Since when does a 26% reduction in net loss precipitate a company's stock selling off nearly 30% in the course of three days? Oh, sure, we could talk about missed expectations, or the fact that the company does continue to lose money. But that's not it.
Level 3 (NASDAQ:LVLT), the company in question, has a long history of selling a pretty good story to investors. It's the low-cost telecommunications backbone provider in the U.S. It has an unparalleled network and has long been a beneficiary on Wall Street of a "growth-to-the-sky" story that has serially attracted some of the smartest investors in America. The story is simple: There is too much telecommunications capacity right now, so the company with the lowest cost structure (Level 3) can apply pressure long enough to remove the marginal players from the mix. This would work because telecommunications and bandwidth demand is growing at such a rapid pace that there will be a cross of decreasing supply and increasing demand, which at the end of the day will give the low-cost provider big margins and pricing power.
That's the story, and it's a good one. Unfortunately, Level 3 spent well over $10 billion building its network, and that sunk cost comes with a fuse -- some $5 billion in debt that must be repaid. Level 3's network can afford to wait for the build-it-and-they-will-come moment of truth. Level 3's equity doesn't have that luxury.
So when the company comes out and says that 2005 is going to be grim, with lower revenues from communications, lower operating margins, and continued (but decreasing) nine-digit free cash flow losses (projected at $260 million), that's just another year's worth of time that threatens to disappear without the rapturous crossover taking place.
The trouble isn't necessarily Level 3. I've held this stock in the past and believe that the company's structure is unparalleled. But the marginal players in telecommunications are doing exactly what the marginal players in the airline industry are doing: Rather than having the car keys taken away and being liquidated, competitors are getting new leases on life and emerging from bankruptcy to continue to keep that supply-demand equilibrium from being reached. I'm thinking of the re-emerged carriers like XO Communications (NASDAQ:XOCM), Global Crossing (NASDAQ:GLBC), MCI (NASDAQ:MCIP), even WilTel, which Leucadia (NYSE:LUK) dusted off from Chapter 11.
The thought has been -- and I think this bears a great deal of truth -- that Level 3, as the low-cost provider, wasn't a victim of the decreasing price environment, but was rather the company applying the pressure in order to starve off its competition. But when CEO James Q. Crowe says that Level 3 does not "intend to pursue volume at the expense of profitability. that price moderation is a key to our financial performance," you get the feeling that the pricing environment has slipped from its control.
What Crowe is saying is that the company will not pursue rock bottom-priced business; rather, it will allow its competitors to destroy themselves. The results of this, of course, are the 2005 projections above. When you are not willing to offer the lowest cost in a commodity business, market share will migrate elsewhere, even in a business with relatively high switching costs like telecommunications.
Level 3 is being boxed in. On one side, it has undead competition that continues to rise wraith-like from the bankruptcy courts to haunt the still surviving. On the other side, it has debt servicing and repayment that looms closer every day -- debt that, if nothing changes, it is unable to pay. If we believe that Level 3 has been applying the pressure in the past -- a reasonable assumption -- we must realize that it is also Level 3 that is crying "uncle."
See also:
- Bill Mann's No Respite for Level 3
- Bill Mann's We Need More Bankruptcy
Bill Mann does not own shares in any company in this article. For some value ideas, including ones in telecommunications, consider a trial subscription to Philip Durell's newsletter, Inside Value.
