Creative accounting, fiber-swap arrangements, mounting debt, and possible bankruptcy -- sounds like just about any company in the telecom carrier space, right?

Yes, but for the most part, public scrutiny has focused on bankrupt carrier Global Crossing Ltd. (NYSE: GX), along with public companies Qwest Communications International Inc. (NYSE: Q), Williams Communications Group (NYSE: WCG), and WorldCom Inc. (Nasdaq: WCOM).

But what about Level 3 Communications Inc. (Nasdaq: LVLT)? Public filings show it's got plenty of complicated accounting moves that could be of interest to the Securities and Exchange Commission (SEC) -- and its heavy debt loads and negative cash flows certainly don't rule out the potential for bankruptcy.

Earlier this week, Qwest and WorldCom received requests from the SEC to turn over documents concerning their accounting procedures. And on Tuesday, the U.S. Congress joined the SEC and the FBI in investigating bankrupt Global Crossing.

Level 3 says that it has not yet received any requests from the SEC to turn over documents and ardently denies that it’s facing liquidity problems. The evidence, however, appears to run contrary to the latter claim at least.

An extensive look at 11 leading carriers recently launched by Light Reading's paid research service, Optical Oracle, finds that Level 3's financial footing is indeed on tricky turf -- and the company is facing a near-term financing crisis.

While the company has managed to reduce its debt by 21 percent, the company still has $6.2 billion in long-term debt. Level 3 recently took on an additional $50 million in debt when it acquired software reseller Corporate Software Inc. (CorpSoft) last month.

In addition to the assumed debt, Level 3 paid $89 million in cash for the company, in what observers say was a deliberate effort to buy revenues and avoid problems with its debt covenants (see Level 3 Acquires CorpSoft for $89M).

"The acquisition was done for one reason, and one reason only,” says Robertson Stephens analyst James H. Friedland. “To prevent them from tripping their debt covenants.”

Here’s the deal: Level 3 has $650 million in available capacity on a $1.8 billion credit facility from a group of investment banks, but it can only access the funds if it pulls in at least $2.3 billion in revenues in 2002 (total revenues for 2001 were $1.53 billion). In 2000, CorpSoft reported $1.1 billion in revenues.

Optical Oracle's forthcoming "Carrier Crisis Report," which will be released to subscribers of the service later today, has found that Level 3 has a possibly lethal combination of lowered revenue expectations, high debt levels, negative cash flow, and dwindling customer base.

The company has also used some creative accounting methods to cushion its pro forma results. Here are of some of the more interesting ones:

Then there is the way the company is handling its debt. According to filings with the SEC through the third quarter last year, the company has been funding some of its debt repurchases by selling investments and raising new debt -- obviously not the best way to go. In addition, the enormous increase in the company’s interest expenses make it ever more reliant on expensive short-term financing.

The bottom line? Interest expenses are rising at a much faster rate than revenues or cash flows. Level 3 did not specify its interest expenses for the fourth quarter of 2001, but its third-quarter results showed that its interest expenses had increased by 186 percent year over year.

In its fourth quarter last year, Level 3 lost a whopping $3.28 billion, or $9.70 per share, from continuing operations. Management reported a pro forma net loss, excluding a $3.2 billion asset impairment charge, of $475 million, or a $1.24 loss per share.

While balance-sheet problems are evident, it is worth mentioning that the company has been cutting costs, and, at the end of 2001, it still had nearly $1.3 billion in cash and cash equivalents. It has also managed to migrate traffic from leased facilities to its own network, thus lessening its reliance on dark fiber sales and resulting in solid gross margins.

Meanwhile, some may be left wondering why Level 3 hasn't announced inquires from the SEC like those that came at Qwest and WorldCom. The company has said that it hasn't received any. It's worth noting however, that the inquiry disclosures from WorldCom and Qwest were voluntary, as correspondence between the federal agency and companies is typically kept confidential.

Revenue swaps associated with Indefeasible Rights of Use (IRUs), a topic of great interest to the SEC in the cases of Qwest and WorldCom, have been an important part of Level 3’s business.

James Q. Crowe, CEO of Level 3, recently issued a statement saying the company had accounted for seven outright capacity swaps last year -- representing 2 percent of its 2001 revenues. He insisted that each one had a legitimate business purpose (see Jim Crowe Speaks). Without insight into the documents concerning the swaps, this is, however, impossible to confirm.

Level 3 officials declined comment on the specific financing and accounting issues raised in this article.

— Eugénie Larson, Reporter, Light Reading
http://www.lightreading.comFor more information on the Optical Oracle research service, go to Optical Oracle



Editor's Note: Light Reading is not affiliated with Oracle Corporation.