By Ryan Barnes. Edited By Douglas A. McIntyre
Level 3 Communications Inc. (LVLT) – Price $6.67; Break-up Value $8
Level 3 is a play on bandwidth, pure and simple. As the internet matures in content offerings, demand for higher bandwidth goes with it. The company owns over 23,000 miles of fiber optic networks, the majority centered in nearly 40 major metropolitan areas. They were also smart enough to leave room in the ground to add new fiber with minimal cost, as the biggest expenses in rolling out new underground lines are the actual construction and right-of-way costs. Level 3 has 11 empty conduits for future fiber inlays; no other U.S. company has more than three.
Level 3 has been very acquisition hungry in the past few years, and it almost seems at times that they have adopted the strategy of “our balance sheet is already ugly, so might as well go for broke”. But the fact remains that they were able to gobble up an extra 8-10,000 miles of network at depressed prices when nobody else wanted it. Now it is time for Level 3 to take a breather, work on integration and debt refinancing, and look to control pricing as bandwidth demand increases.
It seems that we are finally getting to that point in the internet’s maturity that many investors thought would happen three or four years ago, where applications like VoIP and video eat up all the excess bandwidth and make the telcos and content providers go looking for more. Even the major wireless carriers could jump into the game, as they will need a strong network backbone to piggyback their increasingly bandwidth-hungry content on between the cellular sites and switches. This is precisely the environment that Level 3 was designed to make money in. The revenue growth at LVLT is so fast at the moment (in the low to mid-teens sequentially) that we have to look forward a bit more than we normally would in a break-up analysis just to catch up to the momentum.
With a market cap of $7.85b, nearly that much in long-term debt and no net income to speak of, Level 3 is by no means a classic break-up candidate. But considering the revenue leverage inherent in their business model, things could change quickly. While the company’s current estimates don’t show them being cash flow positive during the next two fiscal years, a little debt restructuring and a slight uptick in pricing could cause big changes in a hurry. And if we haven’t already turned the corner on bandwidth demand, then we’re standing at it right now.
Because of the rather unsightly balance sheet, Level 3 is much more likely to be bought out by another public company as opposed to private equity. There have been scattered rumors of someone like a Google or a regional Bell coming in to buy Level 3, but most possible bidders seem content to wait and see how bandwidth demand plays out for the next couple of quarters before buying up a company with nearly $7 billion in junk bonds on the balance sheet. As such, our breakup value will be focused on the value of the fiber network itself, as it would be the singular goal of any potential buyer.
We have put together a range of estimates for the value of Level 3’s network based on the cost one would have to outlay to add the same amount of capacity. To arrive at these figures we used both a weighted average of acquisitions, such as Looking Glass and Wiltel, and recent rollout announcements like Verizon’s FIOS plans. Based on our calculations, the value per mile is between $500k and $700k for the metro areas, with the midpoint at $590,000. Of course, something is only as valuable as what someone is willing to pay for it, but these values are based mainly on what other companies are spending in today’s dollars to build the same types of underground networks.
In order to complete our break-up analysis, we’ll need to take care of the balance sheet. Netting out the current accounts and subtracting LT debt comes to $5.2 billion that needs to be subtracted from the value of the metro network which, by using our midpoint, comes to $13.5 billion. We’ve added in another $1 billion in value to estimate the worth of the long-haul network, which is rather commoditized but represents the relative cost spend by Level 3 to acquire the pieces of it. Adding everything together we arrive at a total break-up value of $9.3 billion, or $8/share. It is important to keep in mind these figures are still based on a relative trough in the industry; any major pulls from the demand side could up the value of the company in a very short time.
Ryan Barnes
Ryan Barnes has over 10 years’ experience in portfolio management and investment research, covering equities, fixed income, and derivative products. Ryan spent the past 5 years working as an institutional trader & manager for high-net worth investors, working with Merrill Lynch, Charles Schwab, Morgan Stanley, and many others. Ryan is currently working as a writer and financial modeling consultant on hedging and capital appreciation strategies, and does not own securities in the companies being covered.
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