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Level 3 Communications, Inc. (NYSE:LVLT)

January 05, 2012 2:10 pm ET

Executives

Sunit S. Patel - Chief Financial Officer and Executive Vice President

Analysts

Michael Rollins - Citigroup Inc, Research Division

Unknown Analyst

Michael Rollins - Citigroup Inc, Research Division

Good morning or good afternoon depending on where you are. For those joining us via webcast, I'm Mike Rollins, Telecom Analyst at Citi Investment Research and Analysis. We're going to continue our next fireside chat track with a focus on the wholesale and the enterprise segments of the telecom market with Level 3 Communications. I'd to welcome back Sunit Patel, Executive Vice President and Chief Financial Officer for Level 3.

Sunit S. Patel

Thank you. I'm happy to be here.

Question-and-Answer Session

Michael Rollins - Citigroup Inc, Research Division

Thanks for joining us. Maybe just to kick it off, you had a very busy year, just closed recently the Global Crossing acquisition, and maybe you could just set the stage with some of -- any sort of key thoughts exiting 2011 and what your operational and strategic priorities are for 2012?

Sunit S. Patel

Yes, thanks, good place to start. So we're now 3 months into the transaction. We closed Global Crossing in early October, so we had early January. And I would say that at this stage, everything we talked about at the announcement and at the earnings release and what we see today has been consistent. We haven't seen anything that has surprised us as such. I think for all the integration planning that we went through has paid off as we sit here today with finishing our budgets for 2012. Looking at everything, we can begin to feel good about everything we talked about at the time of the announcement, whether it's synergy realization targets, timing of that, where we are from an integration perspective, it is probably worth a quick update. So in the past 3 months I would say we have organized the company, generally the organization's well defined right down to the bottom layers. Our sales people all know what customers they're going to be covering. We're kicking off our sales conference next week in Florida, the thousand-plus sales force, sales engineers, product managers. Commission plans are finalized. So those all will be communicators so I think -- and also similarly, our sales people will have visibility to combine company revenues by customer for the customers they are covering, contracts, pricing comparisons. So a lot of work has been done from that perspective at the sales force, which is the main thing, making sure that from a customer perspective and a customer-experience perspective, we are well organized to go to market. So I think all of that is going well. Now obviously the key -- back to your priorities for this year, the key now is execution. I think with all the planning has paid off dividends in terms of organizational clarity, the sales force being able to go to market, and now its execution both on cost savings, on synergies, on the SG&A side, on the CapEx side and on the access cost side. And I'd say that given that we just finished up budgets for 2012, I think everyone has a pretty clear idea what they have to achieve that they've generally bought into, what they have to achieve and signed up for. So we feel pretty good.

Michael Rollins - Citigroup Inc, Research Division

As we think about putting the 2 companies together, the companies operated differently in some respect, the ways in which Global Crossing may have sold capacity for cash up front, sometimes it's different than you, the way you may have done compensation, the way that they recognize some revenue versus you. Are there some things that investors just should be thinking through because we haven't really seen the third quarter pro forma by segment in all the details. So are there certain things that you would want to throw out there just to educate folks on what to expect?

Sunit S. Patel

Sure. Yes, I mean, I think that the good news is for both companies, any kind of upfront cash, revenues as a percent of the overall review base was small, probably a little smaller for Level 3, but you're talking a few percentage points. And I think that Global Crossing had more every quarter, onetime type of revenue that came through early contract terminations, those sorts of things, and Level 3 really didn't operate that way. So there was some difference there. In the scheme of a company of our size, $6.5 billion of revenues, roughly 30,000 customers, it's not really much. It's noise in the scheme of things, I would say. I don't think the accounting policies were that different in the -- to make any difference in the ways the number's going forward. Having said that, obviously, whenever you put the 2 companies together, you have an initial intercompany eliminations because everyone does business with each other in telecom. There's some purchase price, accounting adjustments. People have a flavor for that in terms of the second quarter pro forma that we published. But again, in the scheme of a $6.5 billion company, the adjustments are pretty small.

Michael Rollins - Citigroup Inc, Research Division

How should we think about the pace of integration from here? So as you've laid out your synergy target, some have wondered if that's certain, some have wondered how quickly you could accomplish it. What are your current thoughts on the confidence in the number and the timing over which you could recognize it?

Sunit S. Patel

So I would say that our current expectation is that when we announced -- the time of the announcement, which was that within 18 months or after 18 months after closing, we expect to hit 2/3 of the synergy run rate we've talked about. So for example, we said we'd get about $300 million in EBITDA-related cost savings, and so that means that 18 months from October last year, that when we closed the deal, we expect to hit about a $200 million run rate at the end of that annualized savings in the 18 month -- the 18th month. So I think we're still at the same mark. Our view is still the same. I would say that our confidence around that has improved just because of passage of time, we have completed the company, we've gone through our budget process, we've got 3 months underneath our belts. So I think we feel pretty good about that. Having said that, I think if you look out longer term, and also I think we'll have most of the synergy cost savings basically done by the end of 2013. We should essentially be done. Having said that, with prior acquisitions we have done like for example, in late '05 to early '07, we did 6 acquisitions that tripled our revenue base. Not only did we hit the cost savings target but beyond that, it was the gift that kept on giving, they are longer cycle cost. So we really can't do much in the short term like real estate leases, loan, data center spaces or administrative spaces that are more longer term depending on the lease expires before you could touch those -- the other vendor arrangements that can be like that. So I think that there'll continue to be opportunities to squeeze in. And you've seen that in our results where we have consistently, in the last couple of years, delivered more than 60% incremental margins, that excess of 60% was coming from cost savings from the supplier acquisition. I think that will continue. Our confidence is good.

Michael Rollins - Citigroup Inc, Research Division

Global Crossing has a greater international exposure than Level 3. Do investors need to be more mindful of all this FX volatility that seems to be happening?

Sunit S. Patel

Yes, I mean, I would say that, yes. I mean, our business changes from Level 3, it was about 90% plus of the business was in the U.S., 10% was in Europe and now about 30% of our business will be outside the U.S. which roughly about 18% will be in Europe, a lot of it in -- majority of that in pounds sterling since it's U.K.-based. And in Latin America, 12% of the revenue base, which the biggest contributors obviously Brazil, Argentina and a host of others. I would say that for Latin America, generally speaking, while you have volatility, there's good indexation in the contracts to inflation. On the revenue side, obviously, cost side, we have to deal with. So it's combination of inflation, currency. Obviously, if the inflation is high, you have some level of devaluation. I would say as we look at the macro situation there, the economy has seemed to have slowed down. Inflation is actually abating. In some of these areas, people have tightened up monetary policy, and you do have the ability to go charge cost increases to customers. So yes, I mean I think the short answer is we obviously know how to manage it. We'll probably be forthcoming about things from a constant-currency basis versus on a reported basis and we'll talk more about it. But I think that our net-net position from a cash perspective is essentially not to hold or to minimize the amount of foreign currency balances we hold and to bring it -- convert it to dollars as when it is generated -- that's generally how we are thinking about it.

Michael Rollins - Citigroup Inc, Research Division

So moving over to the core of the business, can you give us an update on how you see the pipeline for sales, the effectiveness of your sales force and just some of the demand drivers for the business?

Sunit S. Patel

Sure, so I think generally, Level 3 standalone, I'll come to Global Crossing; we've seen our new sales grow a little last year compared to the previous year. As many of you know, we have continued to add to the sales force as we bring both companies together and look out over the next year or so. We think that if we do a good job of leveraging the platform we have, we’ll have a larger platform. So we have more network in more places, a larger product set. Global Crossing had a much larger enterprise product set compared to Level 3. Level 3 had a larger product set in some of the content areas. So a larger product set, more network in more places, more customers, we should be able to work on getting more market share than we have been. Historically, as a combined company, obviously, there's always some change when you reorganize everything but once you see past that, we feel pretty excited about the potential we see with this, especially with companies that have needs that span several continents and are under seeing these also. So it could be the large enterprise sector, could be the content sector, many of these companies are household names with operations in many different places.

Michael Rollins - Citigroup Inc, Research Division

I feel like the magic number in the last few years has been the goal for 2% sequential revenue growth per quarter. It is fair to sort of characterize that in the core communications bucket...

Sunit S. Patel

Yes, in our core network services. That's right. That's been our objective.

Michael Rollins - Citigroup Inc, Research Division

And so now bringing the company together, does it increase your confidence to either hit that 2% or maybe to the comments that you were just making, actually do some meaningful, better performance than that 2% over time?

Sunit S. Patel

So I think that Level 3 has been -- if you look at the last couple of years, we've gone from -- when the economic recession hit, we actually went to negative sequential growth and has trended up slowly, breakeven to 0 to 0.5%, 0.5% to 1%, 1% to 1.5%, now we are on the 1.5% growth-type territory. I think Global Crossing, when you bring the 2 companies together, there will be a little bit of noise initially. But generally speaking, I think our objective will continue to be to get to 2%-type sequential growth. Tough to say with a much larger base of revenue, how and exactly when that happens. But just as we look at the combined platform that we have and the ability to -- not just the ability but having more revenue growth engines. For example, in addition to what Level 3 had, which was the midsize enterprise sector, which as you know, has been going -- it took us a year to turn that round, now it's going well, same as large enterprise. Our European business, which has been a steady performer added to that. Now we'll have a Latin America business that's a double-digit grower, and we see no reason why we can't compete or drive that business similarly. And a U.K. Enterprise business, given Global Crossing's extensive U.K. network, gives yet another growth engine that we can capitalize on. So, yes, I think back to your question, over time, we should be able to drive pretty good performance when we combine space of them both.

Michael Rollins - Citigroup Inc, Research Division

Yes, if you think about the economy, the competitive landscape, the demand for the product, would you say the overall environment that you're operating in, taking out execution for a moment, but the environment, would you say it's the same as last year, would you say it's better than last year? How should investors just think about the backdrop?

Sunit S. Patel

I think the secular environment has continued to improve. I mean just 2 -- maybe 2 key points. One, just broad economic terms, when the last financial crisis hit in late '08, early '09, we saw a complete correlation between that and our business. I would describe the current environment -- well you read a lot in the paper, but the business environment is not what like you read in the paper. It's generally have reasonably steady growth in our industry. I think some of that is the secular trend in the industry, which is that the bandwidth dynamics or demand dynamics continue to be positive. We have -- a couple of you have increasing adoption of communication happening to people's eyes versus just only ears. So eyes and ears versus ears, both at a personal level, meaning at home or us as individuals and also at the business levels. I think those dynamics are continuing. Also, more and more companies shifting their presence online in the way they do business, whether it's with consumers or enterprises doing business with enterprises. And I think we are benefiting from all of that combined with the ability to gain market share from incumbents in the U.S, many of them whose priorities are completely dominated by wireless. And I think that gives us an opportunity also to get market share as the demand dynamics change and the manner in which people consume bandwidth is changing and expanding at the same time.

Michael Rollins - Citigroup Inc, Research Division

Of the themes that's been emerging from this conference is that 2011 finally was the year of -- that you have delivered over the Internet in terms of being a meaningful factor representing a substantial growth but getting more adoption, getting out of that innovators into the early adopters, et cetera. Obviously, you're participating in that with your CDN business, as well as with the core business. Can you talk a little bit about the effects that you're seeing for both sides of what you're working on?

Sunit S. Patel

Sure. So as Michael put it, I mean we, on the one hand, serve people that gather together traffic from eyeballs or eyeball aggregators, whether it's cable companies or phone companies, wireline and wireless companies and people that serve up the content that people want to see. And by content, I mean in a multidimensional and not just watching videos that's delivered to them but people that facilitate video-to-video communication, gaming is a big one, the whole thing about 3D TV is coming into the household at pretty cheap price points, higher resolution screens, bigger screens, all means more bandwidth driving. Simple anecdotal things we can look at is when we look at kids today in high school or college, they spend more time communicating live video whether it's on their mobile phone with Apple iPhones or on Skype or other places. Then they do talking on the phone. And as those people enter the workforce, it is also changing the dynamics of workforce communication. More and more of you are seeing on people's -- people that either have laptops that have cameras embedded or little eyeball cameras on top of their computers. So that's slowly seeping into the mainstream, combined with a lot of what people want to do or consume is more into the cloud and it's virtualized, which also, all of that is impacting us or benefiting us on both sides of the equation.

Michael Rollins - Citigroup Inc, Research Division

Has there any – been more developments on the CDN side in terms of customer wins or revenue wins or any other perspectives to add around that segment?

Sunit S. Patel

Yes, so we think of the CDN side, there's several areas of opportunities for us. One is expanding the product offering in the other geographies, like offering our CDN products in Latin America with the Global Crossing business over there, offering CDN for customer of ours who were historically, the U.S. business had expanding their business outside the U.S., which usually Europe and Latin America are logical next places to go to for some of them. And then, we are targeting more and more CDN needs of enterprises because more and more, the content that customers, our enterprise customers put on the Web has a lot more video in it. Even things like, people might not be doing this before but increasingly, they'll go to a McDonald's site or Coors or Bud Light site just to grab the commercial that's based on the Super Bowl, they might want to locate it again or use it for something else. So you're seeing more video content on websites. So one of the things we're offering is Web acceleration types services, part of our CDN services. And that's also -- so those are some of the areas where we think we will continue to expand our CDN business over the next few years.

Michael Rollins - Citigroup Inc, Research Division

Can you talk a little bit more about the turnaround in mid-market at Level 3, where is that coming from, and we're can that go over time?

Sunit S. Patel

So I think the mid-market, we had mentioned, we see as a great opportunity. It took us as I said, 1 or 2 years to get that turned around. And I think the key advantage we have is we have extensive metro fiber networks in 140-plus markets in not just here, but also in Europe. And that's why I was talking about U.K. enterprise business is a good one for us to grow. So what it took is hiring sales force, realistic expectations, having deep detailed knowledge about your network. We're building this close to making sure the coordination between spending the money and seeing the returns come from it is all tied together. And I think that we have improved quite significantly the information assets we have or the information about the assets we have and linking that to what is the available market in a particular building, who are the tenants in that building, what is our cost to build to that building, and how can you do all of that in a very highly automated fashion so you don't have to go through your informal business plans because it's all automated? And I think that's a big change I think compared to when we were in MFS. Everything was you had to walk the street, go physically knock on doors. We still have to do that, but the sales force now -- next week at our sales conference, we are handing out iPads to each and every one of our sales force. On that iPad, they can quote, they can go to a building, hold it up like this, tell them these are the tenants in building, this is the available market, this is the minimum order size you need for us to construct to that building. So just the information, it's sort of like the Matrix movie where you can be taken to any quadrant and within 10 minutes, you can become a complete expert on what's happening in the neighborhood. So I think that -- and we are doing that with a combination of both external databases, internal databases with good algorithms. So that's really -- I think that improves the velocity and the productivity of our sales force targeting the mid-market in a surgical way where the capital we spent is linked together with the commitment to get the revenues. So some of that is really helping our sales force, just leveraging the assets we have. But in a way we can do it. It's very high incremental returns. So we're pretty excited about that business. We think we will be able to continue that growth. Obviously, with the combination of Global Crossing, we'll have a larger base. But I think stepping through that over the next quarter though, we should still be able to get to that point and deliver solid growth. And then the other thing is back to what I said earlier, the mid-market has been ignored a fair bit by the very large incumbents because the top 3 priorities are wireless, the fourth priority might be consumer, first priority might be large enterprise then you go to that mid-market. So for us, the ability to gain market share base -- it's pretty good with having sales person directly calling. We -- the number of customers that our sales person cover in the mid-market per sales person is very small compared to what sales people in the larger companies are expected to cover, which is why we've also been successful at attracting a good sales force from those companies.

Michael Rollins - Citigroup Inc, Research Division

Is there a way you could help frame the size of the portfolio in terms of buildings, and maybe your penetration whether it's in the buildings on average or by customers just to give a sense of where the opportunity is and how it can grow?

Sunit S. Patel

Yes. You heard us say historically that within 500 feet of our network, we have over 100,000 enterprise buildings, and our market share is maybe 2% or 3%. With Global Crossing added on top of that, that those dynamics improve a lot not just from the available market we can go after, but the cost savings we can drive by replacing access cost with on-net connectivity. There is more market we can justify at higher rates over higher rates of return than we could previously without Global Crossing. So I would say that our objective would be to go from adding hundreds of buildings to maybe a couple of thousand buildings. All are over a period of several years. I don't think any of this would affect the overall capital intensity that we have. So Level 3 spending about 12% of our CapEx, I hope our revenues on CapEx compared to other companies that are doing 2x that in CapEx as a percent of revenue for equivalent amounts of revenue growth. And I think that the big advantage we have because we are leveraging a $37 billion initial investment in Level 3 and all the companies we bought. So much higher returns, much higher incremental margins for every million dollar of investment. And so I think that is a big, big plus for us. And so we think we can achieve this by allocating more CapEx to metro builds because we let synergies from both the companies combine together, but not increasing our capital intensity in terms of CapEx as a percent of revenue.

Michael Rollins - Citigroup Inc, Research Division

So from a capital-intensity perspective, you look at what's happening in the data center market, you look at what happens when you add CDN customers, for example. Would there be triggers that would be out there that could cause you to revisit capital intensity to drive revenue?

Sunit S. Patel

I think given the size of the business we have now, it's large enough where we would expect our CapEx intensity to be correlated to revenue. Meaning, higher revenue growth would mean higher capital intensity, lower revenue growth with lower capital intensity. And there's nothing we see in the short term that would change that, I think. Also in the short term, we have CapEx synergies too. And now, this year, some of those will cover some of our CapEx integration costs, but there are recurring synergies going forward. So I think it leads for the next year or 2. We don't see that dynamic changing. And that's consistent with what we've seen in the last couple of years.

Michael Rollins - Citigroup Inc, Research Division

So the relationship is to get back towards that 2% goal of yours, this 12% numbers, that right level and if there's opportunities to go above the 2%, that could create more capital intensity. And if you can't get the 2%, you choose not to because you don't want to chase certain business and capital intensity maybe better, is that the way to think about it?

Sunit S. Patel

Yes. I would say this year is a little different because we have integration CapEx. So I think this year, there will be about 12% or so. And then we'll see what next year brings from a revenue execution perspective. But I think the key is that the paybacks that we have on CapEx are so attractive because we are leveraging the current investment we have that we think that if we were to increase our CapEx as a percent of revenue, you'd see the flow back coming pretty quickly on higher revenue growth and higher EBITDA growth is probably the best way to put it.

Michael Rollins - Citigroup Inc, Research Division

[Operator Instructions] You talked about the opportunity for synergies and are there further opportunities to cut costs organically? Have you -- look at the -- just focusing on the execution versus trying to, in other parts of the business take out costs?

Sunit S. Patel

Yes. I think any time you have a larger business, you have more degrees of freedom on the cost side. I think the key, as we pointed out at the time of the announcement is we both want to make sure that the customer experience and the momentum on the sale side is pretty good. I think we have degrees of freedom to manage cost tightly here or there, but we are being a little careful at the outset. Just making sure that things are coming together pretty well and gelling and we don't run into the kind of issues we ran into last time where we were so focused on the cost savings that it took off the momentum on the revenue side. I think we're being a little more cautious. But as I've said earlier, our confidence is pretty good compared to what we've said previously. And once we get to that period, there will continue to be opportunities for cost savings.

Michael Rollins - Citigroup Inc, Research Division

You laid out the time frame in terms of dollars and savings. As we move through the next 12 months, what milestone should investors be mindful of or watching over to measure your progress beyond just the dollars, what are those steps?

Sunit S. Patel

Sure. I think the -- obviously, every quarter when we announce results, we'll talk about integration costs in the quarter, and we'll talk about the synergy run rate realization. So that should be a reasonable marker. I think beyond that, you will see it in the fact that if you look at our gross margin as a percent of revenue or EBITDA margins as a percent of revenue, you'll see that they will be expanding over the next couple of years. So we feel pretty good about that.

Michael Rollins - Citigroup Inc, Research Division

And how do you view just the backdrop from a regulatory perspective? Are there any things that you see coming down the pipe like special access reform, or the issues around the peering relationship that you have with Comcast, any developments on that part?

Sunit S. Patel

So I think on special access reform, this is an issue I don't think we are betting on anything happening or not happening there. But clearly, I think the -- our box -- I mean, the Verizon and NT [ph] I mean, they have -- they use lockup agreements, which you're entitled a certain discounts from the growth rates, so long as you're spending 90% of which you spent with them the previous year, which obviously locks up a lot of business or limits the amount of business we can bid for or compete within the wholesale market. People have obviously caught on to that and that's the focus of a lot of the complaints, especially since some of these companies are competitors on the consumer side, wireless or wireline with these companies. We have extensive metro networks, so we have some beneficial protection from that. But obviously to the extent that changes, it could be on a larger addressable market for us within the wholesale space. But again, we are reasonably agnostic in the sense we don't really expect much, but it won't be a bad thing to have happen. I think on the Comcast issue, without talking about that in particular, I would say in general, as consumer habits change the way they are, it is something that the industry generally works out. The reason is very simple. If it doesn't get worked out, consumers can start shifting alliances because the Internet access has become a basic right some people would say. And if somebody is messing with that, they'll go switch that person's competition. The industry dealt with those issues back with the SIP comp you will recall a number of years ago. And with a lot of noise, they ultimately all get worked out because nobody wants to really mess up the end-user customers. We are not too worried about that. I mean, it generally works out. It's noise for us right now.

Michael Rollins - Citigroup Inc, Research Division

Anything else that we should be thinking about for 2012. Is -- we have a question there. Sorry.

Unknown Analyst

I wonder if you can talk a little bit about what are your cost savings or some of your cost savings. I think some of the synergies were around moving some of the Global Crossing traffic onto your network and I realize that you guys are still early days, but just wondering if you could provide some thoughts around how that's going so far?

Sunit S. Patel

In terms of what the cost savings would be or...

Unknown Analyst

Just trying to move the traffic onto your network.

Sunit S. Patel

Yes, sure. So I think some of that work happened between the time of announcement and closing where we made sure we established common links between our networks to be able to enable that. And I think that as we've -- just finishing up the budget for 2012, obviously some of that is all incorporated in what we talked about, making of the $300 million of cost savings we had to mark 45% coming in from network expense savings, which comes as a result of that and 55% from SG&A off the $300 million. And I think that at this point, we feel pretty good about what we can achieve on that side. And I would say that we hopefully, over time, should do better on that front, but we are confident it's pretty good. We've got plans in place. People have signed up to deliver on all of that, solve and identify. Everything we identified in the due diligence phase all looks good. I haven't found any negative surprises.

Michael Rollins - Citigroup Inc, Research Division

Great. Well, that brings us to our time today. Thank you for your joining us.

Sunit S. Patel

All right, thank you very much.

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Source: Level 3 Communications Inc. Presents at Citi Global Entertainment, Media & Telecommunications Conference, Jan-05-2012 11:10 AM
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