Lately there have been various research reports hinting or outright speculating about a consolidation event between Level 3 Communications (NYSE:LVLT, news, filings) and glbc. Additionally, I hear new rumors almost daily about talks between the two, and the frequency of Google searches on the subject that reach this site have been spiking for weeks. Whether or not there is fire under all that smoke or not, there is a steady buzz of speculation going on right now. I have written in detail about the strategic attractiveness of this combination before and the hurdles it faced, but it was quite a while ago – almost 2 year now and prior to the recession we are now recovering from. Does such a deal still make sense? Oh yes, and I feel that it is more likely to happen this year than ever before.
The general outline remains the same. The reason this potential combination worked on paper then and still works now boils down to local fiber assets and scale. Global Crossing has two businesses (GCUK and GC Impsat) that have 20-30% EBITDA margins because they have local assets, but the remainder does not and therefore has less than 10% EBITDA margins. Level 3 has metro assets in the USA and continental Europe, and the synergies those assets could bring to Global Crossing’s $1B+ Rest-Of-World transport and data revenues there are very powerful. Add that to the overall longhaul consolidation synergies associated with running one network rather than two, and you have several hundred million dollars in extra EBITDA on the first squeeze of the orange alone. The resulting company would have matching metro and longhaul assets in virtually all major markets across three continents – each able to stand on its own and generating sufficient cash flow overall to handle the debt load while allowing more than enough capex for growth.
Is Level 3 ready? Those skeptical of the wisdom of such an M&A generally have one main objection: that Level 3’s problems over the past few years show that the last thing they need is more stuff to integrate, and that a merger wouldn’t solve their problems finding organic growth. That’s true in many ways, but it’s also beside the point. Level 3’s need for organic growth is derived from its greater need to grow into its debt load – to lower the ratio of its long term debt to EBITDA. That debt and the need to keep juggling it act as handcuffs, limiting Level 3’s options at every turn. If they can overcome it, they will have much more capex available to invest in growth and finally break free from the current endless refi cycle. Certainly there are risks involved in the combination, but for Level 3, size really does matter. While they are close to being large enough in that cash burn is minimal now, the expensive refi’s they were forced to do when the credit markets froze over last year showed that the balance of power remains on the side of bondholders.
Why would Global Crossing be similarly willing? They’ve been quite open about their interest in consolidation for a couple years now, but why? Because they have done as much as they can with their current asset structure, improvements now are incremental but margins remain low. The company has worked miracles since emerging from BK in 2004 still clothed in rags financially. They have brought EBITDA back from the abyss into positive territory even outside of their GCUK and Impsat divisions. But they still lack the metro fiber assets they need outside of the UK and South America, and they can’t make further major improvements in margins without them – some yes, but there’s only so far you can go on someone else’s metro assets. However, they don’t have the capex budget to build their own and such metro assets right now trade at much higher multiples than Global Crossing does (e.g. Abovenet) and thus are hard, if not impossible, to justify financially in M&A. The obvious solution is to merge with a similar carrier that has assets in all the right places and which really needs (and therefore values) the $2.6B revenue pile they bring to the table. There is only one network operator that really fits that bill, and it is of course Level 3.
So there you have it. Level 3’s primary strategic need is for scale to match its debt, and Global Crossing’s primary strategic need is local fiber assets in the US and continental Europe to continue improving its margins. Everybody wins, except of course those on the receiving end of the layoffs that would follow – but that is probably inevitable given the current likelihood of consolidation in the sector overall. The risks of M&A are balanced by substantial rewards, and sooner or later it seems as if they must try it – if only they can agree on a price and find support for the deal in the credit markets. It’s remarkable how little this situation has changed despite the economic hurricane we went through in 2008-2009.
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