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A Fine Line for Level 3

By Alex Salkever

It's no small feat that Jim Crowe, CEO of Level 3 Communications (LVLT), managed to keep his head when those around him lost theirs in spectacular fashion during the telecom meltdown. The Broomfield (Colo.) company that sells wholesale telecom services over a technologically advanced fiber-optic network has steered clear of bankruptcy while numerous other venture-backed telecom startups have either gone dark or restructured as shadows of their former selves.

Brave souls have actually profited on Level 3 over the past year. It shares have risen 22% during that period as Crowe pared costs and nabbed valuable assets from failing telecoms for pennies on the dollar. Equally important, Level 3's software-distribution arm has performed well, accounting for a growing chunk of revenues and offsetting the profitless wholesale telecom sector's drag. Finally, Level 3 has managed to keep access to public capital markets open, something that few other telecom startups can claim at this point. So it's a stock to buy, right?

That's a tough call. The stock price fell sharply after superinvestor Warren Buffett dumped hundreds of millions of dollars worth of Level 3 shares over the summer, according to Street watchers. (Buffett declined comment.) No doubt, that's a bad sign, since Buffett is a buy-and-hold kind of guy. For the most part, Street analysts remain bearish, too. On a scale of one to five, with five being a strong sell, eight analysts polled by Thomson/First Call Credit gave Level 3 a 3.9.

QUIET GIANT. Credit agencies have maintained junk ratings on Level 3 debt. And the telecom sector remains in a deep funk as too much fiber chases too few dollars. So, investors might want to put Level 3 on hold for now, even though Crowe has managed it well considering the horrific business environment. And Level 3 looks better positioned than its immediate peers, but most analysts think the risks likely outweigh the benefits, especially in the near term.

Although few outside the sector would know it, Level 3 is a giant in the wholesale telecom sector and one of the biggest providers of network connectivity and communications services. Five of the six largest Internet service providers use Level 3 to offer dial-up services. Nine of the 10 largest global telecoms use Level 3 for services ranging from software switching of calls and managed security of digital networks to wholesale Internet dial-up connections. Much of Level 3's revenue still comes from bare-bones fiber-optic connections that provide bandwidth to carry voice and data traffic.

However, Level 3's challenges are daunting. Freewheeling spending during the dot-com boom has left it with a $7 billion debt load. Level 3 needs all the cash it can get -- it isn't expected to turn net cash flow positive until 2004. In 2002, it posted a $1.1 billion loss on revenues of $3.1 billion. According to company projections, it should lose $1 billion in 2003 on revenues of $4.2 billion.

WORST-CASE SCENARIO? "In 2002, they burned through almost a billion dollars worth of cash. That can't go on forever," says Peter Cohan, a noted telecom bear and author of Value Leadership (Jossey-Bass Publishers). Level 3 officials say Cohan's charge is false and that the company showed a negative cashflow of $434 million for the year. Still, Cohan has expressed fears that Level 3 could at some point face the tough choice of either a bankruptcy filing or turning control over to creditors, a fate that overtook another high-flying wholesale telecom provider, Williams Communication Group last spring.

Some analysts worry that convertible securities Level 3 sold during the past year might end up diluting shareholder value. "We think the stock is expensive," says Todd Rosenbluth, a telecom analyst with Standard & Poor's, even though he recently upgraded it to avoid from sell.

BIG BUYS. Crowe has acknowledged that Level 3 needs to produce more revenues. "We announced earlier that we have largely completed our defensive moves. Now we're moving to offense, trying to add revenue to what we think is the industry's most efficient network," he says (see accompanying Q&A for more comments from Crowe). That network runs gross margins of 76%, tops in the sector, he claims. Every dollar of new revenue Level 3 brings in can go toward reducing debt.

The CEO believes he can win more business. He acquired some big customers with Level 3's $242 million purchase of Genuity, a bankrupt former Verizon (VZ) subsidiary that sells Internet communications services and is a key backbone provider for America Online (AOL) and Verizon. The deal, which closed in February, 2003, will add $600 million in revenues to Level 3's top line this year through added customer accounts. It will also boost efficiency through eliminating redundancies in services both companies provide.

Crowe boasts that his outfit has the most technologically advanced major network on the planet -- a claim few would dispute. And as prices on basic communications services continue to plunge, Level 3 has tried to use its network to better position itself higher up the food chain in areas such as managed services and wholesale dial-up.

SLUMP SURVIVOR? Analysts give Crowe kudos for managing costs, largely through downsizing and selling off noncore assets, such as the recent $70 million sale of fiber-optic network assets in the Midwest. And Crowe's move to buy subsidiaries that distribute software as part of a grand plan to sell software services over the Net looks smart. Information services, as the line item is called in Level 3's public filings, now accounts for over half of revenues.

All this has happened against a background of cost-cutting and downsizing. "They have been able to rein in costs and capital spending," says Rosenbluth.

Few fault Crowe for how he's handling his company considering the awful telecom environment. Even the potential shareholder dilution, analysts say, is probably a necessary evil for now. While Cohan worries that Level 3's viability is at risk, most observers believe it'll survive this slump with a combination of cash and additional convertible offerings. Furthermore, with its outsize gross margins on telecom operations, Level 3 has huge upside leverage on incremental sales, if the market does turn any time soon.

The timing of such a turn, however, remains the great unknown. "We think they will survive. But we still think profitability is a few years away," says Rosenbluth. "And the question is: At what cost to the shareholders?" That's something investors would want to ask before plunging into what likely remains a risky stock. Salkever is Technology editor for BusinessWeek Online

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