Will Level 3 Communications Regain Its Past Glory?

| About: Level 3 (LVLT)

Will Level 3 Communications (NASDAQ:LVLT) regain the past market capitalization of its glory days? LVLT became a Wall Street darling, the stock soaring to $132, on March 10, 2000, with 334 million shares boasting a market cap of $44 billion. Not long after the Internet bubble burst, companies with massive debt and no earnings started to collapse, and LVLT was no exception. Some of LVLT’s competitors declared bankruptcy, then emerged stronger, via strengthened balance sheets -- one example is Global Crossing (NASDAQ:GLBC). But it’s been a long and painful road for loyal shareholders who never wavered, clinging to their LVLT shares.

Fast forward to the present. LVLT is waiting for approval on the pending acquisition of GLBC. The resulting shares outstanding from this acquisition will number approximately 3.9 billion. That would require a share price of $11.28 to match the market capitalization of $44 billion achieved when LVLT was a Wall Street darling. On the other hand, it shows the effects of dilution LVLT has had to endure to survive. Management gets an A+ at financial engineering, avoiding bankruptcy when others could not, but it came at a price.

GLBC is one in a string of many acquisitions. Beginning with the late-2005 acquisition of WilTel, Level 3 has established itself as an industry consolidator. During 2006, the company went on to acquire Progress Telecom, ICG, TelCove and Looking Glass Networks. In 2007, Level 3 acquired Broadwing, the Content Delivery Network services business of SAVVIS, Inc. and Servecast. But the GLBC acquisition could be the catalyst LVLT has been looking for to kick-start growth, returning it to valuations of past.

Some believe LVLT will break away and become a high-flier once again. So what performance is required for a return to the market capitalization levels achieved in early 2000 in the next five years? The communication margins of a combined LVLT and GLBC is presently running at about 49%. (A recent summary of LVLT-GLBC pro-forma results can be viewed here.) Margins would need to ramp to 65%, with top-line growth reaching 18% by year 5. The following table presents 2010 actual results and 2016 projections using the growth rates required to push the stock above $11 and a market capitalization not seen in over a decade.

Total Rev
Cap Ex
CapEx to GAAP
Comm Rev
Net Earns
Comm Margins
Adj. Ebidta
Adj. Ebidta Margin
Free Cash Flow
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The growth rates sound achievable, so why is the stock sitting around $2? Obviously the market is not buying the above scenario. A big reason is management’s comments.

LVLT management (Sunit Patel) gave the following guidance in July:

As we've indicated in the past, we are shooting for 2% sequential growth -- and I think that the momentum you see in the second quarter should continue in the second half of the year .… Our sales were up in the second quarter. Sales funnels up also. So we feel good about the second half of the year and our objective is to keep increasing the pace of -- and keep working towards our 2% objective.

The market is pricing in Patel's comments as long-term growth. A 2% sequential quarter-over-quarter growth rate equates to a yearly growth rate of 8.2%. If true, the stock is trading exactly where it should be. I have to admit I don’t think it will remain this low going forward, but it’s hard to compete with management’s comments.

We feel management is conservative, and based on their comments we believe a more realistic scenario is margins approaching 56% and communications growth at 11% over the longer term. Even at these growth rates, the stock is attractive at these prices.

The bottom line is until management not only believes they can do much better, but is confident enough to publicly upgrade guidance, it will be a very, very long road back to a double-digit stock price. One or two quarters of good growth will not upgrade the Street’s perception until management gives increased visibility, telling potential investors that better results can be sustained. Maybe they are holding their cards close to the vest until the GLBC acquisition is final.

Management, what say you?

A complete set of detailed financial data and projections can be found here.

Disclosure: I am long LVLT.