Level 3 Communications: Why Earnings Should Bring $3.00

| About: Level 3 (LVLT)
In recent article, I discussed the announced acquisition of Global Crossing (GLBC) by Level 3 Communications (LVLT). The definitive agreement outlined what was reported a tax-free, stock-for-stock transaction.
Not only did this news catch me by surprise, but it forced me to pause and question what year I was in. Two prominent telecom-networking companies are “hooking up." Deals of this sort were commonplace at the onset of the Internet .com explosion of the mid-to-late 90s and early 2000s, when the need for high speed fiber networks placed high premiums on the companies that provided them. At the time, I talked about my expectations for the company and so far things are progressing much better than expected since the company continues to benefit from opportunistic events.
Q1 Review
First, upon closing of the Global Crossing deal, I sensed that the combination of the two companies would likely improve its balance sheet, cash flow, credit profile as well as other benefits of integration and consolidation. According to Sunit Patel, Level 3’s CFO, the transaction would accelerate the achievement of Level 3’s target leverage ratio of 3 to 5 times debt to Adjusted EBITDA.” He was quoted as saying,

“We expect the transaction to be accretive to Level 3’s Free Cash Flow per share in 2013 and to give us the financial strength to capitalize on the many opportunities available in the global market.”

So clearly there are a lot of financial implications and expectations were on this deal. Let’s see how their recent report measured up. Let’s take a look at what Q1 brought and what Q2 will likely bring.
Revenue came in $929 Million compared with $910 Million or up 2% year over year. The company reported a loss of $0.12 cents per share versus 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.
Q1 2011
Q1 2010
$929 million
$910 million
Earnings per share
Free Cash Flow
($115 million)
($90 million)
Cash Equivalents
$1.1 billion
$0.6 billion
Long-term Debt
$7.1 billion
$6.4 billion
Click to enlarge
Looking at these figures above, I have to admit that I thought they could have been better. This is only because my expectation for the company has grown dramatically over the past several months. Jim Crowe, CEO of Level 3 called report “solid.” That description left me scratching my head quite a bit. I remain optimistic about the prospects of synergistic opportunities with Global Crossing and strongly feel that the value of the company will grow exponentially upon the completion of the merger.
In remarkable fashion, the company is slowly and meticulously addressing investor concerns; particularly surrounding its debt. This was very evident in the news released yesterday where the company signed an agreement relating to the conversion of $127,962,000 of 15% Convertible senior notes due 2013. Details of the news are as follows:

Pursuant to a conversion agreement, Fairfax Financial Holdings Limited and certain of its affiliates and certain other investors have agreed to convert a total of $127,962,000 in aggregate principal amount of Level 3's 15% Convertible Senior Notes due 2013. Upon conversion, Level 3 will issue an aggregate of approximately 71 million shares of Level 3's common stock, representing the approximately 555.5556 shares per $1,000 note into which the notes are currently convertible. Level 3 will also pay an aggregate of $28,791,450 in cash, equivalent to $225 per$1,000 note, representing interest that would be due from conversion through maturity date. The shares of common stock to be issued under this agreement are exempt from registration pursuant to Section 3(a)(9) under the Securities Exchange Act of 1933, as amended.

Following this conversion of notes, $272,038,000 aggregate principal amount of the 15% Convertible Senior Notes due 2013 will remain outstanding. The 15% Convertible Senior Notes due 2013 are not callable prior to maturity in June 2013.
Level 3’s debt has always been a concern of mine. But clearly management is demonstrating that they have a plan in place to manage the debt and they are committed to cleaning the company’s books. In addition to the well receive news above what continues to make this a true turnaround story is knowing that the best is yet to come. Investors should continue to be intrigued and be filled with an increased level of optimism that comes with the synergies that it will have with Global Crossing (GLBC) as joint entities.
Earnings Preview
At current valuations and with future cloud demand, there has to be a market for the services that Level 3 has to offer; unique global services platform anchored by fiber optic networks on three continents, connected by extensive undersea facilities. The combined network will be able to serve a worldwide customer set with owned network in more than 50 countries and connections to more than 70 countries. It will then be able to potentially create a company with pro forma combined 2010 revenue of $6.26 billion and pro forma combined 2010 adjusted EBITDA of $1.27 billion before synergies and $1.57 billion after expected synergies.
On the bullish side, upon the completion of the acquisition, I feel not only will it allow Level 3 to lower costs by the combined operations; it will also help increase its average profit edge by adding to its portfolio of enterprise services with higher margins. I feel the company has a great chance of reaching $3.00 upon earnings announcement.

Disclosure: I am long LVLT.