For Level 3, Even a Miss Would Win

February 24th, 2012 by · 24 Comments

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
What I get when I put it all together is a table like this:
Q1/12 Q2/12 Q3/12 Q4/12 Q1/13 Q2/13 Q3/13 Q4/13
 - Core Network Services 1370 1384 1410 1439 1452 1473 1501 1538
 - Wholesale Voice/Other 209 207 205 203 201 199 197 195
Total Revenues 1579 1591 1615 1642 1653 1672 1698 1733
COS 656 655 655 655 654 6504 657 662
Cash SG&A 580 576 574 573 571 569 570 576
Integration spending 25 25 25 25 25 25 20 7
Adj. EBITDA 317 336 362 388 402 424 451 489
Depreciation/Amortization 195 195 195 195 195 195 195 195
GAAP Net Interest 185 185 185 185 185 185 185 185
Stock Compensation 35 35 35 35 35 35 35 35
Tax/Other 10 10 10 10 10 10 10 10
Net Earnings -108 -89 -63 -37 -23 0 26 64
Net cash interest 170 170 170 170 170 170 170 170
Capex 189 191 194 197 198 201 204 208
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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24 Comments So Far


  • en_ron_hubbard says:

    Rob:

    This profile (rapid FCF growth) has been apparent since they published the S4 and gave synergy guidance. In fact, irony of ironies is that the leveraged balance sheet will now work for the stock price as opposed to against it.

  • Anonymous says:

    So looking at their proforma consolidated numbers from 2011, the combined company had revenue of 6.318b and COS of 2.666b and gross margin (GM) of 57.8%. The GM jump off at fourth quarter on a consolidated basis was 58.4%.

    Your numbers have gross margin % growing to 61.8% by 4th Quarter ’13 from a 2011 . You have total ’13 revenue at 6.756b and COS at 2.627b for full year ’13 gross margin of 61.1%.

    So ultimately you’re forecasting roughly $200m in ’13 COS savings. At 58.4% GM (the ’11 jump off gross margin %) the ’13 COS would be 2.823b. At your 61.1% GM% you have COS at 2.627b. That’s roughly $200m in gross margin improvement.

    I don’t share your view there, but I guess time will tell.

    the ’11 jump off numbers used above came from Level3’s SEC filing:

    http://sec.gov/Archives/edgar/data/794323/000110465912007841/a12-4432_1ex99d1.htm

    • en_ron_hubbard says:

      Anonymous,

      I suspect your questions were directed at Rob, but I will offer some thoughts.

      Perhaps you are not factoring into margin improvement the synergy guidance provided by LVLT. They project $300 million in cost savings achieved (on a run rate basis) within 18 months.

      45% of these savings are network related and will appear as reduction in CoS as LVLT transfers GLBC traffic on net, and avoids payments to third party providers. 55% is in SG&A– headcount, systems, etc.

      The net result will be marked improvement in gross and EBITDA margins. This effect will be masked in the short term by expensed integration costs.

      Natural revenue growth, given LVLT’s operating leverage (high incremental margins given a high fixed cost component to the business), will also naturally tend to increase margins over time.

      If you want detail on the cost savings, go to the S4 filed at the time of the merger.

  • schmuckinsurance says:

    anon, go back a little further and look at the incremental gross margins on contributed revenue over time. That’s the driver of rob’s forecast for that line item that I think you are missing, a driver that l3 has actually been over-delivering on looking at the historical numbers.

    ERH – FVF/EV I believe is going to really surprise some of the 30,000 foot PMs(and quants) just the way EPS positive really goosed the Simon Flannery upgrade. If you looked at the Reuters and Bloomberg consensus the day before and after the flannery upgrade – that was the true driver of y’day’s stock move other than the retailer investors of Smith Barney and Cramer. It is kind of funny bc it made Flannery look important but really he was foolish to have such a massively stale EPS number which had compressed the published consensus. I think those paying attention expected that but I actually thought it was going to come from Goldman. Getting back to the fcf/ev – when that begins to move via the scheduled debt repayments in the sellside model(300m ish) in 2013 and 2014 this stock won’t be near this price in my opinion.

    While Rob alludes to my point about being unwilling to talk about the upside case, the other unspoken item is the available stock. Just the top 3 names by my count are 69%(excluding the converts) Loomis and Thornburg(again both convert holders last I checked) make it 77% which doesn’t include corporate insiders or some of the people lurking on this board which I assume have fair values much higher than the Flannery.

  • Albert Upsher says:

    Given the high degree of operating leverage, it has been frustrating to watch L3 operate at or below cash flow breakeven as they dealt with the economy and all their operational problems. With CNS revenues producing incremental EBITDA margins of 60%, as long as they can drive top line growth nirvana is just around the corner. Even Rob’s pessimistic scenario confirms this. If you want to have some fun, run the numbers, if revenue growth accelerates to 15% for a couple of years. Like Rob, I can’t bear to print it.

  • morton dick says:

    Anon,

    LVLT has consistently had incremental rev of 80% + . Aside from growth of CNS , we have the replacement of lvlt “Wholesale Voice” with gross margins of 30% & glbc “Wholesale Voice” with 10% gross margins.

    Notrm

  • Anonymous says:

    En_ron, thanks. I have seen the S4. I just question if these numbers will truly materialize. Time will certainly tell.

    Key here is to watch gross margin %. If that doesn’t consistently improve, Level3 will not achieve these numbers.

    One last point, I believe that headcount associated with operations, the vast numerical (and I suspect financial) majority of reductions, will fall in the COS line, not the SGA line. SGA covers central functions like finance, legal, executives, etc. and selling expenses.

  • CarlK says:

    Q3, 2013=$102M FCF

  • CarlK says:

    Thanks Justgo. I was thinking the same thing. What’s a “net” combined $1M debit/credit error in the high altitude spread sheets being formulated by analysts including men who choose monikers like “enron,” who are looking to find mathematical certainty in something that’s unfathomable, except in their own egotistical minds!

    Unfathomable, this CARROT eating BUGS BUNNY says?

    “DAMN RIGHT!”

    Why? Because the speed at which never before realized “DEMAND” accelerating to a network with the size, scope and scale of Level 3’s nearly $40B in PP&E over a fourteen year period of MASSIVE INTERNET INVESTMENTS, is finally ready to ACCEPT it, and PAY OFF!

    I’ll keep sitting in the corner, like Little Jack Horner, munching on my carrots and LMFAO as Wall Street in their OMNIPOTENCE keeps paying me like Jacob’s Ladder.

    We are climbing higher and higher, soldiers of the BRAVE!

    Carl MUNGER eating carrots because “it’s so simple” to do in order to energize me quickly and efficiently while I wait for these buffoons to turn their HEADS in AWE!

  • level3 says:

    What’s up doctor Munger, the direction of the wind has changed and it is turning heads. LVLT is facing tail winds and those short – holding the bag, will have to face the music & have their heads handed to them. That is no head game, this is the real deal! Think AHead – Level (3)

    The future is ours LVLT Brothers………………………

  • Anonymous says:

    What were the depreciation changes you are talking about?

  • Brian Boru says:

    Rob-

    “But this is the pessimistic scenario, I simply can’t bear to put the optimistic one in print.”

    Maybe you could anonymously post your “optimistic” scenario? Only your webmaster would know for sure.

    Brian

  • level3 says:

    Level 3 was a Private Placement from WEB ( Video )

    The private placment of Level 3 Communications was annouced publicly by O. Mason Hawkins, on June 30, 2002 and in the following video, on March 22, 2005.

    O. Mason Hawkins said, ” Buffett came to us and asked us if we wanted to give (infuse) them some more capital, and so we partnered with Berkshire.”

    (Starting at the 55.40 minute mark, but at the 59.15 minute mark Mr. Hawkins talks about partnering with Berkshire Hathaway. )

    http://www.bengrahaminvesting.ca/Resources/Video_Presentations/Guest_Speakers/2005/Hawkins_2005.htm

    ******************************************
    LONGLEAF PARTNERS FUNDS
    SEMI-ANNUAL REPORT
    at June 30,2002

    Partners Fund – MANAGEMENT DISCUSSION
    by Mason Hawkins, Staley Cates, and John Buford

    After the close of the quarter, the Partners Fund, together with Berkshire
    Hathaway, Legg Mason, and Longleaf Partners Small-Cap Fund, completed a
    private placement in Level 3 convertible notes. Although typically we neither
    own corporate bonds nor do private placements, this was a compelling opportunity
    that the Fund’s flexible policies allowed us to pursue and that we did not
    want to forego. The ten-year notes position Longleaf ahead of the common
    equity, pay a 9% cash coupon, and are convertible at any time to common equity
    at $3.41 per share – a price that is under the stock’s current level, and is far
    below the company’s growing intrinsic value.

    Level 3 owns the best fiber telecommunications network in the industry.
    Importantly, most of its competitors struggle with huge debt levels and further
    significant capital expenditure requirements. Many are now in bankruptcy.
    Customers are universally worried about their service providers’ reliability,
    financial integrity, and ability to provision future needs. Level 3’s superior
    network infrastructure, its servicing capabilities, and its capital resources position
    the company to become the clear industry winner. As we said in the press release
    announcing the placement, We invested in Level 3 to take advantage of
    consolidation opportunities in the telecommunications arena. We believe these
    opportunities are substantial. Level 3 is uniquely and competitively positioned,
    and its management team, led by Jim Crowe, is most able.

  • Anonymous says:

    although in my early comment above i have expressed my doubts about many of the “conservative”, let alone the unspoken aggressive, cash flow targets above, it’s impossible to know today whether or not the future synergies savings and GM% will come on line as forecasted by Rob and others. Only time will tell.

    Since I have no crystal ball to know the future, I will put aside my negative bias that Level3’s poor historic performance will equal future behavior and ask a more simple question for the growing herd of bulls on this stock.

    What is a fair multiple of FCF? Using Rob’s 2013 Q4 FCF number of 211m, which “conservatively” suggests an 844m FCF for full year 2014, that places Level3 trading TODAY at 5.72x full year 2014 FCF. Even assuming a 20% larger FCF number (1.012b) for full year 2014 (than Rob’s 2013 Q4 211m FCF jump off), that still puts Level3 trading TODAY at 4.72x its full year 2014 FCF. This means that Level3 is currently trading 4.72x a FCF number it will not hit for another 3yrs(!!).

    Level3 supporters on this board have discussed the idea of a $4 stock (pre-reverse split) which translates into $60 stock (post-reverse split) or 2.54x current market cap. If Level3 were to trade at $60, its market cap would be $12.268b. With optimistic 2014 FCF of 1.012b, Level3 would be trading at a very rich 12x FCF. At $3 (pre-reverse split) or $48 (post-reverse split) the Level3 market cap would be 9.2b and be trading at a 9.1x multiple of the optimistic 1.012b full year 2014 FCF.

    Those are quite strong multiples of FCF. How agressive? Verizon currently trades at 7.99x trailing 12 month FCF. Comcast at 8.85x.

    Assuming a Level3 trailing 12 month FCF for 2014 of $1.012b and a FCF multiple of 8 that puts Level3’s Jan 2015 market cap at 8.1b. The current market cap is 4.53b. This translates into a Jan 2015 (post-split) price of 42.18. An excellent 21% annual return from today’s current price of 23.58.

    Could the multiple be greater than 8? Yes, it could. CTL trades at a trailing twelve month FCF multiple of 13 but they also have a long string of consistent FCF years behind them to give investors comfort. Level 3, on the other hand, does not.

    CTL 2011 FCF: 1.789b
    CTL 2010 FCF: 1.180b
    CTL 2009 FCF: 0.817b

    LVLT’s trailing twelve month FCF (Sept 10-Sept 11) is -189m. (Don’t have the Q4 FCF number.)
    LVLT’s full year 2010 FCF was -93m
    LVLT’s full year 2009 FCF was 45m

    Time will tell but I think LVLT needs to demonstrate consistency for investors to reward with a multiple like CTL’s.

  • CarlK says:

    Anonymous, you are too intelligent to ignore, so rather than curse you again, I will embrace you. First off, it’s probably more accurate to say that this “growing herd of bulls” you refer to are more or less the same BULLS from earlier years with their HORNS RAISED today. There will be war reparations before this is over.

    Now onto multiples, which is part of the reason I wrote to David Klein on Seeking Alpha what I did.

    If you consider Level 3 a Technology stock like I do, then your multiples for FCF should be 10-20 depending upon BEAR or BULL markets. We are still in a BEAR market, in case you didn’t know.

    Now for the balance answer to this mystery puzzle which another poster, level3, has placed in your face, but you choose to ignore.

    Level 3 Communications, the low cost provider in the space will continue consolidating the industry with their “next acquisition,” thank you!

    If other internet FREE LOADERS with leased networks comprised of ILLEGAL traffic via pirating or smut from Nether-worlds continue to FALSELY represent themselves as the low cost provider in the industry, and Wall Street doesn’t SHOVE a SOCK in his/their mouths, I will be TEMPTED to call that SHORT CABAL in Stamford, CT. myself!

    In concert with all this, Morton Dick’s analysis of the morphing of 30 percent GM “wholesale voice” revenues into 80 percent GM’s tied to bundles “ON NET,” will also add a lot of UPSIDE to FCF numbers moving ahead.

    Moreover, I have claimed that with the amalgamation of Global Crossing and Level 3, GM’s will expand by some unknown, yet to be declared “percentage” as a result of more owned “FOOTPRINT.”

    I have to break now for a munchy, yummy CARROT.

    Robert, you should fix the damn number that is off by $1M.

    • Rob Powell says:

      The number is correct, it’s just that all the numbers have more decimal places in my spreadsheet and the rounding works out that way here. But it’s well within the margin of error of course, so if $102 makes you happy then just think of it that way.

      • CarlK says:

        You have explained it away perfectly. Any chance of you expanding your Cogent analysis to include FCF projections during the wake of this Megaupload debacle and ongoing investigation into their selling practices?

        Good morning Telecom Ramblings; I love the smell of CARROTS in the morning! 🙂

  • level3 says:

    Intrinsic Value is a simple concept. It is the true worth of an enterprise, and will be revealed as the true free cash flows play out. Level 3’s management team is committed to using maximization of Intrinsic Value as its compass, and using the guiding fiber light to look into the future, that will bring in huge huge free cash flow streams, with no taxes for a very long time. NOL’s (net operating loss carryforward)

    Stevie Wonder can even see this in Stamford, CT and the blind mouse lady can too.

  • CarlK says:

    level3, were our Longleaf investors using fully diluted shares including their soon to be conversions when identifying $2.50 pps FCF?

    I also believe firmly, strongly and emphatically that, we are a “TECHNOLOGY COMPANY,” and that will bode well for us moving out of the “Twilight Zone” and towards free cash flow places that few men care to contemplate because their heads remains SUNK in the SAND!

    That Stamford Stevie Wonder Boy better get rid of his Superstitions, or The Devil is going take him away with SEVEN YEARS of BAD LUCK!

    http://www.youtube.com/watch?v=_ul7X5js1vE

    • level3 says:

      CarlK,

      SEVEN YEARS of BAD LUCK! I’ll call and double it to 14 years of LVLT bad luck. I’m all in and remain positively free on my cash flow stance. Looking straight into the face of the big bad bear. With Microsoft & WEB at my back – I can talk smack.

      i.e. we are at current free cash flow now! –

      http://www.longleafpartners.com/commentary_news/audio (at the 3:39 minute mark) – Staley Cates ( The front runner, holding the PRIVATE PLACEMENT FOR WEB)

  • level3 says:

    CarlK,

    In order for me to think that far ahead, will require me to put on my Google Goggles: http://www.npr.org/blogs/alltechconsidered/2012/02/24/147364732/googles-goggles-is-the-future-right-before-our-eyes

    O. Mason Hawkins knows how to think ahead in his calculations and of course the $2.50 per share cash flow prediction, includes all the shares he will convert.

    Please keep in mind I’m thinking one step ahead of what Howard Marks calls First-level thinking and Second-level thinking, in his book “The Most Important Thing.” I call it Third (3) – Level thinking AHead, that takes your imagination far above and into the clouds that serve us all via One Superior Network that connects us all – Level (3) Communications!

    While I have my head in the clouds (data centers), I’d like to thank Rob Powell
    for creating this great site to capture and corner LVLT in the market of Berkshire Hathaway & Fairfax.
    We need to stop looking in the rear view mirror – Think AHead into the future. Level 3 has fantastic real estate and superior building blocks, managed by high integrity people giving us significant operating – good business, good people, good price. Incredibly cheap market price to enterprise value and assets, then throw in future free cash flows.

    This is a happy conversation – like Walter Scott Jr. once said, hold your shares, you’ll be happy.
    Organic revenue growth results and margin flow through for Level 3 Communications are extremely good, giving us significant operating profit leverage, that are compounding and growing. i.e. we are at current free cash flow now! Listen to audio again: http://www.longleafpartners.com/commentary_news/audio (at the 3:39 minute mark) Incredibly conservative

    I’ll close by saying what Howard Marks says – “Investing consists of exactly one thing: dealing with the future.”

    Take out the “T” (at&t) in EBITDA or earnings before interest, taxes, depreciation, and amortization. Get the picture T is gone – at&t long haul copper crap. Dying copper component – T Rex who is more of a resellers not owning metro facilities like Level 3.

    P.S. Anonymous, You are brilliant, please keep up the great posts. But most of all CarlK, takes the carrot cake.

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