Moody's is materially overstating the credit risk of Level 3 Communications (NYSE:LVLT) with its Ba3 rating. Our fundamental analysis highlights a much safer credit profile for LVLT: the company's strong cash flows easily cover all their operating obligations. Moreover, in years when cash flows fall short of debt maturities, the combination of their cash flows and sizable cash on hand should allow them to service all obligations including debt maturities. Furthermore, strong PP&E recovery relative to debt levels drives a robust recovery rate of 132% on unsecured debt. The firm should therefore have access to credit markets if they choose to refinance their debt. We therefore rate LVLT four notches higher at an IG4 credit rating, or a Baa2 equivalent using Moody's ratings scale. (To register for free access to our corporate credit ratings, please click here.)
In addition, cash bond markets are overstating LVLT's credit risk with a cash bond YTW of 3.267% relative to an Intrinsic YTW of 2.357%, while CDS markets are slightly overstating credit risk with a CDS of 178bps relative to an Intrinsic CDS of 108bps.
Cash Flow Profile
We produce a Credit Cash Flow Prime™ chart for Level 3 Communications, as we do for every company we evaluate. The chart provides a far more comprehensive view of credit fundamentals than traditional ratio-based analyses. It shows the cash flow generation and cash obligations related to the credit of the firm, adjusted for non-cash financial statement reporting distortions from GAAP. The blue line indicates the gross cash earnings (Valens' scrubbed cash flow number) expected to be generated based on consensus analyst estimates and Valens Credit's own in-house research team. The blue dots above that line include the cash available at that time while the blue triangles indicate that same amount plus any existing, available lines of credit.
The colored, stacked bars show the cash obligations of the firm in each year forecast. The most difficult obligations to avoid are at the bottom of each stack, such as interest expense. The obligations with more flexibility to defer year to year, such as pension contributions and maintenance capital expenditures, are at the top of the stacked bars. All of the calculations are adjusted for non-cash distortions that are inherent in GAAP accounting, including the highly problematic and often misused statement of cash flows.
If the company generates and has cash levels that are above their obligations, the risk of default is extremely low. Even if the cash generated yearly is close to the levels of the stacked bars, a company generally has the flexibility to defer payments of various kinds. For example, they can allow assets to age a little longer, or they can cut certain maintenance costs such as maintenance capex. While decisions such as those can create other business concerns, the issue in credit risk is simply this: Does the company have enough cash to service their credit obligations?
LVLT's cash flows would be able to service all operating obligations, except in 2020 and 2022 when cash flows fall short relative to all obligations including debt maturities. That said, the combination of their cash flows and sizable cash on hand should allow them to service all obligations including debt maturities going forward. Moreover, the firm has a robust recovery rate of 132% driven by strong PP&E recovery relative to debt levels. The firm should therefore be able to access credit markets to refinance if they so choose.
Like most people, senior executives and board members do what they are paid to do. This is why LVLT's Form DEF 14A is key to understanding this company's fundamentals, something that credit agencies seem to be missing. Our Incentives Dictate Behavior™ analysis focuses on LVLT's senior executive compensation and governance. This analysis is meant to help investors understand corporate governance, how aligned a management team may be with shareholder interests, and the potential consequences of a management compensation framework to the business.
LVLT's management compensation framework is positive for debt holders. Their short-term compensation is based on customer satisfaction, employee attraction and retention, Core Network Services revenue, adjusted EBITDA, Core Network Services Run Rate, and Free Cash Flow. Meanwhile, their long-term compensation is granted through restricted stock units (RSUs) and performance-based restricted stock units (PRSUs) that are based on adjusted EBITDA levels.
As incremental growth in revenue for LVLT does not require material investment, these compensation metrics should drive management to focus on growth while improving asset utilization going forward. The free cash flow compensation metric should limit excess investment in the company's asset base, as well as promote asset utilization and margin improvement. Moreover, LVLT's operational leverage, due to the company's high level of fixed costs, will further drive margin expansion in the event of revenue growth. This is another positive for credit holders as it should lead to higher cash flows available for servicing obligations. However, it is important to note that management is not incentivized to limit leverage. They may therefore increase debt levels to drive growth, especially with the focus on EBITDA levels, a potentially negative signal for credit holders.
We provide analyses of companies' statements on earnings calls, termed Earnings Call Forensics™. This analysis is meant to help assess a management team's confidence in their conference calls when discussing certain areas of the business such as operations, stability, strategies, their ability to manage business risks, and especially, their liquidity and solvency.
In the case of LVLT, the analysis of their Q4 2015 earnings call highlighted mostly highly questionable markers from management. Management appeared confident when saying they expect better performance in LatAm on a constant currency basis. On the other hand, they appear concerned about declining EMEA wholesale and U.K. government revenue, and about the sustainability of North America revenue growth. They also appear to lack confidence in their ability to drive additional cost synergies, and may be concerned about their ability to capitalize on technology transitions going forward. Finally, they may be concerned about the viability of their investments in security services.
Ultimately, a company's credit risk (or lack thereof) is driven by cash available against cash obligations. LVLT's credit risk is being overstated by Moody's and cash bond markets, and slightly overstated by CDS markets. Given LVLT's strong cash flows relative to operating obligations, healthy liquidity profile, and robust recovery rate, ratings are expected to improve and credit market spreads are expected to tighten once the company's fundamentals are recognized.
Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article along with the lead analyst, Caroline Cervillon. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" analysis, particularly in corporate performance and valuation.
Disclosure: I am/we are short LVLT.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Officers of Valens Securities and Valens Credit are engaged and have beneficial interest in an investment management company, Kennebec River Capital, which has positions in Level 3 Communications, Inc. (LVLT) as of the date of this report.