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Level 3 Communications, Inc. (NYSE:LVLT)

Q3 2009 Earnings Call Transcript

October 28, 2009 10:30 am ET

Executives

Valerie Finberg - VP, IR

Jim Crowe - CEO

Sunit Patel - EVP and CFO

Jeff Storey - President and COO

Analysts

Mike McCormack - JPMorgan

David Dixon - FBR Capital Markets

Frank Louthan - Raymond James

Chris Larsen - Piper Jaffray

Tim Horan - Oppenheimer

Ana Goshko – Banc of America

Michael Rollins - Citigroup

Michael Funk - Banc of America

Jonathan Chaplin - Credit Suisse

Operator

Good day and welcome to the Level 3 Communications Incorporated third quarter 2009 Earnings Call. Today's conference is being recorded. At this time, I would like to turn the call 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 third quarter 2009 earnings call. With us on the call today are Jim Crowe, Chief Executive Officer, Jeff Storey, President and Chief Operating Officer, Sunit Patel, Executive Vice President and Chief Financial Officer and Buddy Miller our Vice Chair.

Before we get started I wanted to mention that in addition to the press release and financial exhibits, our presentation summarizing our results, which Sunit will be referencing in his remarks is available on our website 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 3Q '09 earnings presentation.

I also need to cover our Safe Harbor statement, which can be found on page two of 3Q '09 our earnings presentation. And that says that information in this call and in the presentation contains 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 press release, which is posted on our website at www.level3.com, in the Investor Relations section.

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

Jim Crowe

Thanks, Valerie. As is our practice in our prepared remarks, Sunit will discuss financial results for the quarter. Jeff will discuss operational matters, including segment results. I'll provide some brief summary comments, and then we'll open it up to questions. Sunit?

Sunit Patel

Thank you, Jim and good morning everyone. Before I review our detailed results, I'll start with some of the key points highlighted on page three of our presentation. As we have now mentioned for a few quarters, sequential revenue performance for Core Network Services continues to improve, and we expect that to continue again next quarter.

We are reiterating our business outlook for the full-year 2009, and we expect adjusted EBITDA to increase next quarter. Since we reported our previous quarter, we have continued to make progress on the balance sheet by improving our liquidity and paying down near-term debt.

Turning to the detailed results for the third quarter on slide four, Core Services revenue was $859 million, and declined 2% sequentially from the second quarter of 2009. About two-thirds of the decline was in the low margin wholesale voice services revenue.

More importantly, Core Network Services revenue was $701 million this quarter, a 1% sequential decline from $707 million in the second quarter of 2009. This marks an improvement from the 3% sequential decline from the first quarter to the second quarter of 2009, and from the 7% sequential decline from the fourth quarter of 2008 to the first quarter of 2009.

Wholesale Voice Services revenue was $158 million this quarter, compared to $170 million in the second quarter of 2009, and $173 million in the third quarter of last year. As we have indicated previously, we do expect volatility in Whole Voice Services revenue, since that business is mostly a highly competitive spot market business, and we manage for margin contribution versus revenue growth.

Our revenue base continues to diversify the breakdown of Core Communication Services revenue by market group was $485 million for Wholesale Markets, or 56% of revenue, $209 million for Business Markets, or 24% of revenue, $82 million for Content Markets or 10% of revenue, and $83 million for Europe, also 10% of revenue. Excluding the SVC contract, our top 10 customers represented 26% of communications revenue compared to 27% last year.

Turning to Core Network Services revenue by customer segment, our Wholesale Markets revenue grew 1% to $342 million in the third quarter of 2009, compared to $340 million in the second quarter of 2009. This was an improvement compared to a sequential decline of 5% in the second quarter.

Business Markets revenues declined by 4% this quarter to $203 million compared to $212 million in the second quarter of 2009. Sequential performance in the Business Market Group worsened a little from the 2% sequential decline we saw in the prior quarter.

For Content Markets revenues declined slightly to $81 million in the third quarter from $82 million in the second quarter. Content Markets sequential decline of 1% was an improvement from the 4% decline we experienced in the prior quarter. Our European Markets revenue increased 3% to $75 million in the third quarter of 2009, compared to $73 million in the second quarter of 2009.

In constant currency terms European revenues declined 3% sequentially in the third quarter 2009 compared to flat sequential performance in the prior quarter. Jeff, will discuss in more detail our performance in each of the customer facing markets, but at a high level we see strong sales performance from several segments across the business and improving churn.

Other revenues were $42 million in the quarter, and now represent less than 5% of our communications revenue, and will have a diminishing impact on our overall revenue performance going forward. The communications deferred revenue balance was $880 million at the end of the third quarter of 2009, compared to $910 million at the end of the third quarter of 2008, and $905 million at the end of the second quarter of 2009.

Turning to slide five. Gross margin was 59.0% this quarter compared to 59.7% in the third quarter of 2008, and 59.1% in the second quarter of 2009. This slight decline in gross margin percentage was due to the decline in revenue, offset by continued network optimization.

Communications SG&A expense excluding non-cash compensation and restructuring and impairment charges was $316 million during the third quarter of 2009. As expected, SG&A was slightly higher during the third quarter of 2009, compared to second quarter of 2009 SG&A of $311 million.

This was due to the seasonally high utility expenses we see during the third quarter. However, compared to third quarter of 2008, SG&A of $370 million, SG&A declined by 15% year-over-year. We continue to be disciplined in managing expenses tightly while adding sales resources.

Turning to slide six, consolidated adjusted EBITDA was $213 million in the third quarter of 2009, compared to $229 million in the second quarter. The decline in EBITDA was primarily a result of decrease in revenue and seasonally higher utility costs, partially offset by network and operating cost improvements.

Despite the decline in EBITDA, communications adjusted EBITDA margin held relatively firm at 23.9% in the third quarter of 2008, compared to 24.4% in the third quarter of 2008, and 24.8% in the second quarter 2009. At the bottom of slide six, capital expenditures decreased to $75 million in the third quarter of 2009, compared to $80 million for the second quarter of 2009, and $123 million for the third quarter of 2008.

Turning to slide seven, unlevered cash flow once again improved to $152 million in the third quarter of 2009, compared to $124 million in the third quarter of 2008, and $146 million for the second quarter of 2009. Year-to-date, our unlevered cash flow was $341 million, compared to $229 million last year.

Consolidated free cash flow was positive $9 million for the third quarter of 2009, compared to negative $4 million for the third quarter of 2008, and $20 million for the second quarter of 2009. Cash interest expense in the third quarter was about $16 million higher than the second quarter. Despite declining revenues, we continue to improve upon free cash flow compared to 2008. Year-to-date, free cash flow is negative $53 million compared to negative $160 million last year.

Turning to slide eight, we continue to improve our liquidity position during the quarter and into October. During the quarter, we paid off the remaining $55 million of principal due on the 6% convertible subordinated notes and repurchased approximately $39 million of additional debt outstanding in 2010 and 2011.

After the end of the quarter, we announced and completed the issuance of $275 million of 7% convertible senior notes due in 2015 for net proceeds of approximately $274 million. As of September 30, 2009, we had $532 million of cash on the balance sheet, or $806 million pro forma the October transaction, which is more than enough to cover our debt maturities through 2011.

Depreciation and amortization expense was $229 million in the third quarter of 2009, compared to $233 million in the third quarter of 2008. As previously mentioned, we expect depreciation and amortization to average $225 million to $235 million for the quarter.

Turning to our business outlook for the rest of the year, we are reiterating guidance for the full-year 2009. We expect to see the trend of sequentially improving revenue performance to continue into the fourth quarter. Usually the fourth quarter is a little strong seasonally due to the Vyvx broadcast business.

We expect consolidated adjusted EBITDA to be within the range of $900 million to $950 million for the full year 2009. We expect net cash interest expense to remain at $515 million as we indicated last quarter, and continue to expect to be approximately free cash flow neutral for the full-year 2009. Our GAAP interest expense outlook for 2009 continues to be approximately $600 million.

As we discussed on our first quarter call this year, we made some organizational changes internally, primarily managing our large enterprise and some large content customers, out of our wholesale market groups. As such, we will reevaluate our disclosure on market group revenue for next year, and we will provide an update on our fourth quarter call.

The liability management transactions we have completed since December of last year, we have significantly improved our liquidity compared to a year ago, and intend to continue to opportunistically manage our liabilities going forward. We are now in a position where we do not have to refinance any 2010 or 2011 debt maturities.

We’re encouraged by the signs we’ve seen recently around an improving climate across all of our market groups. Given that and the improving flexibility of our balance sheet we feel good about our future.

With that I'll turn the call over to Jeff.

Jeff Storey

Thank you, Sunit and good morning everyone. Overall we remain cautious, we continue to see positive and sequential improvements slowing the decline in revenue. While churn continues to outpace sales, we are encouraged by the opportunities we see in our market groups.

In Sunit's comments, he referenced an improvement in wholesale C&S revenue from a 5% decline in the second quarter to a 1% increase in the third quarter. This is driven by a reduction in disconnects and stronger sales, primarily from wireless and government accounts.

This improvement is significant since Wholesale Markets Group contributes approximately 58% of global C&S revenue. Within the third quarter, wholesale revenue grew in several segments as customers began increasing network capacity purchases, keeping pace with the underlying growth in demand.

As you may recall, we have noted that customers are running their networks harder in the challenging economic environment. In the third quarter, we began seeing signs that customers needed network augment to continue operating. However, I want to note that we are seeing this change occur slowly, and customers across our business are very careful of their purchasing decisions and continue to look for cost savings and network rationalization opportunities.

For our wireless customers, ongoing wireless substitution and the tremendous growth in wireless data is putting pressure on carriers to increase network capacity. Level 3 with our nationwide long haul and local metropolitan footprint is well positioned to help these carriers keep up with this demand. In addition to continued support and success with our traditional services, for example nationwide wavelength, metropolitan area transport and High Speed IP, we are launching innovative and cost effective ways to support our wireless customers.

Last week we announced a new Tower Access initiative, offering direct connectivity from the tower to the Level 3 network. We are working with multiple tower building partners to erect carrier-neutral towers at Level 3 sites throughout the country and connecting those towers directly to our network. We have experienced early success with this program, and are already under way delivering a Tower Access solution to a nationwide wireless carrier that involves connecting five wireless tower sites in Southern California.

As I mentioned last quarter, we had our best sales month ever in the Federal segment during the second quarter. While the Federal segment is still relatively small, it is growing and now represents more than 9% of total wholesale market revenues. We continue to see many opportunities in this segment, as an example utilizing our unique network assets Level 3 provides disaster recovery and continuity of operation solutions to federal agencies.

Our large footprint of On-Net and Near-Net locations for both military and civilian agencies makes us a natural alternative to the incumbent providers. In addition, while other carriers have positioned themselves as direct competitors to the federal systems integrators, we have focused on partnering with them, and have seen excellent traction with our approach. Our announcement this quarter in support of the 2010 census with the Harris Corporation is one example of our success in this area.

In business markets, we're very encouraged by the improvements we've seen this year in sales among large enterprise and mid-market customers, excluding the one-time dark fiber sale, large enterprise sales were flat quarter-over-quarter, but we see a building funnel and continue expanding our product portfolio to address large enterprise needs.

Among mid-market enterprise customers sales improved 12% quarter-over-quarter, while there was a slight improvement in churn as well, we still experienced higher levels of churn than we would like among this customer group, and revenue continues to decline.

Looking at the local market initiatives we launched earlier this year, we are seeing the sales and operational improvements we expected. As you recall in May and June we launched our local market strategy in Washington D.C., Denver, Nashville, Seattle and Buffalo, which also includes this Syracuse and Utica markets. Realizing our traditional nationally oriented sales and support model had not served the mid-market enterprise segment well, we felt that the local presence for sales, service delivery, and ongoing support would better suit this segment.

While we have seen the 12% quarter-over-quarter growth I mentioned a moment ago across the entire mid-market segment, and looking at the initial markets I have listed, we have experienced a 50% improvement in sales Q3 to Q2, and more than 75% improvement Q3 to Q1. As a result, we are accelerating our local market approach into additional markets by hiring general managers, staffing additional sales people, aligning operations in each of those locations as quickly as possible.

You have likely seen our recent announcements that we held our customer launch events in Philadelphia and Chicago. The Miami customer event is tomorrow, with New York and Atlanta next week and the following week respectively. We expect to have launched our local market approach in 31 markets by the end of the year.

As a reminder, while we maybe upgrading capacity and adding buildings to the network, we have been selecting markets, where we already had extensive metro assets. Consequently these launches do not include large capital expenditures or significant network expansions.

Within our Content Markets Group, we experienced seasonal pickup in broadcast and other revenues during the quarter, and expect to see that continue in the fourth quarter. Overall, the content markets continue to be affected by the economic environment, as customers cut back by reducing the number of events they cover, and the level of network redundancy at each event.

While pricing on new CDN services has somewhat stabilized, we did see a negative effect on revenue from price compression in the first half for the year. Within this quarter we launched our Content Analytic service, providing our customers greater information and control over their content delivery. It's been extremely well received by the market.

In constant currency terms, revenue from our European business declined slightly this quarter compared to the second quarter of 2009. This is primarily driven by macroeconomic pressure, typical seasonal traffic declines during the summer months, which we've already seen return to normal levels, and price compression for wavelengths and high-speed IP. While high-speed IP represents less than 9% of communications revenue for Level 3, the effective price decline is much more severe for Europe where high-speed IP is near 30% of our European business.

Within Europe, we see opportunities for growth from our geographic expansion in Eastern Europe, the launch of our Vyvx services, and the growth in the CDN business. On a constant currency basis we continue to expect low double-digit year-over-year revenue growth.

Turning to pricing and demand, we see overall stabilization in pricing. For example, pricing for Colocation services has been stable throughout 2009. As demand continues to exceed supply, we believe Colocation pricing will increase in 2010 and 2011.

Dark fiber pricing is increasing as well. And generally speaking pricing for Ethernet based services has remained stable. While the high-speed IP market continues to compress, we’re seeing signs of improving pricing stability from the higher quality service providers as one of the leading internet providers in the market, Level 3 intends to price our internet services to reflect the quality, reach, performance and resiliency our network brings our to our customers.

I would like to take a moment to update you on another key area of focus for the company, which is operational excellence across the business. We’ve certainly made significant progress with our service delivery and provisioning process and are working on a number of fronts to ensure Level 3 is known as the premier provider of excellent customer service. Specifically efforts to improve billing, network management, and our sales process are all resulting in a better, more reliable customer experience.

Hopefully you've seen the announcement that we hired a new CIO, Mark Martinet. Mark has been the Chief Information Officer and Chief Technology Officer for BT Business in London. We're excited to have Mark join the Level 3 team here in Broomfield with his extensive experience in telecom, information technology and process management. We felt he was the ideal executive to lead our initiatives in IT and the IT team.

We believe that his experience with enterprise customers at BT will be a valuable asset to our organization and that his experience managing a large IT organization during times of disciplined, cost management, and controls are well suited to the needs of our company. Mark will officially join the company in December, reporting directly to me.

In summary, while churn continues to outpace sales, we're seeing improved sales and a reduction in churn in a number of key segments. The federal government, large and mid-market enterprise, cable operators and wireless carriers have all seen improving results. Additionally, we're working very hard on our customer experience, and are pleased with the positive feedback we have received from our customers across the company.

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

Jim Crowe

Thanks, Jeff. I think Jeff and Sunit have done a good job summarizing the quarter, but I would like to emphasize three points. We continue to make clearly visible progress, strengthening our balance sheet and our cash position. We think this is an important factor in ensuring we're well positioned to invest in our business as our customers return to historical levels of purchases.

With the exception of High Speed IP, which comprises less than 9% of our core revenue, pricing trends remain healthy. This has been true for quite some time, and together with effective cost management has helped ensure our incremental margins and operating leverage remain strong. This means that as industry conditions improve, our financial performance can improve at a very rapid rate.

With regard to those industry conditions, as both Sunit and Jeff said, we remain cautious. However, we do see some signs of improvement, and we are particularly encouraged by the performance of our largest business unit, Wholesale Markets group.

That business represents, as Jeff said, a bit under 60% of our Core Network services, and those on the call will recall that Core Network services contributes more than 90% of our gross margin. It is notable that this unit showed positive quarter-over-quarter growth of 1% compared with negative 5% in the second quarter.

With that, operator, I think we're ready for the question-and-answer section.

Questions-and-Answer Session

Operator

(Operator Instructions). Our first question today comes from Mike McCormack with JPMorgan.

Mike McCormack - JPMorgan

First, on the business market trends, it looks like the year-over-year rate as well as the sequential rate of decline has worsened there, and some of your larger peers are starting to see a benefit I think certainly on the year-over-year rate of decline, and just given your scale of the thought we could see things turn a little faster there.

Maybe just give us a sense for, where project unity stands, if it’s provisioning issue, economic issue. It sounds like its not pricing. And then lastly just on the sales force, can you give us any update on where you stand at productivity measures and sales force churn?

Jim Crowe

Yes. I'll take the first question and Jeff you take sales force productivity and churn. With respect to your question, obviously each company has a different market focus some of the companies are the incumbent, others are alternative providers. In our case, I think fundamentally, the answer is what Jeff was referring to. Prior to this year, we had a primarily national management network, customer care, and sales model, and we were selling through our local networks to those who made buy decisions locally.

One of the contributions Jeff, made when he got here at the end of last year is to put a real focus on making sure that we were matched up to the way our customers buy, and I won't repeat the metrics that Jeff walked through in his presentation, but we see clear evidence below the top, which you correctly refer to as a decrease in revenue, but we see clear evidence that those local initiatives are bearing fruit, and we expect that over the next few quarters, we'll see the revenue line reverse and start growing again. Jeff, comments on sales force?

Jeff Storey

Sure. We are growing our sales force pretty aggressively through the last few months and the rest of the year. As a result, there is some churn that comes through that process, as you try and bring people up to speed. We don't see any significant churn among our sales force for the high performers that we have in the company, or the long tenured performers that we have in the company.

Productivity, when you're adding a sales force, is going to be lower than we would like, and it takes a little bit of time to ramp people up to speed, but we’re seeing the desired effect at the overall, if you think back to my comments about the side markets that we launched earlier in the year, with a 50% improvement in the Q3 to Q2, and a 75% improvement Q3 to Q1. We’re seeing the desired effect of the steps we are taking that, overtime we'll increase our sales force and will improve the productivity for each sales person.

Operator

We'll move now to FBR Capital Markets and David Dixon.

David Dixon - FBR Capital Markets

A question for Sunit. There's some significant dislocations and opportunities in the vendor financing market. Just wondered if Sunit, you could talk about the extent to which you as a company are able to benefit from that. You've done a recent deal, significant deal with Huawei, wondered if you could talk to that.

And seems like there is somewhat of a shift in strategy here into taking advantage of some of the wireless tower opportunities as they upgrade to fiber. Jim, I wonder if you could talk about your company's positioning relative to the [ILX] and the cable companies that may be somewhat closer to those to be able to build those laterals to those towers, I wonder how significant that opportunity could be. Thanks very much.

Sunit Patel

I'll take the first question. Historically, we haven't really relied on lender financing. Many times that comes with a lot of strings attached. So that hasn't been a big area of emphasis for us and I think that continues to be the case. I'll let Jim, takeover the next one.

Jim Crowe

Yes, with respect to fiber to wireless towers, I wouldn't refer to it as a shift in strategy. We've said for quite some time that over the longer-term, one way to think about our company is a lot of fiber connecting a lot of antennas. Those antennas, for enterprises, can be within buildings, increasingly wiring closets are on the out, and wireless distribution Wi-Fi and other mechanisms on the way in.

Outside of buildings, on the consumer side, obviously there's an explosion in wireless devices, wireless data. So, we view the longer term development as one in which fiber moves closer and closer to the towers. What we have said is that in general, that the average tower, and this is fairly high traffic tower, had 100 to 200 meg that would be a pretty good size tower, and unless you have a very large footprint, where towers are close by, you are not in a position, where that justifies a build.

Jeff talked about how we're making sure that we don't let opportunities go by. We've got a plan going. We're not going to do something that doesn't get us an attractive return on investment, but over time we think we're very well positioned.

With respect to competition, we will have competition. We always do. However, we like our competitive positioning. We are a neutral party. The average tower has three-plus providers on each. Many of the companies that you mentioned are in pitched battles with the wireless companies over customers. Either they own wireless companies, or they have other services that compete directly.

So, we're viewed as a net neutral party. It's the reason, I would add, that as Jeff said, wireless companies were one of the reasons why we returned to growth in our Wholesale segment. And so that's not divorced from our competitive position. So, we like where we're at. We think there will be a big opportunity overtime and you can expect we'll be focusing on making sure we get a good return on that investment.

David Dixon - FBR Capital Markets

And Jim, you'll be focused on opportunities that reside very close to where your network is today. There won't be significant trenching or activity to kind of build out laterals, which require some significant up front capital with some great [MPV] returns obviously but more in terms of where your network is today?

Jim Crowe

Yes. So I guess the way we think about it is as follows. We have largely moved to a world of converged protocols. IP optical services, Ethernet are the protocols of choice. It's what Buddy Miller, our Head of Strategy used to call IP tone. That IP tone connectivity is common from tower to enterprise building to wholesale location to government location. There are some exceptions, but in general, incremental dollars of investment are all going to that converged IP tone connection.

So when we build, we simply don’t want to build to a cellular tower. We want to pick up wholesale locations, we want to pick up enterprise locations, we want to pick up government locations, content distribution locations, and that's another reason why we have an advantage. We can layer on top all of these demand sets and justify a far better footprint expansion than those that simply want to connect up towers, or simply are building enterprise buildings. So, no, we wouldn't build a major expansion to a single tower, unless it's got an awful lot of traffic. But that's not the model that we're following.

Operator

Our next question will come from Frank Louthan with Raymond James.

Frank Louthan - Raymond James

On the small-medium enterprise side, who are you seeing there as the main competition? I would assume it's still mostly the [bellb], you are running up against. The CLEC’s in some of those markets, and how many contracts do you have for the tower business currently with providers? Just with one major provider, or do you have contracts right now with multiple wireless companies? Thanks.

Jim Crowe

Yeah, I think we haven't said anything publicly about that last, and when we're ready, we'll make announcements. With respect to who we compete with, I think as I believe you would hear from all of the alternative, we’ll call them the CLEC’s, who in general are going to have single-digit market share, we compete with the incumbent phone company. And that's not a surprising statement. We choose to go where we think we have the highest probability of success, which means buildings where we have one, at most two competitors, if it’s a very large multi-tenant building. I assume other competitors make the same choice. So while we maybe in a city with other competitors, the way we and others go to market mean for quite some time we're going to all be competing with the incumbent.

Frank Louthan - Raymond James

And on the content business, what percentage of that revenue is driven by the broadcast TV industry?

Jim Crowe

That's not a simple question to ask -- to answer. If you're asking today what percentage of traffic is long form conventional high quality video, TV programming, movies, and if that's your definition of broadcast, let me ask, is that your definition of broadcast? That is traditional media, movies, television programming, et cetera?

Frank Louthan - Raymond James

Yes, the traditional broadcasting TV networks.

James Crowe

Yes. A lot of movies are owned by studios, who maybe in a conglomerate with broadcasters, but I'll lump it all together, unless you, you're welcome to a follow-up, but I would lump it together and call it traditional media.

The traditional media, last time we looked was maybe 3%, 4% of the views, but a much higher percentage of the bit flow. Let me back up. We estimate and this is an estimate. This is not an easy number to come up with, but maybe 70 plus percent of the traffic on global networks is video today.

If you look in terms of views, the vast majority of that is user generated. That is YouTube style video. Last I looked again it was something like 14 billion views a month of those user-generated fractional screen low res videos.

Growing rapidly, although it did take a pause, when advertising revenues for the traditional guys took a pause, I'm happy to say I've heard [actually] there is a back up, but it took a pause, but coming very rapidly is distribution of traditional media, movies, long form higher quality stuff. That was about 3% of the views last time I looked, but much higher percentage of the unit volume because of the shear size of the objects.

And I would say we're pretty typical. We have got a pretty good share in that market. So, we track the more macro statistics. Does that answer your question?

Operator

That will come from Chris Larsen with Piper Jaffray.

Chris Larsen - Piper Jaffray

If I can move back to the non-carrier trends and just talk a little bit about maybe why you guys are seeing some of the churn up, how long that tail maybe. I know at one point you were focusing on actually some of those lower revenue, off network or lower size customers, and actually allowing that to churn off. Is that part of what the incremental churn is? Or how long should we think about the churn being an extra headwind in your business?

Jeff Storey

With respect to the very small customers, is that part of the churn number, it is, but it's a relatively small piece of the churn number, and not something that we point to internally as a major driver of churn. The biggest driver of churn is then the fact, two facts. One, that we don't have the sales force that distributed around the country that we need to really work with that customer base, and continue to serve that customer base.

And secondly, while we think that our customer experience has dramatically improved, there is a lag effect that customer experience has on enterprise customers in particular. And so those are the two biggest drivers to churn at this point. Both of which were aggressively addressing and improving and seeing the leading indicators that the things we're doing are making a difference.

Chris Larsen - Piper Jaffray

Jeff, I'll just repeat again if you would. How many local markets will we have sales force in by the end of the year?

Jeff Storey

We have some level of sales force in probably 90 markets, but we're aggressively adding sales force in 31 markets by the end of the year. So we have some level that it’s relatively just (inaudible)

Jim Crowe

Yes. I want to emphasize that, if I might, again I said, in an answer to an earlier question that one of the things Jeff brought as a renewed focus on that local sales proposition. I think that those that have a good focus on local sales proposition, all things being equal have weathered the storm a bit better, particularly those that have low market share and are taking share and are less exposed to the macro economy.

Jeff, as you'll recall, was part of building the Cox cable CLEC enterprise, and brings a depth of experience there and not that we weren't working on it, but I think the focus we have on it now is much, much, better. Takes a little time, but again the metrics that Jeff mentioned I think demonstrate some of our early confidence that we'll see real results from this over the next few quarters.

Chris Larsen - Piper Jaffray

That's very helpful. And then Sunit, what was the impact of currencies on the European business this quarter? You made mention of currency, but was it a net benefit, or a net drain when [you’d] look relative to 2Q or 3Q '08?

Sunit Patel

Yes. It was a net benefit, so we reported European revenues were up sequentially, Core Network Services were up 3% on a constant currency basis, they were down 3%.

Chris Larsen - Piper Jaffray

Okay.

Sunit Patel

Now, usually Europe has been a pretty good growth performer, quite consistently, so I think we got hit as Jeff mentioned, a little harder this time with IP pricing. Having said that, we continue to feel very good about that business I think we’re not seeing the kind of churn issues that we've had in the US. They continued to have come up with expansion opportunities and we feel good that they'll be able to grow the business. So we took a little bit of a hit this quarter, but some of it is also, as Jeff pointed out, summer months usually have a little more of a pronounced impact on your usage revenues in Europe, but generally we feel very good about Europe's growth prospect.

Operator

We will move now to Oppenheimer, Tim Horan.

Tim Horan - Oppenheimer

Can you give us maybe your two largest buckets or three largest buckets on your core revenues, what percentage of revenues they are now? And just give a little bit more color on the volume pricing metrics? I know volumes are always very difficult to measure for you guys, but if you can give us some characterization there so we get a better idea on what's going on?

Jeff Storey

I am not sure.

Jim Crowe

By buckets you mean products-by-product?

Tim Horan - Oppenheimer

Yes, special access. IP transport.

Jim Crowe

Yes, the biggest chunk of our revenue is transport and infrastructure, which includes transport, both long haul and metro infrastructure, includes Fiber and Colocation. As Jeff pointed out, generally speaking on the infrastructure side, fiber and colo we continue to see price increases.

On the transport side, I think that for the larger long haul pipes we sell, wavelengths, we see price declines, but on the other hand, the smaller more local metro pipes we think stable to increasing pricing I would say stable in general. So overall, that is the largest bucket of revenue we have probably 40, 50% of a revenue base.

Tim Horan - Oppenheimer

And the volumes on the, sorry 46% in transport and is there anyway to break down transport?

Sunit Patel

Yes, the volumes continue to grow I even during this past year, the volumes have grown. Obviously we got hit hard early in the year by disconnects from people that were putting stuff on their own network as all industry was rationalizing and optimizing, but generally speaking (inaudible) has been good in that area.

Jim Crowe

Yeah. So, just to make -- give some context, we charge generally by the month for all of the services that Sunit just described, and a bunch more. What 90% of our business Sunit is --

Sunit Patel

A visit based, yes. We, except twice a month.

Jim Crowe

Yes, some sort of set price for some set term. So, when one speaks of volume or units, we can see step functions as someone goes from an OC48 to two OC48s, but the traffic within those pipes, we have to interpolate. If you're asking a broader question, we've said pretty consistently, that one it would be awfully nice if the industry got together and agreed on definitions, terms, and ways to measure unit growth. There is no such thing, which is startling, given the importance of the internet to the economy, even.

Two, we and others have said for sometime we think reasonable unit growth estimates are in the very pessimistic, you might think 45, something like that percent annually. If you are more optimistic, you get up into the 65% range. You will find out buyers above that range. We would say generally the trends are towards an increase. You can see this simply as broadband wireless and wire usage and demand continues to grow. But our -- most of our business is not directly usage sensitive.

Tim Horan - Oppenheimer

And now maybe on the IP transport, has there been any change on the growth rate there in the last 12 months?

Jim Crowe

No, actually we I would say, I've gone through a long explanation in previous calls about substitution and all of the other things that affect quarter-to-quarter, but we would say the trends are up, dominated by video distribution, online video distribution. And we've seen no reason to think that unit demand hasn't continued to go up. And I think most carriers would report the same thing. You can hear it anecdotally from all of our competitors that video, video and data for wireless, has just exploded.

Operator

We'll hear now from Ana Goshko and Banc of America.

Ana Goshko – Banc of America

One for Sunit, and then a quick follow-up on something else, but on the maturity profile Sunit, you mentioned that you're comfortable through 2011 now, but if you look a little further you’ve got a particularly big tower in 2013, and wondering how you're starting to think about that. And in particular I think your cost of debt right now is not great by historical standards, but many of your peers, you know, have been hitting the high yield market to address 2013 maturities, because it's open. So in general, how are you thinking about cost of capital versus kind of peace of mind with your maturity profile?

Sunit Patel

I think our approach has always been to be sort of opportunistically and try and move early. And I think if you look at our maturity profile, it looks, as you pointed out, it looks quite manageable through 2012, and in 2013, it does go up. And I think the way we look at it is we try to tap when the market is strong. It sure is strong right now, but, you know, we look at things like how does this impact our interest expense going forward. So when we talk about improvement on the balance sheet, we look at both runway and doing things in a manner that doesn't increase our interest expense burden. So, those are a couple of things we look at, but we continue to look actively at all parts of the capital markets, where there are Windows and we'll continue to do that. Just over the last-year, we've done about $1.1 billion. So, we have been fairly active and we will continue look for opportunity.

Ana Goshko – Banc of America

Okay. Then as a quick follow-up just secondly, I apologize if I'm taking a step back here, but I may have lost forest for the trees some of the detail. On the sequential outlook that you expect better Core Network Services revenue and better EBITDA in fourth quarter, is that largely seasonal because of Vyvx and because of lower cost, or how much of that is actually because you're seeing core improvements?

Jim Crowe

Let me label, as I think Jeff started his talk, I started mine, Sunit started. We remain cautious. We've got guidance, which Sunit reiterated, which implies what you just said. We have, like every company in our industry, and every company in most industries, we're trying to look at seasonality versus the macro economy, versus industry conditions at a time, when the situation in each is literally unprecedented.

That being said, in preparation for the quarter, we always sit down with our business unit's heads, and I would say we echo what most would say, as we see an improvement in the general industry conditions. We, Level 3 tend to sell things that get built into other company's ability to meet their customers' needs.

We've gone through the provisioning cycle Jeff’s talked about at a couple of quarters, that is our customers tend to look out two, three quarters, and talk with us about their needs based on demands for two or three quarters. Obviously when things get tough, they can put that off. Jeff again has talked a lot about running networks hotter.

When things get tight or and/or when the economy improves, we tend to snap back perhaps more quickly than others. We believe we're seeing some signs that that's occurring. I think some of them are just generally observable. On the wireless side, companies are struggling with having enough capacity to meet the demands of wireless data growth.

On the broadband side, networks are stretched, keeping up with customer’s usage, in particular of video. So we believe the fundamentals indicate a return to more historic levels of purchases. We think we're seeing some thawing, so to get directly you have a question, we don't think it's all simply seasonal, but I'll end as I started. We remain cautious.

Operator

We'll move now to Michael Rollins with Citigroup for our next question.

Michael Rollins - Citigroup

I was just wondering if you can give us a little more detail as we think about your new sales strategy. Can you give us a sense of the target market in terms of building that you're going after, or possible tenants, and maybe give us a sense of what kind of share you're starting off with? And then also if you look at the individual segments, is there a way to think about what revenue churn is versus where it's been in terms of gauging the magnitude of what might be the economy effects in the numbers? Thanks.

Jim Crowe

With the customers that we're targeting, the types of buildings that we target, with respect to the buildings, we look for buildings that have high concentrations of customers, or traffic, that are close to our network either on our network or near our network, so that it's easy to build to and cheap to build into. But with the major focus of the buildings that are on-net.

With respect to customers, it's kind of across the board. In the large enterprise segment, we've been particularly successful with the financial services and other customers that need high-performing quality networks, lots of capacity and transmission capabilities. On the lower enterprise segment, it's again, across the board, just matching our products and services to the customers needs. I can't point any specific type of customer. But we don't go really low into the market, it’s a very, very low end of the market. The customers then spend 2, 3, 4, $5000 a month and up is the target that we're looking for.

Jim Crowe

And with respect to your question about churn, happily, as both Jeff and Sunit mentioned, churn did improve. Again, we're cautious, but at the bottom, churn in certain segments was two, three times what it had been historically. Now, that depends on the segment, by customer, by product, but two, three times what it had been historically.

Jeff Storey

Yes, I think one point I would say, Michael, is that, compared to the environment in the first half of the year, where most of our customers, most of their mind share was occupied with managing their current base of spend and finding efficiencies there, we're seeing a shift in terms of mind share, where they're now focused quite a bit more on their needs, as opposed to just focusing a lot of their time on where do I cut my base of costs. So, we are sensing that shift obviously that doesn't benefit us right away, but just in terms of the discussion with customers, their mind share has shifted over the course of the year, positively, I would say.

Michael Rollins - Citigroup

And with respect to Wholesale Markets Group, I think you –

Jim Crowe

That's responsible at least currently for the shift from second quarter to third quarter.

Operator

The next question will come from Michael Funk with Banc of America.

Michael Funk - Banc of America

Yes. I think you had highlighted earlier that sales force is one of the primary drivers of churn, and then you also highlighted you will be launching 31 new local market initiatives by year end. So, how should we think about the sales force productivity ramping in 2010, if you gave some metrics around the earlier markets, and then, second, on the network augmentation that you highlighted. I think this may have come earlier than maybe whatever cautious assumptions that you were including a couple of months ago. So is this [more] than expected, and then finally, was this ramping coming out of third quarter, end of fourth quarter so should we expect more augmentation through 4Q into 2010?

Jim Crowe

Jeff, you want to take that first question, and I'll try on the second.

Jeff Storey

Okay. How to we see the sales force ramping and productivity ramping. First of all the 31 markets aren't 31, in addition to the ones we've already launched. 31 include the one that we've already launched just to make that point clear.

Secondly, it takes us somewhere between six months and nine months to get somebody fully up to speed from a productivity. There are certainly people that we can get up to speed after a couple of months that have more experience, or have a better existing customer base that they bring with them, but on average it's a six to nine months ramp, and that's how you should think about productivity increases.

Jim Crowe

Yeah, as not from zero up to full productivity...

Michael Funk - Banc of America

Right.

Jim Crowe

…but it's certainly from half or less of full productivity up to full. With respect to broad industry requirements for network augmentation, you're asking a fairly speculative question there that's not easy to address with certainty. In general, 80% of the demand we address, 75, 80, and by the way, this is true of the industry in terms of units, at least our analysis and others that I've seen would support this, is created by broadband wireless and broadband wired.

That is, an individual accessing the network with the broadband wireless connection, or a broadband wired connection. And at the other end, servers, owned by traditional and new media search, social networking, portals, e-commerce, with a real emphasis on media, since that form of traffic has such an inordinately large object size. That's 80%, give or take, 75% of the demand. I already went through the ability of those who meet that at both ends, to defer purchases for a fair period of time.

Jeff went into a great amount of detail, I think, in the first or second quarter, about how individual companies can manage around a hotter and a hotter network, and then go for quite a long time until all of a sudden they can't. When that occurs, it starts to create brand challenging events. It starts to really affect customers.

When an individual company makes a decision to say, okay, this is starting to affect my customer experience, and then starts to head down the augment path, is no simple matter, and it isn't the same across the country. All we would say is, we think it is not an inside industry matter that networks are strained because of wireless data, another word for that is media.

If you look at the wireless companies reporting, they talk about text-based 3G broadband and non-text based, and it's the non-text based, it's media, it's iPhones and their (inaudible) that's driving this in part, and then Apple TV, ROKU, and Amazon on-demand, user generated video to the wired broadband.

We think that's visible. How quickly that occurs, who puts it off, all we can say is we're talking to more people, more of the time, as Sunit said, people are far or less interested in and looking internally at cost cutting, and far more interested in talking about expansion. Some quite publicly and visibly, particularly on the wireless side, past that, I just don't think we can be more specific.

Operator

We'll hear now from Jonathan Chaplin and Credit Suisse.

Jonathan Chaplin - Credit Suisse

I wonder if I could just go back to the Wireless Backhaul opportunity very quick quickly. This might be more granular detail than you're able to provide, but it would be great to know, roughly how many towers are sitting on your fiber today, and what the revenue opportunity is there, and then if you look beyond that, at the towers that are economically addressable, based on current demand levels.

What the incremental opportunity could potentially be. We're just hearing consistently from the carriers that they would really welcome an independent backhaul provider, and that of all the likely candidates, no one is really stepping into that market aggressively. So, it just seems like it should be a big opportunity. Thanks.

James Crowe

I mean I would agree with you it's a big opportunity over time. Some of the complicating factors are up until recently, and even today, each carrier attempted to address its tower backhaul needs individually. Even now and the much publicized RFPs that are out on the street, its individual service providers attempting to address their tower backhaul needs.

The average tower, as I repeat, has over three service providers. So, answering the question has a lot more to do with aggregating or integrating demand and answering RFPs. The RFPs are not surprising. There are real problems with tower backhauls. So, carriers are trying to stimulate our side is of the business to build where we possibly can. We're trying to meet that opportunity.

But if you're asking broadly what is the opportunity in the tower backhaul today? I would say I mentioned earlier, a big tower might have a 100, 150 mega bits of capacity. That's one OC3 that's. If we hook up a corporate data center, that is measured, the demand out of that is often measured in orders of magnitude higher numbers than that 10, a 100 times as much.

And there are well over a 100 corporate data centers which have a single provider, typically the local incumbent. So we think the question is upside down. The question ought to be, how do we build an IP optical infrastructure that meets all of the demands for that kind of connectivity, which are enormous. Our industry underinvested in meeting that demand and along the way pickup as many towers as you possibly can.

That's the right way to ask the question, and that's the way we're trying to ask ourselves. There is a understandable focus on tower backhaul, because it’s consumer product that has real problems today much publicized. But keep in mind that it was only a short period of time ago that wireless data was speculative. People wondered whether the US consumer would even want that kind of device.

That was only a few years ago. It was only a few years ago that one meg to the home was questioned as being way too much. Now we've had an explosion, and the simple fact is there is not an IP optical infrastructure in place to meet that demand, which has moved out of the central business districts. That's the question we keep asking, and that's the opportunity we think we're better positioned to deal with than virtually any other company. Next question?

Operator

We'll move now to [David Sherritt] with Barclays Capital.

Unidentified Analyst

First just want to ask on M&A, I mean obviously in July when you saw a consent on the 12.25 that was something that was on your mind at that time, and there's been various discussions in the press of different processes potentially have been taking place or thought of earlier in the year, just your thoughts on where we are now, kind of your focus on I know has always been there I know it's a long-term option, but near-term opportunities in the current environment?

Jim Crowe

I would say the environment with respect to the principals of the companies involved is probably more realistic and there's more recognition that consolidation will continue than has been in the case in quite a long time. The issue has been the capital markets support and deciding what a particular asset is worth.

Ana Goshko mentioned, the capital markets seem to be getting far more friendly. That's been our observation. When the economy collapsed, any individual institution or person's ability to price a dollar or cash flow that occurs in the future, to discount it back to today, that is to understand the price risk, and the price cash flow became very difficult. Big battles about multiples, big battles about what assets were worth and cash flows worth.

That I think people are converging now to a more common understanding. We get those three things in place, the right mindset on the part of principals and the industry, supporting the capital markets, and common views of value, and I think the necessary product heads to consolidation are going to increasingly be there.

Unidentified Analyst

That’s helpful in terms of M&A. If I can add just one other question with regard to just the SG&A and cost base as we get into the fourth quarter. You talked about in terms of the SG&A obviously seasonally higher level in terms of utilities. Do we sort of stay at that level seasonally high. Is this a good base in terms of that seasonality as we go into the fourth quarter, and then just the impact of the additional sales force you talked about at length on the call. What sort of incremental impact does that have to SG&A as we get into the quarter and think about the run rate going into next year?

Sunit Patel

Yes, the seasonally higher expenses for utilities will go down in the fourth, as they have, so our SG&A should improve on that score. Having said that, we are adding sales people, as we pointed out. Now over the last few quarters, we have managed that well by managing other expenses tightly, but I think looking forward over the next year, the addition of more sales people, we'll try to manage that as best as we can with our revenue performance.

Jim Crowe

All right, well. Thank you all for listening, and best of luck to us all. Operator, that ends the call.

Operator

Thank you. This concludes today's Level 3 Communications Incorporated Third Quarter 2009 Earnings Conference Call. Thank you all for attending

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Source: Level 3 Communications, Inc. Q3 2009 Earnings Call Transcript

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