Throwing yet another twist into the chaotic competitive carrier market, Level 3 Communications Inc. (Nasdaq: LVLT) has made a bid for Williams Communications Group Inc., a long-time competitor.

"We’ve received and fielded a number of bids from a number of different investors including Level 3," says a Williams spokeswoman, Patty McKissick. She would not comment on how much Level 3 had offered or when the bid was received. Level 3 would not comment on the report.

According to a report in The Wall Street Journal this morning, however, the Level 3 bid is worth $1.1 billion. The bid reportedly depends on Williams having $450 million in cash on its books, which essentially knocks it down to a $650 million offer. $50 million is expected to be in the form of Level 3 shares -- which would total 9.1 million shares at yesterday’s closing price of $5.50 a pop.

In many ways, the deal is perplexing. Williams is looking to resolve its bankruptcy, yet Level 3 is losing money and has high levels of debt -- not exactly the type of company you want coming to your rescue. With the telecom industry seemingly worsening by the day, some observers say it seems an odd time to hitch together a bankrupt carrier and a money-losing outfit.

"It's a joke," says one fund manager, asking to remain unnamed. "If you tie two rocks together, they still don't float." The fund manager says he does not own, nor has he short-sold, Level 3 shares.

Level 3 has recently been acquiring software companies to boost revenue, which it needs to maintain important debt agreements (see Level 3 Software Play Has Perils). In Level 3's earnings announcement last week, the company announced that quarterly GAAP revenue declined to $276 million from the previous quarter's level of $278 million. The company lost $0.58 EPS (excluding a gain on early debt retirement). The company's operating cash flow, less net interest expense, was a negative $108 million.

The proposed deal does go to some lengths to explain why Warren Buffett, chairman of Berkshire Hathaway Inc. , recently joined Longleaf Partners Funds and Legg Mason Inc. in a $500 million investment in Level 3 convertible debt (see Buffett Boosts Level 3). That investment looks to have strengthened bond-holders' hands in seeing the telecom consolidation play out.

The recent investment in Level 3, according to several sources on Wall Street, is highly favorable to Buffett and his partners and gives little back to Level 3 shareholders. And according to one analyst, a merger with Williams might further strengthen the bondholders' positions.

Longleaf Partners, Berkshire Hathaway, and Legg Mason each bought convertible notes in Level 3 that mature in 10 years and pay 9 percent interest. The investors may convert the notes, at any time, into common stock at a price of $3.41 a share, subject to certain terms.

Many investment experts say this investment was a good deal for Buffett & co. One source said that Berkshire Hathaway already owned Level 3 bonds (this could not be independently confirmed). In such a scenario, Buffett would boost the value of any bonds he held, while at the same time collecting 9 percent interest on the investment. If he chooses to convert the debt to stock, he is already solidly in the green with a convertible price of $3.41 per share (today Level 3 was trading at $5.88, up $0.38 or 6.91%).

In addition, the investment professional said it is common practice in such a deal for the investor to hedge the convertible bonds by shorting the common stock of the company, meaning they would make money if the stock goes down, thereby protecting their investment.

Berkshire Hathaway officials did not return calls requesting comment.

The problem with the deal for existing Level 3 shareholders is that if the new investment group exercises its right to convert, it could own up to 27 percent of Level 3, substantially diluting the existing share base.

Follow us so far? Wait -- there's more. Now back to the proposed deal with Williams.

Level 3 is trying to buy Williams while Williams is negotiating to reemerge from bankruptcy as a standalone company controlled by its bondholders, according to reports. That plan would require another investor, Leucadia National, to invest $150 million. It is unclear whether the Level 3 offer will complicate Williams's efforts to get court approval for the standalone deal.

Legg Mason analyst Daniel Zito says that on reviewing the reported numbers, it would appear that the Level 3 deal is worth a bit less than the standalone deal Williams is currently working on, but that it would bring more value to the bond holders. Legg Mason has recently joined Buffett's investment in Level 3.

"A combined Level 3/Williams could create value on the Level 3 side of the equation at this time," Zito says, but cautions that since the bondholders will be first in line to cash in on the deal, shareholders probably won't benefit much from the added value.

Zito says a consolidation of this kind might be good for the industry in the long run, because it would eliminate pricing pressures from an independent Williams reemerging from bankruptcy with only 10 percent of its prior debt to weigh it down.

"Longer term, this could be positive for the supply side of the long-haul market,” he says.

Investors don’t seem to know what to make of reports of the Level 3 bid for Williams. Following the reports earlier this morning, Level 3’s share price initially tumbled more than 8 percent. Since then, however, it has recovered and was trading up nearly 7 percent in afternoon trading.

Future acquisitions were among the things for which Level 3 said it would use the money from the Buffett consortium. Since the announced investment, Level 3 has seen its stock price nearly double from the $2.89 a share it was trading at just previously. According to a note published by Legg Mason today, the total firm market value has appreciated an estimated $3 billion since the investment.

Level 3 refused to comment on the topics discussed in this article.

— R. Scott Raynovich, US Editor, and Eugénie Larson, Reporter, Light Reading
http://www.lightreading.com