The Bearish Case For Level 3 Communications

| About: Level 3 (LVLT)

Despite a recent pull-back, Level 3 Communication's (LVLT) share price, at $25.64, is still up over 55% from its 52-week lows and currently trades at an enterprise value of almost 10x adj. OIBDA (operating income before depreciation and amortization). I believe that the current valuation for Level 3 is overly generous, when considering the company's current growth trends and the fact that Level 3 is a highly-leveraged, free-cash flow negative company, with substantial execution and integrations risks ahead of them. Of additional concern is the fact that the company operates in a very competitive industry (competing against larger, more established companies like AT&T and Verizon) within a market that has traditionally had very limited visibility and with a business model (competitive local exchange carrier; CLEC) that has historically resulted in MANY bankruptcies.

So why is so much optimism factored into the company's valuation? It certainly doesn't seem to be based on current trends. On a standalone basis, Level 3's revenues were basically flat over the last two years (down 2.8% in 2010 and up 2.7% in 2011). The recently acquired Global Crossing side of the business, on the other hand, did moderately grow sales last year, but revenue fell considerably in the fourth quarter (sequentially) and full-year margins fell substantially during the year (revenue up 4.3% and OIBDA down 5.8% in 2011).

All things considered, neither business seems to be indicating an overly positive growth trajectory, let alone one that would translate into the valuations that the company currently enjoys. Granted, the company projects that adjusted OIBDA will increase 20-25% in 2012 (pro forma for the combined companies), as a result of higher-margin revenue growth and synergy benefits. I would argue, however, that this OIBDA growth is more of a one-off increase (from synergies) than a longer-term growth trajectory, as the market appears to believe.

To better understand the bullish case for Level 3, I simplistically modeled, what I believe to be, very optimistic expectations for the company to try and forecast results that would validate the current valuation (see below). I forecast 5% top line growth each year over the next three years (significantly higher than current trends), an EBITDA contribution of 60% on all incremental revenues (as guided by management for 2012), the full realization of all of the $300 million in merger synergies by YE 2013, on a run-rate basis (and for FY 2014 on a reported basis), only limited additional integration costs (after the $87 that management guided for this year, only a further $44 million in 2013), and only minimal working capital outflows (despite a sizeable working capital deficit, when excluding cash and current debt maturities -- which are already factored into the net debt, enterprise value, and liquidity calculations).

Pro forma
2011 2012 2013 2014
Income statement:
Revenue: 6,318 6,634 6,966 7,314
growth: n/a 5.0% 5.0% 5.0%
adj. OIBDA: 1,216 1,520 1,840 2,114
growth: n/a 25.0% 21.0% 14.9%
margin: 19.2% 22.9% 26.4% 28.9%
OIBDA less acq. costs: 1,303 1,607 1,884 2,114
margin: 20.6% 24.2% 27.0% 28.9%
Interest: 740 725 687
Cash flow:
Adj. OIBDA: n/a 1,520 1,840 2,114
less: capex: n/a 796 836 878
less: cash interest: n/a 680 665 627
plus/minus: working cap: n/a (50) - -
FCF: n/a (6) 323 549
Balance sheet:
Debt: 8,450 8,450 8,127 7,578
Cash: 918 912 912 912
Net debt: 7,532 7,538 7,215 6,667
Market capitalization: 5,340 5,340 5,340 5,340
Enterprise value (EV): 12,872 12,878 12,555 12,007
Net debt/adj. OIBDA: 5.78 4.69 3.83 3.15
EV/adj. OIBDA: 9.88 8.01 6.67 5.68
EV/revenue: 2.04 1.94 1.80 1.64
Market cap/FCF: n/a n/a 16.55 9.73

When incorporating all of these optimistic assumptions, I get to a valuation of 5.7x OIBDA and 9.7x free cash flow at YE 2014 -- when using today's market valuation (i.e. assuming that the stock price doesn't increase over this time). If and when they achieve those bullish projections (and pass the significant hurdles and execution risks that lie in between), I do believe that those resultant valuation multiples would then be reasonable for this type of business and in-line with more stable and mature free cash flow positive telecommunication companies. On the other hand, if Level 3 stumbles and doesn't grow as strongly as expected, I believe that the company could be unable to service its sizable debt burden and bankruptcy could result (a very realistic scenario, in my opinion).

In conclusion, it seems to me that the upside over the next 3 years is essentially that Level 3 grows into its current valuation (under optimistic assumptions) while the downside is a potential bankruptcy. All things considered, I'm very surprised that so many investors apparently see Level 3 as an attractive risk/reward proposition at these current levels. Only time will tell and, perhaps, the long awaited boom in fiber value will finally manifest itself in coming years (after more than a decade of failures and disappointments) and allow for growth in Level 3 that will greatly exceed, what I consider to be, optimistic expectations. I, for one, won't hold my breath.

Disclosure: I am short LVLT.

Additional disclosure: I am short LVLT through out-of-the-money 2013 puts.