contract wise, and I was wondering you know, where we were in that process and maybe some of the internal metrics in terms of satisfaction on some of the newer customers that are coming in. Thanks.

Sunit Patel

Yes. They are going to think about the satisfaction. With respect to pricing, I think it is more useful to think about pricing by product line than it is by customer, since we sell quite often a series of products, which have different characteristics and one of our strengths is being able to offer a complete range of services, usage-based, dedicated Internet access on a monthly basis, voice service as a complete package, and as Jeff said with one exception which I'll mention, pricing trends continue as they have for the last several quarters in a way that we think are frankly pretty positive and healthy. If you -- the closer you get to the fiber, and the closer you get to the Metro, the more of what I'm about to say is correct, but prices have been up and down 10% to 15%, and as you get closer, in pocket we have seen absolute increases in prices for infrastructure, polo, metro fiber, some of the metro data services. The one exception is the one that Jeff mentioned, high-speed IP, where over the last quarter we have seen some more aggressive behavior on the part of certain competitors. Do you want to add --

Jeff Storey

On the customer satisfaction, across the board we see our customer satisfaction improving. You know, we have been very, very open about the issues we had several years ago with customer experience and we are focused on that and we are getting good feedback from all of our customers. With respect to new customers coming in, they obviously didn't experience some of those problems that we had a couple of years ago, and so we think our customer satisfaction with this is untarnished by anything in the past and is relatively good. Along with my comment on unity, this is an area where I'm always perpetually dissatisfied and Jim might say, pleased but always wanting to improve. We focus very heavily on having the best service in the industry and until we're hands down the best provider. We will constantly be focused on and be paying attention to this.

Operator

We will take our next question from Ana Goshko with Banc of America.

Ana Goshko - Banc of America

Hi, thank you very much. Two if I may, the first one is on the communications, other revenue. There was a pretty big step down on a relative basis from last quarter. So it was down $14 million, it is 22%. I know that's comprised of the SBC, which is not your highest margin, but it also includes the managed modem and the USF, which could be very high margin. So wondering how much of that step down was the high margin revenue and how much of that had an impact on the EBITDA and, you know, what your outlook is for the rest of the year on that revenue line?

Jeff Storey

Yes, Ana you're right. We had a steeper than normal decline in that in the second quarter. It was mostly in the higher margin managed modem business. Obviously, our efforts network optimization continues to offset, you know, margin loss from the higher margin revenues. So in this particular quarter it was from the managed modem business. I think going forward, we will see more normal rates of decline that we've experienced over the last couple of years across both the SBC and the managed modem business.

Ana Goshko - Banc of America

Okay, and then --

Jim Crowe

As we pointed out, I guess quite often, a few years ago that these lines of business represented half our revenue. We're now down to mid single-digit. So the effect is just not what it was even a year ago.

Ana Goshko - Banc of America

Okay, and then Jim if as I said ask you just, I mean, M&A outlook. I think in the past quarter or so you had made comments about the potential and the rationale for still combining long-haul networks, you know, within the industry, and you guys described in the Wall Street Journal as looking -- at the Quest network and as potentially being in discussions with Sprint. But it seems pretty quiet on that front, but I would say recently you put out a consent on solicitation on your 12.25 bonds, and the whole point of that would be only beneficial in a M&A scenario. So wondering one, where do you see the M&A opportunities right now, and two, do you happen to have a lot of pots boiling you know, at the moment so much so that you went out to try to get that consent done.

Jim Crowe

Obviously, we don't comment on any specifics. It is not appropriate. The statements we have made, and I think I have made them, I think Buddy Miller, who is our vice-chairman strategy, product and corporate development has made them perhaps more often than I have. And I might add we are hearing them more and more from other carriers that the trends that we have described remain and perhaps become stronger. If I had to sum it up, I'd simply say if you are a net purchaser of facilities broadly defined, you are finding life more difficult or at best you see a future, where margins are under pressure.

That's true of the wireless, wired, and cable service providers, and I see no reason and I haven't talked to anybody that sees a reason to believe that dynamic is going to change. You can imagine scenarios but they seem unlikely. Anytime you talk specifics, it's individuals, individual companies, and their own goals, desires, and strategies. But the dynamic that leads to further industry consolidation, I guess we would say continues and perhaps has strengthened. With respect to the 12.25, I think we put out a press release that described clearly what our position was. Next question.

Operator

We will move now to David Dixon and FBR Capital Markets.

David Dixon - FBR Capital Markets

Okay, thanks and good morning. Just a question on the wholesale segment performance. Jeff, I wondered if you could provide us with an update on the competitor pressure you are seeing in the market there. As you pointed out, there was a sequential step down, but we are just curious in terms of how this might be impacting the increased rate of disconnects in the wholesale segment. Specifically, we are hearing specifically that XO is getting extremely aggressive within the marketplace, particularly for 10 gig wave. So just some clarity there would be helpful as we think about the outlook for this segment? Thanks.

Jeff Storey

Sure. If you look at our competitive position, I think we are better positioned than anybody from a cost -- our network to the sales team that we have, to the capabilities to the combination of metro assets and long-haul assets. So from my point of view, this is not a competitive issue, it is more of a macro economic issue, and as I said if you look at our larger customers, the larger service providers, the large media and entertainment companies, and then the large enterprise customers, their efforts to rationalize their network spend is the biggest driver that we see. And in looking at our share of the market, we have seen an increase in our sales quarter-over-quarter by about 10%. So we feel that we are doing a good job in the market if the overall efforts of our customers to reduce the spend of the driving issue.

David Dixon - FBR Capital Markets

Okay, thanks very much.

Jim Crowe

Next question.

Operator

We will hear from Banc of America and Michael Funk.

Michael Funk - Banc of America

Great. Thank you for taking the questions, what is your commentary on pricing, you know, demand and, you know, some of the other regional factors you could have of expansion of the sales force. Can you confirm that your incremental margin guidance you have given historically is still applicable. And then second, just any additional commentary that you have on any pressure that you are seeing by vertical region in your customer side will be helpful, thank you.

Jeff Storey

Yes, I'll comment on the incremental margin. Yes, I think the operating leverage Michael that we have talked about in the past with respect to incremental margin for core network services in the order of $0.80, and you know $0.20 of SG&A expense of every dollar of revenue. I think we continue to feel good about that. Obviously in the year like this, we are keeping a pretty tight lid on operating expenses, while at the same time investing as we talked about for expansion in cities, but yes, we continue to feel good about the operating leverage and the incremental margins we have talked about in the past.

Sunit Patel

With respect to -- do we see any particular pressure -- we don't see any particular pressure, one geography against another, one customer set against another. There are some pricing pressures that we talked about with respect to products and high-speed IP pricing being the largest ones. So if you look at the customer segments that purchased that, may be a little more pressure among those customers. But that's really the only call that I'd had.

Michael Funk - Banc of America

And that's about 9% of the revenue.

Sunit Patel

And it is a relatively small percentage, little bit less than 9% of our communication revenue.

Jim Crowe

That's US and Europe? Right the 9?

Sunit Patel

Yes.

Jim Crowe

I think we have time for one more question. Operator?

Operator

And that final question today comes from Murray Arenson with Janco Partners.

Murray Arenson - Janco Partners

Thank you. I'll try to squeeze in two if you let me. I wanted to ask you first of all about the CDN market. You talked about pricing pressures there and I know you kind of distinguished your expertise within that area, and I wondered if you are learning anything new strategically about the direction that business is going or if you can just comment further on the pricing pressure. And then secondly, if you'd give us your thoughts on the broadband stimulus opportunity, and how you are approaching that and what your expectations might be on that front?

Jim Crowe

With respect to CDN, let me once again define terms, since content distribution is used fairly broadly to describe a whole set of services. When we talk about CDN, we mean large object CDN and to make that in plain English, we mean video distribution, large software downloads, large gaming very, very big files or streaming flows. As distinct from web page, downloads, e-commerce and all the toolsets and acceleration, monetization tools that go along with that. We said for, I guess, quite a long period of time it doesn't take much math to see it that the Internet over time is becoming an entertainment distribution medium, and in terms of units it is going to be the unit demand and flow is going to be dominated by video and other very large objects.

We believe that the cost to deliver those kinds of objects are going to be increasingly bandwidth that the intelligent traffic management, storage and caching the decision as to where to store, how to store, what needs to be stored where, and of course all of streaming requires bandwidth, and over time if you're not a carrier with your own low-cost source of bandwidth, you're going to end up as a reseller. And I would say over the last 20 years, less than pretty clear resellers can grow to a certain size, but then because they don't control such a large portion of their cost, they get squeezed.

Now we're on record, as having said that we've seen no reason to see any different CDN continues to grow. I might add in Europe in particular it continues to grow. We have seen some additional pricing pressure, I think from fair play CDN providers who might be trying to hold on to market share. But we think in the longer term, what we have said repeatedly is what we'll continue to say is going to become a large object, going to become a carrier business, going to become the bread and butter of providing IP and other forms of IP optical services to a broad range of the market, but Jeff.

Jeff Storey

On the broadband stimulus question, the expansiveness of our long-haul network is well-known. We cover the entire US and a great deal of fiber assets. We have talked a lot about our local metro fiber assets, and Jim referenced 100,000 buildings that are within 5 miles of our network, excuse me 500 feet of our network, I apologize. And if you think about another component that we don't think about as much is that every 60 miles across our network, we have points that we could open up access, and as a middle mile provider in the broadband stimulus that is a unique position that Level 3 can serve, and so we are looking with a number of players to figure out how to open enough access to those -- to all of those locations. We have more than 300 open today. We have hundreds and hundreds of others that might want it, but we are working with a variety of other customers and providers and directly with the federal government to figure out how to open up more and more on ramps to the backbone across the US.

Jim Crowe

Okay, in summary as I'm sure is obvious we remain cautious about shorter-term trends, but we believe even more than we have a couple of quarters ago that the underlying fundamentals remain positive. Consumer unit demand for wireline and wireless broadband, which is the underlying driver for about three quarters of our revenues here in the US and Europe, continues to grow at very, very highly rates as Internet delivery of rich media, especially high-quality long-form video continues to grow rapidly.

Enterprise services represent the remaining quarter of the demand for our services and our low share in the market, and the initiatives that Jeff described that is particularly the additional local sales and operational resources in cities where we already have substantial fiber-based networks, should result in improving results in coming quarters. And pricing with the exception of high-speed IP remains, the pricing environment remains positive. Taken together, these factors resulted in a second quarter sequential revenue decline that was about one-third of that of the first quarter. We expect the rate of revenue decline to continue to slow and approach positive growth and beyond over the course of 2009. Thank you very much for listening and we look forward to reporting to you in the future. Operator that ends the call.

Operator

Thank you. This concludes today's Level 3 Communications Incorporated second quarter 2009 earnings conference call. Thank you all for attending.

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