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Level 3 Software Play Has Perils

Light Reading
News Analysis
Light Reading
5/24/2002

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.
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BobbyMax
BobbyMax
12/4/2012 | 10:20:23 PM
re: Level 3 Software Play Has Perils
The acquisitions made by Level 3 are not likely to help Level 3 boost its revenue. It will also be difficult for it to clear the long term debt of 6 Bilion dollars. There is no craze for IP services that was once anticipated.

It is difficult to visualize as to how these recent acquisitions would help company boost up its revenue
capolite
capolite
12/4/2012 | 10:20:21 PM
re: Level 3 Software Play Has Perils
Level 3 is buying high revenue low margin software companies - which have no relevance to their stated business model - to cover their bank covenants which were based on Jim Crowe's "silcon economics" theory, stolen from Gordon Moore. Level 3 was going to conquer the telecom market and now instead is fighting for survival after wasting over $14B, laying off over half their staff and setting a new standard for sleazy, amoral business practices leading to them being the most hated company in telecom.
A lot of people in Omaha believed in Walter Scott and now have watched Crowe destroy $20B in market cap with his inexperienced 30 year old CFO and a CTO who is an industry disgrace for his business practices.
Walter Scott needs to stop these abuses and speak up for the people who put their trust in him.
optical
optical
12/4/2012 | 10:20:20 PM
re: Level 3 Software Play Has Perils
I would agree about the CTO (Jack Waters). I'm amazed he has survived at L3 this long because the guy has no class, he's guided by pumping up his ego and he's not the great techologist that he claims to be. His people dis-like him and the vendors snicker behind his back due to his "I'm the man, kiss my feet" mentality.

Level 3 has not been well served by this guy and I've lost faith in L3 due to them not doing anything about this guy.
capolite
capolite
12/4/2012 | 10:20:13 PM
re: Level 3 Software Play Has Perils
You nailed Waters cold. His people hate him, he acts out all his psychological and emotional issues in negotiations with vendors and the only person he fools is Jim Crowe. And the sharelholders and bondholders are left holding the bag.
Graeb
Graeb
12/4/2012 | 10:19:40 PM
re: Level 3 Software Play Has Perils
The 2 software company purchases will increase Level 3's top line by +$2 billion assuming the 2 new companies simply repeat last year's revenue numbers.

The only debt covenent in jepordy was the revenue covenent. Prior to the announcements of the 2 purchases, the Company was engaged in talks with their bankers to renegotiate the covenents. This type of negotiation is common. It is just as likely, as not, that the covenents could have been reworked.

Assuming, as the article does, that Level 3 experiences less than $1 billion in revenue growth over the balance of 2002, all of 2003, and most of 2004, Level 3 will again have the opportunity to renegotiate the covenents.

A lot can happen in 2 years!

There are certain facts that speak in favor of Level 3:

They have regularly beaten quarterly estimates for some time now.

They projected they would turn adjusted EBITDA positive last quarter, and they did.

They are projecting positive operating cash flow by the fourth quarter.

If you look at the bonds, they appear to have bottomed and turned up. The stock looks the same.

Bill Miller, a highly respected portfolio manager at Legg Mason, with a long, successful track record has purchased of 35 million shares over the last 6 months.

As to the other posts on this board, it reads as if there are some pretty disgruntled people out there.

Certainly, if I had invested money at the high prices this stock has seen, I would be terribly upset.

So, too, if I had worked for the Company and was let go.

But, the facts I have outlined remain. Neither the article nor the posts accurately portray Level 3.
capolite
capolite
12/4/2012 | 10:18:56 PM
re: Level 3 Software Play Has Perils
You read like some Pravda like spin from the L3 PR department rather than something based on reality:
- The quarterly projections they are now beating are severely downsized from the ones stridently made for years. The real projections are the ones contained in the bank covenants based on their stated business plan. Buying the software companies violates the spirit, if not the letter, of the covenants and highlights the failure and hollowness of their business plan.
-"Adjusted EBITDA?" After Enron how can anyone use a cooked up measurement by a management to cover their failure. There are real measurements, Generally Accepted Accounting Principles, used by every honest, well run company in the world.
-Your claim about the bonds has no data to back up your generalization. In fact, L3 bought back over $2B in bonds at a loss to the original holders of 50-75% of their original investment.
-Bill Miller is a smart guy. He's buying assets valued at 10% of what was spent to create them by the nowhere near as smart management team at L3.
- Trying to dismiss other points of views in a personal attack was a tactic Jim Crowe tried with George Gilder when he pointed out the failure of his business plan. It didn't work to change reality.

Walter Scott is shirking his fiduciary duty if he doesn't step up and do something about the squandering of the investors assets. If nothing else someone at L3 should get Jack Waters the professional counseling he needs if he is going to be on the streets in the communities where our families reside.
Graeb
Graeb
12/4/2012 | 10:18:49 PM
re: Level 3 Software Play Has Perils
"The real projections are the ones contained in the bank covenants based on their stated business plan."

...and just which one of those covenants have they violated?

"Buying the software companies violates the spirit, if not the letter, of the covenants and highlights the failure and hollowness of their business plan."

...where is the covenants do they write about "spirit"? As to the failure & hollowness of their business plan; well, the business plan continues to enable the company to not only survive, but to sign on a couple of new KPNQuest customers last week.

"There are real measurements, Generally Accepted Accounting Principles, used by every honest, well run company in the world."

...Yes, Enron failed in its accounting. Global Crossing and Quest are among many being investigated for accounting regularities. So why is there a deafening silence from the regulators regarding Level 3's books?

"Your claim about the bonds has no data to back up your generalization. In fact, L3 bought back over $2B in bonds at a loss to the original holders of 50-75% of their original investment."

...Two points. 1) The reason to follow prices of bonds and stocks is to get a sense of confidence or lack thereof in the company. The prices don't give you everything, but a wise person doesn't ignore them. 2) We live in a democracy & a free-market capitalist system. No one was forced to buy any Level 3 bonds. No one was force to sell to Level 3.

"Bill Miller is a smart guy. He's buying assets valued at 10% of what was spent to create them by the nowhere near as smart management team at L3."

...Even with you slap at management, you make a better case to buy the stock and bonds rather than sell them!

"Trying to dismiss other points of views in a personal attack was a tactic Jim Crowe tried with George Gilder when he pointed out the failure of his business plan. It didn't work to change reality."

...I leave it to others to read your comments (someone at L3 should get Jack Waters the professional counseling he needs)and my comments, and judge who is making the personal attacks.
capolite
capolite
12/4/2012 | 10:18:41 PM
re: Level 3 Software Play Has Perils
So, in your job at L3, do you keep your eyes firmly closed there as well?
Graeb
Graeb
12/4/2012 | 10:18:37 PM
re: Level 3 Software Play Has Perils
My job at Level 3?

Pal, you are so off base, you're not even in the ballgame!
capolite
capolite
12/4/2012 | 10:18:11 PM
re: Level 3 Software Play Has Perils
Don't you ever answer directly?
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