Level 3 Communications Q2 2010 Earnings Call Transcript

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Level 3 Communications (NASDAQ:LVLT)

Q2 2010 Earnings Call

July 27, 2010 10:00 am ET

Executives

James Crowe - Chief Executive Officer and Director

Jeffrey Storey - President and Chief Operating Officer

Sunit Patel - Chief Financial Officer and Executive Vice President

Valerie Finberg - VP of IR

Analysts

David A. Sharret

Colby Synesael - Merriman Curhan Ford

Donna Jaegers - D.A. Davidson & Co.

Michael Funk - BofA Merrill Lynch

Michael McCormack - JP Morgan Chase & Co

Ana Goshko - BofA Merrill Lynch

Frank Louthan - Raymond James & Associates

Michael Rollins - Citigroup Inc

Simon Flannery - Morgan Stanley

Jason Armstrong - Goldman Sachs Group Inc.

Operator

Good day, and welcome to the Level 3 Communications, Inc. Second Quarter 2010 Earnings Conference Call. [Operator Instructions] And 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, Latana. Good morning, everyone, and thank you for joining us for the Level 3 Communications Second Quarter 2010 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, as a reminder, our press release, supplementary information and presentation slides that accompany this call are all available on the Level 3 website at www.level3.com under Quarterly Financials in the Investor Relations section of the website.

I need to cover our Safe Harbor statement, which can be found on Page 2 of our 2Q10 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.

Finally, 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. I will now turn the call over to Jim.

James Crowe

Thanks, Valerie. As is our normal practice in our prepared remarks, we'll start with Sunit Patel, our CFO, who will discuss some financial results for the quarter. Sunit will turn it over to our COO, Jeff Storey, who will discuss sales and operational matters, including segment results. I'll provide a bit of a summary and some context, and we will then take questions. Sunit?

Sunit Patel

Thank you, Jim, and good morning, everyone. I'll start with the summary of the quarter. This highlights on the presentation on our Investor Relations website, Slide 3. Core Network Services revenue grew 1.3% sequentially on a constant-currency basis, excluding the $7 million asset sale in the first quarter. We continue to expect sequential Core Network Services growth for the rest of 2010. Core Network Services sales grew by 2% sequentially in the second quarter on top of the 15% sequential growth we saw from the fourth quarter of 2009 to the first quarter of 2010.

Churn remained relatively stable this quarter compared to the first quarter. We saw consolidated adjusted EBITDA growth during the quarter, driven by improvement in our cost of sales and better SG&A performance. Our sales force increased by over 2% in the quarter, and we ended the quarter with 509 quota-bearing salespeople. With the increase in sales in the previous quarter, our capital expenditures increased to $104 million in the quarter. Overall, demand for our services is healthy, and we remain focused on sales growth and execution in turning up service.

Turning to the detailed results for the second quarter on Slide 4, Core Network Services revenue was $699 million, up 1.3% sequentially on a constant-currency basis. Core Network Services revenue from wholesale was $342 million, up 2% sequentially. Large enterprise and federal grew 4% sequentially to $142 million.

Mid-market's revenue declined by 3% sequentially to $146 million in the second quarter. We saw declines in voice usage and churn outpacing installs in the quarter. However, we are encouraged by the over 30% increase in sales in the quarter and expect better revenue performance for the second half of the year.

European Core Network Services revenue grew 3% sequentially on a constant-currency basis but declined by 3% on an as-reported basis as a result of the decline in the euro and the U.K. pound.

From a product perspective, on a sequential basis, we saw strong growth in Wavelength and Colocation, or data center revenues. Our CDN, or Content Delivery Network revenues, were up 18% sequentially this quarter. Our Broadcast revenues are up 5% sequentially. Wholesale Voice Services revenue was $163 million this quarter compared to $165 million in the first quarter of 2010 and $171 million in the second quarter last year. We expect continued volatility in Wholesale Voice Services revenue as we manage for margin contribution versus revenue growth.

Turning to Slide 5, gross margin was 59.9% this quarter compared to 58.8% in the first quarter of 2010 and 59.1% in the second quarter of 2009. The sequential improvement in gross margin is a result of continued network optimization, improved margin mix and dispute settlements in the quarter. Dispute settlements were about $1 million in the quarter.

Communications SG&A expense, excluding non-cash compensation and restructuring charges, was $324 million compared to $327 million in the first quarter of 2010. We expect SG&A to increase next quarter as a result of the typical third quarter increase in utility cost. However, outside of this seasonal increase, we expect SG&A to remain relatively flat for the rest of 2010. We continue to invest in sales, sales support and service delivery resources and manage expenses in other parts of the business.

Turning to Slide 6, consolidated EBITDA. Adjusted EBITDA was $209 million in the second quarter of 2010 compared to $200 million in the first quarter of 2010 and $229 million in the second quarter of 2009. Communications' adjusted EBITDA margin was 23.4% in the second quarter of 2010 compared to 22.4% in the prior quarter. Communications' adjusted EBITDA margin was 24% in the second quarter of 2009. Going forward, adjusted EBITDA performance will primarily be driven by the net change in CNS and other revenues.

At the bottom of Slide 6, capital expenditures were $104 million in the second quarter of 2010 compared to $82 million for the first quarter and $80 million for the second quarter of last year. The increase was driven by the 15% increase in sales in the prior quarter that led to an increase in install activity in the second quarter.

Turning to Slide 7, unlevered cash flow was $102 million in the second quarter of 2010 compared to $51 million in the first quarter. Unlevered cash flow was $146 million in the second quarter of last year. Free cash flow was negative $19 million for the second quarter of 2010 compared to negative $90 million in the first quarter of this year and positive $20 million for the second quarter of last year.

As you can see on Slide 8, during the quarter, we redeemed $172 million of the 10% convertible senior notes, which were due in 2011. After the close of the quarter, we paid off the remaining $38 million of the 2 7/8 convertible senior notes at maturity. As of June 30, 2010, we had $442 million of cash.

Our next maturity is on December 15, 2011, where $196 million of the 5 1/4% convertible senior notes come due.

As always, we will continue to be opportunistic with capital markets and liability management activities that improved our liquidity and debt maturity profile. Depreciation and amortization expense was $223 million in the second quarter of 2010 compared to $225 million in the first quarter and $228 million in the second quarter of 2009.

In summary, we feel good about the environment and our opportunities to grow the business. The pricing environment continues to be stable, and we believe we can grow revenues in support of the increases in bandwidth demand that our customers are experiencing. We continue to expect sequential increases in Core Network Services revenue for the remainder of the year. With that, I'll turn the call over to Jeff.

Jeffrey Storey

Thank you, Sunit, and good morning, everyone. We're pleased with the performance of the business this quarter and that our investments for growth are generating results. We saw CNS revenue growth had another quarter of sales growth and the sales funnel remain strong.

We continue to invest in sales and sales support resources and had over 500 quota-bearing headcount at the end of the quarter. We believe we are well positioned to take advantage of the many opportunities we see to support our customers.

Turning to the results by market group, we had a strong quarter in our Wholesale Group. Excluding the one-time asset sale I mentioned in the first quarter call and explained in the press release, we grew Wholesale CNS revenue by 2%. Wireless continues to generate strong revenue growth as we support our customers requirements to keep pace with the explosive growth in wireless data.

We also saw sequential growth in cable and international carriers. As we look at the rest of the year, we expect to see good performance from wholesale customers, offset by some degree of continued pressure from incumbent telcos' network grooming initiatives.

As we previously discussed, CDN services have transitioned from a startup effort to become part of our standard product portfolio. As a result, a large portion of our CDN business is now included in wholesale results. We did see CNS revenue growth during the quarter from our content customers, specifically media, entertainment, satellite and sports, as well as growth in CDN revenues.

Our Large Enterprise and Federal Group continues to deliver strong results and grew CNS revenue 15% year-over-year and 4% sequentially. For our Large Enterprise customers, we are seeing growth from the existing customers as we expand the number of services we sell them while also adding and growing new customers. We've been very successful delivering our standard services to this customer group to meet their growing networking requirements whether for data center connectivity, data networking, voice services or high-capacity scalable IP-based services.

An example of this is Blue Cross Blue Shield who provides healthcare insurance for 39 individual plans nationwide. Blue Cross is a significant customer of Level 3. HealthNow, the Western New York franchise for Blue Cross Blue Shield, is the most recent to select Level 3 as their primary carrier for voice and data services. Level 3 is helping HealthNow migrate to a more efficient and powerful converged network for voice, video and data based on MPLS technology. Seeking a better customer experience from their network provider, HealthNow selected Level 3.

Excellent referrals from other healthcare customers, our willingness to build diverse direct access to their data centers and our long track record of supporting the world's most sophisticated network operators were all factors in the selection of Level 3. We've seen similar results from our federal customers, with solid year-over-year and sequential growth. We have responded to a significant number of RFPs that are pending award and feel we are well positioned for these and additional opportunities based on Level 3's strong IP-based set of services and diverse network footprint.

One example of the success we've seen in growing the Federal business is the recent win with the Social Security Administration. To connect their data centers, these customers needed a highly reliable network provider who could scale to meet the needs of their business. Level 3 was selected to support this mission-critical initiative based on our core competency as a solutions provider in building, delivering and maintaining state-of-the-art fiber-based communications services.

The multiple 10-gigabit wavelength solution offers the Social Security Administration highly available geographically diverse optical network paths [ph] (18:12) between the data centers that are part of this important project. This contract demonstrates how Level 3 services are well aligned with the federal sector, and we believe we have the opportunity to leverage those capabilities with additional federal agencies.

In the Mid-Market Group, as I said on the first quarter call, we expected to see a quarter or two of revenue decline due to continued account cleanup, but then we have largely turned the corner on revenues for this group. Churn did pick up slightly during quarter and disconnects outpaced revenue from new installs. However, Level 3's mid-market approach is resonating with customers in local markets across the country. Based on our local presence and the strength of Level 3's product portfolio, we saw a healthy pick up in Core Network Services sales during the quarter.

CNS sales from mid-market customers increased 10% from the fourth quarter 2009 to the first quarter 2010, and grew by more than 30% from the first to the second quarter of 2010. In fact, we have grown mid-market CNS sales month over month, every month since the beginning of the year. As a result, we have a healthy pipeline of contracts to install and we expect revenue performance to improve in the coming quarters.

We had a great quarter in the European business, which grew 3% sequentially on a constant-currency basis. In particular, we saw growth from financial services customers for taking advantage of our low-latency services. Additionally, we've seen growth from our broadcast customers and a nice increase in demand for our trans-Atlantic routes from across the customer base.

Turning to pricing, we're pleased to report that the pricing remains relatively stable across the board. As has been the case for the last several quarters, pricing for IP and CDN services has been more aggressive than for other services. The price compression even for these services has moderated since last year.

While our service delivery capabilities remain strong, we are experiencing supply chain challenges from equipment suppliers and off-net vendors. As reported in the press, we see evidence that these shortages are industry-wide. We will continue to manage these issues aggressively, working with the supply chain to ensure we have the equipment and the off-net capacity needed to deliver our customers' requirements.

In summary, we feel good about the business. We have a healthy level of signed but uninstalled orders, and the sales funnel for future orders is strong. With that, I will turn the call back over to Jim.

James Crowe

I think Sunit and Jeff have done a good job of summarizing the quarter and the general outlook for 2010. I'd like to add a bit more context.

Over the last several quarters on each of these calls, from the period starting in the late 2008 time frame through late 2009, we said customers had purchased services at volumes significantly below historical levels, and we believe that this level of purchase was inadequate to meet underlying growth in demand, particularly from wired and wireless broadband consumers, which we believe is the substantial portion of incremental demand for bandwidth. Said differently, our customers were using up the normal margin of safety that service providers had historically maintained.

In the fourth quarter of last year, we indicated that we saw evidence that the industry had reached a point where deferrals were beginning to affect the user experience. Much of this has been reported in even the general press with wireless providers, but we also believe it's affecting the industry broadly.

Today, we believe that evidence is even clearer and a lot more widespread, as Jeff mentioned, and as the Wall Street Journal reported, equipment suppliers are struggling to meet demand. This is often a leading indicator of our industry's direction. We believe that this situation, that is the shift from a supply to a supply-constrained environment throughout the bandwidth supply chain from applications and media providers to wired and wireless broadband consumers, is likely to be with us for quite some time.

Overall, we think this is a positive for the industry for Level 3. However, I'd point out that results like are rarely [ph] (22:47) linear. There's going to be volatility, perhaps exacerbated by some of the supply chain choke points that Jeff described. However, we are even more optimistic today than we were even a quarter ago about both the clear and growing demand for our services and about our ability to meet that demand.

With that, we'd like to open up for questions and answers. Operator, would you explain the process, please?

Question-and-Answer Session

Operator

[Operator Instructions] And our first question today will come from Mike McCormack from JPMorgan.

Michael McCormack - JP Morgan Chase & Co

It sound like you're experiencing pretty good change in demand trends by segment. Can you just walk us through sort of the middle market versus large enterprise, what you're seeing at the ground level? Is it a pipeline that's been sitting there that's now starting to flow again? Or is it actually new customers coming in the door? And then secondly, if you can identify what, if any, what the CPE impact during the quarter?

James Crowe

On the first question, Sunit, you're going to handle the second question?

Sunit Patel

Yes.

James Crowe

The first question, I'll start with an overall. Jeff, if you want to comment, please do. Let's divide our customer base into two pieces. The large consumers of bandwidth, access providers, if you would, wired and wireless broadband providers at one end, and the application and media suppliers at the other. And there's a wide range of both, particularly on the application and media side. Jeff gave some color about that. But on that end, we have social networking, paid search, we've got portals, we've got gaming, video is a huge driver. In those cases, we do see new logos, those new companies that are developing, that have a great idea. But the majority of the demand is coming from our large customers, 200, 300 of them that buy something every month, every quarter, and our serviced by a substantial account staff, if you would, depending on their size. As I said in my remarks, and I think Jeff repeated over and over, over the course of 2009, that group stopped buying. We believe there is every bit of evidence that, that can't continue, it's not continuing, and we see it in our sales funnel. The balance of our business, perhaps 25% of industry demand, if you would, is enterprise, it's large and medium. Large enterprises are a hot area for us, double-digit growth. We see no end in sight. That area is being driven by the factors that Jeff mentioned, a clear trend to concentration of processing and storage of information, sometimes referred to as the Cloud, if you would, more and more concentration and outsourcing, a whole broad range of fundamental trends. We think we're really well positioned to meet that demand. Medium business, the middle market, that's up to us. That's a business that we have a very small market share on, where we restructured the company to meet that demand. And Jeff quoted to you the sales statistics, that is signed order statistics, up substantially, 30%, first quarter and second quarter. We had a lot of account cleanup and rationalization to do, took a little bit longer than we thought. But as Jeff said, we think we're at or near the end of that process. Sunit?

Sunit Patel

Yes, CPE is not really a factor for us. I know it is for some of the other guys, so really, CPE is not meaningful at all for us in terms of dollar size or revenues. So it's immaterial.

Michael McCormack - JP Morgan Chase & Co

Sunit, I just wanted quick one on the deferred revenue. I'm assuming it's a net amount. Are there positive offsets to the deferred revenue declining balance?

Sunit Patel

Yes, I mean, $5 million of the $15 million decline is FX related. The rest is what I describe as normal ups and downs on our deferred revenue balance. If you look at that deferred revenue balance every quarter for the last couple of years, it fluctuates to within a plus or minus $20 million from an average. So it's in the range. I mean, we generally have continued to keep up with cash IRU sales that match our deferred revenue, I meant, non-cash revenue recognition or amortized revenue. So no issue there, it's just normal quarterly fluctuation.

Operator

And we'll move next to Colby Synesael with Cowen and Company.

Colby Synesael - Merriman Curhan Ford

I just wanted to talk more about the cost cutting or the improvement in the margin. You noted network optimization and product mix is two examples in terms of where the margin benefits are coming from. I was wondering if you can give us a little bit more detail around that.

James Crowe

Sunit?

Sunit Patel

I mean, network optimization is a continuous effort for us. Obviously, it's not always smooth, there are some lumpiness, some quarters are better than others. Clearly, that was part of the case this quarter. The margin mix, I think if you look at our CNS revenues that we reported on a product basis on our website, you'll see we had a growth in the higher-margin CNS revenues and declines in the lower-margin CNS revenues like enterprise voice, for example. So there's some margin mix benefit there. We had a little bit of margin mix benefit in the Wholesale Voice business, a little less international voice, a little more domestic voice. So most of it is network optimization and some of it is then margin mix.

Colby Synesael - Merriman Curhan Ford

And then network optimization, is there more to do, is there more margin to get out of the business? Or is it more now based off of growth trends going forward?

Sunit Patel

I think that is a continuous effort for us. I would say that if I look back over the last years, we thought we were largely done after we bought all these companies in the period '07, '08 and some '09, but it is an area that we continue to realize benefit as we leverage more and more on that footprint and spend capital expenditures to reduce network spends. So based on from benefit basis, it's ongoing, I would say.

James Crowe

And I think we point out, as we always do, that a return to growth, and as Sunit said, we expect to continue growing for the balance of the year with the kind of incremental margins we have in CNS, which have been right around 80% incremental margins, that in and of itself, indicates we expect margin expansion. And we've said our goal is to get back to the same level of quarterly increase in revenues that we saw prior to the financial crisis, and that was at least 2% a quarter. At that kind of rate, we'll see nice margin expansion, and that's what our clear goal is.

Colby Synesael - Merriman Curhan Ford

So it's not just the sequential improvement in growth that we should be looking but also the 59.9% gross margin, for example, that you referenced, that should also continue to go up as well?

Sunit Patel

Yes, I think. And that is being driven by, as I've said in my remarks, the net change between CNS revenue growth and other revenue decline, the net change of that, obviously, that equation hasn't worked well for us in the last couple of years, but we are sort of at the point where the growth in the CNS revenues would exceed the decline in other revenues. And as that happens, revenue dollar, or revenue we had, we expect to have that at a higher gross margin. As Jim pointed out, our current gross margins are close to 60% for every new dollar of net revenue average is the difference between plus CNS revenues or minus other revenues we think will contribute at about an 80% incremental gross margin.

James Crowe

And just for reference, I'm sure most will remember this, but at one point, we had about half our revenue was in the other revenue column, SBC contract and dial-up access to Internet. That is what percent now, Sunit?

Sunit Patel

It's down to about 3% to 4%.

James Crowe

Right. So it's just math that would say, that delta between CNS growth and other decline, that math is working on our favor now, and that would indicate margin expansion if we continue to grow.

Operator

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

Jason Armstrong - Goldman Sachs Group Inc.

First, on the free cash flow trajectory, if we can look at sort of the trailing four-quarter average here, it's close to flat. I know you guys said in the presentation, 2010 in total is expected to be I think be slightly negative. As we look forward, what sort of time frame should we think about to be firmly back into positive territory in free cash flow? That's the first question. And then second, just on the mid-markets initiatives, can you give us a little bit more of a deep dive in terms of the progress there? I know you mentioned churn trends ticked up a little bit this quarter, that seems like it's fairly temporary in nature, but can' you speak to the competitive activity?

Sunit Patel

I'll take the first question and Jeff can take the second one. So I think on the free cash flow trajectory, we said last quarter that we expect to be negative this year. We had a $20 million one-time settlement that we talked about in the previous two quarters. In the first quarter, we are obviously, with sales orders going up, we are spending more CapEx. So I think the answer to your free cash flow question depends on sort of the trajectory of the revenue growth in terms of the slope of the revenue growth. If the revenue growth picks up pretty sharply, we obviously have to spend more capital. But I think the key thing we are focused on is revenue and EBITDA growth and at the same time, keeping an eye on free cash flow. So it just depends on the trajectory of the revenue growth is the key right now. But I think this year, as we've said, and as we've said in the presentation, we expect to be free cash flow negative. We'll have more to say about free cash flow next year when we get to that point. It depends on the revenue trajectory.

Jeffrey Storey

With respect to mid-market, we're very pleased with the progress that we're making. We've talked a lot about our go-local initiative and how we're orienting our sales force and hiring general managers in each individual territory to manage these businesses on a more local basis. We've aligned our operational and field services support to create a local field for the company, which we think is resonating very well with our customers. And as a result, we're seeing the growth that we've talked about. We've had a 30% increase in signed orders from the second quarter to the first quarter. So we're very pleased with the growth that we're seeing. From a competitive perspective, there are a lot of good competitors out there, but we have a very low market share. And the ability to win in this business is based from our execution, not that of our competitors. So we're very pleased with the progress we're making and think that our sales results are starting to show that progress, and expect to continue efforts to escalate and accelerate that growth.

James Crowe

Yes. Jeff's point about competition, maybe worth expending a bit on. In this case, it's a micro market. This isn't like large enterprise or federal where you have a number of competitors each competing for the same service. Here, what matters is building by building, customer by customer, but typically by what they need on some cycle measured in two, three years, perhaps. They're not in the market everyday. And when you think about the market in that sense, our goal, like other CLECs, if you would, those are the ones that the competitive CLECs, is to go where we compete with the incumbent, not where we compete with other CLECs. There's just too many targets. I'm not saying there aren't situations where it doesn't occur, or there are many situations where we do have only two competitors, ourselves and the incumbent, and that's by design, that's the goal. When you have 2%, 3% market share, it means there are plenty of targets where the incumbent is the competitor. I believe you'd hear the same thing from others who have local facilities and local sales. Next question?

Operator

We'll hear now from Frank Louthan from Raymond James.

Frank Louthan - Raymond James & Associates

Can you give us a little update on your Data Center business? How much floor space do you have to sell? I know you're seeing that as an increasing part of the business coming out of the enterprise. And then can you give us a little bit more color on the sort of the Mid-Market thing? The sales are up nicely, but how should we think about the installs and how long does it typically take to get the sales translated into revenue?

Sunit Patel

I'll take the data center question. I think we have quite a number of facilities across the U.S. and Europe. We were pretty good handle at the amount of space. We have, in some cities, we are getting close to filled up. In other places, we have space. The bigger issue is power. We have to look at power limitations and it's different for every city. In some cases, it's things like the time it takes for utilities to bring in power to you; in some cases, we need to upgrade our power infrastructure in terms of heating, I mean the cooling capacity and the generator battery capacity. So we have a fair bit of space and power with some level of incremental investment to turn that into usable data center space, and we are looking at that. Obviously, one of the big things for our European business in terms of their growth over the last five years has been the growth in the data center business. We have been growing essentially -- our overall collocation, or Data Center business has been growing at double digits every year over the last years. And now we are at a point where with some investment, we can keep that going and we are looking at that.

James Crowe

This is a matter of some strategic importance. We're doing the review that's largely completed. We'll make some decisions here in the coming months. Our Data Center business would be one of the larger collocation Data Center businesses in the industry if it were standalone. It's a big opportunity for us. We want to be sure we take advantage of it properly. Jeff?

Jeffrey Storey

With respect to the Mid-Market question on sales and install, I'll answer the question and then tell you that, in general, my answer is accurate, never in specifics. We look at our turnouts and how long does it takes to convert from an order to revenue. It's somewhere in the 30- to 45-day range, but that's a general answer. When you look at specifics, it depends on the customer requested due date. The customer may request 60, 90 days, or sometime in the future and we turn it up with the first goal of meeting the customer requested due date. It also depends on the service type and whether it's on-net or off-net. If we have an on-net Ethernet circuit, it's going to be much easier for us to turn up than an off-net Ethernet circuit where we have to rely on somebody else to provide the tail circuit. So in general, 30 to 45 days, but specifically we look at other factors more.

James Crowe

And I'd add, to turn into revenue, if you thought about everything being turned up on average in the middle of the month and you've got another 25 days or something, 15 to the end of the month, 10 to the billing. So if you thought in terms of that 30, 45 days plus 25 to the point at which we bill, you'd have a reasonable interval, something like that, 60, 70 days from the signed order to the point at which it generates revenue.

Frank Louthan - Raymond James & Associates

And just one quick follow up on the Data Center business. How much of your -- what percentage of your floor space do you feel you need to upgrade? What would the capital cost in that be in? And looking at this business, is there any aspect of this that you might consider monetizing? It's obviously good M&A market for this to pay down some debt or something like that? Or are you comfortable with how much floor space have right now?

James Crowe

As I said, we're right in the middle of a fairly detailed strategic assessment Sunit and his group are working on. And I think that's about all we will stay right at the moment ago. Next question?

Operator

We will hear next from Simon Flannery with Morgan Stanley.

Simon Flannery - Morgan Stanley

Jeff, I wanted to come in to the commentary around supply chain challenges if I could. Just, can you just be a little bit more specific about what parts, what types of equipment? Is this limiting your ability to grow in any particular areas? And do you have any visibility into this improving? And then, Sunit, just staying on the CapEx theme, is this quarter's level sort of $100 million, give or take, is that sort of a good run rate for the rest of the year given your expectation of continued revenue growth going forward?

Jeffrey Storey

We'll start with the first question on the supply chain. It's been widely reported in the press that there are component-level issues, ASICs and other things that go into all telecommunications equipment, whether it's optical gear or wireless gear or handsets for wireless companies. The same type of components go into those things. So we've seen supply chain bottlenecks on cards and on chassis, and on the various components that we use to turn up services. We have worked very closely with all of our vendors, giving detailed forecast of our demand and working with their executives to make sure that they're delivering on our demand. As one of the largest providers in the industry, we have great relationships with those companies, and expect to be responded to and have our needs responded to aggressively. And so we're spending a lot of time working on this. We think it's industry-wide, but we think we're going to be in a better position to deal with it than maybe some others in the industry.

James Crowe

That's the right point. It isn't that we aren't going to be affected. It's our goal is to be affected less given our -- the sheer volume of what we install, we think we're, if not the biggest, one of the biggest 10 gig, 2.5 gig IP providers in the industry. So we have a lot of buying power and our goal is to make sure that we have a relative advantage.

Sunit Patel

Back to your question then on revenue growth, obviously, we feel comfortable with our ability to grow C&S revenues and that's why we said that last quarter and reinforced that this quarter, so I should say that. And then on the other question you had on CapEx, I think that the capital expenditures in the second quarter might be a good indicative run rate. Obviously, it depends on how things go for the rest of the year, but plus, minus, P [ph] (43:41) I think that's a reasonable run rate for right now given the strong increases in the sales. As we mentioned, sales are up again a little in the second quarter compared to the first quarter.

Operator

And we'll move now to Michael Rollins from Citi Investment Research.

Michael Rollins - Citigroup Inc

One of the themes that has come out so far in some of the earlier results calls has been network grooming by some of the larger carriers. And I think you referenced that as one of the issues affecting wholesale in the quarter. The other thing also which is kind of interesting, some companies pricing up certain routes. I think they were more internationally based where the margins were lower. Can you give us some sort of sizing impact and maybe duration impact in terms of how we should think about grooming in the effect to your Wholesale business? And then secondly, are you seeing any benefit, or any changes to your approaches to the market based on some of these price changes on routes?

James Crowe

Are you indicating, on your second question, that on these routes, prices are up? Is that what you're saying?

Michael Rollins - Citigroup Inc

So a couple of the carriers have cited weakness in parts of their revenue by losing share, or losing revenue because they priced up a couple of these routes, or wholesale voice products that they weren't making a lot of money on. So that was sort of the indications from a couple of the carriers reporting so far. I don't think it was a big number, but it was just an impact into the portfolio of revenue.

James Crowe

All right. So with respect to your second question, Wholesale Voice, I think we've said, if that's what you're referring to, Wholesale Voice for a long time, we've indicated we price for cash margins, and it's going to go up, it's going to go down. We think we have a structural advantage over other competitors because one way of saying it is we are within a local phone call of over 90% of the population of the United States with our own facilities. Those facilities have been built up over the last 10 years or so, and it's expensive interconnection directly with the local telcos. That means we have a big cost advantage and as a result, it's a good cash business. But as we repeatedly say, it's going to fluctuate up and down, we manage it that way. I can't comment on other carriers, but they'd have to indicate their own margin structure. But it's a good business for us. It's a component of other businesses, but we would wouldn't expect to see that as an enormous contributor of gross margin. With respect to your first question, grooming by carriers and it's a fact. This is nothing new. It's been something we've dealt for the last, well, since we started the company. There is a balance, there is business comes in on top of the bucket, and there's business grooming that goes out of the bottom. That balance is roughly the same, and you see some quarterly fluctuations. But the fundamental answer to your question is what are gross margins in the industry by service provider. And we don't see any evidence that there is a giant structural change in the percentage of revenues that service providers, the big service providers pay out. They're still buying enormous quantities. There is a big plus that is coming quickly from tower backhaul, from connecting mobile switching centers and from connecting the content side to those companies. That's offset by their network grooming. And in any given quarter, the balance between that plus and minus can go up or down slightly, but we don't see any structural change in the industry. Does that answer your question? That's a subject that has lots of complexity. I've given you the sort of summary, but does that make sense? Or do you have any other questions?

Michael Rollins - Citigroup Inc

So as we look at the Wholesale revenue in the quarter and, of course, we adjust for the sequential asset sale in 1Q, how should we think about the incremental affect grooming may have had? Or was it just sort of the normal course, and there were other things affecting the sequential comparability in Wholesale revenue? I'm just trying to get my arms a little bit more around that. And the question whether given that other large providers are talking about it as a source of cost savings for this year more than they've talked about it in the past, should we brace for a little more grooming this year, or in the back half of the year versus what we might have assumed otherwise?

James Crowe

No will be the simple answer. And any time you simply focus on grooming, you're missing the overall. Grooming, as I said, is nothing more than large service providers doing what we do, looking to use their own facilities more effectively. To have the whole picture, you have to ask how much are they buying, what about purchases outside their service territory, do they have any remnants of the big mergers which occurred in 2005? We would say that's largely behind us. We're going to see quarterly grooming initiatives. We're also going to see a big benefit over time from our backhaul, from wireless growth and inter-machine -- multi-switching center interconnections, connections to the kind of explosion in content application. So I'll say again, we don't see any structural change. We expect the normal quarter-to-quarter ups and downs and fluctuations. Next question?

Operator

And we'll hear now from Donna Jaegers with D.A. Davidson.

Donna Jaegers - D.A. Davidson & Co.

On cable demand, obviously, Cox and Comcast, are two of your larger customers. They're both rolling out DOCSIS 3.0 for the last mile. What impact is that having on the demand that they have for your guys' services for long haul? And then second question on M&A and further consolidation in the industry, Jim, do you feel like your stock is an acceptable currency to use if you would consolidate more of the industry?

James Crowe

I'll take the second one first. We, not surprisingly, think our stock is significantly undervalued. The question is what about the target and how much synergy is there? And that's a company-by-company specific calculation. We would say, in general, I mean you can do the relative ups and downs with other companies, but in general, we continue to believe the environment is good for further consolidation. We continue to believe $1.00 of revenue is worth more on our network than others, and we continue to believe that the synergies, in many instances, are very large, measured in the hundreds of millions. So I don't think there's structural barriers. There's always specific issues that you have to deal with, with individual companies. Your first question again was?

Donna Jaegers - D.A. Davidson & Co.

Was the impact of cable -- the impact of increased cable last mile services on the demand for your services?

James Crowe

Yes, so we get paid -- I suppose one way of saying it is there is a supply chain, if you would, we're doing a lot of thinking and supply chain terms these days, but a supply chain from the broadband, wired consumer, all the way to the servers at the other end, which serve up all of that enormous flood of information. There were 31 billion videos viewed in the U.S. last month online. Cable continues to be the vast bulk of that content and application delivery to the consumer, wireless broadband is growing, but still, at least by our calculation, it's about 10% of the total. So the vast majority continues to be wired broadband, cable and DSL. There is a big debate in the industry about how much is going to be delivered through their normal services over something, over their video content, how much is going over the top and how will cable participate. There's also a big issue about how they're going to get paid. Clearly, flat-rate pricing for all you can eat is an issue for the industry. So I'd sum it up this way, cable remains an important growing customer. I'd say we get more benefit today on the application content server CDN side than we do directly from the cable companies. I think the cable companies need to think through their business model. Are they going to get paid for access? Are they going to get paid for the content or both? Is it subscription or is it ad? Until that's all sorted out, I think we're going to be supply constrained as I said in my remarks. I mean, it's just a fact. The folks who are inventing ways to use bandwidth are much faster on the feet than those of us who are supplying bandwidth. We've got a supply chain issue and it's got to be sorted out. And until it does, we're going to see a lot more growth at the server out content side than we do at the access side.

Operator

We'll move now to Ana Goshko with Bank of America Merrill Lynch.

Ana Goshko - BofA Merrill Lynch

The first one is a follow-up on the gross margin discussion that you started off with. It's been bouncing around for the last couple of quarters and clearly, a good sequential improvement this quarter. And I think you called out that there is only $1 million dispute benefit in the quarter. So I just want to verify that the margin that we see this quarter is pretty clean and is a good base for us to work with going forward in terms of our modeling our expectations?

Sunit Patel

Ana, just a general comment, obviously, in any given quarter, you will have different things happening here and there that move the margin around a little bit, but it's small on the margin. I mean, within a few tenths of a percentage point, you always have some fluctuations. And yes, the dispute settlement was $1 million. As I said, there are really, on the margin mix, there are a couple of things. One is if you look at within the CNS revenue line, you will see more on net, more than 80% gross margin revenues grew whereas the less than 80% gross margin revenues like the Voice revenues declined. So instead of improved margin mix, you get some of that and then also Voice business. Now, that's a trading business; tough to gauge how that goes quarter-over-quarter. So yes, there'll be so moving around. But I think, again, if you look at our margin performance over the last couple of years, we've done better than 80% incremental margins because if you look at the loss in revenues, our margins should have suffered more than what they've actually performed. So I think that, that just shows continued good work in terms of network optimization which continues. So I would say that yes, there'll be some movement up or down, a little bit quarter-over-quarter, but generally speaking, we've done better than the 80% incremental margins as we've had lots of revenues in the last couple of years. And hopefully, we should be at the 80% incremental margins as we grow our net revenues between the change in CNS and the decline in other revenues.

Ana Goshko - BofA Merrill Lynch

Second question, is the same question asked you last quarter, but it's just on your cash balance and your comfort with it. So if you take into account the July maturity, you're at about $400 million of cash. If you're spending to fund installs and growth in the second half and then we even fast forward to the first quarter of '11 where you usually have a seasonal working capital use, we could really see the cash balance dip below $400 million, which is, I think, the lowest I have ever seen you guys run with cash. And then you do have a maturity coming up at the end of next year. So you seem pretty comfortable with all of this, but I just wanted a better understanding of what your comfort derives from.

Sunit Patel

Well, I mean on the capital investment side, most of our paybacks are within a year so we do see the paybacks being pretty quickly on new CapEx investments given our incremental margin. But as I said in my remarks, we continue to spend a period of time as we always have to make sure that any opportunities for us to improve our liquidity and our debt maturity profile in a way that's accretive to our securities orders. We always actively looking at options there and that's a constant focus for Robin and I.

Ana Goshko - BofA Merrill Lynch

So looking at refinancing opportunities for the two maturities you got in '11 and '12 is really...

Sunit Patel

We are always looking for options, yes.

Operator

And we'll hear now from Michael Funk with Bank of America Merrill Lynch.

Michael Funk - BofA Merrill Lynch

Just on the government revenue, if you can give me some comments on the trajectory of that revenue stream, given the potential lumpiness there with the size of contracts. And then second, just on the churn with the Mid-Market customers, any commentary on the driver of that churn and whether it's customer disconnects due to failures, competitiveness, any additional color there would be appreciated.

Jeffrey Storey

The government revenues trajectory, you're right, it's very lumpy. This is an area that we've been adding sales, resources, adding sales people. Our expectation is that it does generate lumpy performance. We've seen good solid performance over the last, well, since I've been here, the last year and a half. We have responded to a number of RFPs that we have in the works. We think we will win some of those. It's hard to say this quarter's going to be good, this quarter's going to be bad. But generally, we see the trend going up and are pleased with the progress we're making in penetrating that market.

James Crowe

And I'd add, we break it out, we've had double-digit growth in Large Enterprise, Federal, and we'd be disappointed if we didn't continue to see that contribute more than other parts of our business. It's a big market and we think we have the right services.

Michael Funk - BofA Merrill Lynch

Are there very specific contracts that you can point out, or call out, that you may be bidding on the next 12 to 18 months who's sitting out there?

Jeffrey Storey

No, not that I'll comment on, but there are a number of RFPs that we have already responded to, and we see RFPs coming on a pretty regular basis for the types of services we provide. So we continue to work with them. With respect to the Mid-Market question and churn, we have not seen an increase in churn from customer disconnects. We saw an increase in churn from our account cleanup, the aggressive look at our customers to ensure that we have the right types of customers and that they're current and growing with us. So we haven't seen any particular increase from customers choosing to disconnect.

Michael Funk - BofA Merrill Lynch

And then just one more if I could, any comment this quarter on expected grooming from CenturyLink, Qwest? I don't think you caught that in your earlier comments.

James Crowe

We've been through this a lot, and what often happens is we see an initial increase in sales as the acquirer and the acquired companies look to tie their networks together and don't have all the facilities they need to do that. Then there is a period often of grooming where it goes the other way. There's a considerable difference, though, between what we've seen in the past in AT&T, SBC, BellSouth, the Verizon combine, Qwest and CenturyLink, with some exceptions, but largely have rural facilities. And Qwest Classic [Classic Qwest], if you would, as we understand it, self services in larger cities and is a big consumer of access. From the outside, and your question is better directed to them on the specifics, but from the outside, there may be more opportunity in this particular merger for us than others because there aren't large service territories like in AT&T where you can move a lot of access to your own facilities, but that's an impression that we have from the outside. And just the sheer size is different. This is a difference of scale between what we've seen in the past and the size of those two companies. So we don't expect anything big out of it. We don't see any -- we think the pluses and minuses may balance out and maybe slightly to the plus side if we're analyzing it properly. But a fair amount depends on the strategy that the combined companies pursue, particularly with respect to their Qwest Classic business.

We have time for one more question.

Operator

And that will come from David Sharret with Barclays Capital.

David A. Sharret

For Sunit, on the working capital side, obviously, a use of cash in the first half is always -- it seemed typically, though, it would be a good source of cash in the second half of the year over the last few years. Do you expect that again to maybe get back to sort of breakeven in terms of your working capital just for the year to kind of get meaningful source? And then secondly, just in terms of options for liquidity and the cash questions earlier, you've talked about M&A obviously, as an acquirer, are your asset sales a potential source of liquidity as well?

Sunit Patel

Yes, I think on the working capital side, the second half is generally a lot better than the first half. That's always been the case. I think that will be the case again, second half of this year compared to the first half. And you're right, generally, it's been a source in aggregate terms. The question on liquidity, I think when we got hit by the debt to the financial crisis, we answered this question a lot more detail, but we always have options for asset sales. That's always been there. Not that we actively looking at any of that, but that's always there, whether it's our European business, or the Colo business, or Core business. They are always assets that we have. But again, as I said earlier, we have access to the capital markets, we had access in depths of the crisis. When Lehman fell apart, we had access, as you all know. So I don't see that as a problem. We've had good support from our securities holders. I think that continues to be the case, whether it's public holders, the private equity markets, strategic markets. So we don't see that as a problem, per se. It's just a matter of being opportunistic and timing.

James Crowe

Thank you, all, for listening. As we said, I think all three of us have tried to make the point that there has been a change in the industry. We believe it's pretty clear that the wind's changed direction sometime towards the end of last year. We don't expect that the path is going to be linear, but we see every reason to believe that the fundamentals of our industry are strengthening. And we fully expect, and you've heard it from both Sunit and Jeff and I, we fully expect that those improving fundamentals and our position in the industry will result in increasing Core Network Services revenues over the balance of the year, given our incremental margins that bodes well for our overall performance.

Thanks. Operator, that ends the call.

Operator

And that does conclude today's Level 3 Communications Inc. Second Quarter 2010 Earnings Conference Call. We thank you so much for attending, and have a good day.

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