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Mergers & acquisitions

Is Level 3 Next?

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:

  • Level 3 delivered products to Divine Inc. in return for shares of stock, not cash. Management at Level 3 recognized $11 million related to these activities for the nine months ended September 2001. As of September 30, 2001, Level 3 had deferred revenue obligations of $10 million from the transactions. While this only accounts for 6 percent of the company’s deferred revenue balance ($170 million), the arrangement is strange enough to raise questions.
  • The company took $59 million in interest expense and amortized debt issuance costs related to network construction during the nine-month period ended September 30, 2001, spreading the charge out over a longer time period, instead of being expensed in the quarter in which they occurred.
  • The company recognized gains for accounting related to employee benefit plans. Through the first three quarters of 2001 Level 3 recognized $244 million, or $0.65 per share, of non-cash compensation related to tax law changes.

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.com For more information on the Optical Oracle research service, go to Optical Oracle



Editor's Note: Light Reading is not affiliated with Oracle Corporation.
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trepanne 12/4/2012 | 10:46:16 PM
re: Is Level 3 Next? +++Public filings show it's got plenty of complicated accounting moves that could be of interest to the Securities and Exchange Commission (SEC)+++

...except, of course, that the SEC isn't investigating LVLT, because of their squeaky clean accounting ("complicated", i guess, to optical oracle reporters who have a hard time getting out of the pub to spend half an hour understanding it).

+++and its heavy debt loads and negative cash flows certainly don't rule out the potential for bankruptcy.+++

they certainly don't mandate it either, given the large amount of cash and noncore assets on the balance sheet, which sets LVLT apart from every other greenfield optical carrier. LVLT could keep going under present conditions for at least 3 or 4 years, without the slightest improvement, or the need for extra financing.

+++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.+++

$50MM is absolute peanuts, considering that LVLT bought back more than $200MM in long term debt during q1'02 alone, and a couple of billion over the last 9 months.

the reporters writing this are totally innumerate. no sense of proportion whatsoever. "they've wiped out billions of debt, and assumed two orders of magnitude less of new debt! huge red flag!!!"

++++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 ).+++

again, trivial amounts of cash.

however, HOORAY for deliberate efforts to avoid problems with debt covenants and preserve shareholder value! sharp contrast with most other companies in the industry.

this move is totally effective ploy, and one of the major reasons that LVLT will NOT be restructuring for the foreseeable future, unlike WCG.

+++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.+++

totally moronic comments.

i utterly fail to see how LVLT buying back its debt at $0.40 on the dollar... OUT OF EXCESS CASH not needed to fund their business plan to cashflow breakeven... could possibly be construed as a bad thing.

or selling off noncore assets to clean up the balance sheet and cut the cash burn.

i guess "buy low, sell high" is not in the optical oracle quotation dictionary.

+++In addition, the enormous increase in the companyGÇÖs interest expenses make it ever more reliant on expensive short-term financing.+++

errrrrr, DECREASE in interest expenses.

+++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.+++

try picking a different starting & ending point and see if that alters your baseline & rate of increase...

+++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.+++

ohhhhhh... so these are almost entirely noncash losses coming from writing down PP&E? very relevant to the company's near-term survival!

hmmmmmm i wonder what the trendline of the company's EBITDA versus its capex is? might that not be slightly more illuminating as to whether the company has viable prospects near-term?

+++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 3GÇÖs business. +++

not really.

+++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.+++

sorry, what's that number again? 2 percent?

ohhhh, i thought so.

trp
optical_man 12/4/2012 | 10:46:14 PM
re: Is Level 3 Next? trepanne,
hope you are not working there. if so, transfer all of your 401k into blue chips, and unload your options, then call poison control. you've o/d'ed on Level3's kool aid.
Wall Street Journal and MSNBC are now breaking the news on the swaps:

http://www.msnbc.com/news/7262...

Also, as to your comment:

+++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.+++
sorry, what's that number again? 2 percent?
ohhhh, i thought so.

yeah, and bill clinton only broke the law 1 percent of the time he was in office, and killers only kill 2 percent of their time on the loose.
so you're saying there is a "percentage threshold" of illegality that is acceptable in your view? That's sad.
reminds me of the joke about the millionaire offering the clean cut office woman 100K to sleep with him, then after the act, handing her 20 bucks, she replies "what kind of girl do you think I am?", to which he says "well, we've already determined that, now we're negotiating price...."

You really want to defend your statement that if something is only committed 2 percent of the time then it's not really illegal?
fiber_r_us 12/4/2012 | 10:44:55 PM
re: Is Level 3 Next? Crowe said the trades were less than 2% of 2001 revenues. He didn't say the trades were illegal! In fact, he said all of the trades (I think there were 7 of them) had legitimate business purposes. Carriers trade bandwidth all of the time. It is only illeagal if there was no legitimate business reason to trade the bandwidth and that the trade served no other reason other than to inflate the carrier's revenues. So, if Crowe were doing illegal trades, one would assume that he would trade more than 2% of his revenues, otherwise, why take the risk! After all, if he were going to break the law, it doesn't matter how much.
Scott Raynovich 12/4/2012 | 10:44:53 PM
re: Is Level 3 Next? trepanne--

Are you Jim Crowe? Your long-winded message bears an uncanny resemblance to his press releases.

Time will tell. Level 3 declined to comment for this article. In the past they've made statements along the lines that concerns about their liquidity and the industry are overblown. I'd say it's interesting that Level 3 finds itself immune to the exact same problems that have plagued all of the other greenfield fiber carriers.

Just an observation.

-Scott
fiber_r_us 12/4/2012 | 10:44:52 PM
re: Is Level 3 Next? No, I am not Jim... But I have worked with him and his team on several occasions and find him to be very honest and striaght-forward. Maybe the Level 3 executives just planned better and more conservatively than the other players. I am not saying that Level 3 is going to survive, I am not even sure that some of the incumbent IXCs are going to survive! But, the fact that they are still here, are not being investigated by the SEC, and have not announced plans to file bankruptcy, tells me they must have done something better than the others!

I suspect that Level 3 declined to comment on the article because they don't see Light Reading as a relavent source of material for thier business.
Steve Saunders 12/4/2012 | 10:44:51 PM
re: Is Level 3 Next? "I suspect that Level 3 declined to comment on the article because they don't see Light Reading as a relavent source of material for thier business."

Do you think? Or is it just possible that they simply didn't want to answer the questions?

Steve
Scott Raynovich 12/4/2012 | 10:44:50 PM
re: Is Level 3 Next? "I seriously don't think that Level 3 or any carrier's business people pay attention to LR"

fiber_r_us:

I have evidence to the contrary still residing inside my eardrum...
fiber_r_us 12/4/2012 | 10:44:50 PM
re: Is Level 3 Next? I seriously don't think that Level 3 or any carrier's business people pay attention to LR. Thier technical people probably pay a lot more attention. Has Level 3 ever commented on any LR article?
fiber_r_us 12/4/2012 | 10:44:43 PM
re: Is Level 3 Next? I don't doubt that... my point was that Level 3 would not likely provide you with any sort of authorized statement that you could publish. They generally never respond to unfounded accusations. They just won't "take the bait".
doggydogworld 12/4/2012 | 10:44:33 PM
re: Is Level 3 Next? I am a long time LVLT bear, but this article has too many factual errors to be taken seriously.

1. "the company is facing a near-term financing crisis". LVLT has $1.5b in cash and is only burning $200m or so per quarter. The only possible near term crisis is a debt covenant violation, which the CorpSoft manuever probably eliminated.

2. "Level 3 delivered products to Divine Inc. in return for shares of stock, not cash..... As of September 30, 2001, Level 3 had deferred revenue obligations of $10 million from the transactions. While this only accounts for 6 percent of the companyGÇÖs deferred revenue balance ($170 million)".

The Divine transaction was unwound and cleared off the books in August. The $10m deferred revenue as of 9/30/01 is for similar deals with other companies, not Divine. And LVLT's deferred revenue balance on 9/30/01 was $1.337b, not $170m ($170m was just the current portion). So we're talking about less than 1% of total deferred revs.

3. "The company recognized gains for accounting related to employee benefit plans. Through the first three quarters of 2001 Level 3 recognized $244 million, or $0.65 per share, of non-cash compensation related to tax law changes."

I can't find any "gains" related to employee benefit plans. The $244m mentioned is an EXPENSE that LVLT counts for employee stock options. Most companies pretend that options are free and do not expense them. LVLT should be lauded for recognizing a very real (if non-cash) expense that almost every company ignores.

4. "the company has been funding some of its debt repurchases by selling investments and raising new debt -- obviously not the best way to go"

Selling non-core investments to retire debt at a huge discount to par is "not the best way to go"? I guess that's a matter of opinion, but it looks pretty smart to me. The author is wrong about raising new debt -- LVLT hasn't done that for two years.

5. "the enormous increase in the companyGÇÖs interest expenses make it ever more reliant on expensive short-term financing"

Really dumb statement. LVLT is no more reliant on short term financing now than ever. Besides, short debt is cheaper than long debt, not more expensive.

6. "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."

Wrong again. LVLT's 3Q01 income statement shows 183m in interest expense vs. 64m for 3Q00. But that doesn't include capitalized interest, which has practically vanished since network completion. Total interest expense for Q3 of 2001 vs. 2000 was actually 184m vs. 170m, a very small increase. Since 9/30/01 LVLT bought back almost $2.0b of debt, so total interest expense today is actually much less than 3Q00 levels.

7. "at the end of 2001, it still had nearly $1.3 billion in cash and cash equivalents"

It's actually $1.5b counting the 200m in US Treasuries. Plus there's over $500m of stock of RCNC and CTCO (they've filed to sell $150m of the CTCO). Plus a couple hundred million worth of coal mines and toll roads. LVLT may one day face a liquidity crisis, but it's not imminent.

There is a bear case to be made for LVLT -- I've made it repeatedly over the last year on various message boards. But a good argument leverages the facts instead of trampling them. Perhaps LightReading should stick to technical articles.
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