A Level of Patience

Level 3's $10 billion plus fiber-optic network is arguably the low-cost provider of wholesale telecommunications services, putting the company in an enviable and highly valuable position. Plus, with yesterday's deal, the company has the backing of three of the world's most famous value investors. It's a scenario that screams of opportunity, but it's so speculative and complex that it demands an investor's patient study of all the facts.

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By Matt Richey (TMF Matt)
July 9, 2002

One of Warren Buffett's well-known quips is, "There are no called strikes in investing." That may be true, but it still smarts when a stock on your watch list takes off like a rocket. For me, the sting came yesterday when shares of Level 3 (Nasdaq: LVLT) jumped 50% on news of an investment by a trio of the world's greatest value investors: Warren Buffett of Berkshire Hathaway, Mason Hawkins of Longleaf Partner Funds, and Bill Miller of Legg Mason Funds. While I'm a bit sore about missing out on the stock's massive move, I'm now all the more interested in boning up on this fascinating new-era telecom carrier. Today, I want to offer a brief overview of the company along with some notes from yesterday's conference call about the new investment.

Level 3 is a telecom service wholesaler, meaning it targets the top 300 users of bandwidth, including the likes of Cable & Wireless (NYSE: CWP), AOL (NYSE: AOL), and AT&T Wireless (NYSE: AWE), all of whom then sell their services on a retail basis to consumers and businesses. Level 3's strategy since the inception of its business plan in late 1997 has been to combine the latest generations of fiber and optical technologies in order to become the low-cost provider of communications services.

This strategy has recently come to fruition with the substantial completion of the company's North American and European network. This network, which was built over 30 months at a cost of $10.9 billion, is optimized for ultra-efficient Internet protocol (IP) packet-switching technology, and is designed to be almost infinitely expandable at low cost because of its unique multi-conduit design. As a result, the Level 3 Network is claimed by the company to be the world's most efficient telecommunications platform. In the April edition of Outstanding Investor Digest, it was suggested that Level 3's marginal cost of adding new capacity is only half that of its closest competitor.

Low-cost leadership and a $10 billion plus barrier to entry combine to form what would appear to be an immense competitive advantage in an industry, telecommunications service, that's vital to society. In addition, Level 3's management team is widely respected and trusted, especially because of Chairman Walter Scott's ties to Berkshire Hathaway (NYSE: BRK.A), where he serves as a director.

But even a great business plan, ingenious engineering, and smart backing haven't kept Level 3 from running into trouble. Over the past two years, the company's financial planning has been thrown out of whack by a weak economy and the loss of dot-com data customers. As a result, the company has generated far less cash than it's spent building out its vast network. With capital expenditures running well in excess of $1 billion per quarter in late 2000 and early 2001, the company's debt ballooned to nearly $8 billion by September 2001.

But once the network was completed late last year, the company was able to reduce debt by $2.1 billion. By the end of March this year, long-term debt was down to $5.9 billion and operational cash burn was down to only $118 million in the first quarter, including all capital expenditures. At that burn rate, the company had nine quarters worth of cash. The company stated in its 10-Q, filed in May, that it believed the cash on hand in March of $1.1 billion, plus $650 million in untapped credit, would be sufficient to fund the company though free cash flow breakeven, or at least for the next 12 months.

That meant, as of March, Level 3 had enough liquidity to survive, but nothing beyond that to pursue any potential acquisitions. And with numerous telecom companies in or on the brink of bankruptcy this year, Level 3 was missing out on a prime opportunity to scoop up assets on the cheap. In an interview with Reuters yesterday, Level 3 CEO Jim Crowe said, "Time is wasting. Acquisitions are like game hunting. It's not enough to have a gun and dry powder. You also need to have some game come by, and that's always problematic." Apparently, Level 3 management has some game in sight, but until yesterday it lacked the necessary financial ammo. That's what led to the deal with Buffett and company.

With this deal, which closed yesterday, Level 3 attained $500 million in fresh capital in exchange for 10-year notes, which pay 9% cash interest, and the option for conversion into common stock (at the holder's option, at any time, at a price of $3.41 per share). In essence, the investors purchased a call option on Level 3 stock, with their investment protected by 9% interest in the event that the call provision doesn't prove fruitful. Longleaf Partners Funds (Partners Fund and Small-Cap Fund) purchased $300 million of the convertible notes; Berkshire Hathaway purchased $100 million; and Legg Mason purchased $100 million. All three investors also expressed a willingness to consider upping their investment in the future, should the opportunity arise.

Regarding the deal, Warren Buffett commented, "Liquid resources and strong financial backing are scarce and valuable assets in today's telecommunications world. Level 3 has both. Coupled with the management of Walter Scott and Jim Crowe, in whom I have great confidence, Level 3 is well equipped to seize important opportunities that are likely to develop in the communications industry." To this, Bill Miller added, "Spending on communications services is non-discretionary. We believe more strongly than ever that Level 3 is emerging as one of the ultimate leaders, survivors and consolidators in the industry." I can't imagine any stronger votes of confidence than these.

On the conference call announcing the deal, CEO Jim Crowe offered a number of interesting comments, which I'll paraphrase here:

  • Consolidation opportunities in the telecom industry -- that is, to acquire customer bases to the Level 3 Network -- have reached what is perhaps a historically high level.
  • Level 3 is fully funded to free cash flow breakeven, even without the new $500 million cash infusion. This new investment is exclusively to provide for funding additional opportunities.
  • The telecom industry has overinvested in assets over the past several years. Much of that investment is in poorly designed, inefficient networks [unlike the Level 3 Network].
  • Existing industry revenue should be consolidated on the most efficient platform, the Level 3 Network.
  • Attractive acquisition opportunities exist today, and more are expected to become available over the coming months.
  • An attractive acquisition would be one that allows traffic to be switched quickly and efficiently to Level 3's existing network, in current geographies served [North America and Europe].
  • Level 3 is particularly seeking to acquire customers, not additional network assets, although buying such assets may be necessary in order to get the customers.
  • Because Level 3 has the most efficient platform, revenue on the Level 3 Network is worth more than it is on other less-efficient networks.

So what does it all mean? Honestly, I still haven't fully wrapped my head around the situation. Level 3's opportunity is exciting and potentially very large, and the company has some of the most respected financial backing an investor could ever hope for. But assessing the value of Level 3's stock is no easy task, given the murky profit outlook. The company is calling for what I'd call "bondholder cash flow" breakeven (EBITDA, minus working capital needs, minus capital expenditures) by year-end. But in the meantime, communications revenues are still declining, as weak customers discontinue service. Even the basic financial picture is still very risky, given all the debt. Pro forma for the $500 million investment, Level 3 has $1.5 billion in cash and $6.4 billion in long-term debt.

Level 3's tenuous financial status and dynamic industry situation necessitate that I attain a much greater understanding of the company's underlying economics before I'll be able to consider taking a swing at the stock. It's tough to have the discipline to wait, especially given all the strong signals that Level 3 is well positioned versus the competition. But I've learned that waiting for a clear understanding of a stock's valuation is one of the surest ways to prevent investment disasters.

In the meantime, one of the ways I'll be looking to gain a better understanding of opportunities in the telecom arena will be through a forthcoming report by Bill Mann in the soon-to-be-published edition of Motley Fool Select.

Matt Richey is a senior investment analyst for The Motley Fool. At the time of publication, he had no position in any of the companies mentioned in this article. Matt's personal portfolio is available for view in his profile. The Motley Fool is investors writing for investors.