Earlier this week in the discussion following my article a few days ago on CenturyLink's possible interest in Level 3 Communications (NYSE:LVLT, news, filings) I said that the math for Level 3 doesn't require heroic assumptions to get to positive earnings and substantial free cash flow next spring. In fact, the math is so favorable that my model suggests that even if they materially miss guidance throughout 2012, they still likely start generating actual positive earnings and substantial cash flow in 2013.
So let's take a look at such a hypothetical ugly scenario, one where Level 3 clearly misses its 2012 EBITDA guidance while failing to materially accelerate its core network services growth rate for an extended period. The model makes various assumptions:
- 5.2% annualized CNS revenue growth in 2012, and 6.9% in 2013
- Incremental EBITDA margins of 60% on new revenue
- Slowly declining wholesale voice and other revenues at a fixed gross margin
- Realized synergies lag before affecting published results by half a quarter
- Integration spending and synergy realization remain on schedule
- No additional savings are found beyond those already discussed
- Net GAAP and cash interest remain at guidance
- D&A stabilizes at guidance
|- Core Network Services||1370||1384||1410||1439||1452||1473||1501||1538|
|- Wholesale Voice/Other||209||207||205||203||201||199||197||195|
|GAAP Net Interest||185||185||185||185||185||185||185||185|
|Net cash interest||170||170||170||170||170||170||170||170|
|Working capital bias||-110||-35||15||100||-100||-25||25||100|
|Free Cash Flow||-152||-60||14||121||-66||28||103||211|
The synergies are reflected in relatively flat COS and SG&A, as realized synergies should essentially balance the increases that would result from revenue growth. If you add it up, this scenario has revenue of $6.44B missing current analyst estimates in 2012 and doing even worse in 2013, while the 2012 EBITDA number is just 1403, up just 15% over 2011 and badly missing the bottom rung of the 20-25% growth promised by Level 3 in their earnings call.
Yet it doesn't matter! Despite such a clear miss in 2012 and mediocre improvement thereafter the company still reaches earnings breakeven in the second quarter of 2013, on the way to generating more than $200M in free cash flow that year. Earnings per share for 2013 then would amount to be something like $0.30. (Note, the positive earnings comes earlier than anticipated largely due to the change in depreciation scheduled they announced.)
There's no room here for four more columns, but if you then take another year of mere 7% CNS growth and no further integration work and nothing fun to spend additional capex on, the 2014 numbers work out to $2.1B in EBITDA on $7.1B in revenue, with earnings per share near $2 and over $500M in free cash flow. Now I seriously doubt that cash flow would be generated and not used for other growth projects, it's just a number that results from a set of assumptions that have been extended too far.
But this is the pessimistic scenario, I simply can't bear to put the optimistic one in print. Obviously there are risks that would make things worse. The economy could go into another deep recession. Anything that materially affected the business model itself or the competitive environment could change the cost structure or even kill off a chunk of revenue. But for a decade, the bear case against Level 3 has been simply that they can't and won't ever turn the corner on their debt. But with what we know of now, the math just plain works and the bear case needs external help. All they need to do is integrate on a conservative schedule without screwing up and maintain current (low) growth rates -- nothing more is required to turn that corner.
This is precisely why I harped incessantly on the singular potential of a Level 3/Global Crossing merger for three years before it finally went down. It's actually pretty hard to screw up unless some external factor shifts the business model or the integration goes very badly. Such things have happened several times before already of course, but for Level 3 the paradise just over the horizon has never been this close.
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