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INTRODUCTION:

Level 3 Communications (NYSE:LVLT) refocused its business toward the enterprise market. This resulted in the long time CEO being shown the door closing the chapter of LVLT's decade long struggle trying to find its way. Jeff Storey was named the new CEO in April. See our last article for additional insight concerning the new CEO.

Walter Scott, Jr. (Chairman of the Board) summed up best why the time for change is here in the 2012 annual report and proxy:

Our company is also undergoing a transformation in terms of the type of customers we serve. We have moved from being primarily a wholesale provider to a company focused on serving the day-to-day business needs of enterprise customers… Jeff emerged as the clear and obvious choice to lead the company going forward. He knows the industry, having served as president of several companies over the course of 30 years in telecommunications. He knows the company, having brought to it a discipline and focus on operational excellence and a passion for the customer experience. And he has helped shift the focus of the company to the enterprise market, where we are continuing to take market share.

LVLT announced second-quarter results on July 31 reporting shrinking revenue over Q1 masking the bigger picture as the company concentrates its focus on the enterprise business. The company's revenues are reported in two major groups; CNS (Core Network Services) revenue represents higher margin services and "Wholesale Voice Services" and "Other" revenue represents lower margin services. Wholesale Voice Services and Other revenue is trending down, which is expected to continue given the focus on the higher margin CNS enterprise revenue. CNS growth is critical to LVLT's long-term success. CNS revenue is reported in the following segments:

  • North America - Wholesale Channel
  • North America - Enterprise Channel
  • EMEA - Wholesale Channel; EMEA= Europe, the Middle East and Africa
  • EMEA - Enterprise Channel
  • EMEA - U.K. Government Channel
  • Latin America - Wholesale Channel
  • Latin America - Enterprise Channel

THE ENTERPRISE STORY:

The following Enterprise trends established through the first quarter were:

(click to enlarge)

We noted in our last article these trends should improve now that integration is well under way and management can spend more time growing the enterprise side of the business. Here is how the trends stack up after Q2:

(click to enlarge)

The two largest enterprise markets (NA and LA) are continuing to produce growth with the LA market trend accelerating vs. the first data set (higher R2 value).

A note on R squared (R2) shown in the data to put the trends in context. R2 is a number between zero and one whose main purpose is the prediction of future outcomes on the basis of other related information. It describes how well a regression line fits a set of data:

  • R2 <.30 are considered to have no correlation and behavior is explained by chance
  • R2 of .30 to .499 are considered to be a mild relationship
  • R2 of .50 to .699% are considered to be a moderate relationship
  • R2 of .70 to 1.0 are considered to be a strong relationship

Now that the focus has shifted from the massive Global Crossing integration to enterprise it's reasonable to expect the trends to show improvements in the second half. This focus was highlighted with the announcement of the Starbucks deal discussed at the conference call:

Over the next 18 months, Level 3 will upgrade the network for Starbucks' in-store WI-Fi, Internet services and data connectivity for its 7,000 company-operated stores across the U.S., making connections in those locations faster and more scalable than before. This project is all about managing complexity, speed, scalability and flexibility, and we look forward to collaborating with Google to provide Starbucks the solution that will provide the best Internet experience to Starbucks' customers and leverage the best of what Level 3 has to offer.

This adds more fuel to keep the trends intact.

These improvements will become more pronounced as the higher margin enterprise revenue increases vs. the declining lower margin wholesale business, driving improvements in EBITDA , net income and free cash flow over time. For detailed projections see the link at the end of the article.

CONCLUSION:

The overall numbers appear to show LVLT going nowhere, or worse, declining revenues but there is a hidden story if one starts to look under the hood. Over time enterprise growth will stand out as it becomes a bigger part of the overall revenue picture. As such this idea is a multiyear investment horizon not a short-term trade, i.e., 2013 should provide opportunity to accumulate the stock. As growth continues to improve free cash flow will grow substantially over the next five years and beyond, providing long-term value based on the price at the time of this writing.

The long-term risk is if growth stalls, but to date the trend is proving stronger as each quarter is released and the Starbucks deal will only help.

There are short-term threats to cash assuming they are incurred and will not affect where free cash flow is going long term. LVLT has accrued $275 million for various legal proceedings and other liabilities on the balance sheet. This does not mean cash has been set aside so the amount accrued may have no effect on the balance sheet but will affect cash flows. Accruing these charges tell us there is a reasonable expectation LVLT will incur these costs in the future. The issues are:

  • Rights-of-Way Litigation
  • Peruvian Tax Litigation
  • Employee Severance and Contractor Termination Disputes
  • Brazilian Tax Claims

LVLT believes that it is reasonably possible that the Brazilian issue could result in a loss of up to $61 million in excess of the accruals established, which if accrued would raise the total to $336m from $275m. The market will react with the usual shock and surprise to any large charges presenting buying opportunities assuming it is attaining growth. Why? Because these issues are one-time occurrences and will have no effect on longer-term free cash flow if enterprise revenue is on track.

Another issue is the interest rate swap obligations that will cost the company $45 million; to be incurred over the next three quarters.

A complete set of updated financial data used in this article (or to take a more detailed look at the financials) can be found here.

Disclosure: I am long LVLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Level 3 Communications: The Hidden Story