What do the folks at Markel Insurance (NYSE:MKL), Fairfax Financial (NYSE:FFH), Legg Mason (NYSE:LM), Torray, Davis Selected Advisors, and Southeastern Asset Management have in common?
Yes, they're all in financial services in some form or another, with two making their marks primarily as insurance companies and the rest as asset managers. They also make up the roster of investors who bought $880 million in senior notes at Level 3 (NASDAQ:LVLT) earlier this week.
But there's something else.
Each of these companies -- or, in the case of Legg Mason, this division -- is run by value investors. These are people willing to take risks but demanding that those risks are fully compensated. Two of the companies, Legg Mason and Southeastern, invested in Level 3 convertible debt in 2003, along with Warren Buffett at Berkshire Hathaway (NYSE:BRKa) (NYSE:BRKb), and are back at the trough again.
Just like it did the last time, Level 3's stock surged on news of the financing from such savvy, smart, penny-pinching investors. And also just like last time, I'm a bit skeptical that this deal offers much to common shareholders other than yet another stay of execution from Level 3's massive load of debt. It could be that the company intends to buy additional revenues with the cash, perhaps by trying to take WilTel off the hands of wounded Leucadia (NYSE:LUK), or maybe by taking a run at XO Communications.
But then I notice that not only has Fairfax Financial bought into the debt, but also Prem Watsa, Fairfax's CEO, filed with the Securities and Exchange Commission that he had personally bought into the common stock to the tune of 6.6% of the company, or more than $117 million worth at current prices. This is no flier, and it's no sweetheart deal. Unlike Fairfax, which gets 10% on its money and a conversion kicker, Watsa's money is no more privileged in the common than mine would be. Or yours.
Obviously these guys see something at Level 3 that belies its status as a debt-ridden company with a nearly unbroken history of enormous operating losses, in a business that eats its young.
But what do they see? Voice-over-IP revenues, maybe? A smart investment professional with whom I occasionally speak projects that by 2008, Level 3 could be generating more than $250 million in incremental cash flow from residential VoIP alone, not to mention the potential for business VoIP. With the additional debt (which, admittedly, the company might use to retire other debt below face value), Level 3 commits itself to a further $88 million-per-annum service expense, diluting the value of that operating cash flow.
Is it that Level 3's cancellation of its shareholder "rights" plan signals that it's dressing itself up to be acquired? Who'd buy it? A cable company, perhaps, like Time Warner?
I freely admit to being baffled by all the attention that these top-shelf investors are paying to Level 3. That said, here is my take: These investors believe that the telecom disaster is nearing an end with the takeunders of AT&T and MCI, and that what SBC and Verizon wanted was those companies' enterprise customers, not their networks. In effect, perhaps the investors believe that some of the excess capacity is about to get wrung out of the telecommunications system, at last giving Level 3 some pricing power as the demand and supply curves finally converge.
Stranger things have happened, but there is a reason these guys are in Level 3, and I don't think "because we're friends with the CEO" is the answer.
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Bill Mann owns shares of Markel and Berkshire Hathaway. Really, he's not so much obsessed with Level 3 as he is simply fascinated by it. The Motley Fool is investors writing for investors.
