Level 3 Software Play Has Perils

Can Level 3 Communications Inc. (Nasdaq: LVLT) fight off the telecom debt monster by squeezing new revenue out of software acquisitions? That's a good question -- and one that's rising to prominence as the company's software buying pattern unfolds.

The latest purchase is Software Spectrum Inc. (Nasdaq: SSPE). On June 18, shareholders of that company will vote on whether to accept Level 3's offer to purchase the business software distributor for about $122 million (see Level 3 Buys Software Spectrum). But new evidence points to the fact that even if that acquisition is approved, more may be needed if the company is to manage its tricky debt covenants.

If it closes, the deal will be Level 3's second purchase of a software reseller this year. Back in February, the carrier bought privately held CorpSoft Inc. for about $89 million in cash.

Analysts say the purchases are attempts by Level 3 to avoid violating the terms of covenants for over $6 billion in long-term debt (see Is Level 3 Next?). Those covenants call for Level 3 to meet certain revenue minimums in its telecom business, of which the new acquisitions are (or will be) subsidiaries.

But some analysts point out that Level 3 will have to keep buying -- and buying big -- if it's going to acquire the revenue it needs. Consider the following excerpt from Level 3's annual report:

The Minimum Telecom Revenue covenant is calculated quarterly on a trailing four-quarter basis and must exceed $1.5 billion for the first quarter of 2002, increasing to $2.3 billion in the fourth quarter of 2002, $3.375 billion in the fourth quarter of 2003, and $4.75 billion in the fourth quarter of 2004.

Hitting these figures, which basically amounts to tripling revenue in as many years, strikes many experts as improbable in the current telecom environment.

In 2001, for instance, Level 3 posted $1.5 billion in revenue. Even if it adds $2.4 billion from the acquisition of CorpSoft and Software Spectrum to that figure (see below), it's still going to be challenged to hit nearly $5 billion annually.

"If I were looking from a shareholder's viewpoint, I'd ask whether the company isn't paying too much," says Simon Reeves of Pacific Crest Securities. Level 3 is clearly going to need another acquisition to protect its credit covenants before next year, he says, unless "all hell breaks loose" in terms of the carrier's core business improving.

Other evidence points to the fact that Software Spectrum's business may not be as big as expected. Optical Oracle, Light Reading's paid subscription research service, notes that growth in Software Spectrum's cash flow has been decelerating -- which brings up what financial analysts call a "red flag." Over the past three quarters, Software Spectrum's cash flow has dropped from $22 million to $4.4 million.

Level 3 doesn't deny it's eager to acquire revenue. In fact, it's clear that adding revenues to help meet debt covenants was among Level 3's goals. On the date of the CorpSoft acquisition announcement, Level 3 issued a separate press release with financial data that included the following statement from its CFO, Sureel Choksi:

As a result of this transaction, we believe that the company will remain in compliance with the terms and conditions of our credit facility until the second half of 2003... Additionally, given other actions the company may take, and based on our longer term expectations for improvements in our rate of sales, disconnects, and cancellations, new product and service introductions and the potential for additional acquisitions, we believe we will continue to remain in compliance with the terms and conditions of our credit facility over the term of that agreement. [emphasis added]

Both software company acquisition announcements have been accompanied by statements about the revenues each company has the potential to add to Level 3's balance sheet. CorpSoft, for instance, had 2001 revenues of approximately $1.1 billion and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) of approximately $18 million, excluding certain charges. The company also had $50 million in debt, which Level 3 took on as part of the deal. Software Spectrum had approximately $1.3 billion and EBITDA of $24 million for the twelve months ending January 31, 2002.

If Software Spectrum signs off, its revenues will be added to those of Level 3 for purposes of meeting the carrier's debt covenants. Revenues from Level 3's other businesses in mining and toll-road operations don't count toward the telecom figures needed to meet the covenant terms.

— Mary Jander, Senior Editor, Light Reading
http://www.lightreading.com

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