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Level 3 Communications, Inc. (NYSE:LVLT)

Q4 FY07 Earnings Call

February 07, 2008, 10:00 AM ET

Executives

Valerie Finberg - VP, IR

James Q. Crowe - CEO

Sunit Patel - Group VP, CFO

Kevin J. O'Hara - President, COO

Analysts

Mike McCormack - Bear Stearns

Christopher Larsen - Credit Suisse

Thomas Watts - Cowen & Co.

Jason Armstrong - Goldman Sachs

Frank G. Louthan - Raymond James

John Hodulik - UBS

David Janazzo - Merrill Lynch

Ana Goshko - Bank of America

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Fourth Quarter Earnings Conference Call. At this time, all participants are in a listen only mode. [Operator Instructions] Today's conference call is being recorded.

I would now like to turn the conference over to your host Vice President of Investor Relations, Valerie Finberg.

Valerie Finberg - Vice President, Investor Relations

Thank you operator. Good morning everyone, and thank you for joining us for the Level 3 Communications’ fourth quarter and full year 2007 earnings call. With us on the call today are Jim Crowe, Chief Executive Officer, Kevin O'Hara, Chief Operating Officer and Sunit Patel, Chief Financial Officer. After Jim provides opening remarks on the quarter, Sunit will provide a financial analysis of our results and a discussion of future trends. Kevin will cover integration progress and operational highlights. And Jim will then add a few summary comments. At that we will open up the call for your questions.

But before we get started, I need to cover our safe harbor statement. Information in this presentation contains financial estimates and other forward-looking statements that are subject to risks and uncertainties. Actual results may vary significantly from those statements. A discussion of factors that may affect future results is contained in Level 3’s filings with the Securities and Exchange Commission. Please not that on today’s call we will be referring to certain non-GAAP financial measures. Reconciliation between the non-GAAP financial measures and the most comparable GAAP financial measures are available in the press release which is posted on our website.

With that, I will turn the call over to Jim.

James Q. Crowe - Chief Executive Officer

Thank you. It was a solid quarter. Core revenue grew 5% versus third quarter, and we achieved positive free cash flow in this quarter. This does not mean however that we are satisfied with full year results. In fact, as you will see, when we publish our compensation discussion and analysis, the top five executives of our company received no 2007 bonuses, reflecting our disappointment in our performance. As mentioned in the press release, we have modified our guidance comments to focus on what we believe are the real creators of value, our ability to produce and increase cash flow. Consistent with that focus, Kevin and Sunit will be discussing our primary goals for 2008 in some detail. First is accelerating high margin revenue generation by increasing the synchronized combination of sales and installations. And we will be discussing achieving sustainable generation of free cash flow as soon as reasonably possible. I will make some comments on each at the end. Sunit?

Sunit Patel - Group Vice President, Chief Financial Officer

Good morning, Jim, and good morning everyone. In summary, Core Communications Services revenue was above our forecast and adjusted EBITDA was within guidance. We generated positive consolidated free cash flow of $41 million for the quarter compared to negative free cash flow of $248 million in the first quarter of last year, $141 million in the second quarter of last year and $54 million loss in the third quarter of last year. Core Communications revenue was $955 million in the fourth quarter, up 5% sequentially and ahead of our projections of $930 million to $950 million. This was primarily as a result of better than expected wholesale Voice growth. For the full year 2007, Core Communications Services revenue was $3.6 billion. In the fourth quarter, Other Communications Services revenue was $56 million, SBC Contract Services revenue was $73 million, and that includes total performance bonuses of $16 million. These were the final bonus payments available under this agreement and we will not receive additional bonuses going forward.

Communications cost of revenue increased to $444 million in the quarter from $438 million in the third quarter primarily in support of the growth in Core Communications Services revenue. Gross margin increased to 59% in the fourth quarter, up from 58% in the third quarter due to the SBC performance bonus payment and growth in Core Communications Services revenue. For the full-year 2007 gross margin was 58% versus 56% for 2006. This increase was achieved even with our operational challenges for the year and after absorbing Broadwing, which had gross margins of roughly 38% at the time of the acquisition in January of 2007.

Our Communications SG&A expense, excluding non-cash stock based compensation charges and restructuring and impairment charges was $389 million for both the fourth and third quarters. The fourth and third quarters include a reduction in incentive based compensation for bonuses of $21 million and $15 million respectively. These adjustments to incentive based compensation reflect our underperformance in 2007 compared to our operating budgets for the year. As a result, we expect Communications SG&A expense to go up in the first quarter as we revert to normal levels of accruals in our incentive based expenses. Non-cash compensation expense was $50 million in the fourth quarter compared to $24 million in the third quarter. The increase in the quarter was the result of a discretionary stock run [ph] made through the 401K plan for all employees and additional accruals required for employees that are eligible for accelerated vesting and retirement.

Integration expenses included in our fourth quarter G&A expense were approximately $20 million. During the third and fourth quarter, we added resources to improve throughput in critical provisioning areas and service management and did not achieve any additional synergies in operating expenses. In the first two quarters of 2008, we expect to reduce operating expenses further as integration activities fall off. The impact of this reductions will be visible in our operating expenses beginning in the second quarter of 2008. Consolidated adjusted EBITDA was $246 million in the fourth quarter compared to $215 million in the third quarter within the projected range of $235 million to $255 million. Going into the first quarter, we will see a reduction in consolidated adjusted EBITDA with two items driving the largest portion of the decrease. The one-time incentive based expense reduction of $21 million in the fourth quarter and the $16 million of the SBC quality of service bonus add up to $37 million of benefit that will not occur in the first quarter of 2008. Our Communications adjusted EBITDA margin increased from 21% in the third quarter to 23% in the fourth quarter. Communications adjusted EBITDA margin was 20% for the full year 2007 and 2006. Consolidated free cash flow was positive $41 million during the quarter. As we have indicated, our cash flow losses have been narrowing sharply throughout 2007 from negative $248 million in the first quarter, negative $141 million in the second quarter, and negative $54 million in the third quarter.

We were able to improve cash flow during the fourth quarter primarily as a result of sharp reductions in days sales outstanding on our receivables, which were 39 days at the end of the second quarter and decreased to 32 days at the end of the fourth quarter. Additionally, higher consolidated adjusted EBITDA and lower net cash interest expense of $105 million compared to $130 million in the third quarter contributed to the improvement. In the first quarter, our cash flow losses were widened as discussed previously, driven by reduced consolidated adjusted EBITDA plus higher cash interest expense, and negative working capital related to annual bonus payments and prepayments on maintenance contracts, business insurance and property taxes.

Depreciation and amortization expense was $225 million in the fourth quarter, declined from $249 million in the third quarter. The decline was primarily due to a purchase price allocation adjustment on the Broadwing acquisition. This adjustment increased the goodwill ascribed for the transaction and reduced the amount allocated to intangible assets which are typically amortized. In 2008, we expect quarterly depreciation and amortization to be approximately $220 million to $230 million per quarter on average. As mentioned in our press release, we are making several changes to the way we will provide revenue detail for actual results and to the guidance metrics we have provided historically. First, on the revenue side, going forward, we will report revenue by market group rather than the product view we have previously provided. What this means is that we will report our revenues by wholesale, business, content and European market groups. We will also continue to report our revenue by Core, Other and SBC contract services. Within the Core revenues, we will break that out into higher margin, core network services and lower margin wholesale voice services. This breakdown is consistent with our internal management reporting hierarchy and the way we manage our sales efforts. We will not provide the product level detail we have in the past, such as transporting and infrastructure, IP data, voice and Vyvx.

As we've indicated in the past, the level of substitutability between T&I and IP data has been increasing. And therefore trends in our business are gauged better looking at the revenue trends by market group and core network services. Consistent with our view on looking at trends, beginning with the first quarter earnings we will post a presentation on our website that will have in it the key points in the quarter and a graphical and numerical view of the historical trends on revenue, expense, cash flow and other key metrics.

I will now, turn to the changes we're making with respect to guidance metrics. The most significant change is that we will no longer be providing quarterly guidance going forward. We came to this conclusion after considering several factors, seasonal trends, our focus on managing the business for long-term value creation, normal quarterly volatility and usage patents, discussions with several of our long-term holders and industry practice. And most importantly, we believe that trends in revenues, expenses, cash flows and other metrics are better indicators of long-term value creation.

Turning to 2008, I will not cover any specific metrics for the first quarter but will point out certain items to consider with respect to our fourth quarter results that are seasonal or non-recurring in nature. I already pointed out earlier that within the SBC Contract Service revenue, reported for the fourth quarter, the performance bonus of $16 million will not recur going forward. In addition, the incentive based expense benefit of $21 million in SG&A in the fourth quarter will also go away in the first quarter.

Turning to our Core Communications Services revenue, there are two components going forward, higher margin core network services revenue and lower margin wholesale voice services. As we indicated last quarter, our focus within the wholesale voice services business is to manage it for margin and not for revenue growth per se. Most of our investment capital will be directed at growing the higher margin core network services business. As has been the case over the last few years, the sequential growth in our Core Communications Services revenue is more heavily weighted in the second half of the year. Some of that pattern is due to seasonality we've discussed in the past and is quite visible in our Vyvx business, whose fourth quarter is typically the strongest. We expect, for example, the Vyvx revenue to decline to more normal levels in the first quarter.

In summary, given the patterns we've seen in the past, the seasonality we've discussed and the volatility in the wholesale voice business, which was a positive surprise in the fourth quarter. We expect core communication services revenue to be flat to slightly down in the first quarter. Thereafter, we expect Core Network Services revenue to grow each quarter and to see growth in Total Communications revenue as gains in Core Communications Services revenue outpaced the declines in other and SBC revenues.

As mentioned previously, for the full year 2008, we expect Core Communications Services revenue to grow in the 8% to 13% range. As in past years, we do expect to see some seasonality with stronger top line growth in the second half of the year. For 2008 specifically, stronger second half growth is also expected to come from improving sales and installs over the course of the year as we improve our operational capabilities. We expect gross margins to improve slightly in 2008 from 58% in 2007. We expect our consolidated operating expenses, excluding stock based compensation to come down in 2008 from about $1.6 billion in 2007. As we indicated in our third quarter earnings call, we expect consolidated adjusted EBITDA of $950 million to $1.1 billion in 2008. I will refer you to the presentation made available on our website on December 19th, 2007 for a fuller discussion of the factors that determine where we end up within that range.

In summary, where we end up within the range is highly dependant on the point at which the combination of sales and installation rates showing improvements over current levels. Consistent with our previous guidance, capital expenditures are projected at 12-14% of revenue for the year. With lower integration CapEx this year, our total 2007 capital expenditures are expected to be significantly lower than the $633 million we incurred in 2007. As Jim indicated, one of our primary goals this year is to set the company on a pathway to achieve sustainable free cash flow. We made a lot of progress on that front over the course of 2007, and as a result, our cash flow losses in 2008 will be a fraction of the loss in 2007. As I explained earlier, the majority of our free cash flow loss in 2008 will occur in the first quarter of 2008 and we expect the cash flow losses in subsequent quarters to be modest and to decline on a trend line basis.

With that, I will turn the call over to Kevin.

Kevin J. O'Hara - President, Chief Operating Officer

Thanks, Sunit. Despite the challenges in service delivery that we discussed in our third quarter call, we were able to meet or exceed revenue guidance for the fourth quarter. This was largely due to meeting our revenue objective for higher margin Transport & Infrastructure, IP & data and Vyvx services and exceeding our objectives for wholesale voice services. As previously discussed, wholesale voice revenue had been fairly volatile throughout 2007, but volatility declined this quarter and we experienced greater growth than expected. It's important to note that growing wholesale voice does not rely on the part of the service delivery process that was constraining growth in Core Network Services. Further, the incremental gross margin for wholesale voice is approx. 30% compared to the 75% to 80% incremental gross margin that we enjoyed for Core Network Services, thereby dampening the gross margin benefit of the revenue out performance.

Our European business grew 12% quarter-over-quarter and our content business grew 7% during the quarter. Neither of these groups have been previously impacted by our service delivery challenges. Wholesale market grew 6% driven primarily by gains in wholesale voice and business markets group was largely unchanged from the previous quarter. Both our Business Markets Group, and Wholesale Markets Group have been impacted by the service challenges and the growth rates this quarter, while consistent with the guidance set out for the third quarter reflect those challenges.

Our service challenges in 2007 arose from the rapid integration of the companies we acquired and the complications associated with simultaneously trying to operate the disparate processes and system of the acquired companies while developing the long-term operating environment. The service challenges fell into two broad areas, service quality and management, that is, how well do our network and services perform from a quality standpoint once service has been initiated for a customer and service delivery, the process of taking a customer order and then activating the service.

Our service quality and management deteriorated through the first half of 2007, but as a result of the numerous organizational process and systems changes, we have generally returned to the quality levels that we enjoyed prior to beginning the integrations and our performance metrics are generally equal to or better than the levels that our customers were experiencing at the beginning of 2007.

An exception to this statement is certain enterprise customers on legacy networks that have not yet been fully migrated to the Level 3 network. These quality issues are isolated to a few areas and plans are in place to migrate the balance of services in the first half of 2008. Despite these exceptions, overall performance for BMG customers is back to where it was prior to the integrations.

Our service delivery processes are more complex in service management and they will take longer to fully resolve, but we made good progress during the quarter. In order to quickly and smoothly provision new service orders, the product being sold and ordered must be clearly defined and all required technical information must be captured and consistently delivered to the provisioning organization. The provisioning group must then be able to activate the order with little or no rework of process fall off. I will talk about each of these steps in more detail.

During the quarter, we reviewed every product in our portfolio and assessed the completeness of all the attributes necessary to activate an order with a consistent and positive customer experience. Since many of the products, particularly those that are sold to our BMG customers came to Level 3 through acquisitions, the state of product readiness varied widely. While plans had previously been in place to refine the product definitions as part of our new integrated process and systems, the variations and the amount of rework being caused by inconsistent or incomplete product definitions caused us to reprioritize this effort. During the quarter, all definitional work was completed, more rigid entrance criteria was established and further product and system specific training was given to sales people, order entry, and order management personnel and our provisioners.

Sales of some products were suspended if the level of product readiness was deemed to be a source of significant operational challenges. For the products where we temporarily suspended sales, we have now either reintroduced the product or are scheduled to reintroduce the majority of the remaining products by the end of the first quarter. This step obviously reduced the level of signed orders but this was a necessary step since we had previously struggled to install those services within promised intervals at time that disappointed our customers. This action, among others, is the reason we have said, were generally meeting promised installation intervals. Once a sale order is signed, the order must be presented to the operations group with all of the supporting technical details. The complete list of necessary information is referred to as entrance criteria. Entrance criteria for all products have not been established as clearly as they should have been and in some instances the differences in legacy systems made it difficult to track compliance. We have now established clear entrance criteria for all products that have the ability to track compliance. But the product definition and the entrance criteria work are critical to ensuring a smooth provisioning process, but both require that our sales force can fall into more rigorous sales and order process.

While it’s in their self-interest to adhere to these revised standards, we assume it will be a number of months before we reach our targeted performance in this area. Our Provisioning Group has been mapping all interim operating processes and identifying process or data gaps. In addition, a resource assessment for each stage of the process has been made and adjustments to staffing levels made in response. Some of the service delivery challenges are not process related but are a result of network and inventory data from legacy companies that is either difficult to find or requires manual intervention to use. We have developed some manual processes to work around these issues but the ultimate solution will not come about until full network inventory is migrated to the Unity platform.

We have now rolled out the Unity product catalog application to all of our business groups. We have rolled out coding to all of our business groups and order entry for many of our products to all of our groups. The order entry consolidation was a critical step necessary to simplify the front end of the service delivery process. All new customer orders for these products can now go through the new system. However, changes to existing services and customers still go through the legacy systems and will continue to go through those systems until we migrate the existing customer and service data to Unity. This migration is scheduled to begin in the first quarter and continue through the year.

During the fourth quarter, we established a dedicated service delivery team to work all orders in the backlog that were deemed to be aged or likely beyond the customer desired delivery date. By year-end we had reduced the size of this aged backlog by more than 75%. Of the reduction, approximately half of the orders were installed and half were no longer required by the customer and were canceled. This is consistent with what we had expected. We expect the remaining order in the aged backlog to be installed during the first quarter. We have established installation intervals that we can communicate to customers with confidence. Some of these intervals are longer than our historic intervals and some are longer than some of our customers' desires. Our goal is to return to industry leading intervals for delivering on-net service and match industry standards for off-net services.

For four of the last five months we have installed more service than we have sold. This is partly due to the improvements I just discussed but it is largely due to the fact that our level of sales over this period decreased in response to the previous quality issues, reduced product set and longer intervals. We believe that today, we could install a higher volume of orders than we did during the fourth quarter. In order to do this we need to increase the level of sales we experienced during the quarter.

We have historically tracked qualified sales opportunities in a sales funnel and could assess with reasonable accuracy what near-term sales were likely to be as a percentage of that funnel. And we could tell with a reasonable degree of accuracy what future installations would be based on previous sales levels. Since the best leading indicator of sales performance in those installs is the health of the funnel we have been spending a fair amount of time in this area. As our service issues grew throughout 2007, the size of our funnel generally remained constant but the rate at which we converted opportunities to signed orders dropped off. By late in the third quarter we are still seeing strong demand but our sales force was reducing their near-term outlook based on customer feedback, and as a result our funnel started to decline. Reduced levels of sales typically lagged the decline in funnel by 30 days and installs lacked by another 45. A large part of the reduction in sales was due to the fact that during the third and fourth quarters, a number of existing customers simply bought less incremental services from us and turned to alternatives.

However, as a result of the improvements outlined above, our funnel has grown for the last few months and sales for WMG, our most impacted group increased in December and then again in January. While sales have improved and our funnel health is improving, absolute levels of sales are not yet back to where we were this time last year. Our goal now is to increase the rate of sales to utilize the improved installation capacity that we believe currently exists. However, we believe that just as the drop in sales lack the service issues, a corresponding increase in sales will lack the service improvements. To shorten this lag, we have rolled out incentives to the sales force and customers to try and accelerate the process. In addition, we started to recruit additional salespeople with an emphasis on Business Markets Group and Wholesale Markets Group. The ramp in sales people will be gradual and measured. Importantly, we did not see any increase in voluntary turnover from our sales force in the quarter.

While it’s difficult to determine with certainty the precise trajectory of increasing revenue resulting from the combination of increasing sales and installations, we believe that the revenue ranges provided in the full year guidance appropriately bound the outcomes. In a number of places I referred to organizational changes that we made during the quarter. Specifically, Andrew Crouch, previously the Head of Sales for Wholesale Markets has been named President of the Wholesale Markets Group. Jack Waters, our CTO, has the added responsibility for global network services. Raouf Abdel remains the President of Business Markets Group and Neil Hodges has been named Executive Vice President of sales and operations with responsibility for Global Network Services, WMG and BMG. Surial Choxy [ph] for Product Management and Marketing, Surial will report to Buddy Miller, our Vice Chairman. Buddy retains responsibility for our Content Markets Group and our European business.

To summarize our progress, we think we have made meaningful improvements. We believe we have largely restored our high levels of service quality and we are now focused on increasing our level of sales and meeting the installation expectations of our customers. We started disclosing our top 10 customers in 2001 because at that time our revenue concentration within our top customers was very high and the credit worthiness of many of these customers was in question. Today, we have far less revenue concentration. In addition, the credit quality of our customer base has improved dramatically. For these reasons we will no longer disclose our top 10 customers as we go forward. However, for this quarter, our top 10 customers in alphabetical order were Alltel, AT&T, BT, Comcast, Commonwealth of Pennsylvania, EarthLink, Sprint, Time Warner, Verizon, and Vonage. These customers represent 31% of Communications' revenue, excluding the SBC contract revenue.

In summary, we continue to execute against the plan discussed during the fourth quarter and we believe that we are on track with the needed service delivery improvements. The service environment has improved and continues to improve. We continue to see a favorable demand in market environment. The timing of the benefit from the actions we have taken is difficult to predict with precision but we are optimistic that they will have the desired effect over the course of 2008. Jim?

James Q. Crowe - Chief Executive Officer

Yes. As indicated in the press release and as I mentioned earlier, our two primary goals for the year are accelerating high margin revenue and achieving sustainable free cash flow. Both Kevin and Sunit provided a fair amount of detail on each of these goals. I would like to provide some additional context. Last quarter, and in presentations since, we have said that our issues in 2007 were under our control. We said that demand and the pricing environment were positive and that our ability to market and sell our services were demonstrated by factual data. We provided that data including actual signed orders, which we believe demonstrate that, but for our internal installation problems, we could have exceeded our previous public goal of 15% to 17% revenue growth.

As Sunit mentioned and provided the details, that data is available on our website. While we are certainly monitoring the effect of the economic slowdown, we have seen nothing to-date which changes our view. Kevin provided you with a fair amount of detail about our efforts to improve our sales and installation throughput and our expectations with respect to the results of those efforts. I want to emphasize a couple of points. We will fix our problems. We now, believe we have created additional installation capacity and we are working hard to increase the rate of sales to utilize this capacity. As Kevin said, in the near term, the precise shape of the revenue improvement curve is hard to predict. However, I want to emphasize our firm conviction that we will increase sales and installation rates and that resulting revenues levels we will take full advantage of the demand that demonstrably exists for our services. And that what we need to do is under our own control.

With respect to achieving sustainable free cash flow positive, I would also like to add some commentary. We believe it is strategically important to achieve this goal. Simply put, discretionary expenditures will have a high hurdle rate reflective of this importance. By this I mean expenditures made in 2008, which reduced cash flow in that year and returned for a benefit in future years have a higher discount rate until we achieve positive free cash flow. You will note for the first time, we publicly declared that we expect to be free cash flow positive for the full year 2009. I would like to add that we would be disappointed if we do not achieve free cash flow break-even on a trend line basis some time later in this year.

Operator, we are now ready for the question and answer session.

Question and Answer

Operator

[Operator Instructions]. Our first question is from Mike McCormack from Bear Stearns. Please go ahead.

Mike McCormack - Bear Stearns

Thanks. Hi guys. Just a question going into 2008, if you look at the numbers in this quarter and I think it might be fair to strip out the accrual for compensation expense. You missed the guidance number on the quarter on an EBITDA basis. Just trying to get a sense for how comfortable we can be going forward that we are going to be obviously pressured in Q1, but there must be a very significant ramp in second half on EBITDA. So is the thought process there that we are going to have, the current provisioning situation which I presume is getting better and then just sales being added on top of that to improve it? Then secondly, on the growth in the current quarter in the top line, it looks like voice was a pretty significant contributor there, is that just traditional wholesale voice termination or is that voice-over-IP stuff? Thanks.

James Q. Crowe - Chief Executive Officer

With respect to your second question, we would have to define some terms here. For us, we convert traffic to IP on our network. We have an interconnected circuit switch network. But our advantage in wholesale voice comes from cost advantages we have having to do with the depth of our network penetration. If I understand your question correctly, it is voice termination, but we think we have some advantages there versus others. And for wholesale voice termination, which is defined I think in numerous of our presentations, we think we have a long-term advantage. With respect to your first question, I am going to make a general comment and Sunit you might comment on the statement that we would have missed, guidance. We provided a range of $950 million to $1.1 billion for 2008 EBITDA. Sunit mentioned that there is a fairly detailed explanation of all of the factors, which determine where we end up in that range. That analysis is available, I think you said on the December 17th presentation on our website, is that the right date?

Sunit Patel - Group Vice President, Chief Financial Officer

19th.

James Q. Crowe - Chief Executive Officer

19th, excuse me. And I will repeat what Sunit said. In summary, where we end up depends on the rate or the point at which we do see improvements in the current rate of installations, supported by an increase in the rate of sales. Sunit, you want to comment on the fourth quarter?

Sunit Patel - Group Vice President, Chief Financial Officer

Yes. I think we had mentioned that when we released the third quarter that we have had some benefit in the third quarter from incentive based compensation. And consistent with where we thought we would end up for the year, it does obviously have an impact on our bonus accruals and so that was in the thinking with the guidance we had provided. So, we don’t feel we missed guidance that was certainly part of the thinking when we did provide guidance for the fourth quarter.

James Q. Crowe - Chief Executive Officer

Okay. Next question?

Operator

Our next question is from Chris Larsen from Credit Suisse. Please go ahead.

Christopher Larsen - Credit Suisse

Hi, thank you. I guess a question for Kevin. I wonder if you could comment on customer churn and what sort of impact that may have had to backlog and would the customers that may or may not be churning or saying when they are churning. And then second, may be anyone, I guess [inaudible], if you could talk a little bit about headcount trends. I know you have been reducing headcounts, where are you in relation to your previous goals with the headcount reductions from the Broadwing acquisition and then plans for ’08 and how Project Unity covers [ph] in on that? Thanks.

Kevin J. O'Hara - President, Chief Operating Officer

Sure, Chris. We haven’t seen any change in churn. In fact our churn trends are actually pretty positive. So, the service issues that we have not manifested themselves in any change in the kind of erosion that we are seeing on the base. And in fact as we've stabilized our service quality issues, we think that largely becomes a known issue.

James Q. Crowe - Chief Executive Officer

Okay, why you're thinking about those next to let me just make a comment here, make sure we define terms here. Churn means after we begin billing that customer, do we lose customers, and the issues we've had have been in backlog where Kevin went through a detailed explanation. But, we haven't seen customers leave us once they're turned up. And in fact as we've... as Kevin said the trend has been positive.

Sunit Patel - Group Vice President, Chief Financial Officer

In terms of headcount Chris, we had a slight uptick in the fourth quarter partly because we started to recruit some sales folks and mainly however as we were adding some resources into service delivery and service management. As we go into 2008, we're going to continue with the integrations as we went through 2007 on a pretty regular basis as we achieved milestones on the integration. They would lead to reductions in force and we would expect some of that continue into 2008. Also as we see some of the delivery of our project unity improvements in our business processes and systems, we would expect to realize some efficiency gains from there as well. So, I'd say that from a headcount standpoint, you're going to continue to see some of the trends that we saw in 2007, consistent with what we announced at the time of the acquisitions, which were some synergy objectives and a lot of those synergy objectives came from headcount reductions. It's just a continuation of what we were doing throughout last year.

Christopher Larsen - Credit Suisse

And then Kevin, if I just [inaudible] Jim's comment about the churn, maybe if I ask question different way, can you... have you seen a change in the backlog from customers giving up or canceling their orders before they were installed and how much that factor into the reduction in backlog.

Kevin J. O'Hara - President, Chief Operating Officer

Sure. So, the technical term for that is pre-install cancels no to get the inside base of all. But, for the age backlog, we said that about half of that reduction was a result of actually installing new orders and about half was a result of customers canceling the orders. Of the remaining 25%, we think it is going to be less than 50/50 and significantly less than 50/50 with the higher percentage getting installed at much lower percentage getting cancelled. We think, we've worked our way through that. In terms of normal cancellation because there is always some percentage we haven't seen any material change in the normal rate of cancellations other than in the age backlog and that one we've disclosed.

James Q. Crowe - Chief Executive Officer

Put some time frame around that, what Kevin is saying is that starting effectively at the beginning of the fourth quarter, we modified our installation intervals, improved our installation intervals and the absolute level of sales dropped and we are meeting customer expectation generally today. The comments we've made are about orders that we received in the first half of the year, not of orders we're receiving today. With respect to your question about Unity, Unity continues on plan, I think we've said publicly a number of times, we've... we're spending a very large amount of time and energy and effort improving the current operating environment. Meaning a series of legacy processes and systems that we acquired along with the acquisitions we made. As you'd expect, we are also spending a fair amount of time to make sure that the transition from those improved processes... improved legacy processes to unity is done with an appropriate eye to risk and benefit. We are up in the amount of training, we are up in the amount of user acceptance testing etcetera. But in general, we continue on the overall schedule for unity deployment that... which we have said publicly would largely be done by the end of this year.

Christopher Larsen - Credit Suisse

Thank you.

James Q. Crowe - Chief Executive Officer

Next question.

Operator

Our next is from Tom Watts from Cowen and Company. Please go ahead.

Thomas Watts - Cowen & Co.

You commented that some of the service deliveries you did didn't effect Europe at all and we saw excellent growth there. And then also had a limited impact on the content businesses I believe. Can you tell us a little bit more about what you are strictly, you're seeing in the markets there. How effective you are finding the sales forces particularly in the content business some of the new products you're rolling out where you are in that product roll out cycle and what success you have to date?

James Q. Crowe - Chief Executive Officer

Yeah. With respect to Europe, as the numbers I think, they speak for themselves. We have seen excellent growth, and we anticipate excellent growth in 2008. It is the kind of growth we have seen previously in Level 3 before the acquisitions. It’s a well-run business in Europe, they have done a great job, and we think we have a compelling set of products largely cross-border products and that there are a large number of customers who find those products useful. As in the U.S., a good portion of what we're seeing is demand-driven by the rapid increase in broadband... consumer broadband penetration. There are quite a number of individual domestic providers of consumer broadband, who need pan-European network support, pan-European connection to content, Transatlantic connection to content, that is a trend we do not expect to see change any time soon, and we are a direct beneficiary of it.

We have good network reach and we have opportunity to increase our network reach in Europe. With respect to content, and I... let me make sure we define terms here, because this is often a term that is used broadly. For the kind of content distribution that we are very excited about, we are referring to the movement of very large objects, meaning streamed video or downloaded video files. We monitor that with the traffic on our network and those kinds of objects represent more than half the traffic on our network and we represent a significant portion of the Internet. So we think that's clearly representative of what's happening to the Internet broadly defined not something I suspect surprises many on the call. In order to success... that's in contrast by the way to CDNs used for small objects for web page acceleration, e-commerce etcetera. The latter kinds of CDN networks use Edge servers in large numbers to deal with small objects. It’s good business, but not one we have targeted.

What we have targeted and where we think we have significant advantages is using the combination of bandwidth, storage or caching and intelligent traffic management, whether there is a lot of intellectual property to move large objects, video, both streamed and files and it's growing rapidly, it's a business that we are very excited about. But as I think Kevin has said a number of times and I'll repeat, the growth is heroic, it's triple-digit percentage growth. But it's on top of a relatively small base. Now given what we expect, we don't think that base is going to be small for long. In longer term, it is our belief that what we now call high speed IP, what we now view is Internet Protocol transport and transport broadly defined will undergo a change.

Given that video represents more than 50% of the traffic. Given the relative size of video files and the stream video versus other forms of content, doesn’t take much math to figure out that some number of years out, video will represent the vast majority of the traffic on the Internet. We are positioning ourselves because we think what we call transportable, what we call IP etcetera today will largely be about CDM. That's why we're so excited about spending so much time on it. And I'll say again, we think because we have both bandwidth, storage and the intellectual property to do intelligent traffic management. We are in a normal unique position to benefit from that trend. Next call, item, the next question?

Operator

Our next question comes from Jason Armstrong from Goldman Sachs. Please go ahead.

Jason Armstrong - Goldman Sachs

Hey, thanks, good morning. Just a couple of questions. I wanted to sort of clarify the economic comments. Jim, I think you said no economic data points really changed your view about the opportunity. I just want to clarify is this no change in the demand environment that you can take anything related to the economy or is this more reflective of... you got so much opportunity for improvement in sales channel activity that anything you have seen on the macro doesn't really impact your view of the business and the opportunity here. And then second question is just sort of long-term capital intensity in the business, you talked about CapEx declines in '08. I think your pointed historically to sort of 12% to 14% of revs it seems like we are headed there in '08 and I just wonder if, number one is that the correct interpretation and then as we look beyond '08, is there anything that you can point here in terms of big projects that would take us out of that ratio? Thanks.

James Q. Crowe - Chief Executive Officer

Well, Sunit is gathering his thoughts on the second question. I'll talk about the comments about the softening in the economy. I have nothing to add to the many opinions that I'm sure all of us see on the future of the economy. There is certainly a lot of conflicting opinions, but there also seems to be a general consensus that the economy is going to slow down. I guess what we would say is to date, we have not seen any indication of any softening in demand or any issues with respect to pricing that affect our view on the outlook for our ability to sell and market our services. The question you specifically asked, what is the relationship between the macro economic environment and our own position as a company with relatively somehow, If I'm paraphrasing, but I believe you are asking given that we have a very small percentage of a very large market are we somewhat insulated from the macro economic trends.

Historically, certainly, since we have been involved with alternative communication [inaudible] the breakup of the AT&T. As we have gone through business cycles, the alternative providers quite often have an opportunity to increase the amount of market share they have because slowdowns tend to make customers, particularly business customers, who might in a better environment pay less attention to sharpening the cost and so look at alternatives. And we are fundamentally about the propensity to switch. And we see the propensity to switch from say the incumbents to alternatives potentially go up when times get a little tougher. We represent a value alternative. That's about 25% of our business, the business user. The balance is about wireless demand and about the consumer Internet user at one end, connected up to an exploding amount of content at the other end. You could certainly draw your own conclusions about the macro economic effect on wireless demand and entertainment driven content on the Internet, but we have not seen any reason to believe that our ability to take share there or to benefit from growth is going to be affected. That's what drives us.

Jason Armstrong - Goldman Sachs

Okay. And on the CapEx?

Sunit Patel - Group Vice President, Chief Financial Officer

Yes, on the CapEx, Jason, I think yes, we are consistent with what we have said for some time 12% to 14% of revenues, the big difference between last year and this year is last year guidance was 12% to 14% of revenues plus about a $100 million or so of integration capital expenditures. This year we expect the integration capital expenditures to be pretty small, minimum. And so we are comfortable that we will be able to hit what we have talked about in terms of guidance within the 12% to 14% of total revenues for CapEx guidance.

Jason Armstrong - Goldman Sachs

Okay, as you look out beyond '08 is there any sort of big project you can think of that will pump you out of that range?

Sunit Patel - Group Vice President, Chief Financial Officer

No. I think the only one comment I would make is to the extent that our revenue growth rate increase and we are focused more on the higher margin increase, meaning from a mix perspective, that might take us to the high end of that range, but at least for the next year or two I think that continues to be the range we are comfortable with.

James Q. Crowe - Chief Executive Officer

Yes, and I'd add that that range historically does include network upgrades. We've seen a fundamental upgrade in our optical network from discreet optronics to photonic integrated circuitry. We have seen a pretty good shift from core routing to Ethernet switching, and we will see those kinds of shifts in the future. And they are included [inaudible] range. So, we have that, it might trend up a bit for a year and then we are done and it might trend down a bit for a year.

Jason Armstrong - Goldman Sachs

Okay thanks.

James Q. Crowe - Chief Executive Officer

Next question?

Operator

Our next question is from Frank Louthan from Raymond James. Please go ahead.

Frank G. Louthan - Raymond James

Yes, a couple of questions. Just to go back to Mike’s question originally on the accruals, you mentioned the $15 million accrue in the third quarter, I don't remember you discussing that in the past and you have got an exact number here of $21 million, is that exactly the amount we should expect to hit the first quarter, and just kind of curious how we should think about that? Then you have been saying you are going to get about $200 million of synergies, I think this year, just kind a curious where you came in on that for the year? Thanks.

Sunit Patel - Group Vice President, Chief Financial Officer

So I think with respect to your first question, when we had the earnings release from the third quarter, you will see it say that we benefited from reductions to incentive based compensation expense. So we didn't talk about it, we didn't talk about amounts per se. I think and then with respect to the $21 million of bonus expense accrual reduction on incentive based compensation reduction, yes, that benefit will not occur in the first quarter. So you will be in that range, obviously, there are lot of moving parts with operating expenses whether it is, things like sales commissions or utility bills and other things, but this, specifically the $21 million benefit in the fourth quarter will go away in the first quarter. And on the synergies, I think we said that at the third quarter we largely achieved the goal we had on network expense synergies, which was $80 million and we achieved that a quarter earlier. On the operating expense side, we did about $120 million of benefits and I think we were largely there not the full amount, I think it's about $108 million or so roughly, but we didn't achieve any incremental synergies in the fourth quarter for the reasons I talked about as we work to improve our... increase our resources on provisioning and service management areas. However, as we go into 2008, as I indicated, the operating expense reductions will continue and they will become visible in the second quarter of 2008 and will trend down from there consistent with what Kevin talked about. So I think that the target we have set from a synergy perspective while expense has ticked up here in the fourth quarter, will largely achieve that or do better than that on the operating expense side and they will become visible over the course of 2008.

James Q. Crowe - Chief Executive Officer

Yes, so sum that up we... we got roughly $190 million of the $200 million and you should think not that, that is not an opportunity it simply got shifted for the quarter as we focused on improving service quality and service delivery.

Frank G. Louthan - Raymond James

Okay, great. And then on the backlog, you mentioned 75% improvement there, it is a nice improvement. But where are we relative to historic norms? Can you give us an idea of the average installed times where they are running now or looking at your backlog, how much more improvement needs to go to get back to say the historic norms for backlog?

James Q. Crowe - Chief Executive Officer

Well, I would refer you to that presentation of December 19th, Mike there is a chart in that presentation that might be useful, it displays actual sales, installs and drives backlog and it kind of shows you what happened. What we did in response to increasing backlog and increasing install intervals was divide what we've already sold and what was in backlog and what was over due, which Kevin referred to as age backlog from current sales and we did that in the fourth quarter... early in the fourth quarter. With respect to the aged backlog, Kevin, explained that and mentioned that 75% of that aged backlog has been dealt with. We had another 25% roughly half went into revenue and have disappeared. That's consistent with the assumptions we made when we provided fourth quarter and 2008 guidance. From the point at which we divided the effort, and actually I had two different teams working on each. A combination of improving installation intervals and a reduction in sales to the levels that we were able to install in acceptable intervals, means we are not disappointing customers.

As Kevin said, we provide customers with a realistic estimate of the time to install. In some cases, I should say, in the past we've been, we believe industry leading in our install intervals. Today, we think we have work to do to get back to that effort level but, we're not disappointing customers. So, when we sell services, we're straightforward to the customers about what it is going to take to install and then we've been installing it largely within those intervals. So, that's the way to think about it. Today our cycle times still need some improvement on certain products. But, they're consistent with the promises we're making to our customers.

Frank G. Louthan - Raymond James

Great. Thank you.

James Q. Crowe - Chief Executive Officer

Next question?

Operator

Our next question comes from John Hodulik, from UBS. Please go ahead.

John Hodulik - UBS

Hi guys. Thanks good morning. First, just a quick follow-up on Frank's question, if you guys, having installed or provisioned 75% of the backlog, the age backlog that you have in the fourth quarter. You know, you would expect that to give you a little bit of a bump, certainly on a sequential basis, but just in general in the first quarter revenues that you start to recognize revenues from all those installations that's [inaudible] during the quarter. But, it seems like you guys are talking about the normal seasonal slowdown in the first quarter. Is there anything… is that seasonal slowdown expected to be greater than what we've seen in past years to the extent that the improved provisioning that we saw in the fourth quarter, doesn't, or at least partially offset that? And then, two quick follow-ups, I think Kevin you talked about increasing the... some adding to the sales force. Or you know what kind of magnitude are we talking about, could you just talk about the size of the sales force, how much do you expect to add and in what areas, weather it’s the business side or the wholesale side? And then, just one last housekeeping, the $16 million SBC bonus payment. Was that the only bonus pay you got during the year or what was the number for the year?

James Q. Crowe - Chief Executive Officer

I'll take the first and you can take the second Kevin and we will give Sunit lots of time to think about the third. With respect to the installation of the backlog, I think I know in presentations, we said we expected roughly half to go way half to be installed starting in the quarter. That's all been baked in, if you would in the guidance we've provided. That’s not suffered on top of our anticipation of where we would end up in the fourth quarter, where we would end up in the first quarter etcetera and the EBITDA guidance ranges we've provided for the year. All that's included in our assessment. So, it's not a separate add-on or subtract line item. You want to talk about service?

Sunit Patel - Group Vice President, Chief Financial Officer

John, we ended the year with between 400, 450 quota bearing heads. There are sales engineers and sales support people that take our total sales force above that. But that's in the neighborhood of 400 to 450 in terms of people carrying a quota. Going into the first, by the way that Business Market Group is our single biggest sales force followed by Wholesale, then Content then Europe. We're going to be adding and have started in business markets and in wholesale markets and then selectively adding sales resources in content markets and European markets. We're… the words I used were gradual and measured, we wan to make sure we don't get out in front of our headlights. But, we would probably be gradual and measured but add every month to the extent we can continue to keep up with an installation capability focused on the BMG and WMG. So, I've got a range of numbers but it's going to vary as we go through the years based on making sure that we stay and think between our sales efforts and our installation efforts. But it's meaningful over the course of the year.

James Q. Crowe - Chief Executive Officer

And, I think it's perfect, I'm sure that you pick this up from Kevin's comments. But I do want to underline it. There's been a shift since the last quarter. Last quarter we said we were focused on understanding the bottlenecks and improving our installation efforts. As Kevin said, we believe we have capacity available in our factory, if you would, and we are now focused on ramping up sales force and rate of sales to utilize that capacity and then increase sales and capacity in a synchronized fashion. That's a better shift and an important matter for us going forward. Sunit?

Sunit Patel - Group Vice President, Chief Financial Officer

On the SBC bonus payment, the amount for the year in 2007 is about $25 million. So we've got the benefit of $16 million in the fourth quarter. So what that means is going from '07 to '08, we won't have... that's a $25 million benefit that goes away.

John Hodulik - UBS

All right.

James Q. Crowe - Chief Executive Officer

Kevin, correct me if I'm wrong, but I believe the total was $50 million for the SBC quality of service payments.

Kevin J. O'Hara - President, Chief Operating Officer

Over the last few years?

James Q. Crowe - Chief Executive Officer

Yes. That was the maximum available and I'm pleased to say we achieved the maximum available. It was triggered by specific quality of service metrics and we were able to achieve 100% of the available bonus. But there is none left.

John Hodulik - UBS

Got you.

James Q. Crowe - Chief Executive Officer

We've time, I think for two more questions.

Operator

Our next question comes from David Janazzo from Merrill Lynch. Please go ahead.

David Janazzo - Merrill Lynch

Good morning. Jim, can you update us on the status of the CFO search?

James Q. Crowe - Chief Executive Officer

Yeah, sure. It progresses and we are, as I've said a number of times. I'd refer you to the press release. We have a certain set of criteria. We're focused on meeting that criteria and convincing Sunit to stay with the company. At the same time we'll see how we do on the latter. With respect to the former, we'll make announcements as appropriate.

David Janazzo - Merrill Lynch

Any comments on timing?

James Q. Crowe - Chief Executive Officer

None other than the ones in the press release, and we'll make announcements as appropriate. We're focused on getting the right candidate not meeting a specific date and past that press release, I think is the best place to look. Last question?

Operator

Our last question comes from Ana Goshko from Bank of America. Please go ahead.

Ana Goshko - Bank of America

Hi. Thank you very much. Two questions. One is, wanted to get some insight into what you expect the profit contribution or EBITDA contribution from your non-core segment. So, for SBC, I know you have disclosed you have got $36 million gross margin left on that contract on that take or pay. Do you think that's going to be full stop once SBC [ph] finishes out their commitment, or is there the possibility that there is going to be a tale as they have difficulty potentially transitioning the last part of the business there? And then on the other part of your non-core, which is pretty, much just [inaudible] and the associated reset comps, that's been declining at a pretty steady pace quarter-over-quarter. So should we expect that same sort of steady decline or is there anything that you are aware of like contractual volume step-downs or pricing step-downs or any indications from any of your customers there that that pace of decline would be different from what we have been seeing? And then, second topic is, I just wanted to revisit your decision on discontinuing the quarterly guidance. I know you gave a list of reasons, but frankly in the past that hasn't been an area that you... that's been an area of weakness. You've always really been pretty solid in terms of projecting what your one-quarter ahead guidance is and it does serve a purpose of spending market expectations correctly. So, wondering if that decision is a function of your visibility not being as solid as it has been in the past and is that tied to all these provisioning issues that you've been experiencing recently?

James Q. Crowe - Chief Executive Officer

Yes, with respect to your question about SBC, we are projecting the amounts that are disclosed that are the contractual minimal. Whether or not SBC will be all right, we should say AT&T faster, slower, or there is more upside is best directed to AT&T, we assume that they will migrate off and that that will be the end of it and that's what's reflected in our guidance and our assumptions. Anything else would be upside but we're not expecting it. With respect to the other, which is largely dial access connections to the Internet or managed modem, you are correct we don't.... it has been a rather gradual trend, we don't expect any changes to that. With respect to your question about discontinuing quarterly metrics, couple of points. First, we are not abandoning providing guidance if anything as Sunit said, we expect to provide what we think is more relevant and useful guidance. I've had a conversation with quite a number of our larger holders who... and I sum up the advice I got this way, you ought to tell the market, which you believe are the real long-term creators of value and the metrics you use to manage the company. The reason we chose to switch now is we did in history. When we started we had no revenue effectively and we had to provide guidance that was useful to investors. We concentrated at the time on construction metrics on our ability to expand our network and we provided a fair amount of detail because we thought that was useful. As that effort dropped away, we switched to providing a different set of metrics that we thought were useful. We're simply today doing the same thing, as the company changes, matures, we continuously ask ourselves what is useful to our investors. And that question wasn't answered in a vacuum. I'd also say that you can certainly search on earning guidance on the Internet, I know you have that those who opine on best practices, on corporate transparency, I think line up behind the statement that says transparency is good, focus on the short term isn't. Focus on the real creators of value, which is your ability to generate cash over time is what is useful to investors. And that's what we are focusing on. So, we view this is as a logical progression that tracks the companies changes and maturity. Those are our reasons. Well, thank you. I appreciate your interest and good luck to all.

Operator

Ladies and gentlemen, this conference will be available for replay at 1 pm today Central Time and will remain available through February 21st. The dial-in number for the replay is 320-365-3844, access code 906704. Again that dial-in number is 320-365-3844, access code 906704. That does conclude our conference for today. Thank you for your participation. You may now disconnect.

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Source: Level 3 Communications, Inc. Q4 2007 Earnings Call Transcript
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