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Level 3 Communications (NYSE:LVLT)

Q4 2010 Earnings Call

February 02, 2011 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

Christopher Larsen - Piper Jaffray Companies

David A. Sharret

Colby Synesael - Merriman Curhan Ford

Edward Katz

Donna Jaegers - D.A. Davidson & Co.

Michael Funk - BofA Merrill Lynch

Timothy Horan - Oppenheimer & Co. Inc.

Jason Fraser - Raymond James

Michael Rollins - Citigroup Inc

David Dixon - FBR Capital Markets & Co.

Scott Goldman - Bear Stearns

Operator

Good day, and welcome to the Level 3 Communications Inc. Fourth Quarter 2010 Earnings Conference Call. [Operator Instructions] 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. Good morning, everyone, and thank you for joining us for the Level 3 Communications Fourth Quarter and Full Year 2010 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, Vice Chairman.

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 in the Investor Relations section on the Quarterly Financials Page.

I need to cover our Safe Harbor statement, which can be found on Page 2 of our fourth quarter '10 earnings presentation, and that says that information on 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.

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 also available in the press release, which is posted on our website at www.level3.com.

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

James Crowe

Thanks, Valerie. Consistent with our previous practice, we'll begin with Sunit, who will discuss financial results for the quarter for the previous year and provide an outlook for 2011. Jeff Storey will discuss operational matters, including segment results and I'll provide a contextual summary. We'll open it up for questions. Sunit?

Sunit Patel

Thank you, Jim, and good morning, everyone. I'd like to start with some of the highlights of the quarter, which can be found on Slide 3 of our presentation.

We continue to make steady progress in the business demonstrating solid growth in Core Network Services revenue and in adjusted EBITDA compared to the prior quarter and the year-earlier quarter. Core Network Services sales were up 7% sequentially in the fourth quarter. We saw another quarter of margin improvement and strong positive free cash flow in the fourth quarter of 2010.

Turning to the detailed results for the fourth quarter on Slide 4. Core Network Services revenue were $720 million in the fourth quarter of 2010, up 1.8% sequentially or 1.4% on a constant currency basis. Core Network Services revenue from Wholesale was $347 million, up 1% sequentially. Large Enterprise and Federal CNS revenue was flat at $144 million due to an expected expiration of a contract in support of the U.S. Census. For Large Enterprise, we did see sequential CNS growth of approximately 1%. Mid-market revenue continued to show nice improvement with 3% sequential growth in Core Network Services revenue to $151 million. European CNS revenue grew 3% sequentially on a constant currency basis or 7% as reported.

For the full year 2010, Core Network Services revenue was $2.8 billion, essentially flat compared to full year 2009. From a services perspective, our CDN revenue grew 27% sequentially compared to 11% in the prior quarter. CDN services now represent about 2% of our CNS revenues. Wholesale Voice Services revenue was $161 million this quarter compared to $161 million in the third quarter of 2010 and $162 million in the fourth quarter last year. For the full year, Wholesale Voice was $650 million, a decline of 2% compared to the full year 2009. Other Communications revenue was $23 million in the quarter. For full year 2010, Other Communications revenue was $114 million, reflecting a decrease of 41% compared to the full year 2009. This is consistent with historical trends. As mentioned by our fourth quarter results, Other Communications revenue is now only 2.5% of Total Communications Revenue.

Turning to Slide 5. We saw a decline in cost of revenue and realized further improvements in gross margin during the quarter due to high margin CNS revenue growth and an improving margin mix. Gross margin increased to 61.1% this quarter compared to 60.6% in the third quarter of 2010 and 60.2% in the fourth quarter of 2009. For the full year 2010, gross margin improved to 60.1% compared to 59.4% for the full year 2009.

Communications SG&A expense, excluding non-cash compensation and restructuring charges, was $330 million, an increase from $325 million in the third quarter of 2010 and $328 million in the fourth quarter of 2009. While utility expenses decreased as expected, we saw an increase in sales and sales-related expenses during the quarter. We increased our quota-bearing headcount in sales and added people to our service delivery function.

Turning to Slide 6. The improvements in adjusted EBITDA we've seen all year continued in the fourth quarter. Consolidated adjusted EBITDA increased to $226 million in the fourth quarter of 2010, compared to $218 million in the third quarter of 2010 and $217 million in the fourth quarter of 2009. Communications adjusted EBITDA margin improved to 24.6% in the fourth quarter, up from 24.1% in the prior quarter and 23.8% in the fourth quarter of 2009. For the full year 2010, consolidated adjusted EBITDA was $853 million compared to $909 million for the full year 2009.

At the bottom of Slide 6, as you can see, capital expenditures were down slightly to $117 million in the fourth quarter compared to $133 million for the third quarter and an increase from $80 million in the fourth quarter of 2009. For the full year 2010, capital expenditures increased to $436 million compared to $313 million for the full year 2009.

In general, we leaned forward on capital investments given positive sales and other leading indicator trends. Increasing year-over-year spending was directed at supporting customer installations, extending our reach with customer contractual builds, network upgrades across several layers and increased inventory levels to compensate for vendor delivery issues. We also made investments in service capabilities like adding broadcast service capabilities to NFL and NHL venues across the U.S.

Turning to Slide 7. Unlevered cash flow was $183 million in the fourth quarter of 2010 compared to $89 million for the third quarter and $218 million in the fourth quarter 2009. For full year 2010, unlevered cash flow was $425 million compared to $559 million for the full year 2009. Free cash flow was positive $73 million for the fourth quarter of 2010 compared to negative $61 million for the third quarter and positive $97 million for the fourth quarter of 2009. For the full year 2010, free cash flow was negative $97 million compared to positive $44 million for the full year 2009. Changes in unlevered and free cash flow between 2009 and 2010 for the full year are primarily as a result of the increase in capital expenditures in 2010.

Turning to Slide 8. As you can see from the transactions we have announced recently, we'll have no remaining maturities in 2011. Given our pro forma cash balance of $709 million, we can comfortably pay down our 2012 maturities. In 2013, the only maturity is the $400 million of the 15% convertible senior notes. With the progress we've made on liability management over the past years, we are very comfortable with our debt maturities and believe we'll continue to improve our credit profile. We continue to remain focused on reducing our leverage ratio or debt to EBITDA to our target of 3x to 5x.

Turning to our business outlook for 2011 on Slide 9, I'll start with the first quarter. As has been the case for several years, our fourth quarter revenues see the benefit of increased demand from our broadcast services due to the increased number of sporting events. While the first quarter we'll see the typical drop in broadcast revenues, we still expect Core Network Services revenue to grow slightly in the first quarter compared to the fourth quarter. Second, we expect consolidated adjusted EBITDA to decline a little in the fourth quarter of 2011 due to typical first quarter increases in payroll taxes as well as some small increases in cost or revenue from the expiration of certain volume discounts. As is consistent with previous years, free cash flow use is heavy in the first quarter, driven by working capital uses due to annual bonus payments, prepayments and maintenance contracts, property and payroll tax payments and higher sequential cash interest expense. For example, cash interest expense is expected to increase from $111 million in the fourth quarter of 2010 to $157 million in the first quarter of 2011. We also expect to recognize a $20 million non-operating loss as a result of the exchange of the 9% notes in January and the redemption of the 5.25% notes in February.

Turning to the full year 2011, we generally expect continued Network Services sequential revenue growth. Given our high incremental margins, we expect consolidated adjusted EBITDA to increase in line with CNS revenue growth. We have continued to add to our sales force and are very focused on increasing sales, driving downturn by improving our customer experience and also improving our capability in installing customer orders.

In 2010, our outstanding customer billing disputes came down more than 80%. We expect that some of these efforts will result in improving revenue and adjusted EBITDA performance over the course of the year.

In 2011, we expect capital expenditures to be about 12% of Communications Revenue, which is about what we saw in 2010. Last year, we had to spend additional capital to increase our warehouse inventory levels as we experienced delays from equipment vendors that affected our ability to turn up sales orders.

In 2011, as equipment vendors have reverted to normal delivery schedules, we should be able to decrease our inventory levels. What this means is that capital expenditures actually spent will increase in 2011 as we drive stronger revenue performance. In 2011, we expect net cash interest expense to increase to $555 million from $522 million in 2010.

In 2010, changes in working capital were a source of about $2 million of cash on a consolidated basis. In 2011, as our Communications Revenue grow, we expect working capital to be a use of cash.

In summary, we expect free cash flow for 2011 to be negative. We typically evaluate our revenue reporting once a year to reflect changes in the way certain customers are classified within customer segments. For 2011, we will be maintaining the same customer-facing reporting groups: Wholesale, Large Enterprise and Federal, Mid-market and Europe. However, we will have some customer movement between these groups that will result in some changes in the segments beginning in the first quarter.

As we've done in the past, we will provide the historical quarterly revenue for 2010, pro forma for the changes so that investors have comparability to prior periods. Also in the first quarter of 2011, we expect to begin reporting revenue churn. We are pleased with the steady progress we have made in 2010. We expect to keep improving in 2011.

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

Jeffrey Storey

Thank you, Sunit, and good morning, everyone. I'd like to take a moment to provide an overall summary of the business and review the progress we made in 2010.

We continue improving our provisioning intervals and installation capabilities, increasing average installs by more than 20% from the first quarter to the fourth quarter of 2010. Throughout the year, our focus on the customer remained our top priority. Our teams work together everyday to make our customer experience the best in the industry, and I'd like to thank them for their efforts and the significant progress we made. As a result of the sales force expansion and the increasing tenure of our newer hires, we continue to grow sales in 2010. Fourth quarter sales were up 7% over the prior quarter and more than 20% annually.

In general, we believe that our provisioning intervals are among the best in the industry. And for several services, we are second to none. Together, these achievements are heading us in the right direction and we are optimistic about 2011.

Turning to the results by market group. Wholesale revenues grew 1% during the quarter in part due to seasonal Vyvx broadcast revenues but also from the steady growth we've seen from our wireless, cable and other content, media and entertainment customers. Revenue for Large Enterprise and Federal was flat quarter-over-quarter. Federal revenues were down as a result of the scheduled end of a large contract supporting the U.S. Census. This contract fully wound down in the fourth quarter of 2010.

Large Enterprise revenues were up approximately 1% sequentially. As I've noted before, Large Enterprise revenue growth can be lumpy due to large contracts that may hit in any given quarter. In contrast to the first half of 2010 when we saw higher sequential growth, Large Enterprise revenue growth was more muted but still up 16% fourth quarter 2010 versus the fourth quarter 2009 and 13% for the full year 2010 over the full year 2009.

Within the Federal sector, we continue to gain traction in growing the customer base both directly with government agencies as well as through systems integrators. As an example of this is the contract we announced yesterday to support the FBI with the relaunch of their website utilizing Level 3 CDN services. Within Mid-markets, we built on the 1% sequential growth we saw in the third quarter of 2010, delivering 3% sequential growth in the fourth quarter.

The investments we've made in growing this business, our local market focus, increases in quota-bearing headcount and launching new enterprise-focused products and services are all beginning to show results. We believe our results bode well for the future of this large and important market.

We also increased our focus on key verticals for this channel, notably, financial services, regional service providers and healthcare. Focusing on healthcare for a moment, healthcare IT departments face unprecedented challenges. Medical-related data is more than doubling in volume annually. Compliance requirements have increased steadily and 100% uptime for critical care applications is essential, all while healthcare organizations face intense budget pressures.

To address these requirements, healthcare customers are looking for efficient and scalable architectures, resilient business continuity and disaster recovery solutions and highly secure connectivity, all strengths of the Level 3 network and products. Dialysis Clinic Inc., a national non-profit organization dedicated to caring for patients with kidney disease, is one example of a healthcare customer benefiting from our portfolio of services and our extensive local and national footprint. Dialysis Clinic needed to connect hundreds of clinics across the country with a rapidly growing volume of medical data and increasing file sizes to be shared among their clinics, latency was a key requirement for this customer.

Level 3's low latency capabilities coupled with a breadth of our network footprint were key factors in their decision to select Level 3 as their network provider. Within Mid-markets alone, we more than doubled our sales in the healthcare vertical Q4 to Q1 2010. Our European business continues delivering great results, 3% sequential revenue growth this quarter on a constant currency basis. Increasing traffic demand, strength in transatlantic demand and CDN opportunities drove this growth.

With the January 2011 expansion of our business-grade IP and VPN services in the U.K., France and Germany, we expect to see additional opportunities to grow Enterprise revenues in Europe and we're ramping our sales force to support this initiative. As with our domestic Enterprise launch, we expect growth to start up slowly and build over time as we take market share.

From a product perspective, growth in the transport and data services categories led all of our products. Transport revenue growth was driven primarily by demand for Wavelengths and Ethernet Private Line. Our metro and long-haul assets position us very well as the need for these products continues to grow. While a portion of the data services revenue growth was a result of the seasonal increase in Vyvx broadcast services, we also saw growth in virtual private networking, High Speed IP and content distribution network revenues. Infrastructure revenues were slightly down as a result of fewer one-time items compared to the third quarter and Enterprise Voice revenues continue to decline.

Turning to pricing. We continue to see pricing in line with my comments over the last several quarters, aggressive pricing for High Speed IP and CDN services offset by rapid unit growth with stable pricing dynamics for the rest of our services. The pricing environment in Europe remains highly competitive and is largely unchanged from the first half of 2010.

As I mentioned earlier, we continue to make progress on our provisioning intervals, and in fact, Level 3 was recently awarded the ATLANTIC-ACM 2011 Global Wholesale Best-in-Class Award for provisioning. To quote the President of ATLANTIC-ACM, "Our survey results reflect customers' recognition of Level 3's commitment to delivering a positive customer experience and advanced network services. Level 3's year-over-year improvement across all service categories indicates that their continued efforts to be a leader in the customer service are paying off in the eyes of the customers."

While our own Level 3 surveys have shown similar results, it's great to have a third party confirm our findings. At the same time that we've improved our provisioning capabilities, we still see significant increased delivery time frames from our two largest off-net vendors. As I noted last quarter, their performance reinforces our decision to continue building metro fiber and adding new on-net buildings.

Looking back over the year, I'm pleased with the investments we made to scale our business, enhance our global product portfolio particularly for ethernet and IP services, all while consistently improving our customer experience. It's a great foundation to build on for 2011. Beyond the momentum we've seen going into this year, we are highly focused on further increasing our sales effectiveness, adding to the sales force and delighting our customers at every opportunity.

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

James Crowe

Thanks, Jeff. As usual, Sunit and Jeff have done a good job summarizing the quarter and the general outlook for 2011. I'd like to add a bit of context.

I think that the past year, 2010, will be remembered in our industry as the year of the visual Internet. By that statement, I mean that for the American consumer, online delivery of video content, including long-form full screen movies and TV shows is now a reality. Americans now spend as much time online as they do watching TV, a startling shift in viewing habits. A particular note is the fact that 18- to 24-year-olds get more of their video entertainment from broadband connections than from traditional cable TV satellite or DVDs. And many, if not most observers, forecast that the explosion in the number of smartphones and tablet devices will mean that wireless services will increasingly be part of the same visual Internet.

It's well to remember how recent and how startling this new trend is. Only a few short years ago, some industry experts argued that one megabit per second to the home would be overkill and that the American consumer would use cell phones for voice and certainly not broadband services. Well, today it's clear that we can now add another term to the old saying, you can't be too rich, too thin or have too much bandwidth. And I believe there is no company in our industry better positioned to benefit from the visual Internet than Level 3.

I further believe that we are now seeing the implications of our broad set of services and in particular, our investment in IP backbone services, capacity and in CDN are paying off. Our unique assets and our great people, our significant operating leverage are all becoming visible in our financial results.

And as both Jeff and Sunit have made clear, we're tightly focused on ensuring that our ability to satisfy this growing customer demand leads our industry on all service metrics. As I've said before and I'd like to point out again, like life, financial results are rarely linear. However, given underlying trends in our market, our optimism about our future continues to grow.

Operator, would you describe the Q&A process, please?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question will come from Jason Armstrong with Goldman Sachs.

Scott Goldman - Bear Stearns

It's Scott Goldman on for Jason. Hard to ignore the recent wave of M&A over the last week or so with Terremark and NaviSite. I'm wondering if that, Jim, if you can kind of comment on that and how that changes your strategic outlook and maybe the way you guys monetize your awards, data center business? And also how you think about is there a need or an opportunity to move more into the managed hosting and cloud services as we're seeing other carriers kind of pickup in that space?

James Crowe

Yes. There's two, I think, questions there. The first is what are we doing with our extensive set of data center spaces? As we said a couple quarters ago, we had conducted a fairly comprehensive strategic review of those assets and determined that we had very high payback opportunities in a number of those locations, and we're proceeding to invest capital. We did in 2010 and we'll continue in 2011 in those areas where we have clear customer demand. We also said though that we have such great opportunities to put capital to work, expanding our metro networks adding buildings for the reasons that Jeff Storey articulated. That's a very high return opportunity. But in general, we think our core business of providing communications services is where we will continue to focus. With respect to any need to add cloud services or more application-oriented services, simply put, we don't think that's our business. We think competing with those organizations with great expertise, building applications, putting them on servers and making them available over the Internet is a place where our own expertise doesn't come to bear. We will continue to sell services to those kinds of companies. In fact, a substantial majority of our revenue comes from those kind of companies. And we see no reason to think we won't benefit directly from the growth in cloud and application provider over cloud-based services. So we like our business and we'll continue to focus on it.

Scott Goldman - Bear Stearns

If I could just quickly follow-up, maybe Jeff can answer. I'm wondering from a sales perspective, if you guys are seeing particularly in the Large Enterprise and the Federal side, a growing demand from customers who are maybe looking to kind of move into that managed hosting and/or cloud side, and whether you may feel a need somewhere down the road, given Jim's comments, to maybe partner in that area going forward?

Jeffrey Storey

Let's say we partner with others, today. Jim accurately described it, that those providers are large users of bandwidth and people wanting to connect to those providers are large users of bandwidth, and so we partner with them today. I'd expect that, that would continue going forward across Large Enterprise and Mid-market customers.

James Crowe

Yes, I want to add a little more color to this. For several years now, we've been, I think, consistent that we believe our industry is moving to a world where applications and content that previously had been accessed over other modes, cable TV or integrated into telecom networks, was being separated. And those who have great expertise in providing Internet-based code, Internet-based applications, Internet-based comment are going to separate from the network and that's a business that will grow rapidly, and that our piece of that will be serving those kinds of companies. And today, it is accurate to say that social networking, business applications, online cloud-based services for Large Enterprise or Small Enterprise are largely served up by new companies who need the services of companies like Level 3. And we've said from the start, our goal is to be the high-margin, low-cost provider of connectivity to those kind of cloud-based services. So this trend is something that we believe we've benefited from for a number of years. And now, as it's really exploding, we expect to see some substantial benefits going forward.

Operator

And we'll hear next from Colby Synesael of Cowen and Company.

Colby Synesael - Merriman Curhan Ford

You mentioned CapEx of around 12% of Communications revenue. I think in the past you said that CapEx of roughly 12% to 14% of revenues would imply somewhere around 2% sequential growth. So I was wondering if you could kind of tap that back into previous comments? And then also, I think as it relates to guidance you mentioned that you expect EBITDA to grow at a similar rate to revenue. And I just wanted to make sure that you actually expect absolute growth rates to be similar or are you implying that with high contribution margin that EBITDA should actually be growing faster than revenue?

Sunit Patel

Yes, I'll take the second part of that first and then I'll come back to the CapEx. So generally, and I think we've said this in the past that given our current EBITDA margins of 24% or so and incremental EBITDA margins of 60%, if you work that math for our CNS as revenues, it translates into every 1% increase in the revenue growth rate, translates into a 2x increase in the EBITDA growth rate just given that operating leverage. I don't think anything has changed there. That's what we actually meant. I don't think I said that the rate of EBITDA growth would be the same as the rate of revenue growth that's about a 2x relationship given the current and incrementally EBITDA margins. On the capital expenditures point, I think that as I was saying, we will get some benefit this year from capital we already spent last year to buff up inventory levels, so we'll get some inventory liquidation there, which means that effectively, we'll be spending more capital than the 12% because we'll get some benefit of using up inventory levels from last year. So what that says, as I also mentioned in my comments, that we expect revenue performance to improve over the course of this year. So whether you look at that in terms of year-over-year performance improving or whether you look at us driving better sequential growth rates over the course of 2011, we think the capital spending captures that. Having said that, certainly, if revenue growth picks up more, we'll spend a little more capital on the margin as we've talked about earlier, most of our capital spending on the margin is also success-based.

Colby Synesael - Merriman Curhan Ford

So whatever our assumptions are for growth that should be accelerating through the course of 2011 based off of your comment?

Sunit Patel

Yes, generally, your comparison should keep improving. Yes.

Colby Synesael - Merriman Curhan Ford

You talked about the focus on reducing leverage. And I was curious, is that something going to come from the actual fundamental business improving revenue, et cetera? Or are you contemplating something like an asset sale or accretive M&A to help improve that leverage as well? How important is it to you to get that leverage down quicker than what you may do just by the business by itself?

Sunit Patel

Well, I mean, I think on leverage, the key point is that the debt divided by EBITDA, we've kept on increasing EBITDA, so we've moved from an annualized EBITDA in the first quarter of last year of about $800 million. And as we exited 2010, our EBITDA run rate has moved to about $900 million annualizing the fourth quarter EBITDA. So I think the point there is that as we keep driving sequential EBITDA improvement across 2011, it means that the debt to EBITDA should keep coming down. On a longer term basis, I think we hope that through driving revenue and EBITDA improvements, we'll also have the benefit of debt reduction. We do have certain amount of debt that's convertible. So I think the combination of those things should allow us to get there or here. But I think the point is that last year, we decreased our debt to EBITDA over the course of the year to increasing EBITDA. We continue to focus on increasing EBITDA in 2011. We should also improve the debt to EBITDA.

James Crowe

I might add. This is Jim. I might add that and reinforce what Sunit said, we expect to see improving results. You can take a look at the trend over 2010. It's what we thought would happen and we expect to see that trend continue. Given the math that Sunit articulated, we think that organically, with those kind of results, we can achieve our leverage ratios in a meaningfully short timeframe. This isn't a decade-long effort. If there are opportunities to achieve leverage improvement through M&A or some monetization of asset, it will pass the test that we've articulated before. It should pass the test. Any transaction needs to be delevering and accretive on a free cash flow per share basis versus what we would have done organically. And we haven't changed our point of view there. So yes, if there's something that makes sense for our investors, and one of the criteria of making sense is it's delevering, we'd certainly look hard at it.

Operator

And we'll hear next from Tim Horan with Oppenheimer.

Timothy Horan - Oppenheimer & Co. Inc.

Jim, maybe a little bit more clarity on the guidance. Your current trends, do you think you can end the year more like 4% type of revenue growth, accelerating to 5% to 6% next year? And I meant secondly, just to add on to that, I guess the Street's a little upset by the free cash flow guidance. At this stage and given how much basic infrastructure you have in place, is there a way to focus a little bit more on success-based CapEx to enable better free cash flow growth the second half of this year or into '12? Or do you just think the opportunities are large enough that you want to continue to pull the metro fiber and the returns are high enough that you're willing to make the long-term investment still?

James Crowe

Well, I'll answer the second question, while Sunit's thinking about the first. We have opportunities and we think they're demonstrated opportunities to put capital to work at returns -- there are 12 to 18 months. When you have that kind of opportunity, we're not going to walk away from it. We think we have adequate liquidity. We think the kind of investments we're making are supported by sales. These aren't investments in prospective builds. They're not investments in projects that are speculative. These are in response to customer-signed orders. And of course, we're going to make those kind of investments and the result is some negative cash flow in 2011, but we think that will be a short-term matter. And we think with those kind of investments, we'll see positive cash flow over time. Sunit?

Sunit Patel

Yes, so on the guidance, again, as we've said and we'll repeat again, we've maintained firm 1%-plus sequential growth pace over the last few quarters and I think that given our investments in increasing the sales force and reducing churn, the combination of that should see improving continued improvement in that pace. So we're very focused on moving up from the kind of 1%-plus base that we've had over the last few quarters. And I think, as Jeff pointed out, we're making the investments to do that and we feel good about the ability to increase that pace. And then back to the free cash flow thing, as I mentioned, working capital is now becoming a use of cash as the overall or total revenues of the business are now growing. But it's not a big number in the scheme of a $3.7 billion revenue business, you do have working capital, that's in the order of tens of millions. That's not surprising there. So I think the key measure is really looking at EBITDA minus CapEx, minus interest expense. And we're very focused on that improving and I think that continues to happen.

Operator

And we'll move now to David Dixon with FBR Capital Markets.

David Dixon - FBR Capital Markets & Co.

I wanted to switch gears a little bit to help us better assess the risk of the business going forward. Would you be able to help us in quantifying the risk of the impact of rather the unfavorable peering result with the disputes in place right now? And help us just more broadly speaking as you're seeing it seems that the industry is tightening up in terms of peering rate imbalances, forcing other increased CapEx or move to pay peering. I'm just trying to get a better sense of how you broadly assess that risk to the business model going forward?

James Crowe

Yes, we've said repeatedly that the amounts involved in the dispute we had with Comcast or what we foresee in under any reasonable scenario aren't material to our financial results in 2010 or in 2011. The question you're asking about the broad trends in the industry and are they good net-net? Are they negative for Level 3? Most emphatically. We built our company believing that we were going to see what I referred to as the visual Internet, that is, we're going to see more and more content, particularly high-bandwidth content video move from traditional distribution media, DVDs, optical disks, cable TV, satellite, to the less expensive transmission media, that is IP optical networks, Internet. That's not speculative anymore. It is totally understandable that those who have business models that are threatened are going to react. We've seen this same sort of thing for 25 years, first in the telephone business, now in the Internet business. In general, we like where we sit, in general, all the trends on what we built the company around. Remember too that while it is a strategic matter for us that the Internet and the delivery of content over the Internet continue to grow, we're very diversified and we are facilities-based. 90% of our revenues come from the kind of facilities we have and from transport that isn't affected by any kind of interconnection agreement plus, minus or neutral. So we like where we sit. We think in the longer term, the basic trends and forces are on our side. We don't think anything is likely to come out of any arguments about traffic and balances or paid peering interconnection that is going to be materially negative to Level 3 when offset by all the positives that come from fundamental industry trends.

David Dixon - FBR Capital Markets & Co.

And Jim, just to follow-up there, so if I understand you correctly, that even if other carriers are watching this decision closely or this outcome closely, even if other carriers followed suit in a move to paid peering, that wouldn't have a material impact on the business cost structure?

James Crowe

That's correct.

Operator

And we'll move on to Michael Rollins. [Citigroup]

James Crowe

I want to add one other comment though. I want to make sure we're clear here. Why is Level 3 pushing so hard if the terms of interconnection are not financially material? What is financially material over the long term is the continuing development of the Internet as a medium for distribution of video, of content, of very high-bandwidth information both on the wire and the wireless networks. That's going to happen. The way in which policymakers, regulators and industry participants work out the difficulties we're all dealing with can, at the margin, slow or speed up the overall development of that overall trend. And that, we are interested in and that we believe it is in not only our self-interest but the country's to see move forward quickly rather than be impeded.

Operator

And Michael Rollins with Citi.

Michael Rollins - Citigroup Inc

If you can give us maybe some more details around the CDN in terms of the types of capital intensity you're expecting as the business grows as a percent of revenue? And can you talk a little bit more maybe about the ways Level 3 differentiates the selling process to customers for the CDN? And what about Level 3 gives you an edge over your competition to provide the quality services that you're providing?

James Crowe

Yes, Sunit will think about capital intensity while I take a shot at your second part. We've said for some time that we believe, and we believe very firmly, supported by, we think facts, that underlying cost of transport is the biggest single input into the cost of producing CDN. It is also a major determinant of the quality of a CDN service, things like latency, if you're watching a movie, how many re-buffers per hour, all the things that really matter to viewers, we think we have more control over more factors than any of our competitors. That simply gives us the ability to control our cost better, to have better margins and to have better quality of service. And we believe that third-party measurements and our own and our customers would indicate we're as good or better in terms of quality than anyone else, and we certainly think we have a control over cost that are better than anyone else. So if you're in the shoes of someone who's been -- or many who are looking to move content over the Internet, we think the combination of our facilities-based services, our quality and our value proposition are very compelling. I'd also add that we can add services like combining live broadcasting through our Vyvx service with CDN that is a unique offering. It is compelling to those that may be in sports or other live venue kinds of media. So the breadth of the services are another key. And as Sunit's metrics identify, we're seeing significant success. Our growth rates are quite high on what is getting to be a meaningful part of our revenue. Sunit?

Sunit Patel

Yes, on the capital intensity, Michael, it's consistent or comparable to other services. CDN doesn't have any higher capital intensity. CDN capital -- well, CDN has to compete with capital for other opportunities we have and the payback is consistent with the payback as Jim mentioned. I'll repeat again, most of the capital we spent on the success base is the paybacks anywhere from six to 18 months. So CDN falls within that range, and so no different from any of our other services.

Operator

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

Michael Funk - BofA Merrill Lynch

I have three quick ones: one, on the balance sheet; second, on guidance; and third, on some operating trends. First one for you though, Sunit, on the balance sheet, clearly, the capital markets are open to you with the recent deals and I was hoping to get your thoughts on how you think about addressing the 2013 and 2014 maturities, specifically about taking advantage of the current capital markets versus waiting and potentially spreading out new issuance?

Sunit Patel

Sure. The 2013 maturities is essentially a non-callable maturity. So while you can inventory cash on it, there's not really much. It's a convertible note to it. It's still far away, so we have to see what happens. As far as the 2014 debt maturities go, as many of you might have noticed, the bonds have rallied a fair bit over the last quarter or so. And we continue to look at actively at opportunities for us to address maturities. But I think now, we've got plenty of time to address those and we continue to look actively at what's the right thing to do when, and I think so, we'll just keep taking a look at it.

Michael Funk - BofA Merrill Lynch

And then just on the guidance that you talked about expecting term and volume discounts, potentially pressure costs during the first quarter. Jeff mentioned adding headcount over in Europe. As we think about the trajectory in the shape of spending or cost steering 2011, how should we factor that in?

Sunit Patel

Well, I mean, I think the investments we are making in headcount or operating expenses all in the investments serve to increase our selling capability and turning up service. So we think those are great places to increase expenses and we've certainly seen our sales year-over-year, as Jeff pointed out, up more than 20% in 2010 compared to 2009. Most specifically, the change from Q4 to Q1, the pay increase in payroll taxes, which is a bigger part of the increase, is normal. It happens every year. I think if you look at our EBITDA performance Q4 to Q1, that's always been the case. The term and volume discounts, I think we cite that in previous years again in the first quarter given the timing of those arrangements. But I think just to sum it up, the impact of both those things from Q4 to Q1, we're talking mid-single digit sort of range in millions. So it's not anything earth shaking, but the payroll taxes really is seasonal item and we get the benefit of that as most of those get cleared during the first quarter. The benefit comes in the rest of the year. But term and volume discounts per se again, keep in mind that we have continuity into our gross margin through richer margin mix, continued margin optimization, all those opportunities are still there. So we view that more as a one-time thing depending on the timing. It's not a sustained issue that we are worried about. So I think that we continue to see steady improvements in gross margins and EBITDA margins.

Michael Funk - BofA Merrill Lynch

Jeff, maybe some commentary on operating trends and specifically revenue growth from new versus existing customers in Mid-market and Enterprise, maybe customer churn? And then finally, maybe kind of a projection for building additions during 2011, and CapEx related to that?

Jeffrey Storey

Operating trends in general, as we've said before, just to add on to Sunit's comments, we are very focused on cost as a company. And while I talk about headcount increases, Sunit's absolutely right when he describes it as increases in our ability to sell and turn-up services. So increases in sales, quota-bearing headcount and the people to support those sales and turn-up. Across the company, we are very, very focused on cost and we'll maintain that. A lot of what we're doing is primarily centered on improving the customer experience, driving sales and at the same time increasing efficiencies so we have a number of initiatives internally. With respect to the exact capital on building adds, we continue to add buildings along the lines that Sunit and Jim have both talked on. We're looking at paybacks for those buildings. I don't have the number in my head about what the capital we spent for 2010 was, but we are getting more and more aggressive. I think Sunit said that in his remarks we're leaning in to building our network. We believe that has a critical advantage to us as we add more and more buildings on net. And we take away the provisioning problems that our off-net vendors are having. We put more of the customer experience in our own hands rather than relying on others. And so we will continue those operating trends. If you look at 2011, we are focused on sales and sales effectiveness and growing the business and satisfying the customer.

Sunit Patel

And one point on the building adds, yes, I mean, the investments, the return opportunities we have with building adds is enormous. I think we have materially increased our information about buildings that we can go to. And I think the rate of building adds will pick up dramatically between now and the end of the year with some of the capabilities that we have introduced, and all again, at very, very attractive returns from a payback or an IR perspective. So I think that's something you'll hear us talk about more but we are now positioned to really drive significant rate of building adds over the course of this year.

Operator

And Simon Flannery with Morgan Stanley has our next question.

Edward Katz

It's Edward Katz for Simon. A couple of questions, I was just wondering if you could give some more color around the Census contract and specifically how much that may have benefited your growth in Large Enterprise and Federal for 2010? And then the second was just if you give any more details around the Netflix contract? Clearly, the hedge is very strong subscriber growth in last quarter. Is there any directional commentary on how we should think about the revenue ramp? And then I guess to what extent do you think there could be additional CapEx associated with the deal next year?

James Crowe

I'll take the Netflix question, while Sunit and Jeff debate on who should answer the first question. Netflix, as is typical in these kinds of arrangements subject to a confidentiality agreement, I would simply say that there is no meaningful revenue in 2010. I think that's something we've said. And that your observations about the very rapid growth of Netflix is accurate. I think they added 3 million subscribers in the last quarter. They've said publicly that they have international aspirations. We certainly hope we can help support those. But I would say broadly, Netflix is a leader or in the vanguard of something that is fundamental and is going to continue. And I'll repeat again, this is about a major shift in the way those at work and at home consume information. We are shifting obviously and rapidly to more and more visual information, telepresence, entertainment, gaming, social media, political discourse, commerce, are all becoming more and more visually oriented. I think I've mentioned this before. I'll provide an advertisement for Cisco's Visual Networking Index. If you simply type that term, Visual Networking Index into Google or your favorite search engine, you'll get the site and the statistics, which last year were actually a bit conservative in terms of the trends they identified. Clearly to make clear of what we're talking about here, yes, Netflix is in the vanguard and we're pleased to be able to work with them. But theres' something fundamental going on, and we think our company is as well positioned, perhaps better positioned than any other communications company to leverage that trend. Did I buy you enough time to answer, Sunit?

Sunit Patel

Yes, I think the U.S. Census, just background, I think most of you know this, but the U.S. conducted a Census that wound down last year. So I don't think the Census, they started revving up for it in '09. So if you were to take out the revenues from that contract in '09 and '10, I don't think you'd see much change in the Large Enterprise revenue growth as such. This was just a -- it was a contract, as I say, to gear up for the Census and as the Census activities wound down, the contract wound down. But backing that off in '09 and '10, you won't see much change in the Enterprise.

Operator

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

Donna Jaegers - D.A. Davidson & Co.

Two questions I guess for Jeff. Can you give us a little more color, a little more quantification on the percentage increases that you're adding to your sales forces, especially in the Mid-market? And then in the past, you guys have given some color on customer and revenue churn in Mid-market. Can you give us a little more detail there?

Jeffrey Storey

Sure. On the sales revs, we ended the year 2010, up about 16% over where we ended the year 2009. For 2010, we have about 530 quota-bearing headcount selling on the street. The places that we've added are in Mid-market and in Large Enterprise and Federal. So the prices that we've been adding sales people are in those areas that we see the growth opportunity. So Mid-market had a disproportionate share of that increase versus some of the other groups. With respect to churn, the churn -- other than the one contract that we just discussed, the Census contract, churn has improved over the course of 2010 and we expect those trends to continue. We've talked about, and Sunit may have comments on, beginning to report churn going forward a little bit more than we have. Sunit?

Sunit Patel

Yes, so I think, as I mentioned within the stock reporting churn beginning with the first quarter and on the historical trends so you'll see the improvements. So we will talk about that a little more going forward. But generally, I think, Jeff, the churn improved over the course of 2010 and we hope to improve quite a bit over the course of 2011.

Donna Jaegers - D.A. Davidson & Co.

And Jeff, just to doublecheck, you said 16% growth in sales headcount for 2010?

Jeffrey Storey

Yes, end of year to end of year.

James Crowe

Those sales force tend to be local in the markets where we're offering to Mid-market Enterprises. And if you take a look at the trend in Mid-market CNS growth, it's probably the most -- the biggest turnaround in the company. We went from negative growth to 3% or 12%, 13% on an annualized basis over the course of 2010. And a reduction in churn made a meaningful difference in those kind of results.

Operator

We'll hear now from David Sharret with Barclays Capital.

David A. Sharret

I just wanted to just follow up one additional question on the balance sheet side, obviously, Sunit, you addressed earlier 2013 and 2014, but I just want a follow-up on your comments about 2012. I think, if we're going to have -- you mentioned that you have a liquidity to deal with those in cash, I just want to make sure I have the right take away from your comments. You're saying it's your intention to pay those down with your existing cash or are you just saying you have a liquidity and you still could evaluate potentially refinancing those at some point over the next year and a half as well?

Sunit Patel

I think we're saying both, right? We have the cash to pay down and I'll leave it at that. I mean, I think if you look at the size of the maturity in relationship to our cash, we've got plenty of margin on safety there.

David A. Sharret

But potential refinancing could still be on the table as opposed to taking the cash position down?

Sunit Patel

I don't know. We might even just take out the debt. We haven't really made a decision on that.

Operator

And we'll move now to Chris Larsen with Piper Jaffray.

Christopher Larsen - Piper Jaffray Companies

Of your cap spend, can you just give us a sense for what's your network maintenance versus growth CapEx? And secondly, in '09 and 2010, you really focused on improving your install times and ramping the sales force. And it feels like today that your sales force may be not 100% where you wanted it to be but it's getting there and your install times are better. What would be -- what prevents you at this point from accelerating your topline growth rate? Is it just jurisprudence or other structural issues that you're still working through to not accelerate the topline beyond 1% sequentially?

Sunit Patel

I'll answer the first question you had, which was our maintenance capital spending is running at about $150 million to $200 million a year, so the balance is success-based.

James Crowe

We are accelerating our growth. That's what we've done since the fourth quarter of 2009 when we identified what we thought was a bottom drive from the financial crisis. We've tried to indicate that we are accelerating our growth. We said earlier that sales were up 20%. Let me just make sure we're clear about what that means. Those were signed quarters. Those aren't something in a funnel. They aren't a channel hope. Those are signed orders that convert into revenue. And with respect to why we can't see a step function in revenue growth, it's because we want to make sure that at the same time our install intervals and the quality of service we provide improve along with our rate of sales. And that means we've got to keep in balance the ability to turn-up service rapidly at intervals our customers expect and our sales. A third issue, which Jeff identified and I'd underline, off-net vendors, particularly our two largest off-net vendors, those who provide tail circuits. Let's say there's an order that involves 20 locations, on average, let's say 16 are going to be on-net, four might require an off-net circuit. Those intervals are stretching out significantly. That's a problem for the whole industry, including those two large incumbents. We are dealing with that problem by adding more and more on-net capability, more and more buildings but it is a drag. That has caused an issue. But we continue to be very confident that our sales and our revenues will grow and accelerate to use your term.

Operator

And that final question will come from Frank Louthan with Raymond James.

Jason Fraser - Raymond James

This is Jason Fraser in for Frank. Just to return a little bit back to the Mid-market segments, I wonder if you could talk a little bit about what you're seeing in pricing there? What trends you've experienced and what you're seeing from a competitive standpoint? And lastly, what are your expansion plans for the remainder of 2011 in the segment?

Jeffrey Storey

So pricing in Mid-market is typical to what we see and for other customer groups, we see pricing pressures on IP services and CDN services and less pricing pressure on some of the transport services that we sell. Ethernet Private Line is a great product for us in our Mid-market. Virtual private networking is a great product for us in our Mid-market customers, and the pricing trends in some of that is more stable. But in general, pricing is consistent with comments over the last year and I don't see much difference by Mid-market. Expansion plans? We continue to expand our sales force in those areas and we're trying to continue to improve the productivity per sales rep. So we don't have any plans to go out launching in other markets. We think we have the markets that we need to be in fairly well covered with our network, but we are continuing to expand our sales force, continuing to expand their capabilities so they can be more successful in selling. And then the thing we've already mentioned three or four times, when we get an opportunity to go on-net with a customer, we're looking at how when we sell to a customer, how can we get to that building, but when we route the fiber to that building, how do we pass four other buildings that we can make them easy to add on-net. We've talked to you before about it. There are 100,000 buildings that are within 500 feet of our network and we are very aggressively looking at all of those buildings and figuring out how to optimize -- every time we add a customer to the network, how to optimize for the opportunity that other customers near there may provide us. So those are the expansion plans.

James Crowe

Well, if you sense a growing optimism on our part, you're accurate. We believe that we are not constrained by our market. We believe that internally, we've taken the right kinds of steps to make sure that we can sell more and we can predictably turn up more with intervals our customers want. We think that, that kind of math will work over time. We're increasingly confident about our future and we look forward to reporting it to you next quarter.

Operator, that's the end of the call.

Operator

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

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