It's almost that time again for followers of Level 3 Communications (NYSE:LVLT, news, filings), since the company reports earnings tomorrow. What should we expect, looking into the teeth of a recession? If the rest of the sector so far is any indication, the story will almost certainly be that Q4 wasn't disastrous, and that guidance for 2009 will be disappointing. My model for Level 3's operations is of limited value under these economic conditions, because the effects of the macroeconomic environment are a real wildcard and affect each of the company's segments differently. But of course, that won't stop me from trying, so without further ado:
Core Revenue Growth: For Q4 I have core revenues coming in a bit light at $979M, which works out to 7.3% growth for the year after excluding both the Vyvx Ad business and the deferred adjustment in Q2. This is frankly because I haven't heard anything great on the grapevine for Q4, but I would love to be proven wrong. And given the state of the economy and the ultra cautious nature of projections across the sector, I think it would be foolish to expect Level 3 to project a big number for 2009 so I have this at 5%, or in Level-3-speak: "mid single digits".
Wholesale Markets: This segment should actually benefit somewhat from the recession. Cutbacks in carrier capex imply more leasing and less building, which means more business for wholesalers. As the Level 3's largest segment, where wholesale revenues go will define 2009. I have them at $546M in Q4, showing some growth but less perhaps than the usual big Q4 have seen in years past. For 2009 they should see growth but once again weighted toward the second half of the year.
Business Markets: This segment has been stagnant since its inception, as Level 3 has struggled so far to transform it into an engine for growth. There is new leadership (Jeff Tench for the group and Jeff Storey as COO) and some hope for a turnaround in 2009, but the recession will be a heck of an obstacle. So until they show me something, the best I can hope for is that they don't lose ground.
Content Markets: There are no indications that the economy has hurt the CDN business, nor does the Vyvx business seem at risk. Level 3 needs a growth engine and everyone has always thought that while CDN services haven't exploded quite yet, in 2009 the content markets group might begin to show some muscle.
European Markets: Powerful growth has been the rule here for a couple years now. Will the recession hurt this trend? Most of Level 3's European revenues are of the wholesale variety, so carrier capex cutbacks in Europe should actually benefit the company. On the other hand there is probably some exchange rate exposure in the UK. The challenge is to continue growing, keep the good times flowing.
Other Revenues: Interestingly, the economy probably helps the company's other revenues a bit. AT&T's cutbacks in capex imply that they are less likely to migrate the remaining SBC contract revenue as quickly. Managed Modem revenues will probably continue their steady plunge.
Cost of Sales: COS should slowly improve over time, but given the efforts at capex reduction I think it would be unrealistic to expect much improvement in 2009. My guess is for communications gross margins to hold steady around 59.5% in Q4, and my 2009 projection is for 60%, any extra savings would be welcome.
SG&A: With energy costs declining from their peak in Q3, we should see the full effects of the cost savings the company has been promising. However, the layoffs in Q4 will result in an extra charge of $12-15M for severance and such, which will temporarily offset those savings but lower the 2009 SG&A numbers. In a presentation last month, the company mentioned the goal of bringing SG&A as a percentage of revenue toward the low 30s, a feat that would finally justify the purchase prices of those 7 acquisitions. I see it in 2009 reaching the 32.5% range by the end of the year if things go well.
EBITDA: While my Q4 number of $260M is lower than some, I believe that is because I am including one-time severance charges from the layoffs announced in December. I find the various analyst projections for 2009 rather curious, as some are in the neighborhood of $1050M with flat revenues, which implies negative progress in 2009 on costs since the Q4 EBITDA run rate would be $272M which would be $1088M annualized. I see 2009 EBITDA of $1100-1150M, with cost savings leading the way. Actually, my model predicts a bit higher than that, but given the economic conditions I've cut the number in the name of caution.
Cashflow: The company says it is free cash flow positive, the street doubts it very much given the conditions. From what I hear internally, everything is about cashflow there and costs are on a very tight leash. I expect the company to reiterate its positive free cashflow projection for the full year 2009, but they will give a wide range for the actual number and it will of course be negative in Q1 due to seasonal working capital flows.
As one of the major telecom soap operas for more than a decade, the only thing we can be reasonably sure of is that the story will continue. Stories of the company being in danger of being crushed by its debt are from those who just haven't been watching long enough.