The genesis of this post came from two articles. The first article I read was on Lightreading.com. The following quote caught my attention:
Level 3 Communications Inc. (Nasdaq: LVLT) says its vast fiber network will help turn its newly acquired content delivery network [CDN] business into something that can compete with Akamai Technologies Inc. (Nasdaq: AKAM) and Limelight Networks LLC .
Frequent readers know that I have posted several times on the subject of Akamai and content. My purpose is not to rain on the Level(3) (note I will use L3 in place of Level(3)) CDN parade, but I fail to see to the comparison between how Akamai delivers content and how L3 delivers content. The Akamai strategy uses distributed hosting servers and content caching. The supposition by L3 that their fiber backbone will be a competitive advantage to a CDN is very much in question. The assets that L3 bought from Savvis were the combined Digtal Island and Sandpiper content delivery networks.
Digital Island and Sandpiper started as separate companies in the late 1990s. They merged in a $621M deal in October 1999. In May 2001, Cable and Wireless bought Digital Island for $340M. In January 2004,Savvis bought the U.S. assets of Cable and Wireless for $155M, which included the combined content delivery network of Digital Island and Sandpiper. In December 2006, Savvis sold their content delivery network to L3 for $135M. The facts that we can determine from these transactions are that the combined CDN of Digital Island and Sandpiper has been declining in value from $621M (1999), to $340M (2001), to $155M (2004) to $135M in 2006. If Savvis CDN was an undervalued asset that was a competitive worry to Akamai, I would have assumed that Akamai would have bought the Savvis CDN. Akamai is the CDN market leader, they have an awesome multiple, they can clearly afford $135M or $200M and could have outbid L3 – but they did not. Why? Akamai has paid enormous attention to Digital Island in the past including litigation. Akamai must not have really considered the Savvis CDN much of a competitive threat and the declining value of the asset over the past seven years does support this assumption. In terms of L3, does a $135M deal solve a $7.36B problem for a company that has lost money for nine (9) straight years?
The second article that started this post came from 24/7 Wall St. on the breakup value of L3. Before we discuss the 24/7 Wall St. article, we need to review a brief amount of L3’s history over the past ten years.
Is History on the Side of Level(3)?
I took the time this weekend to review L3’s recent investor presentations and press releases. As a company, they do many presentations to the investment community. Over the past fourteen (14) months, L3 has issued 81 press releases. These 81 press releases can be grouped into five categories:
Debt/Financing 32.89% New Business 18.42% M&A or Asset Sale 17.11% Earnings/Annual Meeting 17.11% Investor Conference Presentations 13.16% Marketing Initiatives 7.89%
13% of L3’s press releases are to inform the investor community of the intention to present at a conference. One the benefits of Regulation FD, is public companies must post investor content for public consumption and we do not have to travel to a conference to get the materials. The reason why 32% of L3’s press releases are about debt, or financing is because L3 has a large debt position (~$7.36B) and has been acquiring companies with debt. Back in the 90s, to build long haul optical backbones required vast sums of money. These sums were raised through equity offerings as well as debt financing. Six years on from the bursting of the telecom bubble, the debt levels incurred by many service providers have been addressed through bankruptcies and asset sales. L3 is one of the few new entrant service providers not to declare bankruptcy and still have a large debt to service.
When the telecom bubble burst post-2000, L3 found itself with a fiber optical long haul network and not many customers who needed their network. The L3 business plan looked similar to other long-haul wholesale service providers such as Qwest, 360 Networks, IXC (i.e. Broadwing) and Williams. I distinctly remember being in Dallas in 1998 when a senior executive of a large service provider told me that (paraphrased) “…owning a wholesale business in the telecom business is a nice complement to a retail business, but if you do not have a retail business it is a terrible business to be in.” When the shock of the telecom market correction evolved from a market correction to long term reality, the L3 leadership realized that long-term survivability of the company was at stake and it was not going to be addressed through force reductions. I speculate that the need to overhaul their business with a retail component was crystallized into a plan of action in late 2004 or early 2005. The good news about L3’s debt levels was the company was protected from hostile bids and LBOs. The challenge before the L3 team was (1) refinance the debt moving out the maturity dates, (2) find a retail business that generates profits to fund the debt payments and (3) hope that something comes along that needs our backbone capacity.
To solve the issue of being a wholesale supplier in a world run by giant consumer oriented service providers, L3 decided to acquire retail CLECs and other backbone providers to end the ruinous price war for LH capacity. The question that should be asked is: does the strategy of buying small CLECs or broken LH companies lead to the creation of a high quality company? Here is how L3 has spent $3.91B of shareholder capital over the past sixteen months:
- 10.31.2005 L3 Acquires WilTel for $680M (Removes LH Competitor)
- 01.26.2006 L3 Acquires Progress Telecom for $137M ($70M+ Annual Revenues)
- 04.16.2007 L3 Acquires ICG Communications for $163M ($70M+ Annual Revenues)
- 05.01.2006 L3 Acquires Telcove for $1.23B ($400M+ Annual Revenues)
- 06.05.2006 L3 Acquires Looking Glass for $165M
- 10.17.2006 L3 Acquires Broadwing for $1.4B (Removes LH Competitor)
- 12.26.2006 L3 Acquires CDN Network from Savvis for $135M (Complement Vyvx)
Here are four links to recent presentations by the L3 leadership team: 01.11.07, 12.07.06, 12.04.06, 10.19.06 and 05.24.06. If you are looking for an interesting post on using numbers and metrics to describe a business, read this post by Scott Maxwell. I am not suggesting any form of deception in the L3 presentations, but I do think there are many unqualified assumptions made about their business.
Aspects of the L3 Business that Require Investigation and Explanation :
I started the process of looking at L3 by reviewing their last set of investor presentations. There are often clues in these presentations if you compare a series of them over time to see how the content changes, is removed, what content is added and how content is emphasized and deemphasized.
- 01.11.07 Presentation Page 2: The first slide outlines L3’s Strategy which is “Continue to leverage the most cost efficient network, Offer the right services, drive growth through customer centric organization Maintain the most cost-effective operations, Add value through opportunistic M&A, Maintain financial strength.” The succeeding slides tend address each of these bullets, but rarely provide any metrics to substantiate the claims or the strategy. There are no real details on “right services” that L3 provides to their customers, because I think their primary service is simple transport. If you look at slide 6, which outlines L3’s customer focus the hidden message is very clear. All the customer logos on the right hand side of the slide have a common component to their business: consumer and business end-users. That is the crux of the L3 business dilemma. They are a wholesale business and rely on their customers to acquire end-users and therefore are at the mercy of the customer’s acquisition rates.
- 01.11.07 Presentation Page 15: Shows that L3 pushed out the looming debt collision by two years from 2008 to 2010 and 2011. $4B of the debt now matures in 2010 and 2011.
Profits : L3 has not made an annual profit in nine (9) years. The last annual profit came in 1997. Google was not even incorporated in 1997 (it was founded in 1998) and Bill Clinton was President. Ten years later, Hillary is running for President and Google has a market cap of $144B. The following chart is a simple revenue and expense table for L3. The question that this historical performance leads to is: when will their business model be profitable and will it generate enough profits to pay off the debt?
Leadership Question :The company has been on an acquisition plan over the past sixteen months, but what evidence do we have that this leadership team has the skills to integrate the acquisitions and execute on the disparate nature of the businesses they have acquired? We cannot look L3 in the way we look at SBC or Verizon. The question is still to be answered of whether L3 is goes the way of Worldcom or not. I am not implying fraud; I am implying the missing historical collaborative evidence. Name another large, profitable service provider that built a backbone to start a wholesale business, incurred a mountain of debt and became a successful company? Those with a long knowledge of telecom history will offer MCI (debt financed the Microwave network) and Sprint. Yes, it took MCI and Sprint twenty years to build their businesses. Does L3 have twenty years?
Extra Fiber Story :I do not believe in the promotion that extra fiber capacity provides L3 with a distinct competitive advantage. This comment was again propagated by 24/7 Wall St. post on the breakup value of L3. Here is a quote from the 1999 L3 Annual Report on the company’s strategy to “…Become the Low Cost Provider of Communications Services,” page 4. The challenge with being the low-cost provider; it usually means you are also the low cost profit center and unless you have business scale on the level of Wal-Mart, it is hard to generate vast profits from low-cost bids. For those who are reading and thinking “low cost” and “low bid” are mutually exclusive, I state that in would of service provider pipes, low cost means lowest bid and win on price. Now L3 does have nice margins and they promote this fact in their presentations, and they have taken out other LH competitors to stabilize market prices, but something is wrong with the business model because they are not profitable. Joseph Nacchio was famous for using AT&T’s balance sheet to destroy LDD pricing in the 80-90s in war with MCI. Service provider wars are fought on price. I think L3 knows that competing on price in a bits/per second market structure is not a strategy for long term success. When Level(3) tells the world about all their excess wholesale fiber and low-cost network, I think the smart purchasing agents in companies like Google, Microsoft and Wal-Mart are eager to start the next round of contract negotiations because they view optical circuits as a commodity. The question to be answered is how do L3’s assets evolve into a profit mechanism that allows them to win and control market share?
Video Driving Bandwidth Story :Here is the challenge with the whole video is consuming internet bandwidth story: too many people are promoting this story liberally and detailed metrics are hard to find. The challenge has always been the last mile connection to the end-user. I have posted in the past how Verizon is affecting this market by pulling fiber to the home with additional data here. Even though we are seeing increased broadband penetration in the US read this link and this link, we are still missing data points to collaborate assertions that backbones are running out of capacity. One would assume that Verizon and AT&T, who have been very aggressive to pull fiber or broadband to homes and offer triple play services, would need to upgrade the capacities of their long-haul backbones to support the video traffic. Has anyone seen an RFP from Verizon or AT&T for a new backbone? I have not. I know they are adding 10G channels to support capacity demands and I know they are looking 40G solutions, but they are not pulling fiber and building new backbones. If the two biggest service providers are not upgraded their backbones, why should we believe that video is going to drive a vast amount of traffic (i.e. business) onto the L3 backbone?
Historical Fate of L3’s Peers :Here are acquisition values for five companies:
- AT&T $16.9B
- MCI $8.6B
- Sprint/Nextel Merger $35B
- Broadwing $1.4B
- Williams $680M
How do these historical comps frame the value of L3? Before we get to that question, who would want to buy an unprofitable company with $7.3B in debt? SBC bought AT&T. Verizon bought MCI. Sprint and Nextel merged. Comcast? Time-Warner? Qwest? Maybe a European PTT? None of these companies will buy L3. I think the good news is that the L3 leadership will have an uninterrupted opportunity to fix their business because they are clearly worth more then Broadwing, but less then MCI and that is a value that will not work with the L3 shareholders.
How Does a Backbone Improve a CDN: In the category of “please explain in detail” I would place the statement that L3’s backbone will enhance the CDN they purchased from Savvis. Maybe it will, but the CDN market share leader is Akamai with a market cap of ~$9B and they do not have a backbone. I think L3 wanted the Savvis CDN, because they need direct connections of end-users. The question is can they build a competitive CDN offering that takes market share from Akamai? I doubt it, but talking about a high-end CDN is far more appealing from a business perspective then talking about wholesale fiber circuits. As a reality check, the CDN network L3 bought from Savvis had an annual revenue run rate of ~$20M in 2006. Akamai finished 2006 with $428M in revenues. The good news is there is plenty of room to grow L3’s market share of the CDN business – the bad news is Akamai’s business 20x L3.
In three prior posts (First 2ndDotCom Bubble, Updated 2nd DotCom Bubble and the Clearwire post) I began developing a behavioral attribute matrix to test for hubris and the formation of an investment bubble. Serendipitously I thought to use the matrix to evaluate the Clearwire IPO news of the last few weeks. I have evolved the matrix a fourth time to frame the L3 investment question. I am using the January 11, 2007 Level(3) Investor Presentation and looking for examples in the presentation that match the behavioral attributes:
The good news is that L3 investor presentations are not full of hype and unsubstantial claims. I think several of their business points need clarification, supporting collaboration is often missing and I suspect it is not included in the presentations because the business drivers they cite as foundations for the future are still anecdotal in nature.
This leads back to the 24/7 Wall St. post on the breakup value of L3. I will agree that L3 was designed for a market in which there were many types of service providers and L3 could focus on being a carrier for the service providers. I do agree with the supposition in this post that we seeing the emergence of bandwidth drivers. “It seems that we are finally getting to that point in the internet’s maturity that many investors thought would happen three or four years ago, where applications like VoIP and video eat up all the excess bandwidth and make the telcos and content providers go looking for more…This is precisely the environment that Level 3 was designed to make money in.” I disagree with two points. (1) I do not think we see enough evidence to support a statement that the internet’s maturity is reaching a point envisioned 3-4 years ago, although I would promote this belief if I worked at L3. (2) I also disagree with the assertion that “Even the major wireless carriers could jump into the game, as they will need a strong network backbone to piggyback their increasingly bandwidth-hungry content on between the cellular sites and switches.” I will agree that applications are driving bandwidth, but there are only four major wireless providers in the US and three of them have there own backbone and I do not see T-Mobile calling home to Bonn for $8B to spend on a US backbone.
I doubt Google or MSN or Yahoo is going to step outside of their business model to buy a backbone when then can lease what they need when they need it. I would be surprised to see L3 acquired by another service provider when all of the service providers who could buy them already have a backbone and breaking up a company with $7B in debt is challenge.
Here is a 1999 profile of Level(3) from Network World:
Crowe's Level 3 is building an end-to-end IP network that will - if everything goes according to plan - carry a big chunk of the converged voice and data traffic of tomorrow. Level 3 will build local networks in major U.S. cities and interconnect them over a fiber backbone, all at a cost of between $8 billion and $10 billion. Crowe's aim: to undercut entrenched carriers on price and gobble up big corporate users' rapidly growing data traffic. Crowe figures his advantage is that he 's building Level 3's network, which won't be fully operational until at least 2001, from the ground up to support IP data packets. The incumbent telcos, on the other hand, are struggling to retrofit their circuit-switched systems to handle all the data flows. That means higher costs for them and plenty of opportunity for him.
In hindsight, the incumbent telcos did quite well and they are now the companies pulling the majority of the fiber in the market. The conclusion concerning L3 is that there is not enough external evidence to support a thesis that company will be well positioned to grow in future years. Some trends are emerging that are in L3’s favor, but there are too many questions concerning their ability to execute to leverage these events into meaningful value for shareholders.
Disclosure: Author has no position in stocks mentioned