Level 3 Communications (NYSE:LVLT, news, filings) is at a critical phase in its integration of the Global Crossing business, but one for which it won't get much credit yet when it comes to reporting earnings this week. It's sort of like being 1/4 of the way done cleaning out the garage - the mess can actually appear worse to an observer even if things are going exceptionally well. With unfavorable seasonal factors in both cash usage and revenue growth, higher integration spending prior to the synergies to be derived from it, and impatience from a market whose short term horizon is as short as ever, this is a "can't please anyone" quarter if there ever was one. Here are my guesses and some more specific thoughts:
|- North America - Wholesale||388||390||Steady but seasonally slow growth|
|- North America - Enterprise||588||591|
|- EMEA - Wholesale||94||95||Pressure in UK gov revenues offsetting other gains.|
|- EMEA - Enterprise||80||81|
|- EMEA - UK Government||50||48|
|- Latin America - Wholesale||35||36||Steady growth|
|- Latin America - Enterprise||133||135|
|Total Core Network Services||1,368||1,376||Anything above 1368 maintains the momentum.|
|- Wholesale Voice & Other||211||209|
|Total Comm. Services||1,579||1,585||Rounding up to Yahoo Finance's composite number|
|Comm. COGS||660||657||Not including integration costs|
|Comm. Cash SG&A||587||580|
|Integration Costs||23||30||Integration spending up from $23M|
|Comm. Adjusted EBITDA||270||318||Includes integration & transaction costs|
|Adjusted earnings per share||-0.62||-0.52||Excluding one-time costs|
|Adj. Gross margin %||58.2%||58.5%|
|Adj. EBITDA margin %||17.1%||20.1%|
|Capital Expenditures||148||175||Accelerating integration capex spending|
|Free Cash Flow||103||(100)-(200)||Seasonality, payables cleanup, integration => red|
Revenue growth: This works out to sequential CNS growth of 0.6%, but anything above zero and less than 1% will be within my expectations and indicate they're probably still on track. The company has been fighting hard to maintain its organic growth momentum, but given continued European pressures, the seasonality of Vyvx, and perhaps some of the minimal but non-zero single-homed churn this quarter will be their stiffest competition of the year. I've taken a swing at predicting segment results under the new segment reporting structure.
SG&A & COGS: The way my model works out for the lower edge of guidance, mid-single digit organic growth and steady integration progress will basically cancel each other out for several quarters, leaving total SG&A and COGS relatively flat for several quarters from this point. Since Q1's sequential organic growth should be muted, SG&A and COGS will decline in Q1.
Integration progress: They will probably have spent $30M in integration costs, realizing about $40M in synergies during the quarter. Both numbers could be higher, but probably not much lower. There seems little risk of hitting a speed bump this early in the process, but many synergies they have acted on won't have fully shown up yet. Perhaps they will have connected the transport backbones and will begin to apply their metro reach to GLBC's revenue in the US during Q2.
EBITDA & EPS: My EBITDA number here is probably fairly conservative, but I'd rather not let my optimism get out of hand too early - I hope they beat it soundly. Whatever the number is, to make guidance they'll have to step their way to more than $400M in Q4. Earnings per share excluding one-time events should improve steadily every quarter from this point onward, passing the break-even mark early in 2013.
Free Cash flow: This will be the painful number, perhaps even more than is usual for Q1. Capex will be up, integration spending will be up, and working capital usage will be seasonally high. It's all necessary and expected, but will probably be what the headlines focus in on after they quote the revenue number.
Further thoughts: A successful integration will see Level 3's numbers dramatically transformed over the next four quarters, but it will be hard for those not already intimately familiar with Level 3 to see that potential in whatever they report this week. The stock has given back much of its March surge to $27, so I don't think the market is expecting fireworks either.