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Level 3 Communications, Inc. (NYSE:LVLT)

Q1 FY08 Earnings Call

April 23, 2008, 10:00 A.M. ET

Executives

James Q. Crowe - President and CEO

Sunit Patel - EVP, CFO

Neil Hobbs - EVP, Operations

Analysts

John Hodulik - UBS

Jonathan Chaplin - J.P. Morgan

Ana Goshko - Bank of America

David Janazzo - Merrill Lynch

Thomas Watts - Cowen & Co., LLC

Frank G. Louthan IV - Raymond James

Colby Synesael - Merriman Curhan Ford Corporation

Johathan A. Schildkraut - Jefferies & Company, Inc.

Simon Flannery - Morgan Stanley

Operator

Good day and welcome to the Level 3 Communications Incorporated First Quarter 2008 Earnings Conference Call. Today's conference is being recorded. At this time, I’d like to turn the conference over to Valerie Finberg, Vice President of Investor Relations. Please go ahead.

Valerie Finberg - Vice President of Investor Relations

Thank you, Jessica. Good morning everyone, and thank you for joining us for the Level 3 Communications' first quarter 2008 earnings call. With us on the call today are Jim Crowe, President and Chief Executive Officer and Sunit Patel, Executive Vice President and Chief Financial Officer, who will provide remarks on the results of the quarter.

Before we get started, I wanted to mention that in addition to the press release and financial exhibits, a brief presentation summarizing our financial results is available on our website at www.level3.com on the Investor Relations home page. On today's call, we will be referring to certain non-GAAP financial measures. Reconciliations between the non-GAAP financial measures and the most comparable GAAP financial measure are available in the press release and on our website.

I would also like to remind all participants that information we will discuss today 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 actual results is contained in Level 3's filings with the Securities and Exchange Commission.

With that, I’ll turn the call over to Jim.

James Q. Crowe - President and Chief Executive Officer

Thanks, Valerie. Also in the room with us here today are Neil Hobbs, our Executive Vice President of Operations and Buddy Miller, our Vice Chairman who is responsible for corporate strategy, corporate development, and product management. They are here to make sure Sunit and I at least stay out of trouble to the extent they can avoid it. In our prepared remarks today, Sunit and I will discuss the following.

Sunit will begin with a discussion of the financial results for the quarter and expectations for the year. Then, I'll cover market demand, pricing trends, operational highlights for our various market groups, and during both our remarks we will cover in some detail the progress we are making in achieving our two key goals for 2008. First is to generate sustainable positive free cash flow as soon as reasonably achievable, and the second is to increase sales and installation rates to match the already demonstrated demand for our services. Sunit is going to discuss the first goal and I’ll discuss the second. I'd also like to make an additional point and you’ll hear this from both Sunit and I. This is the first quarter in some time where year-over-year results are comparable and organic growth is measurable and not affected by acquisitions. Sunit?

Sunit Patel - Executive Vice President, Chief Financial Officer

Thank you, Jim, and good morning everyone. We are pleased with the progress we made during the quarter and feel good about the trends we see in sales and installations. Jim will go into more detail on these trends after my remarks on our financial performance.

Core Communication Service revenue was $958 million in the first quarter 2008, up 10% over first quarter 2007. Last quarter we stated that Core revenues would be flat to down slightly sequentially and our reported Core Communications revenue for the first quarter was about flat compared to the fourth quarter of 2007. Core Network Services revenue grew 8% over the first quarter 2007 to $774 million and declined as expected 1% from the fourth quarter of 2007. Core Network Services revenue in the quarter included $136 million of local and enterprise voice revenue. Wholesale Voice Services revenue grew 23% over the first quarter 2007 and 7% over fourth quarter 2007 to $184 million.

The year-over-year growth in Wholesale Voice Services came primarily from the Conferencing Segment, Cable and Wireless Segments. We continue to expect volatility in Wholesale Voice Services, as we manage for margin contribution versus revenue growth. The breakdown of Core Communications revenue by market group for the quarter was $541 million for the Wholesale Markets Group or 57% of revenue, $240 million for the Business Markets Group or 25% of revenue, $100 million for the Content Markets Group, which was about 10% of revenue, and $77 million for the European Markets Group or about 8% of revenue.

In terms of year-over-year performance in percentage terms, our European Markets had the strongest growth, about 29% when adjusted for foreign exchange, followed by the Content Markets Group, which grew in the mid-teens, and Wholesale and Business Market Groups that grew at about 6% to 7% year-over-year. Other and SBC Communications revenue, in the first quarter Other Communication Services revenue was $51 million, down 39% from a year earlier quarter as a result of expected declines in managed modem revenues. SBC Contract Services revenue was $57 million in the quarter, down 31% from a year ago. This is the first quarter in which the agreement with SBC did not include a performance bonus, which was $3 million in the first quarter 2007 and $16 million in the fourth quarter 2007.

As of the end of the first quarter, $15 million of the gross margin commitment remained under the agreement, which we expect will be met during the second quarter, meaning AT&T's minimum commitment on gross margin will be satisfied. As such, we are evaluating how we report these revenues going forward beginning with our third-quarter earnings report. Cost of revenues and gross margin, Communications cost of revenues increased to $459 million in the first quarter. Gross margin was 56.9% in the first quarter 2008 compared to 56.6% in the first quarter 2007. Our gross margin was $607 million in the first quarter of 2008 compared to $587 million in the first quarter of 2007. Our incremental margins for Core Network Services and Wholesale Voice Services are expected to be about 80% and 30% respectively.

In addition, we should benefit from further network optimization. Effective the beginning of the year, some of the incumbent carriers increased their access charges. We are passing those increases on to our customers and raising our access prices that we charge. That shoots up our gross margins over the course of 2008. As we stated last quarter, based on our current outlook, we expect our 2008 gross margin percentage to improve slightly from the 57.9% we reported in 2007.

SG&A, our Communications SG&A expense, excluding non-cash stock-based compensation charges and restructuring and impairment charges, declined to $395 million during the quarter compared to $451 million in the first quarter of 2007. While SG&A increased from $389 million in the fourth quarter of 2007, keep in mind that the fourth quarter of 2007 SG&A benefited from a reduction of $21 million in incentive-based compensation based on 2007 performance.

Adjusting for that benefit, our SG&A expense decreased by $15 million from the fourth quarter of 2007 to the first quarter of 2008. We expect continued reductions in our SG&A expense over the balance of the year. These reductions are coming from all areas ranging from headcount reductions, moving work offshore, reductions in discretionary expenses, and reductions in non-headcount expenses.

Included in the first quarter restructuring costs of $7 million was entirely severance costs. Adjusted EBITDA, consolidated adjusted EBITDA was $211 million during the quarter, a 24 % increase over $170 million in the year earlier quarter. For the fourth quarter 2007, consolidated adjusted EBITDA was $246 million.

As I noted on the fourth quarter call, we expect a decline in the first quarter compared to the fourth quarter with two items driving the largest portion of the decrease. The one-time cash-based incentive 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, which we knew we would not see this quarter.

However during the first quarter, we were able to ramp down operating expenses a bit more than we expected. In addition, we had a one-time benefit of $5 million primarily from a buyout agreement with a customer in our coal operations. Communications adjusted EBITDA margins increased from 16.2% in the first quarter 2007 to 19.2% in the current quarter, and declined from 22.7% in the fourth quarter 2007.

Cash flow, consolidated free cash flow was negative $160 million in the quarter compared to negative $248 million in the first quarter of last year. We expect our free cash flow to be break-even on a cumulative basis for the remaining three quarters of 2008. This compares to a free cash flow loss of $154 million for the last three quarters of 2007.

Our cash use generally increased in the first quarter and that was expected and specifically in the first quarter, we had higher cash interest expense of $139 million compared to $105 million in the fourth quarter. Also, we had higher negative working capital related to annual bonus payments and prepayments on maintenance contracts and property taxes. Our accounts payable balances were lower due to lower capital expenditures in the first quarter of $112 million compared to $153 million in the fourth quarter. Our receivables balances were also slightly higher. In addition, in the quarter we paid off $26 million of 2008 debt maturities.

Depreciation and amortization expense was $240 million in the first quarter 2008 compared to $221 million in the first quarter 2007. The increase was a little higher than originally estimated because of depreciation on capital asset projects placed in service late in 2007 and early 2008. We now expect quarterly depreciation and amortization to be between $225 and $235 million per quarter for the rest of 2008.

Our business outlook, as noted in the press release we are reaffirming our previous guidance for 2008. Since our last earnings release, our confidence in our outlook has improved. Demand remains solid, pricing trends are good, our sales are increasing, and we have ramped up our insulation capacity. We feel confident about our plans to reduce overall operating expenses. We continue to expect Core Communication Services revenue growth of 8% to 13%. We expect consolidated adjusted EBITDA in the range of $950 million to $1.1 billion.

Our outlook continues to assume the inclusion of the Vyvx Ads business. Consistent with our previous guidance, capital expenditures are projected at 12% to 14% of revenue for the year. As mentioned on the fourth quarter call, with lower integration capital expenditures this year, our total 2008 capital expenditures are expected to be significantly lower than the $633 million we incurred in 2007. For the second quarter, we expect our adjusted EBITDA to ramp up at a rate that should give investors increasing confidence in our adjusted EBITDA outlook for the year.

Turning to our balance sheet, I’ll address our 2009 and 2010 debt maturities. Our debt-to-EBITDA ratio has been improving steadily over the past few years and that trend should continue over the course of 2008 through 2010 through EBITDA growth. We paid off $26 million of 2008 debt that matured March 15th of 2008 in cash during the first quarter. Our 2009 maturity of $362 million are due in September of 2009 and as we will be generating cash, we also feel comfortable that we can handle those maturities with cash on hand.

As has been the case historically, we expect to refinance the roughly $900 million due in 2010, long before 2010. We have a proven track record of refinancing our debt well in advance for our maturity and feel confident that we will do so for the 2010 maturities. I would also like to note that for those investors who may not be familiar with our debt structure, we have no financial maintenance covenants in our indentures or credit facility.

With that I'll turn the call over to Jim.

James Q. Crowe - President and Chief Executive Officer

Thank you, Sunit. As Sunit has pointed out, demand for our products remain strong, as many other observers have noted. Underlying drivers of demand include rapid increases in online delivery of very large streamed and downloaded files, especially video and to wireless devices. comScore recently reported that over 10 billion videos, that’s 10 billion, were viewed in February alone, a year-over-year increase of 66%. We benefit directly from those trends, since we are a leading provider of both the connections to the Internet for the owners of content at one end and to the broadband networks, which consumers utilize at the other. For wireless service providers, we provide a range of services, including switching center interconnection, content access, and a range of voice termination services. For both sets of customers, major differentiators include our combined metro and long-distance network reach, breadth of services, and lack of conflicts. By the latter I mean that unlike some of our competitors we are not competing with the services provided by our cable, wireless, and content customers.

A third major source of demand is from enterprise customers. Again our end-to-end network is a major differentiator. We also find that desire for alternatives to the traditional local exchange carriers often because businesses want redundant suppliers is a real competitive advantage.

Across most of our products, the pricing environment remains healthy, as evidenced by the continuing stability of our incremental margins as Sunit pointed out. For transport and infrastructure services, including long haul and metro dark fiber, wavelengths, private line, and Ethernet-based services, prices are generally stable and in some cases such as colocation and metro dark fiber are actually up in absolute terms.

IP-based services, including high-speed IP, continued to display quite a different dynamic. We expect price declines over the year to continue in the 25% to 30% range accompanied by unit demand increases in the 75% to 80% range, a very healthy relationship. Voice service pricing remains stable to slightly down across the board. I mentioned earlier that our incremental margins remain stable across our revenue categories. We currently report those revenues in four categories and I'll discuss the margin profiles in order of expected future gross margin contributions.

As explained in the press release and by Sunit, we expect the SBC Contract gross margin commitment will be met in the second quarter, so I’ll not spend any time on it. Other revenues consist of declining dial access services and related revenues and have gross margins… incremental gross margins in the 90% range. Fortunately, the drag from this declining business is largely behind us since these services are only a small single-digit percentage of 2008 total Communications revenues.

Wholesale Voice Services continued to generate incremental gross margins in the 30% range. These high margins result from our deep local infrastructure, which is a significant competitive advantage. Since we manage Wholesale Voice Services to a gross margin, not a revenue target, we expect this superior gross margin performance will continue although at the expense as Sunit pointed out of some revenue volatility.

We continue to expect that our key Core Network Services will generate incremental gross margin contributions in the 80% range. Our extensive metro and long-distance reach and our focus on selling on-net services gives us confidence we can maintain this kind of performance.

I'll now discuss the trends for each of our market segments. Our European Market Group, which as Sunit said, generates about 8% of core services, continues to grow in a very, very healthy manner at rates approaching 30%, excluding foreign exchange benefits. IP-based services and fast-growth Eastern European economies, a region of particular interest to us following the completion of a network expansion to that area, are both contributors to positive sales and sales funnel growth. We are also seeing strong demand for both terrestrial and transoceanic wavelengths, particularly from carrier and mega content segments.

Our Content Markets Group contributes about 10% of our core revenues with most of that growth currently generated... most of its growth currently generated by high-speed IP and our Vyvx video distribution services. We expect that content distribution services will be a significant contributor to future growth. Since the term content distribution network is used in a wide variety of ways, let me define what we mean by that service.

I'm not referring to webpage acceleration, e-commerce, tool sets, etcetera, that is the more traditional services offered by content distribution service providers, which constitutes a substantial majority of the current CDM industry revenues, but rather the distribution over the Internet of very large objects like video. This is a much newer business and is not large today in absolute terms, but given the rapid adoption of online streamed and downloaded media, we like many others think that such services will be an important part of our future services portfolio.

We think the keys to success in this market include low-cost bandwidth; appropriately sited server infrastructure to store content; innovative services, which enable owners to monetize their content; intelligent traffic management to distribute the content in an economically efficient manner; and importantly intellectual property rights, that is the patents, which enable you to operate in this rather litigious market. The importance of this last point was made apparent by the recent outcome of the Akamai-Limelight case.

We believe that we are uniquely positioned to bring all of these key competitive success factors to the market. And while it’s still a small revenue source in absolute terms, we are particularly encouraged by current sales in our growing sales funnel and by the dozens of service trials we are participating in, win it with many of the largest owners of online content, most of whom are existing customers for our more traditional services.

Our Business Markets Groups contributes about a quarter of our core services revenue and represents our single largest near-term market opportunity. While this unit generates about $1 billion of revenue, this is only a very small percentage of the enterprise market, which is addressable by our current metro footprint. We sell a set of transport, IP, and voice services generally provisioned over our owned fiber connected directly to the buildings in which our customers reside. Our Wholesale Market Groups represents about 57% of our core services revenue. We sell a complete set of building block services, which enable cable companies, wireless providers, carriers, and other major users of bandwidth to build these components into their network infrastructures.

The breadth of our offerings are unmatched and are valued by our customers who depend on these network elements to reliably serve their customers. Our sales funnel in this market is growing and we expect that we will convert this funnel to increasing revenues. Converting sales funnels and signed orders into billable revenues leads me to my final topic. We've said in a number of forums that our operational goals for the year were focused on increasing our sales and install rates to match the already demonstrated demands for our services. To put that statement in some context, last year we reduced guidance for revenue and adjusted EBITDA for the fourth quarter of 2007 and for the full year of 2008.

Even though as we reported today, our year-over-year revenue and adjusted EBITDA growth was 10% and 24% respectively, we had initially guided to better performance. This was a serious shortfall on our part. Historically, we’ve worked hard to set realistic goals and then achieve them. And I believe we have a track record of doing just that. As we have said repeatedly, our problem was not caused by market demand, pricing, or our inability to market and sell our services, but rather to bottlenecks in our service activation processes, which we could and should have prevented.

I am pleased to report that through the efforts of the whole Level 3 organization, we believe we can now say this problem is largely behind us. This does not mean that we won't experience occasional bottlenecks, that is a part of all service activation processes. However, we do believe we now have sufficient installation capacity to increase our sales to rates that match the demonstrated demand for our services. In fact, we began that effort earlier this year. We achieved these improvements in our installation processes through a series of efforts that can be summed up in three categories. Early on we completed an internal and independent third-party diagnosis of the root causes of the service activation bottlenecks and we added resources as appropriate.

We also significantly improved the match between the way that the detailed technical descriptions of orders are prepared by sales and sent to service activation and what is required to efficiently provision that order. Previously incomplete order descriptions were a major source for the increased activation times. And importantly, we have greatly improved our ability to forecast a realistic range of future order flows by product, so that operations can model and plan for the required resources, with sufficient lead time to avoid creating bottlenecks in the future. We began taking advantage of the improved installation process early in 2008. We ended 2007 with approximately 400 quota-bearing sales representatives. We plan to increase that number to approximately 500 by the end of June. We have already hired or have signed offers from about two-thirds of that increase and that total does not include approximately 200 additional sales engineers who partner with the sales representatives and provide technical support. It does take some time for new sales representatives to achieve full productivity, but we expect over time sales will increase proportionately as headcount increases.

The improvements I have described have generally occurred within the current legacy processes and systems. By that I mean with some exceptions, we are still largely utilizing the less efficient processes and systems that were employed by the companies we acquired over last 18 months or so. At the same time, we are on track to migrate to our Unity processes and systems over the course of this year. Unity is our integrated set of business processes and systems that we have developed over the period of the last two years and are deploying as we speak.

To date we've achieved several important milestones, we've deployed a unified product catalog for our services, we've released a unified order entry system for Wholesale Markets Group and Business Markets Group. We launched the Unity order management system for the majority of our enterprise services. And in March, we deployed the base functionality for our consolidated network inventory management system. This release is particularly significant, since having an efficient unified way to view committed and available network capacity is a key step towards enabling an even more efficient service activation process.

We currently expect that by year-end, two-thirds of our high-margin Core Network Services revenue will be handled by the Unity platform. This is a key development since we believe that we can further increase sales, increase margins, and improve our customers’ experience as Unity is deployed. That concludes our prepared remarks this morning.

Operator, would you please describe the question-and-answer process?

Question and Answer

Operator

Thank you. The question-and-answer session will be conducted electronically. [Operator Instructions]. We will take as many questions as time permits. And our first question today comes from John Hodulik with UBS.

John Hodulik - UBS

Great. Thank you. Two quick questions. First, I think Jim on the December call you guys said that the guidance was sort of bounded on the low end by the fact that if installations don't increase, you can hit the low end of the guidance. Now, I just want to... sort of looking back on that, considering that you're seeing improvements in the installation rates, does that mean that you guys should... or shooting more towards the high end of the guidance range, first of all? And then second of all, now that we’ve seemed to have uncovered some of the bottlenecks of the installation process, how fast do you think that Core Network business can grow? You are adding sales and new resources or asked a different way, how fast do you think the market is growing for your Core Network Services, now that we seem to have some runway here? Thanks.

James Q. Crowe - President and Chief Executive Officer

Yes, in some ways the two questions are related. First of all, the guidance range continues to appropriately bound we think the outcome, both in terms of revenues and EBITDA, as Sunit discussed in some detail. And I’m going to take a minute to describe a better math that I'm sure many are aware of, but it bears directly on your question. And it goes under the name of the rule of 78, it means in a recurring revenue business, the increase in billing that we enjoy in January, the incremental increase, we get to bill 12 times in February. If we increase by the same amount, we’ll use $1 million to make the point. We get to bill that 11 times or an incremental of $11 million and so forth, 10, 9, 8. What that says is, if you add an incremental $1 million each month, the total increment for the year is $78 million. It also means that the first... from a GAAP accounting point of view, the first three, four months, say four months of the year, my math is right, represent about 55% of the incremental billing units. 55% of that 78 increment. So, I go through this a bit of math to say that while we are very, very confident, as Sunit might well have detailed, that we are going to ramp up our sales and we think over time the 8 to 13 is a good range to think in terms of over the course of the year.

A week or two one way or another, a month or two one way or another has a pretty good effect on the GAAP reported revenue for the year. It doesn't affect obviously if you are a longer-term holder and you're looking at the intrinsic value created, it has much less of an effect. But we are in a position to declare with certainty the exact shape of the ramp and thus feel that the range continues to bound appropriately the outcome. With respect to your second question, what could we sell in an unconstrained environment, that is, if we are not constrained by our service activation process? I guess what we would say is we don’t know. We know that and we've provided a fair amount of data, which continues I believe to be available on our website. Actual sales and actual install data referred in the first half of last year, which on the base beginning last year would have supported our Core Network Services growth rate in excess of 20%.

What I can say is we feel comfortable that we can increase our rate of sales this year on a fairly continuous basis assuming our service activation process continues to improve and we are going to continue to look at sales people, we are going to continue to look to increase sales and service activation, we are going to continue to improve our Unity, our deployment processes, and we have not seen constraints in the marketplace. So, I guess what we would say is, we are certainly targeting the kind of growth rates that we set, guided to last year and we would like to think we can exceed those. Next question?

Operator

We'll move now to Jonathan Chaplin with J.P. Morgan.

Jonathan Chaplin - J.P. Morgan

Hi. Jim, I am wondering if I could just follow-up on that, the last question. Given that you had 400 sales people during the course of last year and that was enough of the sales channel to get you 20% roughly in organic revenue growth. And you are expanding your sales force by 20% because you are seeing a greater opportunity. It sounds like that we should infer from that that the revenue growth you should be able to get with that sales force once they are fully operational should be 20% or greater. I just want to make sure that that... that that make sense. And then it's... I understand how the rule of 78 works. But I'm wondering if by the time we get to the fourth quarter, if we are looking at revenues on a year-over-year basis, we shouldn't be seeing growth at or around those 20% plus levels. And then I'm wondering if I could just ask Sunit, what level of cash you’d feel comfortable with on the balance sheet and whether the free cash flow trends through next year are going to look similar to how they've looked this year and that there is a big drag on cash in the first quarter. I'm just trying to get a sense of where the cash balance will be by the time we get around to the September maturities and how much cash you feel you need on the balance sheet? Thanks.

James Q. Crowe - President and Chief Executive Officer

Why don't you take the last question first, so I can think about the first two?

Sunit Patel - Executive Vice President, Chief Financial Officer

Yes. I think on the cash flow front, I think we will generate a fair bit of cash next year. The first quarter normal seasonal working capital trends next year will occur again, but keep in mind that use of cash with get smaller and smaller just because of improvements in EBITDA. So, if you look for example last year, we lost $248 million in the first quarter, now some of it was due to acquisition-related payments and this year the first quarter loss was $160 million. So, it will continue to narrow. Similarly as I explained when you look at the trends over the three quarters of last year, we had losses about $150 million or so. And this year we are saying for the three quarters it’s break-even. So, the year-over-year improvement will continue to look quite good going into the next year. So, back to your question of how much cash we need on the balance sheet, I think that once you have free cash flow and our debt-to-EBITDA will be in the 5s next year or better, but we don't need more than a few hundred million dollars of cash on hand. And as I said, the maturity is not until September of '09. So, we think we are in good shape on that and with that kind of leverage ratio, I think we’ll have plenty of degrees of freedom to refinance any maturities well ahead of time.

Jonathan Chaplin - J.P. Morgan

Thanks, Sunit.

James Q. Crowe - President and Chief Executive Officer

With respect to your first two questions, I think directionally your points are sensible. We do believe as we've said that Phase I of improving our service activation and sale process is to get back to the kind of sales we enjoyed at the beginning of last year. And we've said repeatedly, if we had more capacity we could have sold more. What the ultimate limit is, obviously it's bounded by the fact that as the base gets bigger, an absolute increase becomes a smaller and smaller percentage. Churn tends to be a function of the base or percentage of the base that tends to offset growth. All of the re-rates, pricing, ups and downs, all of those go into the final calculation of percentage increases in Core Network Services. However, we have said and I would repeat, we think growth... top line growth that approaches 20% is certainly a worthy goal, it's the kind of goal that we have set ourselves and we continue to believe that is realistic. How quickly we achieve it depends on the factors I've mentioned, if we achieve it depends on the factors I've mentioned. It also… I’d want to point out, it takes time to hire and to make each sales representative productive. It often is a six-month ramp from the time you hire till the time an individual sales representative starts to generate the sort of monthly incremental revenue we expect. So, all of those go factor in just as it took us some time last year through our own problems to slow the flywheel down. It will take us some time to speed the flywheel up. But growth in the kind of high single... double-digit or high-teens, 20% is certainly a goal that we've set ourselves. Next question?

Operator

We’ll move now to Ana Goshko with Banc of America Securities.

Ana Goshko - Bank of America

Hi, thank you very much. Two questions, first on the Wholesale Voice line…

James Q. Crowe - President and Chief Executive Officer

Ana, I'm sorry, but we can... in fact, we can't hear you. We know you're talking, but we can't hear the words?

Ana Goshko - Bank of America

Can you hear me now?

James Q. Crowe - President and Chief Executive Officer

Yes, that's much better.

Ana Goshko - Bank of America

Okay. Thanks very much for taking the question. I have two, first on the Wholesale Voice line, that was strong in the fourth quarter, in fact stronger than expected and again very strong this quarter. And I know you talk about the volatility in that segment and the strength in this quarter came from cable and wireless. Could you give us just more color on the range of the potential volatility there, the competitive dynamic, and what's that driving the recent strength? Are you competing at price, are you winning from... from certain other of your competitors? And then secondly just on the comments on refinancing the 2010 converts, I want to understand what you think your options are for that refinancing. My understanding is, right now the bond... our debt incurrence dropped as scheduled in the first quarter. So, you are pretty much capped out at the level of Level 3 financing, so wondering what... where you think your options are to raise that money?

James Q. Crowe - President and Chief Executive Officer

Yes, with respect to Wholesale Voice, it is a price-sensitive market, we compete on price. It is necessary to provide... the kind of customers that we have demand a level of quality, a level of reliability as a requisite, a prerequisite to become qualified to provide the service. We sell both domestic and international termination to major customers who turn around and sell to important individual users. So, a necessary level of reliability and quality is a prerequisite, after that it’s price-sensitive market. Quite often we were dealing with organizations that have sophisticated, least cost routing systems. Those are software-driven systems, which in real time or near real time can move fairly large volumes of traffic based on very, very small changes in price, seeking the very best price generally to pre-qualified… or almost always to pre-qualified suppliers. I believe it would be accurate to say that we enjoy much better margins than our competitors. We do so because historically, first on as we built out our dial access network, we interconnected very deeply with local exchange carriers in the US particularly. We had… at one point we used to report 2 million local exchange interconnections and we have a better cost structure, we think, than most of our competitors, but it is a price-sensitive market and we target a margin contribution, not a revenue target. So, I think of it as a trading business similar to the kind of trading businesses many of the financial services companies that those on the call are part of deal with every day. And predicting revenue is not something we would do, we think the base is fairly stable, but incremental ups and downs across that base we just simply have said is volatile. Sunit?

Sunit Patel - Executive Vice President, Chief Financial Officer

Yes. Ana, for your question on capital access, I think we've stated this before and I'll say it again. We continue to have pretty deep access in the market, couple of markets selling to convertible market. We have always had access to both public and private. As you know historically to give you just one point of example, back in 2005 and our debt-to-EBITDA ratio is 15 to 1. We capped about $880 million in the private convert market. So, all I would say is very significant access for us. We certainly don't think that we need to raise capital at this kind of… for our securities prices. And the debt markets also are open to us. The only issue for us is, we think the price is high and we can wait for better times, better pricing. Our bonds have rallied together, with the high-yield market has shown a lot of improvements over the last month. So, we just continue to watch all the various markets. But I think the bottom line is we always had and continue to have pretty good access to the capital markets, both public and private. So, while we might be more limited at... in terms of issuing debt at the finance school level, we still have plenty of room at the ink level.

Ana Goshko - Bank of America

Okay, great. Thank you very much.

James Q. Crowe - President and Chief Executive Officer

Next question?

Operator

Our next question comes from Michael Wallance [ph] with Citi Investment Research.

Unidentified Analyst

Hi, good morning. Just a couple questions. First, if you could talk about where you are on the backlog that you talked about on the fourth quarter call. And in terms of then looking at the customer segmentation, the second question I had was just on enterprise. And enterprise seemed to move up just very modestly in the quarter sequentially. How should we think about the growth of that specific segment going forward and what kind of impact the sales funnel in the pipeline is seeing from at least the 400 sales people that are currently in the system and you are attacking the customers and prospective customers? Thanks.

James Q. Crowe - President and Chief Executive Officer

Neil, would you like to take the question on backlog?

Neil Hobbs - Executive Vice President, Operations

Yes. In terms of backlog because we've been in... we've been improving our installation capability, the backlog has come down and the historical backlog has decreased. Of course on overall backlog as we sell more, we just have to work out what we think an acceptable level of inventory should be over a period of time. But we are quite happy with the backlog [inaudible] level that our customers are happy with.

James Q. Crowe - President and Chief Executive Officer

And the aged backlog that we reported has effectively gone now.

Neil Hobbs - Executive Vice President Operations

Has effectively gone.

James Q. Crowe - President and Chief Executive Officer

Yes.

Neil Hobbs - Executive Vice President Operations

But of course the backlog continues to build up as we have sales success.

James Q. Crowe - President and Chief Executive Officer

Yes, that's aged backlog. I think we talked about on a couple of the previous quarters is down to the vanishingly small level, it’s gone. We turned up about half of it, as we've said publicly half disappeared. With respect to your question about enterprise, let me generalize and then I’ll give you a specific answer on your sales representative question. As Sunit provided you the year-over-year growth rates, you'll note that Content Markets and European Markets both had very healthy growth rates, in that both Wholesale Markets and Enterprise Markets were the ones that tended to be in the mid-single digits kind of growth rates, they both tend to be, as you have all seen, it tends to slow in the first quarter and grow. But they... that's not... that's directly related to our service installation problems. Those are the two units that were most affected by our service installation bottlenecks. Those are the two units that sell combined metro/long-haul circuits, so-called hybrids circuits in our terminology. As we've said repeatedly, those are high-margin, they are very desirable from a customer point of view, and they are the kind of circuits we most struggled during the second half of 2007 to effectively provision. The improvements we've identified on this call and in the press release to our service activation process directly benefit both Business Markets Group and Wholesale Markets Group. With respect to Business Markets Group, that's the place where we have the largest, in absolute terms, increasing sales representatives, we are hiring now. That's the place, as I said, we think we have the biggest market... near-term market opportunity just because of the sheer size of the market. Our sales proposition is to address the middle market with scalable straightforward product set. The high end complicated kind of managed services as we’ve said over and over again, we’ll leave that to other organizations, it's not our desired market. The low end, the 2 to 50-seat kind of enterprise is not our target market, it's in the middle where we historically believe the majority of value in the enterprise space has been created. We sell on net, that's our goal, that's no small part why we struggled in the second half, and it’s the reason that we focus so much of our service activation energy in this area, improving our service activation processes, and we expect to see real improvements over the course of the year tempered by the caveat that it takes time to bring individual sales representatives up to productivity. But we do expect to see proportional increases in sales, as we add sales count over time as those sales representatives become productive. Next question?

Operator

David Janazzo with Merrill Lynch has our next question.

David Janazzo - Merrill Lynch

Good morning. Jim, you announced the number of management changes last month. Can you discuss with us why you made those changes, what is the importance of some of the changes and are you now complete in the process?

James Q. Crowe - President and Chief Executive Officer

I will start with your last point, yes. We are complete in the process within the normal caveats of any organization with 7,000 people. I would point out for those that haven't perhaps tracked us over the years that we've had a... I guess you would say a very stable management organization. I think that still continues to be true. We had two changes; the first was our Chief Operating Officer, Kevin O'Hara. We agreed [inaudible] and he left, the reason we've discussed at length simply had to do with the different points of view about organizational matters and how to approach fixing the problems that we've discussed, we believe, are largely fixed on this call. Neil Hobbs, who you’ve heard from on the call took over most of Kevin's responsibilities. He had all of our operations before, they all reported to him. He used to be responsible for all the sales, and for the last several months he was responsible for Wholesale Markets Group and Business Markets Group. The change in reporting was to add European Markets Group and Content Markets Group to Neil. So, from his perspective he added two very important units, but not a major increase in his overall responsibility. We did take product management that used to report to Kevin O'Hara and assigned it to Buddy Miller, as I mentioned at the start of the call. We think that's a logical split. We did that actually before Kevin left several months before. We think there's a direct tie between strategy, which Buddy has been responsible for quite a long time, and product management. Those changes have gone smoothly.

The second change was Buddy… or Brady Rafuse. Brady was assigned to Neil Hobbs and was responsible for European Markets Group, Content Markets Group. We think very highly of Brady and he did a great job. Brady is headquartered in London and had an enormous travel burden, particularly with respect to content... Content Markets Group, the distribution of content over the Internet, it’s a global business. The content owners are distributed across the globe heavily centered on the West Coast to the US and the travel burden was very difficult and Brady simply came to us, said, “I would like to focus on my personal relationships.” And I wish him the very best, it's a difficult choice for… that every senior executive has to make every day and we wish him the best and know he will have a successful career, whether he decides to come back to Level 3 or go on to something else. So, that had to do with a personal issue. And as I say, Neil Hobbs is responsible for those organizations. We had an individual James Heard in the UK who has been running Europe day-to-day for over a year now and Grant van Rooyen has been running the Content Group day-to-day for several months now. So, those transitions have gone smoothly and I’ll repeat what I said at the start, we don't expect or plan any other changes. Next question?

Operator

We hear now from Tom Watts with Cowen & Co.

Thomas Watts - Cowen & Co., LLC

Jim, you had mentioned the intellectual property that you own together with the CDN assets you purchased. I seem to recall that the previous owner of those assets had had a legal case with Akamai. There’s the preliminary findings, but then they agreed to a standstill for a number of years, which I think expires later this year. Could you give us any more color on that and is there an opportunity... is that an opportunity for you, is that a risk for you, how should we think about that?

James Q. Crowe - President and Chief Executive Officer

First of all, the intellectual property that we acquired is a part of the overall intellectual property portfolio that we own. For instance, we had... we have some, I think approaching 900 patents that we've perfected or filed. Quite a large number of those we've developed, filed on our own. We continue at a pretty good clip to file for protection of the kind of intellectual property that we develop on a daily basis. We signed a cross-licensing agreement with IBM and if memory serves, that covered some 40,000 patents on their side and accessed all of ours on our side. And you are correct. We acquired certain CDN-related intellectual property from SAVVIS at the beginning of last year. And you're correct that it was the subject of a dispute between Akamai and if memory serves, Digital Island some years ago. I won't spend much time analyzing the details there because I'm not confident. And I also believe that’s subject to confidentialities of various sort, I'd simply say we are very comfortable that we have the rights to the current and future intellectual property that we need to conduct our content distribution business. We’ve spent a great deal of time on that. I think you'd find we’re one of the very few newer communications companies with the kind of extensive patent portfolio that we enjoy. Content distribution is not the only area that we think are going to be the subject of disputes in the future. Voice-over-IP has been the subject of disputes in the past. We believe that it is a battleground, it's going to be an increasingly important battleground. As a citizen, I might decry that outcome. But as a part of Level 3, we think it's important to make sure that we have the rights to all of the intellectual property we need and we’ve built internal expertise and quite a portfolio to make sure that we continue to do that. Next question?

Operator

Next question comes from Frank Louthan with Raymond James.

Frank G. Louthan IV - Raymond James

Great. Thank you. Can you give us an idea on the CapEx, obviously down a little bit in the quarter and you’ve mentioned a relationship with accounts payable down and the CapEx was down. Is that going to reverse going forward and give us an idea of what percentage of your CapEx is more success based? And as your sales grow, is that… how is that going to grow and give us... you still have confidence that you're pushing towards free cash positive, if can you give us an idea on those relationships that would be great? Thanks.

Sunit Patel - Executive Vice President, Chief Financial Officer

Sure. I think in the fourth quarter, our capital expenditures was $153 million as we moved quickly to make sure that we were working on improving our installation periods for turning up new service. So, we enjoyed some of the benefit of that in the first quarter. But I think, in general, we continue to feel very comfortable about 12% to 14% of our total Communications revenue being where the capital number is going to end up. And I think that last year the guidance for capital was the same, but in addition to that we had $100 million of integration CapEx. So, this year that integration capital expenditure has largely gone away and you can see that the total revenue trend, for example, just if you look at the year-over-year Communications revenue, we grew a little more than 2% in terms of total revenues. I think given that we want to have the $100 million in integration CapEx gives you an idea of this... that's above… that’s kind of size or reduction in the capital expenditure side. So, I think if you just think about the capital in average terms over the course of the year that should give you a pretty good idea of what the capital will be over the course… over the balance of the year.

James Q. Crowe - President and Chief Executive Officer

And I would emphasize we remain comfortable with the fundamental relationship between revenue growth and capital intensity remains solid. It's true that if we grow at the upper end of the range, we'll use... we'll be at the upper end of the 12% to 14% range in capital and the lower end and we factored that into our free cash flow projections.

Sunit Patel - Executive Vice President, Chief Financial Officer

And then in terms of your second question, the relationship between what you described as maintenance capital versus success-based capital, we think our maintenance capital expenditures is about $200 million, so the rest of the capital expenditures is success based in nature, meaning driven by revenue growth.

James Q. Crowe - President and Chief Executive Officer

And again I think Sunit said this quite a number of times, he probably gets tired [inaudible]. The 12% to 14%, I think Sunit developed as a shorthand way of saying, for each incremental dollar of revenue it cost us roughly $0.25 to $0.50 of capital, success based. That's on top of that $200 million in maintenance. And the 12% to 14% is that same relationship at the kind of growth rates we expect.

Frank G. Louthan IV - Raymond James

Okay, great. And you talked about getting the installation times and so forth back down to where you are comfortable, but you are selling at the appropriate level. So, what has the installation time for circuits in those areas where you are having some trouble? What has that gotten down to in terms of number of days to get an installation in?

James Q. Crowe - President and Chief Executive Officer

Neil?

Neil Hobbs - Executive Vice President Operations

It's difficult to answer that question directly because it really depends whether the service is off-net, it’s on-net, and it varies completely by product set and market we are operating in. But it’s fair to say we’ve seen a good improvement in cycle times to the level that we are now satisfying our customer demand, the most important for us, the thing for us is that we satisfy our customer requirements and [inaudible] satisfied.

Frank G. Louthan IV - Raymond James

Great. Thank you.

James Q. Crowe - President and Chief Executive Officer

We have a customer commitment date, a CCD associated with each order and when you say we are meeting our requirements, we are meeting our customer commitment dates largely.

Frank G. Louthan IV - Raymond James

Absolutely.

James Q. Crowe - President and Chief Executive Officer

And that's really important. If you wanted to know our goals, our goal is for on-net service to lead the industry and we are not there yet. We are meeting our customers’ needs. I think this is a distribution curve, I would say for some services were better from the competition, other services were at the competition, but we use to be… prior to all the acquisitions, we think we led the industry in terms of installation intervals for complicated end-to-end circuits and we intend to get back there. For off-net circuits by definition, we have to meet the industry since we are working through other communications companies. And we hope that this year we'll make real progress in getting back to leading the industry for those end-to-end metro/long-haul, metro kinds of services.

Frank G. Louthan IV - Raymond James

Okay, great. Thank you.

James Q. Crowe - President and Chief Executive Officer

I think we have time for two more questions.

Operator

We'll move now to Colby Synesael with Merriman.

Colby Synesael - Merriman Curhan Ford Corporation

Great. Thank you for taking my question. You mentioned in your remarks that you guys expected SG&A to go down for the remainder of the year. And I was just trying to get a sense at least in this quarter how much of your SG&A was a result of integration costs and what is your expectation at least for the second quarter, maybe for the remainder of the year?

Sunit Patel - Executive Vice President, Chief Financial Officer

Yes, I would say that integration costs are no longer easy to separate out. We basically made this part of our day-to-day processes, which is to continue to improve our operating expense efficiencies, as some of the Unity deployments take place as Jim talked about. So, a combination of business process improvement and also just the systems deployments is helping us. I think the driver for the cost reduction… as I indicated on the last quarterly call, we started taking actions late in the fourth quarter. You're beginning to see some of the benefits of that. And I think, as I mentioned in my remarks, over the course of the year, you’ll continue to see operating expenses coming down every quarter, I think, for the rest of the year given all the various actions that we’ve taken that I talked about.

Colby Synesael - Merriman Curhan Ford Corporation

And that's obviously despite the fact that you are ramping your sale force probably fairly aggressively?

Sunit Patel - Executive Vice President, Chief Financial Officer

That is considered in all of that, yes. So, we are... you are absolutely right. We are increasing our resources with respect to adding more quota-bearing headcount. But while we are doing that, we are also reducing our overall operating expenses.

Colby Synesael - Merriman Curhan Ford Corporation

Okay. Thank you.

James Q. Crowe - President and Chief Executive Officer

Next question?

Operator

Next question comes from Johathan Schildkraut with Jefferies & Company.

Johathan A. Schildkraut - Jefferies & Company, Inc.

Thank you. Most of my questions have been asked and answered. But I did have one for Sunit. During your prepared remarks, you noted that you had expected Core Communications revenue to drop in the quarter… or Core Communications Services rather to drop during the quarter. And I was wondering what was behind that expected drop and what should we expect from that line through the course of the year? Thank you.

Sunit Patel - Executive Vice President, Chief Financial Officer

Okay. Yes, I think we had said that… last quarter we said that Core Communications revenue, which is made up of two components that we report, Core Network Services and also Voice Services, we said that Core Communications Services revenue would be flat to down slightly and the reason we indicated at that time was due to normal seasonality we expect. For example, in our Vyvx line of products and some of our other services where we typically do see this year-end seasonality, meaning weakness from fourth quarter to first quarter driven by capital expenditure cycles of a lot of our customers. So, I think that what you saw… what we ended up reporting was slightly better on the margin instead of being flat to slightly down. We were flat. But I think that as you look at the revenue trends for Core Network Services over the course of the year beginning in the second quarter, we should start seeing the kind of growth we've been talking about from a sequential perspective improving over the course of the year.

Johathan A. Schildkraut - Jefferies & Company, Inc.

Thank you.

James Q. Crowe - President and Chief Executive Officer

Last question?

Operator

Our last question comes today comes from Simon Flannery with Morgan Stanley.

Simon Flannery - Morgan Stanley

Okay, thank you. Thanks for taking the question. Sunit, you had made a comment about your EBITDA ramp saying it was going to increase in Q2 at a rate sort of giving components about the full year. I just want to make sure I am understanding that right, if you were growing say $20 million sequentially, that would sort of get you to the low end of the EBITDA guidance. So, that sort of gets us to sort to $230 million number for Q2 and then $250 million, $270 million that kind of thing to get to the low end, is that the right way of interpreting your comment?

Sunit Patel - Executive Vice President, Chief Financial Officer

Yes, although keep in mind in the first quarter the Communications EBITDA was $205 million with the $5 million benefit from coal was a one-time benefit. But I think generally speaking, yes, I mean, the ramps that you are assessing are correct and as I say we... the second quarter ramp will provide evidence for that.

Simon Flannery - Morgan Stanley

Okay. Thank you.

James Q. Crowe - President and Chief Executive Officer

In many ways, this is the market we'd hope for that we believe would develop and that we built our company to serve. We think we have right now worked the right services and the right people to capitalize on the opportunity. I think we've been straightforward about the internal bottlenecks, which last year prevented us from fully benefiting from that opportunity. Also I believe for the reasons that Sunit and I detailed in our remarks today that those issues are largely behind us and that we can now get down to the much more satisfying business of meeting our customers’ needs. Thank you for listening, and we look forward to reporting our progress in the next quarter. That's the end of the call, operator.

Operator

This concludes today's Level 3 Communications Incorporated first quarter 2008 earnings conference call. Thank you for attending and have a good day.

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