Level 3 Communications (LVLT) Jeffrey K. Storey on Q2 2016 Results - Earnings Call Transcript

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Level 3 Communications, Inc. (NASDAQ:LVLT)

Q2 2016 Earnings Call

July 27, 2016 10:00 am ET

Executives

Valerie Finberg - Vice President-Investor Relations

Jeffrey K. Storey - President, Chief Executive Officer & Director

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

Analysts

Simon Flannery - Morgan Stanley & Co. LLC

Colby Synesael - Cowen & Co. LLC

Eric Pan - JPMorgan Securities LLC

David Scott Goldman - Jefferies LLC

Nick Del Deo - MoffettNathanson LLC

Timothy Horan - Oppenheimer & Co., Inc. (Broker)

Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Level 3 Second Quarter 2016 Earnings Conference Call. During the presentation, all participants will be in a listen-only mode. Afterwards, we will conduct a question-and-answer session. As a reminder, this conference is being recorded on Wednesday, July 27, 2016.

I would now like to turn the conference over to the VP of Corporate Communications and Investor Relations, Ms. Valerie Finberg. Please go ahead.

Valerie Finberg - Vice President-Investor Relations

Thank you, Frank. Good morning, everyone, and thank you for joining us for the Level 3 Communications' second quarter 2016 earnings call. With us on the call today are Jeff Storey, President and Chief Executive Officer; and Sunit Patel, Executive Vice President and Chief Financial Officer.

Consistent with the SEC's recently issued compliance and disclosure interpretations relating to non-GAAP metrics, we have made some changes to some of our presentations. For example, in the revenue table on page three of this morning's press release the column labeled Percent Change, Modified and Constant Currency is equivalent to the column labeled Percent Change, Constant Currency found in previous earnings' press releases.

The earnings presentation we will review this morning contains the reconciliation of our non-GAAP financial measures to the most comparable GAAP measures. This presentation, along with all of our other earnings materials, are available in the Investor Relations section of the Level 3 website at investors.level3.com.

The modified prior period results we are discussing today exclude the company's Venezuelan subsidiary that was deconsolidated at the end of the third quarter 2015 and reflect changes made to customer assignments between the Wholesale and Enterprise channels at the beginning of 2016 due to mergers in certain customers and other changes. Unless otherwise noted, in our remarks today revenue and sales comparisons to prior periods are provided on a year-over-year modified and constant currency basis.

Our Safe Harbor statement can be found on page two of our 2Q 2016 earnings presentation. The presentation and remarks contain forward-looking statements that are subject to risks and uncertainties. Results may vary significantly from those statements and additional information is available in the Investor Relations section of the Level 3 website and in our filings with the SEC.

With that, I'll turn the call over to Jeff.

Jeffrey K. Storey - President, Chief Executive Officer & Director

Thanks, Valerie. Good morning, everyone and thank you for joining us. As you can see from our results, we continue to see good margin expansion, growth in adjusted EBITDA and free cash flow, solid sequential growth in EMEA Enterprise CNS revenue and strong growth in both sequential and year-over-year LatAm Enterprise CNS revenue. While we're pleased with our overall performance, we were not pleased with the revenue growth in North America Enterprise CNS and believe we have room to improve.

Our focus on driving profitable revenue growth through taking share in the market has not changed. While results are never linear and North America Enterprise CNS revenue growth was below our expectations, we did see strong year-over-year and sequential CNS revenue growth from large, multinational customers. We also continue to see the market moving toward Level 3 as our customers' networking requirements continue to grow, and require the products and services we offer.

Our focus on Enterprise wireline services and our ability to solve our customers' challenges is a differentiating factor that is becoming more critical every day. Sunit will go into more detail, but our capital investments, our relentless focus on execution and the operating leverage we gain from scale and efficiency are consistent with our guiding principles of managing the business for growth and increasing free cash flow per share.

As usual, after Sunit reviews the detailed financial results, I'll provide commentary on what we're seeing in the market. After that, we will open it up for your questions. Sunit?

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

Thank you, Jeff, and good morning, everyone. I'll quickly share a few financial highlights for the quarter, which can be found on slide three of our presentation.

We grew Core Network Services or CNS Enterprise revenue by 5.3%. Excluding the contract renewal we mentioned in the press release and UK government revenue, we grew CNS Enterprise revenue by 6.3%. We increased adjusted EBITDA by 10% to $715 million. And finally, we generated strong free cash flow of $264 million.

We continued to grow Core Network Services revenue this quarter and saw improvement in both EMEA and LatAm Enterprise CNS revenue. In North America, as noted in the press release, we saw some headwinds in the quarter, mostly due to a one-time event and slightly higher Enterprise disconnects at the small end of the customer base.

Across all three regions, we also saw an increase in Wholesale customer disconnects, primarily driven by industry consolidations that took place over the last couple of years. Overall, we are not pleased with the revenue performance in the quarter, and feel we should be performing better, especially in North America.

Additionally, as we have seen over the last year, the strength of the dollar against many other currencies has affected our reported results and led to differences in constant currency and actual growth rates. This is shown on slide four.

As you can see on this slide, reported revenue growth rates by region on both a constant currency and an actual basis. As a reminder, U.S. dollars make up 90% of revenue followed by the British pound at 4%, and the euro at 3%, the Brazilian real at 2%, and all other currencies making up the last 1%.

Overall, total revenue grew 1.6% and CNS revenue grew 2.8%. Enterprise CNS revenue, excluding UK government grew 5.9%. Revenue from our large, multinational customers, which represent 17% of total Enterprise CNS revenue, increased 12%. Total Wholesale CNS revenue declined 3.4%, driven by the disconnects, I just mentioned.

On a regional basis, North America CNS revenue grew 3.5% year-over-year, with flat performance on a sequential basis. Enterprise CNS revenue grew 5.9% and Wholesale CNS revenue declined 2.2% this quarter.

This quarter, as we indicated in the press release, Enterprise performance experienced some pressure resulting from a renewal and extension of a large contract with a top customer. With this renewal, we issued a $5 million credit in the quarter and extended the length of the contract by two years, with more than $100 million in additional revenue expected during the extension period. Excluding the effects of this contract renewal, our North America Enterprise CNS revenue would have grown 6.4% on a year-over-year basis. Additionally, we saw churn increase from a number of smaller, less profitable customers.

Offsetting the industry consolidation impact in Wholesale, we benefited from approximately $10 million in dispute settlements in the quarter. As you may recall, we had a similar amount of dispute settlements in the second quarter of 2015.

Moving to EMEA; in the second quarter, CNS revenue declined 4.6% with Enterprise CNS revenue excluding UK government growing 1.9%. On a sequential basis, Enterprise CNS revenue excluding UK government grew a strong 2.9%. We saw continued strong sales production from Enterprise customers, both on a sequential and year-over-year basis. Wholesale CNS revenue declined 7.2%.

Before we move on from EMEA, one topic that has recently gained attention is Brexit. Many of you have been asking us how this might affect our business in both the short-term and long-term.

As I mentioned earlier, the British pound represents approximately 4% of revenue and the euro about 3%. Looking back at the second quarter, the average rate for the pound was 1.44 (8:46). The average rate since Brexit vote on June 23 has been 1.32 (8:53). While it had a minimal effect on our second quarter results, the weaker pound will affect our reported revenue results in the third quarter, but will have a minimal impact on adjusted EBITDA and free cash flow for the rest of 2016.

At this point, we've not seen any changes in customer buying patterns because of Brexit. We did not see any customers' past purchases at the end of the quarter based on the vote. And as I mentioned, sales were strong. We expect that Brexit could cause some uncertainty in the region and the macro environment in general over the next couple of years.

In Latin America, CNS Enterprise revenue remained strong, growing 9.6% year-over-year and 2.5% on a sequential basis. Wholesale CNS revenue declined 9.4%. Wholesale customer consolidation also affected Wholesale Voice Services revenue or WVS, which declined 16% to $100 million in the second quarter 2016. For the full-year 2016, we now expect WVS revenue to decline by approximately 15%.

Moving to our revenue mix, which can be found on slide five, North America represents 82% of our CNS revenue, followed by EMEA at 10%, and Latin America at 8%. Our Enterprise customers represent 72% of CNS revenue, while Wholesale customers make up the remaining 28%.

Turning to slide six and revenue results by product group, IP and Data Services grew 5.1%; Transport & Fiber grew 0.3%; Voice Services declined 4.4%; and Colocation & Data Services grew 14%, mostly due to the settlement in North America Wholesale. A few highlights from an individual product perspective included managed security growth of 30%, CDN growth of 22% and dark fiber growth of 13%.

From a sales or bookings perspective, for the second quarter, total sales production as well as sales productivity continued to improve. Sequentially, we saw sales production increase in all of the regions we serve.

From a head count perspective, we added both quota and non-quota bearing head count to our sales organization. We increased QBHC by roughly 20 in the quarter. At the same time, we added five specialized non-quota bearing security and CDN sales representatives to help identify and close opportunities for these growth products. From a pricing standpoint, we've not seen much overall change over the last several quarters.

Moving to slide seven, Network Access Margin expanded to 67.1% compared to 66.0% in the second quarter 2015. The improvement in Network Access Margin was driven by continued high-margin CNS growth, combined with low-margin WVS revenue declines and the settlement that I mentioned earlier, which was 100% margin. We expect continued margin expansion for the remainder of the year, as we tightly manage third-party costs.

Turning to slide eight; adjusted EBITDA was $715 million for the second quarter 2016. This compares to $650 million in the second quarter of 2015. The improvement in adjusted EBITDA was driven by continued high-margin CNS growth combined with low-margin WVS revenue declines. We also continue to expand adjusted EBITDA margin, which improved nicely to 34.8% in the second quarter of 2016 compared to 31.9% in the second quarter of 2015.

Year-to-date, capital expenditures were approximately 16% of total revenue. As a reminder, CapEx can be lumpy in any one quarter, and for the full-year, we continue to expect capital expenditures to be approximately 15% of total revenue.

The company generated free cash flow of $264 million in the quarter compared to $90 million from the year-ago quarter. During the quarter, we successfully completed the refinancing of approximately $775 million in senior notes.

As a result, the company incurred a loss on extinguishment and modification of debt before taxes of $40 million, or approximately $0.11 in basic earnings per share. We exited the quarter with our net debt to adjusted EBITDA ratio of 3.5 times and remain focused on getting to the low-end of our target leverage range of three times to four times.

The effective income tax rate in the second quarter was 22%, resulting from the release of a valuation allowance against the deferred tax assets of our German subsidiary. Year-to-date, our tax rate has been 33%. In the third quarter, we expect our tax rate to be higher than 33%; and for the full-year 2016, we continue to expect our GAAP income tax rate to average about 30%.

As I mentioned earlier, our revenue performance is not yet at a level that we are pleased with. Looking back at the effects of churn on our business from both Enterprise and Wholesale customers, we are updating our expectations of revenue performance for the full-year and now believe that our CNS revenue percentage growth with the exceptional Latin America Enterprise revenue growth will not be as strong as last year.

We do expect better Enterprise CNS sequential performance for the remainder of the year in line with the growth rates that we have seen in previous quarters. Additionally, I would like to note, as we look to the third quarter 2016, it has been a particularly hot summer, and we expect to see our typical increasing utility costs, generally in the high single-digit millions of dollars resulting from higher summer cooling requirements in our data centers.

Also, from a North America Wholesale CNS revenue perspective, please keep in mind that we will not see the benefit of the second quarter dispute settlement recur in the third quarter. Because of our ongoing focus on profitable revenue growth, combined with our continued disciplined cost management, we remain confident and are reiterating our adjusted EBITDA outlook of 10% to 12% growth, and we continue to expect to generate free cash flow of $1 billion to $1.1 billion. All other outlook measures remain the same and are highlighted on slide nine.

We've made a lot of progress on profitability since the acquisition of tw telecom in the fourth quarter of 2014. Prior to the acquisition, Level 3's adjusted EBITDA margin was 28% to 29%; and tw telecom's EBITDA margin was 33% to 34%. Today, our adjusted EBITDA margin is about 35%.

In summary, we continue to make the right investments in the business to drive profitable revenue growth. Our financial position continues to strengthen with our net debt to adjusted EBITDA leverage ratio well within our target range and a cash position at nearly $1.3 billion. We are also focused on delivering better revenue performance for the remainder of the year, especially in our North American Enterprise business.

With that, I'll turn the call back over to Jeff.

Jeffrey K. Storey - President, Chief Executive Officer & Director

Thank you, Sunit. I'd like to make a few additional comments on our revenue growth this quarter and provide our updated view of the market and the opportunity.

On the Wholesale side, we've said for the past three years or four years that we generally expect Wholesale CNS revenue to be flat to slightly down over the long-term. We maintain that view, and nothing about the long-term Wholesale opportunity is surprising to us.

Just as we continue to reduce our Network Access Costs, enabled both by the tw telecom acquisition and our targeted network grooming activities, we see our Wholesale customers doing the same with their own network costs.

The timing of disconnects in the quarter was slightly surprising; and although, we anticipated them over the long-term, recently we've seen more than expected. Having said that, these disconnects were largely the delayed result of wireless consolidation over the last couple of years.

From an overall Enterprise market perspective, our view of the opportunity has not changed. Market needs have been evolving as we have expected. Customers whose networking capabilities are an integral part in driving the success of their own businesses need more and more bandwidth. They need sophisticated and adaptive security services to defend against escalating attacks. They want a smooth migration path to the cloud to help capture efficiencies in their businesses and to support their digital infrastructure. They require the ability to easily address all of their networking needs, including voice and video. And they want to address these challenges on a global basis. All of these requirements are not only still true, but are accelerating for our large and multinational customers.

Looking at Enterprise revenue in North America, we saw several factors affect revenue growth, some beneficial and some challenging. Let me address the challenges first. As Sunit noted, in conjunction with a significant contract extension with one of our largest customers, we incurred a credit during the quarter. While the credit created a headwind on growth in the short-term, this was an easy decision for the long-term.

Additionally, we've seen an increase in disconnects from smaller customers. While we don't like losing revenue, disconnects from lower profit or even unprofitable customers are acceptable. In general, we do a better job serving, and our profitability is higher with larger customers. Even with the disconnects this quarter, adjusted EBITDA and margins grew nicely, reinforcing our focus on efficiency and profitable revenue as key drivers for us. However, to ensure we are managing our customer base appropriately and retaining every customer that makes sense, we have a number of initiatives to better manage that base of smaller customers.

On a positive not, as Sunit mentioned, we saw strong growth from our largest customers. These customers tend to have the most advanced and complex network demands and tend to be the early adopters of our products and services.

To give you an example, Johnson Matthey is a leading global specialties company, whose history dates back as far as the early 1800s, as one of Britain's oldest, multinational companies listed on the London Stock Exchange, underpinned by science, technology and their people.

As a global leader in sustainable technologies, they aim for their products to enhance the quality of life of millions through the beneficial impact on the environment, human health and wellbeing. They employ 13,000 people in 30 countries worldwide, and their products and services are sold across the world to a wide range of advanced technology industries. For example, as the world's largest manufacturer of catalytic converters, around a-third of all cars worldwide are fitted with the Johnson Matthey catalyst.

Johnson Matthey has historically been managing their information technology and networking environment in-house in a localized fashion, with different strategies based on the company's divisions and regions of operation.

To support their objective to deliver superior long-term growth, they developed a global transformation program to centralize IT and technology, transitioning many varying strategies into one new vision. They view their global networking approach as a critical enabler to the overall transformation, and one of the first steps in this large undertaking was to address their disparate network strategies with multiple incumbent venders to a single, global networking provider.

Many of the large, global incumbent telcos competed for this business. Following a comprehensive RFP process to evaluate the market, Level 3 was selected as the global networking provider, based on our global network footprint, our advanced capability to protect the network from security and cyber threats, our capability to provision direct access to key cloud vendors, a mature, multi-regional account team support program and the ongoing value partnership offered through the continued access to Level 3's expertise and people to support their transitional journey into the future.

Throughout the process, Level 3 was able to demonstrate increased agility and flexibility over the incumbent providers in areas of technical, commercial and service management. This will see Johnson Matthey relinquishing the responsibility of managing a handful of disparate divisional networks in-house to a single, global network managed fully by Level 3, bringing up numerous resources which can now be applied elsewhere to keep business transformation initiatives.

We will be providing Johnson Matthey with a global, fully managed, 130-site network layering managed security, WAN optimization, application performance management, Cloud Connect services and Voice Complete services across a single, global platform. We are also providing a comprehensive suite of professional services to simplify the delivery of this complex global solution and to maintain high service levels across the world.

Johnson Matthey is an excellent example of a company that relies on their network to transform their operations. Level 3 is uniquely positioned to serve these types of companies.

I'll spend just a minute on the investments we're making to improve our growth prospects across the board. As I've mentioned before, we are investing in the vision of one, which includes one set of products that we've taken to an expanding market, one network to deliver those products globally, one set of operational support systems to enable the differentiated customer experience and one team with the singular goal of making Level 3 the premier provider of Enterprise networking services.

From a product perspective, we continue to invest in a comprehensive and evolving product portfolio, building on our existing capabilities, whether it's adding offerings to our security portfolio, or enabling our hybrid WAN capabilities, or continually expanding our Cloud Connect capabilities, our goal is to ensure we are meeting our customers' growth, efficiency and security challenges now and in the future.

We believe that investing to expand our network and build directly to our customers' locations provides a better experience and will facilitate future revenue growth as we add product capabilities to those customers on net locations. We've also standardized across the network on a global SDN-enabled Ethernet platform, providing efficiency both for our customers and for our own operations.

Operational support systems remain a key focus for the company as well. I believe we have more to do to make it easier across our entire quote-to-bill process. Better systems and better data both drive efficiency, which drives effectiveness, resulting in a better customer experience and enabling greater sales. In other words, operational excellence drives growth.

Beyond investing in the business, I want to take a minute to address the topic of capital allocation. We don't have an update at this time, but I wanted to note that we've heard your suggestions on our options for deploying any excess cash. We continue to work closely with our board of directors on the best and highest use of that cash, including M&A and the potential return of cash to stockholders.

With that, let's get to your questions. Operator, would you explain the process?

Question-and-Answer Session

Operator

Thank you. Our first question comes from the line of Simon Flannery with Morgan Stanley. Please proceed.

Simon Flannery - Morgan Stanley & Co. LLC

Great. Thank you very much. So, Sunit, nice progress on the balance sheet, the leverage down to 3.5 times; you've now got $1.3 billion of cash on hand. So, can you update us on the thoughts about using that to de-lever, using that for M&A, using that for buybacks, et cetera? What's the thought process there given the opportunities and the future cash flow that's coming as well? And what's your timeframe for considering that? And maybe, Jeff, you can also just comment on the M&A environment broadly? We haven't seen you do a deal here for some time at this point.

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

Yeah. So, I'll take the first question and Jeff can take the M&A. So, the leverage is coming down, just driven by EBITDA growth. So, we're not looking to deploy cash to pay down debt per se, and we haven't done that.

And then as far as M&A and return on capital goes, I think as we've said for some time, we were focused on integrating and putting both the companies together. I think we are in decent shape, there, as the margin expansion progress we've made demonstrates. And we continue to remain focused on organic revenue growth and continued EBITDA growth.

So, we're down to then M&A and returning capital to shareholders. On the returning capital to shareholders, as Jeff pointed out, I think this is a subject that we are in continued discussions with the board. Don't have an update at this point in time, but it is important to us. It's front and center, and I think that's the key message from us. We're not yet at the low-end of our leverage ratio, which is we've said you want to be at the low-end of three times to four times, which means at three times, but we're obviously making good progress to get there in the next few quarters.

Jeffrey K. Storey - President, Chief Executive Officer & Director

With respect, Simon, to the M&A environment more broadly, I'm glad that you feel like it's been a long time since we did TW Telecom, because that means it's been an uneventful, seamless transition. But, it's only really been about 1.5 years. So, we remain focused on being an acquisitive company. We look at opportunities. I think we're in a good position if something were to come available. We've made tremendous progress on the integration, and capturing the synergies, and operating as one company, and having a single product portfolio, and all of those things that I talk about.

So, we're pleased with where we are, and we'll stay attentive in the market. We don't comment on any particular target, but we look at M&A very aggressively. We think we're good at it. We think we've got a proven track record of creating value for our shareholders through it and expanding our products and capabilities for our customers. So, we'll stay focused on it. And we'll stay focused on making sure that we fully integrate and complete all the other transactions as we go along.

Simon Flannery - Morgan Stanley & Co. LLC

Okay. Thank you very much.

Jeffrey K. Storey - President, Chief Executive Officer & Director

Sure.

Operator

Our next question comes from the line of Colby Synesael with Cowen & Co. Please proceed.

Colby Synesael - Cowen & Co. LLC

Great. Two questions, if I may. First on the revenue, it seems like the area of weakness is more so churn than it is bookings; you continue to message that bookings trends are doing well and I'm just trying to get a better sense of how much visibility you have on churn. It seems like you've kind of got caught off guard this quarter and I guess I'm trying to get a sense of what's to prevent that from happening in the third quarter and fourth quarter, and really on a go forward basis.

And then my other question had to do with M&A. When I think about the types of businesses that could be of interest to you, fiber companies, perhaps data center collocation companies, those companies from what I understand trade at multiples well above where you trade, at least right now, on an EBITDA basis and, at least at this point, are less focused on free cash flow. Would that prevent you from chasing or going after those types of deals because the mandate you've given out to investors has been a focus on improving free cash flow per share, and does that to some degree restrict what you're really able to go after? And with that said, it seems like the likelihood of M&A then is pretty small.

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

Well, so let me talk about visibility. Look, in general, our visibility has been pretty good. As you pointed out, the bookings trends are positive and strong. We generally know what our install intervals are from the time we get a customer order and that's been predictable.

The churn has been relatively steady; it's picked up. I would say, within the quarter really, there are two things that it's tough to have visibility into. One, customers that are going to disconnect we don't typically know ahead of time. Remember, in the Wholesale business these are carriers. I think while we knew the consolidation had happened, we hadn't seen any activity for a while and it sort of all showed up in one quarter across all three regions.

Some of that, as Jeff pointed out will continue, but it's tough to evaluate the timing. So, it's tough to have visibility on that. Customers don't tell you, especially in the Wholesale side, when they're going to disconnect some service. They don't have to, so you only have thirty days' notice. So, I think that one was surprising, and it was the same thing across all three regions; large carriers, consolidation activity, and grooming activity.

With respect to the Enterprise business, again, when you look at the three regions that we have, North America being the largest, in general our visibility is pretty good. I think the contract extension, that was tough to see a quarter ahead of time. But, as Jeff pointed out, we are very happy with that outcome. We think that's a great outcome for us.

The churn picking up in the smaller customer base, some of that was unprofitable customers. Having said that, we certainly didn't like losing some of these customers; and as Jeff pointed out, we've taken measures to make sure that we are taking better and better care of those customers at the smaller end with an inside sales group, or even in some cases, coverage within a GM's purview within a city. So, we are going to stay pretty focused on that.

So, I think from a visibility perspective – and the other thing, with respect to your question on third quarter and fourth quarter, you know we do feel we should see pretty good trends, comparable to what we've seen in previous quarters with respect to North America Enterprise and overall sequential performance in that sort of 1.5% to 2% type performance. So, we did hit a speed bump in the quarter. NOR, (32:30) it had been tough to get full visibility into it for all the reasons I explained, and we've got a long track record of churn being quite predictable; just this quarter was a little tougher.

Jeffrey K. Storey - President, Chief Executive Officer & Director

With respect to M&A, Colby, I don't feel the same way that you do. I think that we have lots of M&A opportunities out there and that while we are focused on free cash flow per share, that is not our sole focus. We're also focused on being a growth company. And so, we make decisions every day that balance our free cash flow per share with our growth. For example, capital; we could cut our capital spending significantly and drive great free cash flow per share for a short while, but we're not focused on that. We're focused on being a growth company and driving the free cash flow per share.

So, as we look at M&A, and you mentioned fiber companies, we look at fiber companies post synergies and believe that we are very good at acquiring and capturing synergies and moving networks together, combining networks, and creating value for shareholders through that.

And so, I don't feel that the M&A environment is necessarily constrained. I think that we're going to be smart. We don't have to do M&A. We're going to be smart about the things that we do. We'll continue to be disciplined in our decision making with a variety of factors, not just one, but with a variety of factors. And I mention every single time our free cash flow per share target and so that is an important aspect of the guidelines that Sunit and I use internally, but so is being a growth company and being efficient in the market.

Colby Synesael - Cowen & Co. LLC

Thank you for the color.

Jeffrey K. Storey - President, Chief Executive Officer & Director

Sure.

Operator

Our next question comes from the line of Philip Cusick with JPMorgan. Please proceed.

Eric Pan - JPMorgan Securities LLC

Hey, guys. This is Eric for Phil. Maybe if I can ask some of the previous questions a different way. You're getting very close to the low-end of your target leverage, probably hit that maybe next quarter or in the fourth quarter. Should we expect you to dip below that briefly while you look for your next deal, instead of capital returns? Or do you have a hard floor that you try to stay above?

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

Well, so we had 3.5 times. The low-end of three times to four times would be right at three times, which as I say, it is a few quarters away. And then I think that, that is the low-end, that is our target leverage, and that's where we'd like to be. We think it's appropriate to balance both how much we leverage the balance sheet for our shareholders' benefit on a recurring revenue business. Can we dip below that? Yeah, we could, if we don't do any M&A activity and/or return capital to shareholders. And as we said earlier and as Jeff pointed out, this is a topic that's of a lot of interest with us and with our board, and in terms of returns of capital to shareholders. So, between that and M&A, I think our goal is to kind of be above three times.

Eric Pan - JPMorgan Securities LLC

Got it.

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

Be at the low-end of three times to four times.

Eric Pan - JPMorgan Securities LLC

And then on the disconnects, besides industry consolidation, what other reasons why customers disconnect? Is it pricing? Is it the product set? Is it the network footprint? And where do they go when they disconnect? Do they go to the incumbent or other competitive carriers?

Jeffrey K. Storey - President, Chief Executive Officer & Director

Sometimes they go to us. There are lots of reasons, and you're right, Eric, in characterizing it that way. There are lots of reasons that customers disconnect. Sunit was talking about the Wholesale consolidation, and that was from carriers that had done some wireless combinations a couple of years ago. We knew those disconnects were coming. We didn't expect maybe to come at the pace that they did. Some of them we thought we'd get last year we didn't get last year. So, we don't really know the timing, but we know the magnitude of them.

Within the Enterprise space, customers can disconnect from one of our products and services and go to another of our products and services, as they transition to newer and advanced technologies. They can leave us. They can just disconnect an old platform as they migrate locations to some other locations. So, there are a variety of different reasons.

What we saw in the second quarter more than we expected was the low-end of our customer base. And so those, Sunit talked about a little bit of the efforts that we're going to do to make sure we're paying attention to them. We want to look at them from a full customer lifecycle management perspective, make sure we're talking to them, make sure we have account reps assigned to them, that we're dealing with them. And those that are not profitable, that we help migrate off our services, but those that are marginally profitable, see if we can make them more profitable for us, but work with them more closely across the lifecycle of their customer experience with us.

Eric Pan - JPMorgan Securities LLC

Got it. Thank you for taking questions.

Jeffrey K. Storey - President, Chief Executive Officer & Director

Sure.

Operator

Our next question comes from the line of Scott Goldman with Jefferies. Please proceed.

David Scott Goldman - Jefferies LLC

Hey, guys. Thanks for taking the questions. I guess just to follow-up on the previous questions around the low-end disconnects, presumably that's more on the legacy tw telecom side than it is legacy Level 3, but regardless of sort of where they're coming from, I guess what'd be helpful for me to understand is sort of how much more exposure you think you have for those types of customers? I understand you've undertaken a number of initiatives to sort of prevent or eliminate some of that churn that maybe you saw? But, understanding how much more exposure you might have to that real low-end might be helpful?

And then on the customer extension, wonder if you could help us understand; one, a little bit more about the credit, was that merely just to get the extension or was that for other reasons? And two, how do we think about that incremental $100 million layering in, I think it's over the next two years? Is that sort of rated – ratably over the two years? Or is that back-end loaded? Or how do we think about that? Thanks.

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

Yup. Yeah. So, I think on the low-end customers, we don't think they export (39:08) – they were legacy TW Telecom customers, in general. And again, if you look at our history over the last couple of years, this has been relatively in good shape. We saw a bump in the quarter, again based on what we know today. We think that our churn will trend back down again. It's not as big a portion of our business per se, but certainly churn on the margin picking up in a quarter does hurt, as the performance showed.

With respect to the contract renewal, it wasn't like the contract was expiring in the next year or two. We had some – couple of years, or year or so – one to two years left on that, and so it's a two-year extension, which we think is very good, because we've already made the investment and so we just get a lot more profitability out of that contract with the extension.

As far as – then there are no specific issues per se to cite, other than it's a large customer. They did have leverage. We think we're providing good service to them. And so, we're happy at the end of the day after going through a negotiation to come out with this outcome.

Jeffrey K. Storey - President, Chief Executive Officer & Director

And let me add one quick thing on disconnects. Look, we have a desire to be very transparent about our revenue. We work really hard to do that now with you guys. And so, we're trying to talk about the various things that contributed to the second quarter revenue and what we consider underperformance in North America.

But, I don't want to overemphasize the disconnects as a result of our efforts to be transparent. It's something that is a focus for us, to make sure that we are getting profitable customers, we're maintaining profitable customers. And as a result, you see our main expansions. You see the progress we've made. Sunit talked about as two standalone companies – as a combined company, our EBITDA margin is now better than the two standalone companies. And so, we are focused on that.

Sunit also mentioned that going forward sequential revenue growth ought to return to kind of what we've seen in the past. And so, I don't want to overemphasize the disconnect at the lower end of the base. It is an issue. We are paying attention to it, but it's also something that we deal with on a daily basis.

David Scott Goldman - Jefferies LLC

Understood. If I could just follow-up on, again, just understanding the $100 million and how that may layer in? And maybe, Jeff, is this something that we may see more of these types of contract renewals going forward where you can maybe extend out the life of the contract well before the expiration of the others and enhance the revenue opportunity there?

Jeffrey K. Storey - President, Chief Executive Officer & Director

No, this is unusual. We don't typically see – this is a large customer. So, no, you haven't seen us mention this in the past. There are things that go on, but not this level of magnitude.

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

Yeah. I think that's the part that's unusual, Scott, is the level of magnitude. We do this every day. We work with customers to expand and we extend their network services with us. Sometimes they involve credit. Sometimes they involve network expansion. Sometimes it involves us building into the site to put it on net, but we work with them looking at their network needs, and we make long-term decisions for what's best for us.

And so, it happens all the time. We don't talk to you that much about it, because it doesn't happen – the numbers aren't big enough to move things. This time we felt it was appropriate to talk to you about it. But it does happen all the time, and it's part of our strategy.

As you know, most of our revenue growth comes from existing customers. So, we work very hard with them to make sure we're expanding our capabilities with them and extending contracts into the future.

David Scott Goldman - Jefferies LLC

Great. Thanks so much.

Jeffrey K. Storey - President, Chief Executive Officer & Director

Sure.

Operator

Our next question comes from the line of Nick Del Deo with MoffettNathanson. Please proceed.

Nick Del Deo - MoffettNathanson LLC

Hi. Thanks for taking my question. First, IP and Data Services growth ticked down a couple of percentage points from where it's been over the last few years. Was that simply from the customer credit and churn items you called out? Or were there any other contributing factors?

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

That was mostly from the churn that we talked about.

Nick Del Deo - MoffettNathanson LLC

Okay. And then regarding the Wholesale CNS churn, is this something you'd expect tapers off in coming quarters? Or could deals like AT&T/DIRECTV, and Charter/TWC, and Verizon/XO lead to some continued pressure on that line going forward?

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

I think that – and Jeff's talked about this, that over a long-term period we expect to see Wholesale decline slightly. So, I think, in general, we're still in that zip code. This quarter was a little unusual in that it happened in all three regions, in terms of its magnitude. But, in general, no, we expect these industry consolidation trends to continue to impact our Wholesale business over the next years.

Nick Del Deo - MoffettNathanson LLC

Okay. So, the chunk and how it's recognized, there's no reason to think that overall that changes?

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

But, we are not – nothing has – not of this magnitude. No – overall, that we saw in this past quarter.

Nick Del Deo - MoffettNathanson LLC

Okay. Great. Thanks.

Operator

Our next question...

Jeffrey K. Storey - President, Chief Executive Officer & Director

Operator, I think we have one last question.

Operator

Our next question comes from the line of Tim Horan with Oppenheimer. Please proceed.

Timothy Horan - Oppenheimer & Co., Inc. (Broker)

Thanks, guys. Just to summarize, can you just maybe characterize the demand environment out there? I mean you had a great example of one customer moving to the cloud. I'm assuming you were having hundreds of these conversations. I guess as the overall market, do you expect to grow faster the next couple of years than we've seen? Do you think you can kind of gain a little bit more share? And I guess – and this point too, at a high level strategically, do you think it's more likely for Level 3 to become part of a much larger organization in the next few years? Or do you think kind of organic growth and M&A is the way to create more shareholder value for customers and investors? Sorry.

Jeffrey K. Storey - President, Chief Executive Officer & Director

Sure. Sure. With respect to the market and what do we see in the market, yeah, I talk about this a lot and I hate to sound like a broken record for you guys, but the market is good for our products and services. All of the trends that we see customers needing in the future are coming true.

More and more bandwidth, increased complexity as they have to create hybrid networks for tying their own data centers together or content distribution in some places that waive services in others. The mix of networking challenges they have fit our product portfolio very well. All the while, the increasing security challenges where we can give them advanced threat intelligence, we can work with them to really protect their network, to protect their data, protect their enterprises.

So, the market dynamics are continuing exactly as we've talked about for the past couple of years. We're seeing them – the timing is always hard to predict. I think it will continue to accelerate. It has been accelerating. I think it will continue to accelerate for a while. It gives us great opportunity to take share, to your point, Tim.

We take share in the market. That's how we want to grow, by going to our – the customers, the potential customers that are out there and saying, transition to a new network, to new technologies and do that through Level 3. And just like Johnson Matthey, we can help you solve your global networking challenges, whether they're voice services or security services or transport services, we can help you solve them because we have a wide product array over a global footprint with – and yet, we're still nimble and agile and flexible in the way that we can deal with the customers.

And so, we're absolutely focused on taking advantage of that market opportunity to create share, take share from those customers. And Sunit referenced that our largest customers, which I think was about 17% of our revenue, grew at 12%. And that is a good growth rate for us among those customers. And that – they are the vanguard of the companies that are making these transitions. But, I believe the transitions happen for all customers that are out there.

Now with respect to us being part of a bigger organization, I want to be part of a bigger organization, but I want to grow it organically. I want us continue to grow, satisfy our customers' needs, but we have to remain flexible, we have to remain nimble, because that's how we win. We win by differentiating our experience against these massive companies that are out there.

And so, we don't comment on any rumors or speculations about one M&A project or another. What we do know, that we control our own destiny, and that our ability to execute is what determines our success. And so, we are going to stay focused on growing with our customers, on maintaining the nimble character of Level 3 and the flexible character of Level 3 that delivering those services globally for our customers in more, and richer, and deeper ways of interconnecting with them. And so, we are focused on our own execution.

Timothy Horan - Oppenheimer & Co., Inc. (Broker)

Thank you.

Jeffrey K. Storey - President, Chief Executive Officer & Director

Thank you. Thank you all for taking the call. I'd like to close with just a few thoughts. We talked about expanding margins. We've talked about our sequential growth in EMEA. We think that we're making good progress there.

We talked about our strong growth in Latin America, both sequentially and year-over-year in our Enterprise CNS revenue and so we're pleased with that. We're not yet pleased with our – we're not pleased this quarter with our revenue growth in North America, but we are focused on it. We are attentive to it and believe that we're making great progress with our customers. We'll continue to focus on some of the issues that we talked about.

Take market share. We grow by taking market share from the incumbents and expanding our customer base. We will stay focused on that. Our products and capabilities are meeting the evolving needs of those customers and Enterprise customers, in particular.

We continue to see the benefits of the operating leverage and expanding our margins and growing our adjusted EBITDA. And finally, we continue to focus on increasing free cash flow per share now and over the long-term.

Thank you all for joining today's call and for your support. Operator, that concludes the call.

Operator

Thank you, Jeff. We would like to thank everyone for your participation and for using the Level 3 Conferencing Service today. This does conclude the conference call. We ask that you please disconnect your lines. Have a great day, everyone.

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