Why Level 3's Stock Price Has Become Expensive

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 |  About: Level 3 Communications, Inc. (LVLT), Includes: GLBC
by: Richard Saintvilus

Level 3 Communications’ (NYSE:LVLT) stock has been on a tear over the past three months. I have been one of the biggest supporters of the company and the stock. I had previously written about the excitement that the company had generated when it announced earlier this year of its pending merger with Global Crossing (NASDAQ:GLBC).

I wrote then how I thought the Global Crossing transaction made Level 3 more valuable or even undervalued upon the announcement. I pointed to how the deal would create a company with a unique capability to meet local, national and global customer requirements in a wide range of markets. By combining the strengths of each company, the new entity will offer enterprise, government, wholesale, content and web-based customers a comprehensive portfolio of end-to-end data, video and voice solutions.

Since none of this has yet to occur, I am left re-assessing Level 3’s current valuation. The only logical conclusion that I can come up with is that the stock is now expensive. But before you disagree with me, let’s walk through a couple of recent events.

Since March 1 of this year, Level 3’s stock has risen from $1.38 to reaching $2.46 for almost 80% gain in a short three months. The obvious question remains, what was the catalyst for this? I was not able to find any.

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Level 3 50 Day.PNG

The graphic above tells it all. Even only from a period of May 17 to present, the stock is still up a remarkable 33%. The current 50-day moving average sits at $1.68, so it begs the question, can investors expect some type of retrace to a lower level? When a stock demonstrates such performance with no clear fundamental reason, the obvious answer to that question has to be yes. I realize that I will anger some investors for this perspective, but this is the only logical outcome. Will it happen? I don’t know, but the chances are that it is more than likely to occur sooner rather than later.

My reasons for saying this are pretty clear. Level 3 reported results for Q1 that were un-inspiring. Revenue came in $929 million compared to $910 million, or up 2% year over year. The company reported a loss of $0.12 cents per share vs. a loss of $0.14 cents a year ago. Free cash flow was pretty disappointing at a loss of $115 million. This stood out a bit more since the loss was narrower the year before at "only" $90 million.

Metric

Q1 2011

Q1 2010

YOY

Revenue

$929 million

$910 million

2%

Earnings per share

-$0.12

-$0.14

14%

Free Cash Flow

-$115 million

-$90 million

-28%

Cash Equivalents

$1.1 billion

$0.6 billion

83%

Long-term Debt

$7.1 billion

$6.4 billion

11%

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Jim Crowe, CEO of Level 3, called the report “solid." That description left me scratching my head quite a bit. I remain optimistic about the prospects of synergistic opportunities with Global Crossing, but after hearing this call I was left to wonder how the company was going to generate sales at a decent rate. Looking at these figures above, I find it hard to find any positives. The long-term debt figure stood out like a sore thumb and really curbed my enthusiasm about the long term outlook.

Prior to the deal, many experts who studied Level 3’s business and books were firm believers that the company needed Global Crossing’s acquisition or some means of leveraging its debt to present more balance. It is now quite evident that Level 3 has pretty much extended its resources and has done as much as it possibly can with not only its current assets, but also how it is structured. Though the company has made some improvements and realized some incremental growth, margins (in my opinion) remain putrid.

Summary

With future cloud demand, one has to realize that a market exists for the services that Level 3 offers. With Global Crossing on board, the combined companies will be able to do some great things. But I have to be honest and say that the stock is now grossly overvalued at current valuation. The $2.46 price does not justify a share price for a stock with such low margins in a business where it can’t raise prices. At this current level opportunistic investors may consider the stock as a short and based on what I consider $2 to be fair market value.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in LVLT over the next 72 hours.