Level 3: A Takeover Target With 100% Upside

by: Jeremy Richards

Investors have recently asked my opinion on Level 3 (NASDAQ:LVLT), inquiring as to if I continue to hold the stock. In my article in November 2010, the stock was trading at $1.12. At that point, I stated that I expected LVLT to hit $2 by April, 2011. As those who follow the stock know, it recently hit a high of $1.65. And currently, I think the recent pullback to the $1.30 range represents a compelling entry point. The stock offers investors much more upside reward than downside risk. My 12-month price target is $2.75 (over 100% upside) and my 3-year target is $5. Here are the key reasons behind my conviction:

1) Fiber Assets and Balance Sheet Improvements- The fiber assets alone are worth tens of billions. In the early 90s when all the fiber was laid, the cost was about $14 Billion, and today, the replicable cost would easily be four to five times that amount. Besides the cost, it will be difficult to replicate laying of so much fiber in metro areas, since it involves digging up roads, cutting lines, etc. Even when one subtracts the company's debt of approximately $6 billion from the 1990's cost of fiber, there is an $8 billion surplus.
Since the company trades at a market cap of approximately $2.2 billion, there is substantial surplus value. In 2009, there were rumors that Sprint might buy Level 3, but writers reported that Sprint (NYSE:S) wanted to see balance sheet improvement before considering a deal. At that time, the companies discussed a joint venture. But,time passed without the companies striking a joint ventureship deal, mainly over disputes over the terms of the deal. Now, the likelihood of a takeover by Sprint has become more probable. Level 3's recent re-structuring of its debt considerably strengthened its balance sheet, making it a much more attractive target to Sprint.
2) Insider Buys - It is bullish to see insiders buying Level . Insider John T Reed bought 123,580 Level 3 shares on Feb. 9, 2011 costing approximately $152,000. Additionally, seven other insiders have bought Level 3 stock on the open market over the past 6 months. Insiders now hold 16% of the company. Institutions hold 74% of the float. I believe short sellers are on the wrong side of the trade as they hold short over 97 million shares about 14.5% of the float.
3) Institutional Buys- Hedge funds are buying Level 3. Renaissance Technologies is a New York-based fund with 2,753 reported holdings that carried a value of more than $24 billion as of Dec. 31. Renaissance Technologies wasn't shy about making purchases in the fourth quarter of 2010. The largest purchase of its investment in 26 companies was that to buy 10.7 million shares of Level 3 (article).
4) Recent Deals expected to add to revenue-
-In November of last year, Netflix (NASDAQ:NFLX) selected Level 3 for a three-year deal to serve as a primary content delivery network [CDN] provider for Netflix, to support the company’s streaming functionality and storage for the entire Netflix library of content. Level 3 has stored the entire Netflix streaming library of more than 20,000 titles. Level 3 started serving traffic on January 1, 2011. Analyst Jennifer Fritzsche of Wells Fargo and Co. says, “The Netflix win is likely to be meaningful to incremental revenue growth for the company...”. Dan Rayburn, a Frost & Sullivan analyst, said he expected Netflix to end its relationship with Akamai (NASDAQ:AKAM). If this occurs, I estimate that Level 3 will capture 80% of Netflix's business with Limelight (NASDAQ:LLNW) providing the other 20%.

-On Feb 28, 2011; Level 3 announced a strategic long-term agreement with leading Middle East telecommunications operator Saudi Telecom (NYSE:STC) to enable international IP and content distribution services in Saudi Arabia and across the Middle East. “With the largest international network in the Middle East and Africa, Saudi Telecom is the only Middle East operator today that has international connectivity by way of both multiple submarine cable systems and a terrestrial cable system via the recently launched Jeddah-Amman-Damascus-Istanbul (JADI) link,” said Saad Demyati, Saudi Telecom’s vice president of Wholesale Business Unit. “Our relationship with Level 3 allows us to offer the reliable, high-quality global connectivity and end-to-end solutions our customers increasingly demand, with the unique benefit of access to a fully redundant and scalable Tier 1 network.”

-On March 1,2011, Level 3 announced it has been selected by Crytek GmbH, one of the world's leading independent development studios for interactive entertainment, to support the company’s website content delivery needs.

5) Technical Indicators - Level 3 recently traded at high of $1.65 on Feb. 18, 2011. In my opinion, this is an excellent chance to buy the stock on this recent pullback. Technical indicators show Level 3 is now extremely oversold. Also, it is interesting to note the recent bullish options activity.

Final note: In the last earnings report on February 2, 2011, CEO James Crowe made comments during the conference call which provide an excellent summary of what is to come for Level 3:

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 … And I believe there is no company in our industry better positioned to benefit from the visual Internet than Level 3.

Disclosure: I am long LVLT, NFLX.