Level 3 Comunication LVLT
April 19, 2002 - 11:36am EST by
nish697
2002 2003
Price: 4.50 EPS
Shares Out. (in M): 0 P/E
Market Cap (in M): 1,800 P/FCF
Net Debt (in M): 0 EBIT 0 0
TEV: 0 TEV/EBIT

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Description

Level 3 (LVLT) Bonds – Very Low Risk and a 25+% annualized Return for 6-8 years.

What is one of Bill Miller’s largest holdings in the Legg Mason Value Trust? What “tech play” is Warren Buffett rumored to own? The answer is Level 3 Communications. Buffett is thought to own the bonds and Bill Miller has both the stock and bonds. Let’s examine why both these successful “value” managers have such big stakes in an industry that’s on its knees at present.

Level 3 is a global provider of bandwidth and related services primarily to the networking/telecommunications industry. Level 3 was formed to develop and operate a global IP network offering the lowest cost per bit transported of any network in the world. I believe that the Level 3 is misunderstood by the market and thus its bonds offer very high annualized returns for 6-8 years while being a very safe play. It is these characteristics that have attracted Miller and Buffett.
=
The company IPO’ed in early-1998 and stock hit a high of $130/share at the peak of the Nasdaq frenzy in Q12000 – sporting a market cap of about $46 Billion. Today the shares are 97% off their high – changing hands at about $4.50.

Its customers include Microsoft, AOL Time Warner, Yahoo, France Telecom etc. Their business model is like Intel. “Design Wins” are more critical than present revenues as once they get in the door, they can substantially expand. Level 3 has been consistenly getting terrific design wins.

The company took a hit on its receivables and future recurring revenues when the dot coms crashed. Initially it was a big beneficiary of the surge in bandwidth needed by the dot coms. However, the original business model was never based on the dot coms. They showed up and turbo charged the growth engine for a while. Level 3’s business model rests on five core assumptions. They are:

1. Internet Protocol (IP) will be the dominant means of transporting voice and data long term.

2. The most efficient means of transporting this information will be optics-optics for a long time.

3. “Lighting” all the dark optics that’s been laid will take about $500 Billion is investment in equipment. At the current rate of equipment expenditure, this will take over a decade.

4. It will be far cheaper and more efficient even for facilities based service providers to outsource their optic-optic links and capacity to companies like Level 3.

5. Regardless of the fate of the dotcoms, data traffic will continue to grow at very high rates for the next decade and longer.

Prior to fund management, I spent 5 years designing and marketing high-speed data networks for Tellabs. I agree 100% with all of Level 3’s assumptions being valid.

The state of the capital markets has meant that most of their competitors will be out of business because they are not nearly as well financed as Level 3. The dot com crash and weak economy has meant that there is a glut of bandwidth at present. This is depressing prices and profitability temporarily. Level 3 estimates that this inventory glut will be cleared in a few months.

More interesting (and far less risky) than Level 3 stock are its bonds. The company issued about $8 Billion in various debt and convertible debt instruments over the last four years. These bonds are now sporting annualized yields of 25-30%. Level 3 is a very well financed company. The stock and bonds are trading assuming the company is a bankruptcy candidate. Nothing could be further from the truth.

Here is the listing of its debt by seniority as of 12/31/01 (in thousands)


Bank Debt: $1,125 ,000
Mortgages: $232,000

Secured Subtotal: $1,357,000

9.125% 2008 Sr. Notes $1,430,000
11% 2008 Sr. Notes $442,000
10.5% 2008 Sr. Notes $583,000
10.75% 2008 Euro Sr. Notes $307,000
12.875% 2010 Sr. Notes $386,000
11.25% 2010 Euro Sr. Notes $93,000
11.25% 2010 Sr. Notes $129,000

Senior Unsecured Subtotal $3,370,000

Convertible Sub. Notes 6% 2010 $728,000
Convertible Sub. Notes 6% 2009 $612,000

Subordinated Unsecured Subtotal $1,340,000

TOTAL DEBT $6,067,000

On the liquidity side, the company has $1.5 Billion in cash and securities and $650K in unused credit facilities for total availability of $2.1 Billion. The nature of Level 3’s business is high upfront fixed costs to build out the network and then they sit and collect revenue as the pipes get used. Level 3 spent over $10 Billion building a state of the art fiber-optic IP network around the country, Europe and Asia including high-speed trans-Atlantic fiber-optic links.

Their network buildout is complete. Over 80+% of new capex going forward is tied to revenue. Their revenue history is:

1998: $392 Million
1999: $515 Million
2000: $1.2 Billion
2001: $1.5 Billion

Their free cash flow (after all capex) for the last three years is:

1999: ($2.9 Billion)
2000: ($4.4 Billion)
2001: ($2.1 Billion)

This year they expect well under $1 Billion in negative cash flow and next year well under $500 Million before Level 3 expects to become cash flow positive by 2004. It expects to use its cushion of $2+ Billion conservatively over the next three years until it turns cash-flow positive. In light of the dot-com crash and adverse capital markets, the company has turned very conservative on its capital outlays. Here is an excerpt from a 2/25/02 press release:

________________________________

“As of the end of fourth quarter 2001, Level 3 had available liquidity of approximately $2.1 billion, consisting of $1.5 billion in cash and marketable securities and $650 million under its undrawn and available revolving credit facility. These amounts exclude any proceeds from the sale of non-strategic assets, such as the proposed Commonwealth Telephone transaction described below.
Since the end of 2001, Level 3 has completed a number of strategic transactions, including the sale of its Asian operations to Reach Ltd. As a result of this sale, the company expects to save approximately $300 million through free cash flow breakeven. Additionally, Level 3 has closed the acquisition of McLeodUSA's wholesale Internet dial access business.
Level 3 has also recently announced or completed certain financial transactions to further strengthen its balance sheet and funding position. On February 8, 2002, the company announced its plan to sell approximately 2.75 million shares of Commonwealth Telephone in an underwritten public offering. Additionally, during the first quarter, Level 3 has retired approximately $195 million face amount of debt securities, approximately half through debt for equity swaps and the balance using excess cash to repurchase debt. Including these transactions, Level 3 has retired approximately $2.1 billion face amount of debt over the past six months on what the company believes are attractive terms.
"Taking into account all recent transactions and events," said James Q. Crowe, CEO of Level 3, "we believe that Level 3 remains fully funded to free cash flow breakeven with a substantial cushion in accordance with our business plan, even if our current rate of sales does not improve over time."

Analysts are projecting that Level 3 will have about a $500 Million shortfall of cash eventually. They get these projections by reducing revenue numbers but assuming no reduction in capital expenses etc. The company vehemently disagrees with these projections. Their perspective is that they will edit expenses to be in line with revenues as they have already done.

So we have two schools of thought on Level 3. The company says they have no problem (even if business does not improve) and analysts think they’ll crash and burn like all the other bandwidth providers. Who is right? Who should be believed?

This is where the “DNA of Level 3” becomes critical. It is this DNA structure that gives me comfort on the bonds. Level 3 Communications originated in 1985 as Kiewit Diversified Group (KDG), a subsidiary of Peter Kiewit Sons’, Inc. In 1997, the company embarked on the plan to build an advanced worldwide fiber optic network. In 1998, KDG sold off its non-telecom assets and renamed itself Level 3. Walter Scott, Jr. is the Chairman of Level 3. He is the CEO of Peter Kiewit and sits on the Berkshire Hathaway board.

Charlie Munger and Warren Buffett have the highest regard for Walter and respect his business abilities. It is rumored that Berkshire Hathaway has bought about $350 Million of the Level 3 bonds recently (Barron’s, July 16, 2001, Page 15). I would not be surprised to find truth in the rumors. Buffett loves to buy distressed bonds that have a very high probability of being paid in full. He has known the Kiewit folks for 40+ years.

Walter Scott Jr. is on Berkshire Hathaway’s board. Even the skeptics acknowledge that Level 3 has the best management team in the industry. I don’t think its possible that Buffett would have anyone with an ethos problem on his board. If Walter Scott Jr. is the high ethos guy I think he is, then there is NO WAY he’d let a CEO of his company lie or set false expectations about their financial position. On every conference call Jim Crowe has repeatedly mentioned that they are funded to cash-flow break-even with a substantial cushion even if business does not improve.

I spent about three hours listening to the entire Q&A web cast with the CEO of Level 3 at their recent annual meeting. I walked away with the highest regard for the CEO, Jim Crowe. I’d strong recommend listening to the web cast (its on www.level3.com). The meeting was run virtually identical to the Berkshire meeting and Jim is a huge Buffett fan and has adopted Buffett’s shareholder orientation. He has no stock options or restricted stock etc. He bought all his shares at the time the company was renamed.

The 5000+ employees of Level 3 only have Outperformance Stock Options (OSOs) which only kick in if the stock outperforms the S&P 500.

Walter Scott, Jr. recently added to his 35 Million shares by buying shares from Jim Crowe (who had borrowed money to buy the shares). He also recently infused $50 Million into RCN – which is a Level 3 unit.

Level 3 has several bonds to choose from. All have YTM in the 25-35% range. I believe that they’ll be paid bin full at maturity. Once the company achieves cash flow break-even, then paying the bonds is not difficult.

Catalyst

The bonds may start moving up next week after Level 3 holds their Q1 call and revises their financial projections. Long Term the bonds will move up once the street sees evidence that they are right. As all the marginal players go away, revenues and profits improve and free cash flow is achieved even sooner.
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    Description

    Level 3 (LVLT) Bonds – Very Low Risk and a 25+% annualized Return for 6-8 years.

    What is one of Bill Miller’s largest holdings in the Legg Mason Value Trust? What “tech play” is Warren Buffett rumored to own? The answer is Level 3 Communications. Buffett is thought to own the bonds and Bill Miller has both the stock and bonds. Let’s examine why both these successful “value” managers have such big stakes in an industry that’s on its knees at present.

    Level 3 is a global provider of bandwidth and related services primarily to the networking/telecommunications industry. Level 3 was formed to develop and operate a global IP network offering the lowest cost per bit transported of any network in the world. I believe that the Level 3 is misunderstood by the market and thus its bonds offer very high annualized returns for 6-8 years while being a very safe play. It is these characteristics that have attracted Miller and Buffett.
    =
    The company IPO’ed in early-1998 and stock hit a high of $130/share at the peak of the Nasdaq frenzy in Q12000 – sporting a market cap of about $46 Billion. Today the shares are 97% off their high – changing hands at about $4.50.

    Its customers include Microsoft, AOL Time Warner, Yahoo, France Telecom etc. Their business model is like Intel. “Design Wins” are more critical than present revenues as once they get in the door, they can substantially expand. Level 3 has been consistenly getting terrific design wins.

    The company took a hit on its receivables and future recurring revenues when the dot coms crashed. Initially it was a big beneficiary of the surge in bandwidth needed by the dot coms. However, the original business model was never based on the dot coms. They showed up and turbo charged the growth engine for a while. Level 3’s business model rests on five core assumptions. They are:

    1. Internet Protocol (IP) will be the dominant means of transporting voice and data long term.

    2. The most efficient means of transporting this information will be optics-optics for a long time.

    3. “Lighting” all the dark optics that’s been laid will take about $500 Billion is investment in equipment. At the current rate of equipment expenditure, this will take over a decade.

    4. It will be far cheaper and more efficient even for facilities based service providers to outsource their optic-optic links and capacity to companies like Level 3.

    5. Regardless of the fate of the dotcoms, data traffic will continue to grow at very high rates for the next decade and longer.

    Prior to fund management, I spent 5 years designing and marketing high-speed data networks for Tellabs. I agree 100% with all of Level 3’s assumptions being valid.

    The state of the capital markets has meant that most of their competitors will be out of business because they are not nearly as well financed as Level 3. The dot com crash and weak economy has meant that there is a glut of bandwidth at present. This is depressing prices and profitability temporarily. Level 3 estimates that this inventory glut will be cleared in a few months.

    More interesting (and far less risky) than Level 3 stock are its bonds. The company issued about $8 Billion in various debt and convertible debt instruments over the last four years. These bonds are now sporting annualized yields of 25-30%. Level 3 is a very well financed company. The stock and bonds are trading assuming the company is a bankruptcy candidate. Nothing could be further from the truth.

    Here is the listing of its debt by seniority as of 12/31/01 (in thousands)


    Bank Debt: $1,125 ,000
    Mortgages: $232,000

    Secured Subtotal: $1,357,000

    9.125% 2008 Sr. Notes $1,430,000
    11% 2008 Sr. Notes $442,000
    10.5% 2008 Sr. Notes $583,000
    10.75% 2008 Euro Sr. Notes $307,000
    12.875% 2010 Sr. Notes $386,000
    11.25% 2010 Euro Sr. Notes $93,000
    11.25% 2010 Sr. Notes $129,000

    Senior Unsecured Subtotal $3,370,000

    Convertible Sub. Notes 6% 2010 $728,000
    Convertible Sub. Notes 6% 2009 $612,000

    Subordinated Unsecured Subtotal $1,340,000

    TOTAL DEBT $6,067,000

    On the liquidity side, the company has $1.5 Billion in cash and securities and $650K in unused credit facilities for total availability of $2.1 Billion. The nature of Level 3’s business is high upfront fixed costs to build out the network and then they sit and collect revenue as the pipes get used. Level 3 spent over $10 Billion building a state of the art fiber-optic IP network around the country, Europe and Asia including high-speed trans-Atlantic fiber-optic links.

    Their network buildout is complete. Over 80+% of new capex going forward is tied to revenue. Their revenue history is:

    1998: $392 Million
    1999: $515 Million
    2000: $1.2 Billion
    2001: $1.5 Billion

    Their free cash flow (after all capex) for the last three years is:

    1999: ($2.9 Billion)
    2000: ($4.4 Billion)
    2001: ($2.1 Billion)

    This year they expect well under $1 Billion in negative cash flow and next year well under $500 Million before Level 3 expects to become cash flow positive by 2004. It expects to use its cushion of $2+ Billion conservatively over the next three years until it turns cash-flow positive. In light of the dot-com crash and adverse capital markets, the company has turned very conservative on its capital outlays. Here is an excerpt from a 2/25/02 press release:

    ________________________________

    “As of the end of fourth quarter 2001, Level 3 had available liquidity of approximately $2.1 billion, consisting of $1.5 billion in cash and marketable securities and $650 million under its undrawn and available revolving credit facility. These amounts exclude any proceeds from the sale of non-strategic assets, such as the proposed Commonwealth Telephone transaction described below.
    Since the end of 2001, Level 3 has completed a number of strategic transactions, including the sale of its Asian operations to Reach Ltd. As a result of this sale, the company expects to save approximately $300 million through free cash flow breakeven. Additionally, Level 3 has closed the acquisition of McLeodUSA's wholesale Internet dial access business.
    Level 3 has also recently announced or completed certain financial transactions to further strengthen its balance sheet and funding position. On February 8, 2002, the company announced its plan to sell approximately 2.75 million shares of Commonwealth Telephone in an underwritten public offering. Additionally, during the first quarter, Level 3 has retired approximately $195 million face amount of debt securities, approximately half through debt for equity swaps and the balance using excess cash to repurchase debt. Including these transactions, Level 3 has retired approximately $2.1 billion face amount of debt over the past six months on what the company believes are attractive terms.
    "Taking into account all recent transactions and events," said James Q. Crowe, CEO of Level 3, "we believe that Level 3 remains fully funded to free cash flow breakeven with a substantial cushion in accordance with our business plan, even if our current rate of sales does not improve over time."

    Analysts are projecting that Level 3 will have about a $500 Million shortfall of cash eventually. They get these projections by reducing revenue numbers but assuming no reduction in capital expenses etc. The company vehemently disagrees with these projections. Their perspective is that they will edit expenses to be in line with revenues as they have already done.

    So we have two schools of thought on Level 3. The company says they have no problem (even if business does not improve) and analysts think they’ll crash and burn like all the other bandwidth providers. Who is right? Who should be believed?

    This is where the “DNA of Level 3” becomes critical. It is this DNA structure that gives me comfort on the bonds. Level 3 Communications originated in 1985 as Kiewit Diversified Group (KDG), a subsidiary of Peter Kiewit Sons’, Inc. In 1997, the company embarked on the plan to build an advanced worldwide fiber optic network. In 1998, KDG sold off its non-telecom assets and renamed itself Level 3. Walter Scott, Jr. is the Chairman of Level 3. He is the CEO of Peter Kiewit and sits on the Berkshire Hathaway board.

    Charlie Munger and Warren Buffett have the highest regard for Walter and respect his business abilities. It is rumored that Berkshire Hathaway has bought about $350 Million of the Level 3 bonds recently (Barron’s, July 16, 2001, Page 15). I would not be surprised to find truth in the rumors. Buffett loves to buy distressed bonds that have a very high probability of being paid in full. He has known the Kiewit folks for 40+ years.

    Walter Scott Jr. is on Berkshire Hathaway’s board. Even the skeptics acknowledge that Level 3 has the best management team in the industry. I don’t think its possible that Buffett would have anyone with an ethos problem on his board. If Walter Scott Jr. is the high ethos guy I think he is, then there is NO WAY he’d let a CEO of his company lie or set false expectations about their financial position. On every conference call Jim Crowe has repeatedly mentioned that they are funded to cash-flow break-even with a substantial cushion even if business does not improve.

    I spent about three hours listening to the entire Q&A web cast with the CEO of Level 3 at their recent annual meeting. I walked away with the highest regard for the CEO, Jim Crowe. I’d strong recommend listening to the web cast (its on www.level3.com). The meeting was run virtually identical to the Berkshire meeting and Jim is a huge Buffett fan and has adopted Buffett’s shareholder orientation. He has no stock options or restricted stock etc. He bought all his shares at the time the company was renamed.

    The 5000+ employees of Level 3 only have Outperformance Stock Options (OSOs) which only kick in if the stock outperforms the S&P 500.

    Walter Scott, Jr. recently added to his 35 Million shares by buying shares from Jim Crowe (who had borrowed money to buy the shares). He also recently infused $50 Million into RCN – which is a Level 3 unit.

    Level 3 has several bonds to choose from. All have YTM in the 25-35% range. I believe that they’ll be paid bin full at maturity. Once the company achieves cash flow break-even, then paying the bonds is not difficult.

    Catalyst

    The bonds may start moving up next week after Level 3 holds their Q1 call and revises their financial projections. Long Term the bonds will move up once the street sees evidence that they are right. As all the marginal players go away, revenues and profits improve and free cash flow is achieved even sooner.

    Messages


    SubjectWhile I hate long writeups, I
    Entry04/23/2002 06:33 AM
    Memberbedrock346
    more meat.

    Since you were at tell labs for five years, tell me did you agree with all the assumptions of LVLT for those five years (assumptions that were missed). If LVLT is so healthy, why did they have to buy another company to create EBITDA to meet bank covenants? Bill Miller has been very wrong on this stock and this space. He was also a big buyer of AMZN stock in the 40s and Exodus stock before it filed. He has been a buyer of LVLT for a long ride down as well.

    Buffet is sited as the perenial savior of this company, yet not one dime of new money from BRK/A has hit the tape. One of the reasons this stock was so inflated is that Crowe is a captivating speaker. A lot of growth managers believe their overoptimistic targets without being crooks.

    What do you mean by design wins? How do they add to free cash flow? As some of LVLT competitors are restructured doesn't it place LVLT at a competive disadvantage since is will retain its mountain of debt. The revenue growth numbers are impressive. But if I spen ten billion dollars, I can create a big money losing company as well with a big revenue base. How does i become profitable? What are you margin assumptions? If revenue growth is flat, where can they cut cost and capx to get to breakeven after debt service? This question is the crux of the issue? Show me how without heroic growth in revenue and margins how LVLT services its debt. Why should I pay an infinate multiple of EBITDA for a company that loses lots of money when comps like Qwest with a monopoly business and a similar broadband network trade for 5x EBITDA?

    SubjectCouple of questions
    Entry04/23/2002 11:30 AM
    Membergrah141
    Thanks for the writeup.

    I got the impression that you relied heavily on the Miller and Buffett investments as a significant reason for future growth.

    Do you know of any filings or other substantian other than Barrons that indicate Buffett or allied companies have taken a position in LVLT bonds?

    Second, after pulling the N forms for the Legg Mason fund it seems they have suffered serious losses in the common but I didn't see any mention of the bonds, could you direct me to that part?

    And lastly did you crunch any numbers to see if @ 20-25% per year on the bonds, Miller could recoup his losses?

    Thanks

    Subjectgreat idea
    Entry04/23/2002 12:50 PM
    Memberad188
    This is a great idea for a bond investment. We own it. With a current yield of 20-25% for most series, you get at least 3/4 of your investment back in coupon before any risk of solvency appears. Great risk/reward.

    SubjectReply to Bedrock
    Entry04/23/2002 02:08 PM
    Membernish697
    My tenure at Tellabs was from 86-91. It was before Level 3 existed in its present form.

    They purchase of the software company was buying a somewhat synergistic business with over $1 Billion in revenue for under $100 Million. It kept the bank covenants intact. In my mind, it was a very brilliant move to avoid the covenant violation. If you consider the universe of businesses they could have bought for under $100M to fit the bill, the acquisition was perfect. So I think it shows a CEO who's thinking right.

    Time will tell if Miller makes or loses money on this one. Yes, he has had losses before, but he will make a boatload on the LVLT bonds.

    The 6% 2009/10 bonds went as low as 18 a few weeks ago. At those prices, you get your investment back in 3 years and still have a 100 cent claim plus 33% current yield for several years. With current cash and projections, you'd get most of your $$$ back in interest before the most pessimistic view on when LVLT runs out of $$$.

    BRK need not disclose their position on the bonds, so it not hitting the tape means nothing. Same is true if Buffett bought a hundred million face value for his personal account.

    Design Wins:

    Level 3's network is not a commodity. Companies have to interface to it and link their network infrastructure with Level 3's. Same is true of their dial-up modem offerings like managed modem. When AOL uses LVLT for their pipes and managed modem its a design win for LVLT. It means that subsequent spending/expansion by AOL is very likely to go to LVLT because they are "pregnant" with them. Thus their business not only has recurring revenue built in, but also most future customer expansion goes to them as well.

    In addition, the managed modem offerings and the leased lines are like Executive Jet's business. More planes become a barrier to entry. The more lines and modems LVLT has, the bigger the moat.

    Financial:

    Look at their press release today.

    At the end of 2002, they expect to have:

    - $1 Billion in cash plus $650 Million credit line available.
    - Positive Operating Cash Flow by Q402.
    - Operating Cash Flow of -50M for 2002
    - Operating Cash Flow includes all cash outflow except interest. Interest expense is about $500-600 Million.

    So by 2003, they start 2003 with $1.65B and a cash burn of about $300-500 Million max. By 2004, the company turns cash flow positive with a max. burn of $300 Million. They have a$800M-1B cash cushion.

    Their are not optimistic. Projections are based on no improvement in business fundamentals from Q42001.

    SubjectReply to Grah141 Questions
    Entry04/23/2002 02:18 PM
    Membernish697
    My interest in LVLT was piqued about 10 months ago when I talked to an individual who had worked with the Kiewits for a while, was very familiar with the LVLT folks etc. Subsequently I learnt of Miller's stake and Buffett's stake.

    Buffett is rumored to have the bonds. Buffett did say in a speech I heard in December 2001 that BRK has about $2 Billion in junk bonds. I'd guess a LVLT bond investment would fit all his screens since it is heavily based on getting the investment back with the coupons. He has Walter Scott of his board and has spent time with Crowe, so he has probably assessed their perspective and ethos. a broker frirnd of mine with Merrill who grew up in Omaha also independently believes Buffett has LVLT bonds.

    I think the LVLT stock is a bad investment choice (no margin of safety) and disagree with Miller here. The book "The Man who beat the S&P" by Janet Lowe that just came out talks about the LVLT bond stake.

    I did not crunch numbers on Miller's return. I crunched numbers on my return and it was a total no brainer.

    SubjectReply to ad188 - Great Idea
    Entry04/23/2002 02:33 PM
    Membernish697
    Thanks ad188. My sentiments exactly. Its like shooting fish in a barrel. So much for an efficient market!

    SubjectExtremely Attractive
    Entry04/24/2002 02:14 PM
    Memberround291
    Thanks for posting this idea. I know little about the company and industry but intend to do some research on the basis of your write-up.

    A couple of questions:

    1) Does the company have any other non-telco, fiber businesses that may be attractively divested? Might management sell these assets for cash?

    2) What is your opinion on future pricing in the markets the company serves?

    3) What might go wrong in the business or the industry that could likely to impact credit quality negatively and positively?

    SubjectReply to round291 - Extremely
    Entry04/24/2002 05:06 PM
    Membernish697
    1) From its history with Kiewit, they have some totally unrelated businesses (e.g. coal mine etc.). In addition, they have some restricted securities like Commonwealth Telephone that they've filed to sell etc. The company has mentioned these assets will be sold (but not in a fire sale). They have also mentioned that they are funded to free cash flow break-even with a substantial cushion without any sales. So the excess real estate, securities and coal mines etc. are all additional cushion providers.

    Management has sold related assets (like its Asian network to Reach) to reduce capex and increase the cash cushion. This is the most cavvy team in the business. They have backers (Walter Scott Jr.) who are also very pragmatic realists. So they will sell whatever can be sold as a good business decision.

    2) This market is not price driven. It is reputation and quality driven. Companies like AOL, Yahoo and Microsoft have a lot to lose if their bandwidth provider is cheap but unstable. One of the things that has amazed me about LVLT is their ability to keep selling given the price of the stock and bonds. Their Fortune 500 clients must be concerned about their financial stability - just as the street is - but they've been able to sell through it. I believe that its a bit of chicken and egg. Their sales would take off if the stock were at $20 and the bonds were close to par AND if the sales took off the bonds would be at par!

    Nonetheless, their ability to sell in the current environment only means that things can only improve.

    Downside risk is related to additional terror attacks or a blackout of their network. If their reliability went down for ANY reason we'd have a problem. They need to execute well, but this is the best team one could choose to execute well.

    If the economy improves and their competitors lose clients due to their instability, that's good for LVLT. If the economy deteriorates or their network health goes down, that's bad news.

    SubjectFurther Thought
    Entry04/25/2002 08:54 AM
    Memberround291
    I took a read of the 10-k last night and was struck by boldness of the original business plan. Essentially, the company planned to continuously upgrade its network (requiring capital) to offer better performance at dramatically lower prices thereby stoking what it apparently believes is extremely price elastic demand (lower prices create proportionately more demand). This struck me for a couple of reasons. First, this seemed like a blueprint for spending rather than coining money. In this light, what does "fully funded to cash breakeven" really mean? What happens after "cash breakeven"?

    I also gave some thought to the nature of end user demand. Is it really as price elastic as the company seems to think? Judging from recent performance during this economic downturn, apparently not. Certainly some businesses compete on the basis of the rapidity with which it can communicate with customers (ie ISPs), but this is a limited group. One has to assume that new reasons to communicate with customers will emerge as the costs of communicating drops. This is a major assumption.

    Assuming that the company continuously spends to improve the network (and offer customers access to it) and current price trends, the company will need continued access to debt and equity markets...even after "cash breakeven". The implication is that the credit worthiness of the company may never improve dramatically and permanently. In which case, my 11% bonds never trade above par or only do so during short periods of investor optimism. There may be a trading opportunity but not a good reason to hold to maturity.

    Also, I'd argue that price in the market does impact the price the company can get for access to its network. As floor level pricing drops so will "premium" pricing. This is particularly worrisome given the restructuring of competitors.

    If the bonds go bust, there seems to be little to be encouraged about judging from recoveries in this market place. The downside in this case is severe as rapidly declining network asset values are baked into the original business plan.

    Seems like there is more risk here than meets the eye. Any thoughts?

    SubjectReply to Round292 - Further Th
    Entry04/25/2002 10:04 AM
    Membernish697
    Level 3's business model has analogies in microprocessor industry. Intel's whole business model is based on rapidly increasing processing power per chip and exponential drop in price/transistor. It required huge R&D expenditures to play the game and increase volumes of transistors shipped exponentially as prices fell. Its the same with bits/second run though a pipe. Intel has been consistently profitable while investing huge, growing numbers into R&D.

    Today in computing, we are bandwidth constrained, not processor speed constrained. No expert will argue with the conclusion that bandwidth will go through exponential increases over the coming decades. We had a hiccup in the last 2 years as dot coms caused a bandwidth surge (above normal) and caused the glut when they died. 9/11 and the recession didn't help matters. So the long-term trend of rapid increases in demand for "fast fat fiber pipes based on IP" is pretty much guaranteed. Long term, the present glut will be gone and prices will reflect reality of cost structures.

    LVLT's business in smack in the center of that coming demand. They are better than any telco at managing a multinational IP based high speed network. So many of the telco's outsource to them.

    Cash Flow break-even means that they are generating $600+ million towards payment of interest. No one else is on their heels (e.g. Intel vs. AMD). So they can take a breather. After breakeven, in 2005, they starting taking debt down with excess cash flow of $500 Million+ annually. They are using a pittance of their existing capacity, so increasing revenues (even with falling prices) is natural.

    In addition, after cash-flow break even, the company has a number of addition levers. For example, they could issue equity to wipe out some of their debt etc. Also, remember that they have $1 Billion+ available in 2004. They could buy back addition debt and if the debt is still at 25-35 cents on the dollar, they could wipe out 50% of their debt with buying back the bonds etc.

    Subject'cost of production'
    Entry04/25/2002 04:57 PM
    Memberpeter315
    nish,

    You don't seem to have talked about LVLT's cost of production - while some of the game is service, etc, LVLT's business model is fundamentally premised on being THE Low Cost Producer.

    Obviously this is what they are aiming for in the long run - do you have any evidence that they have achieved this yet - any price comparisons?
    To me this is the key point - if they're able to stay the low cost producer due to the setup of their network (all IP) then the long term looks a lot better (they just have to survive the short term)


    Re the managed modem business, they don't exactly have a huge market share - isn't it a bit early to be talking moats here? I like the business if they can get in dirt cheap - it's a dying business, but hopefully will take 10+ years to do so and spin of cash


    peter

    SubjectReply to Peter315 - Cost of Pr
    Entry04/25/2002 05:22 PM
    Membernish697
    This is business with high upfront fixed costs and relatively low maintenance costs. The high fixed cost is done and you're paying cents on the dollar for the infrastructure.

    LVLT is, at present, focused on maximizing throughput through its infrastructure. Their business model is premised on the IP infrastructure - which is the lowest cost of transporting a bit. They do this better that all telcos and, to the best of my knowledge, better than all competitors. That's why they have France Telecom, AOL. Microsoft, Yahoo etc. as clients.

    This is the same management team that built the hugely successful MFS and sold it to UUNET (which then got sold to Worldcom). They are the very best at running IP pipes in the world.

    Managed Modem is a cash cow and a means of broadening their offerings to customers as well as leveraging their fat IP pipes. I agree that managed modem is not a growing market and indeed will decline over time.


    SubjectUUNET
    Entry04/29/2002 06:19 PM
    Memberbedrock346
    Jusdging by the price of WCOM's stock and bonds it doesn't look like this management team built anything of lasting value. Instead, it looks like they sold to a greater fool during the telcom bubble.

    SubjectReply to Bedrock - UUNET
    Entry04/30/2002 12:38 AM
    Membernish697
    Worldcom acquired several terrific companies - MCI, UUNET etc. MCI was a true innovator and took on the big monopolist AT&T and led to the breakup of the bell system. MCI was a terrific company. Do you think they were a fly-by-night operation as well?

    MFS, which was built by Crowe was another terrific company.

    To say that LVLT is bad because WCOM stock is down is taking a very myopic perspective. WCOM is down for a myraid of factors - none of which have a whole lot to do with UUNET or MFS. MFS was a good, sustainable business that might be still doing well today had they not become part of Worldcom and got caught up in all of WCOM's issues.

    The entire telecom sector has gone though severe disruption in its business model. That's why most of the service providers are on their knees, not just Worldcom.

    To conclude, I'd like to say that its a free country. You can take the horse to the water but you can't make it drink. The ideas posted at VIC have basically brought the horses to the water. How well you do is a function of which watering well you decide to drink out of and how much you drink. I happen to believe that this is an awesome well to drink from with great upside and very limited downside, but each horse can make its own decision. In the end we can watch the derby and see who won and lost. Time will tell.

    All the facts are available publicly. Some will drink and some will take a pass. Such is life.

    SubjectEnterprise value?
    Entry04/30/2002 09:28 AM
    Memberraf698
    Nish,

    It appears that you have taken a straightforward line of thought. The involvement of these experienced investors suggests the long-term financial viability of the enterprise. Add to your list of investors the involvement of Wallace Weitz (equity), and Longleaf (bonds).

    In any case, with the company stating in words and actions that they are funded to breakeven, isn't this a simple case of leverage in the share price? Taking a share price of 4.30, with cash per share of 3.83, and debt per share of 15.83--leaves an enterprise value of 16.30. If the enterprise value manages to increase 50%--to 24.45, while the cash runs down to let's say, .50, and the debt remains the same, then the share price would increase 4.82--to 9.12/share.

    So, if one takes the assumption that any business will survive, then it is most advantageous to be as highly leveraged as possible. The leverage that would not have been possible in establishing LVLT has instead been arrived at by the process of their share price collapse.

    Thus, I was hoping that this thread would try to zero in (and that may be the number!) on the appropriate enterprise value for LVLT. It already has compelling leverage.

    SubjectReply to raf - Enterprise Valu
    Entry04/30/2002 11:14 AM
    Membernish697
    Its likely that an investment in the stock may be a great investment as well. With the bonds available at such deep discounts and the big coupons one gets to collect every 6 months, why mess with the stock? The bonds offer 20-30% returns annualized for 6-8 years. Very very few investments can offer that rate of return for that long a duration. So why take the stock? Take the bonds with the big margin of safety. In the unlikely event of default the bondholders will own the company and give you a nice cushion against investment value being decimated.

    Yes, what are the odds of Wally Weitz, Long Leaf, Bill Miller and Warren Buffett all buying the same tech investment. Close to zero, but they all did!!

    More importantly, what is the probability that they are all wrong?

    Its a total no-brainer.

    I've taken the horses to the water. Its time to quench your thirst!

    SubjectWhat information do you have t
    Entry04/30/2002 11:49 AM
    Memberblue320
    What information do you have that makes you think Buffett has bought it?

    SubjectReply to Blue320 - Buffett
    Entry05/01/2002 12:46 AM
    Membernish697
    The following data points seems to indicate Buffett owning the LVLT bonds:

    1. The July 2001 Barron's article suggesting Buffett bought LVLT bonds.

    2. The high regard Buffett has for Walter Scott Jr. and thus his knowing LVLT's situation very well.

    3. In a Dec. 2001 speech in Chicago, he mention that BRK had about $2 Billion invested in Junk Bonds. Seems likely that LVLT would be one of the purchases.

    4. His deep interest and expertise in distressed bonds throughout his career. He specifically eluded to his expertise in being able to pick the right junk bonds.

    5. The specific price and characteristics of the bonds (basically you get principal back by way of dividend coupons before the company gets anywhere close to a cash shortfall.

    6. When Wally Weitz, Longleaf and Bill Miller own the bonds and all are disciples of the messiah, then why wouldn't it be plausible that the messiah owns it as well.

    7. Company has Omaha roots, Kiewit roots. Both are familiar to Buffett and he likes familiarity.

    8. Broker friend of mine at Merrill independently also suggests that bond traders know he owns the bonds.


    SubjectBond Repurchases
    Entry05/01/2002 08:10 PM
    Memberround291
    Would you please address the company's bond purchase and equity swap efforts. Last year it looked like they bought in some bonds at $0.35 - $0.45 on the dollar. With the callable 9.125% bonds currently trading around $0.45-$0.50, and assuming no appreciable improvement in credit quality (reasonable in this environment and considering the assinine longer term business plan), my best buyer is the company. But at those prices, which represented meager premiums at the time as far as I can tell, there ain't a whole lot of juice to be had...and lots of downside risk. Why bother?

    This is starting to look extremely less attractive to me the more I learn about the situation.

    Also, the company might be much more interested in buying an institution's hundred million dollar position than my 20 or 30 bonds. Seems like an extreme risk for a little guy investing his own money.

    With regards to Buffett, I recall him once describing his aversion to investing in telecommunication company equity due to the heavy and continual capital requirements. I can't think of a single telco that has made it into his portfolio...can you? His ability to apply some moral suasion/jaw boning and get his buddy Scott to buy him out at a slight premium is a clear advantage...one most of us don't have.

    SubjectReply to Round291 - Bond Repur
    Entry05/02/2002 12:29 AM
    Membernish697
    I have never suggested that the bonds be bought with the intent that the company buys them off of you. The bonds should be bought and held to maturity or sold when the street price affords an attractive return.

    Buying the bonds with the intent of selling them to the compaqny at a profit is a highly risky, highly speculative exercise that I would not recommend.

    SubjectHolding to Maturity
    Entry05/02/2002 07:08 AM
    Memberround291
    I would think that holding the bonds to maturity is an even riskier proposition, especially when your talking about maturities of over five years. Again, this company will continually need access to the capital markets to be successful...funding will be required to finance ongoing capital investment and operating losses. As a result, and considering the current balance sheet, credit quality improvement is a long way out. And improvement in credit quality from the current CCC is what will drive bond prices.

    Hey, these bonds are rated as they are for a reason. What is it that you know that the rating agencies don't? When might the bonds get upgraded? To think that we'll get twenty plus yields by holding bonds to maturity (default is more like it) is quite ambitious and very unlikely, in my opinion.

    Here's what you have to assume:

    - Unit demand growth far out pacing projected price erosion
    (by the way, this is where your analogy to microprocessing fails...that industry experienced unit demand growth and relative unit price stability...though price/performance certainly dropped as a result of ongoing product enhancement)

    - Healthy, oligopolistic competitors (certainly helped the Bell companies keep prices high)

    - A supportive regulatory environment (regulators are great at creating and maintaining oligopolies...think FNMA/FHLMC/GNMA, over the air network TV/radio/wireless telephony, bond rating agencies, brokerage pre-negotiated commissions, airlines pre-deregulation etc)

    This business, as a matter of fact, looks a lot like the airline industry with high fixed costs and low marginal unit costs. The demand characteristics are also comparable, growing as business health improves with a strengthening economy and deteriorating when the economy weakens. Like the airlines, there are plenty of substitutes available to most customers for the services offered by the company. So...cyclicality and high capital intensity.

    Confused...

    Subjectindustry characteristics
    Entry05/02/2002 07:24 AM
    Memberpeter315
    round,

    As near as I can tell, Level 3 are aiming to have the lowest marginal cost of provisioning - their sunk costs are probably not too dissimilar to their competitors, but adding more capacity should be a lot easier.

    Some things that might support this view (aside from network structure) are;
    - rapid provisioning on new customer demand
    - ability to survive largely as a "carriers' carrier" to date, rather than supplementing this with voice traffic (higher revenues per unit in the short term, but unlikely to be as scaleable in the long)
    - pricing offered for bandwidth (I don't have these figures, but they might give indications for/against)


    Peter

    SubjectBuying vs. puts
    Entry05/02/2002 07:59 AM
    Memberraf698
    FYI, a colleague mentioned to me yesterday that he purchased some of the step-up notes versus the 1/04 LEAPS--in his case, the 5.00 puts.

    He saw it as a way to cover himself for 89% of the bond cost--although I haven't run the numbers, I believe that he is still exposed to an unchanged situation--let's say, a stock and bond price that is nearly unchanged. My point is that if you believe the bonds are cheap, then they must be cheap to something--the 5.00 strike, Qwest stock, something. I originally purchased LVLT in the two handle, because it seemed cheaper than the bonds, Qwest, the options--but now, it all seems like one large wash, and none seem that much more attractive than the others, and I'd flattened up and moved on.

    However, I did think that someone with a better understanding of the liquidation/success scenarios might come up with a decent scenario analysis on the bonds vs 1/04 puts--after all, this is only twenty months out, and how much can happen in this humdrum industry in twenty months? :)

    SubjectReply to Round291 - Holding to
    Entry05/02/2002 10:16 AM
    Membernish697
    Why is holding to maturity high-risk when you've gotten all your money back well before maturity via the coupons? Its zero risk to hold the bonds past 2005!

    Rating Agencies do not care about the following factors that are fundamental here:

    1. Walter Scott Jr.'s Ethos and Kiewit's DNA structure.
    2. Company's projections. Its the same reason the Lehman bond analyst Ravi Suria is dead wrong about Amazon. Bond analysts and rating agencies fixate on what the balance shhet tells them. Its a rear view mirror view of the world, not the Munger/Miller Latticework of mental models view of the world.
    3. Why would Long Leaf and Wally buy? This is one of the ONLY bond investments Longleaf has?
    4. Rating agencies don't care about design wins and its implications on future revenue.

    I am assuming that their revenues will increase in the future - even with falling prices. Its unlikely we'll see further price drops. We've already seen dramatic drops and additional capacity is not being added - indeed excess capacity is gradually reducing.

    I disagree with the airline analogy. All airlines have similar safety/risk characteristics and are clones of each other on given routes. LVLT and its competitors are not clones. Network health and quality matters a lot as does management and technology competence.




    SubjectReply to Raf698 - Buying vs. P
    Entry05/02/2002 10:18 AM
    Membernish697
    I am not an expert on options etc. There may well be a near risk free hedge play here with the LVLT stock and bonds in combo, but I'll leave that to someone else on this board to advise us.

    Anyone want to answer Raf's query?

    SubjectCarrier's Carrier
    Entry05/02/2002 10:22 AM
    Membernish697
    The Carrier's Carrier strategy at LVLT is a solid long term strategy.

    They arr focused on the 300 largest global consumers of bandwidth. Many of these are carriers. They are able to do it better. faster and cheaper than the monoliths who are typically their customers. So outsourcing to LVLT is a no brainer and typically LVLT will win much of the business when it goes head to head in these outsourcing deals with other competitors.

    They are the best "toll bridge" for the carriers to use to fulfill customer demand and there aren't many bridges as good as LVLT.

    SubjectZero Risk
    Entry05/02/2002 11:20 AM
    Memberround291
    If there were zero risk the bonds would be trading at a premium today. There is, in my eyes and the eyes of the thousands of people who make up "the market", quite substantial risk in this paper.

    Nish, I'm really on the fence with this one and have been reaching out for help on how to ballpark the downside, and an expected case (which I assume would be modeled on the basis of company operations stabilizing and finances improving modestly). You've nixed my questions (bond repurchase program and impact, impact of coming balance sheet restructuring of competitors etc) without providing much additional information. Are my questions that off base?

    SubjectReply to Round - Zero Risk
    Entry05/02/2002 11:46 AM
    Membernish697
    Most of the LVLT bonds have a 20-25% current yield presently. So you'll have 60-75% of your principal back by the end of 2004 (when they stop burning cash). You'll have nearly all of it back by 2005. So if you own the 2010 6% converts, you have a claim to a 20+% current yield for another 5 years. If they hiccup after 2005, you're ahead of all the shareholders and are guaranteed to make money on the investment as all the chips are off the table.

    I did not mean to nix you on the bond repurchase. Just wanted to express that one should not buy the bonds assuming LVLT will buy them off of you.

    The competitor balance sheet restructurings they have been living with for a while now so those have been everyday realities for LVLT for over a year. Again, the top 300 user of bandwidth will not take the lowest bid. They want a good price, but reliability and stability is fundamental.

    Looks like you're at the watering well and are about to quench your thirst!

    SubjectA few thoughts
    Entry05/02/2002 12:42 PM
    Memberbrian755
    While the LVLT bonds may be a good investment, there are, I believe, many issues assumptions you have to become comfortable with to invest in them.

    1) Pricing. Pricing will undoubtedly continue to decline, as it has for years. The real issue here is whether it will decline, but rather at what rate. The problem for LVLT and its competitors over the last 2 years or so is pricing declined extremely quickly, some reports stating 80% year over year. There have been signs that declines have stabilized somewhat and have returned to more normal levels, 20%-30% year over year. LVLT could grow revenues in this environment, but it will not be helped by increasing prices. Just not going to happen.

    2) Cash flow break-even. LVLT reaching cash flow break-even by 2004 is based on numerous, some may say still excessively aggressive, assumptions. As with the industry of the whole, LVLT’s health depends upon data volume growing extremely quickly over the next few years.

    3) LVLT’s original business plan was not as focused on the “carrier’s carrier” strategy as it is today. Rather, it was based a lot on dark fiber sales, sales that have all but dried up at present. In many respects, the carrier’s carrier strategy is a complete change of business plan. In fact, many people (myself included) believe LVLT made a catastrophic error when it originally built out its network by focusing solely on IP and not ATM. This strategic decision alone hindered, and still continues to hinder, LVLT from entering the carrier’s carrier market as voice over IP never materialized and LVLT could not, and still cannot, offer voice services to its customers.

    4) Liquidity. While LVLT does indeed have a large amount of cash and an undrawn credit line, the company would have been in default of its minimum revenue bank covenant if it did not acquire CorpSoft, a company that has a lot of revenue, little to no margin and little to no relation to LVLT’s core business. The company managed to avoid covenant default, but I can’t believe the banks were too happy about the move. Also, WCG, one of LVLT’s competitors, recently entered bankruptcy even though it had $1 billion in cash and an undrawn $500 mil credit facility.

    Bottom line, the bonds do look interesting if the company’s growth assumptions are correct. However, LVLT and its competitors have been way off on their assumptions up until now (which is why they are all in this mess in the first place), so I would take their assumptions with a large grain of salt right now.

    SubjectReply to Brian - A few thought
    Entry05/02/2002 01:27 PM
    Membernish697
    Thanks for your analysis Brian.

    I agree with you on pricing.

    Their cash flow break-even is based on no change in business fundamentals from Q42001. I don't consider it aggressive.

    Dark Fiber was an adjunct to their plan. They make much more with lit vs. dark fiber. They had great margins on dark fiber esp. if they were carrying a lot of lit traffic on the same routes.

    Data traffic is, and will be, heavily IP based. And it will grow substantially. So, not carrying voice, is not a big problem. It would have helped to carry IP-voice, but there is huge growth ahead of us in IP-based data traffic.

    In past calls they've stated their bank relations are excellent and thought that even if they had a covenant violation, the credit line would still be there. It might have required higher interest rates etc.

    There are clearly two schools of thought on LVLT. Those that are drinking from the well (Miller, Buffett, Wally, Longleaf, me) and those that will just look at the well and do nothing. That's what makes life so interesting.

    SubjectOutstanding Investor Digest's
    Entry05/02/2002 03:52 PM
    Memberraf698
    Just a head's up. The latest issue of Outstanding Investor Digest just landed on my desk, and it devotes approximately fifty (!!!) pages to LVLT. So, read up and enjoy--needless to say, it goes into considerable depth, and I'm only half way through the writeup.

    SubjectSSPE
    Entry05/02/2002 04:02 PM
    Membersparky371
    Any thoughts on this SSPE buy? Does this smack of desperation that they are paying out cold hard cash to get revenue to keep their credit covenants in place? Thanks.

    SubjectReply to Sparky - SSPE Acquisi
    Entry05/03/2002 01:47 AM
    Membernish697
    They didn't spend much in cash ($122 M) to buy over $1 Billion in revenue. Their bank covenants raise revenue requirements pretty steeply after 2002. So this gives them more cushion to avoid a covenant violation etc.

    Smart move by Crowe & Co.

    BTW, OID has done a phenomenal job on LVLT on the issue that I got today. Once you read that 50 page treatise, all possible questions are answered about this exceptional opportunity.

    Enjoy!

    SubjectOID
    Entry05/06/2002 10:49 AM
    Membersparky371
    Thanks. Have it with me; now to wade through it...

    SubjectReply to Sparky - OID
    Entry05/06/2002 12:48 PM
    Membernish697
    Just a note of caution on the OID writeup. I did not realize until I focused on the date that the Jun Crowe piece is from January, 2001 NOT January 2002. Its pretty dated. The other analysis by Lawson and Longleaf are recent.

    I think Crowe's analysis has not lost its relevancy (its basically timeless in its thesis), but the reader should be aware that the data is 15 months old.

    SubjectOID Summary
    Entry05/06/2002 09:58 PM
    Memberround291
    For those of us that don't subscribe, would one of you guys care to summarize the arguments made?

    Thanks

    SubjectReply to Round - OID Summary
    Entry05/07/2002 01:30 AM
    Membernish697
    Its hard to condense the 50 pages into a few paragraphs. At the risk of sounding like an OID ad, I'd like to suggest that the extent of learning and profit potential from OID would pay for itself rather quickly. If you like VIC, you'll like OID. Perhaps they'll give/sell you the latest issue. Check them out at www.oid.com

    I think the LVLT analysis alone makes the subscription worthwhile. The issue carried indepth Q&A and analysis by Jim Crowe, Lawson (of Weitz funds) and Longleaf.

    Lawson owns the stock and suggests the stock is worth atleast $20 and probably north of $100. He also attaches probability analysis to likelihood of going to $20 vs. 0.

    Longleaf owns the bonds and their thesis is similar to the arguments presented here.

    I thought they did an excellent job of presenting the enigma that Level 3 is.

    Subjectinvocations and problems
    Entry05/27/2002 01:50 PM
    Membermichael99
    Seems that the bulls on LVLT have several things in common, the very first of which is the invocation of Miller and Buffett and Scott (the Level Three "DNA") and recently OID (Lawson, and Emerson even dragged Mason Hawkins into this), and the second of which that a) they will be the low cost producer (this being key) but that b) they won't be in a commodity business. What can I say about the first point? All three have made mistakes before, but really their involvement (IF Buffett is even involved) is a moot point to an objective analysis of the business.

    But re: (a) and (b), IMO such theorists aren't checking their p's and q's. In my understanding, a commodity business is defined by price competition, and being the low cost provider is mandatory to generating significant sustainable ROI. Why must LVLT be the low cost provider if they aren't in a commodity business? Is the argument that they will have pricing power? In that case they don't have to be THE lowest cost provider. But really, I don't believe they will have pricing power, and neither does LVLT according to their funny original business plan.

    The fundamental problem with the demand elasticity argument made by Crowe and sucked up by LVLT bulls for a few years now is that regardless, you don't generally want to be in a business where price is the determining factor of demand. This is a commodity business by definition of nearly 100% price competition, IMO, and even if it isn't a commodity business for a short time in the future, that problem can usually be solved by the capital markets very quickly. It's a mistake, IMO, to think that the current circumstance of telecom capital markets will continue if high ROI can indeed be justified somewhere - ANYWHERE.

    Anyone who subscribes to OID will also get a special double issue that features among others another favorite of the LVLT DNA crowd, Charlie Munger. In it, Munger talks about deciding whether technology will help you or KILL you. This judgment, he argues, ought be based on the type of business you are in. My basic interpretation of his argument is that in commodity businesses, where price determines market share, price is driven down to cost, productivity determines cost, technology determines productivity, and hence the benefits of technology flow to the customer, not to the producer.

    Along with airlines and textiles, I'd shove telecom into these categories of business. When needed, capital flows into telcom very fast, but not necessarily to the incumbents' benefit. When demand turns and more fiber is needed, more lit fiber is needed, or whatever, the capital spigot will once again flow freely, erasing any aberrational high ROI. Capital can't resist high ROI commodity businesses, especially in telecom. It seems the only area of telcom where monopoly rents are earned and competitive advantage is sustained is where the government crafts rules or deftly turns a blind eye in a manner that provide such an advantage.

    To make another invocation popular with the LVLT DNA crowd, when a business of a poor reputation meets management of good reputation, it is classically the management whose reputation becomes sullied. It does not seem unreasonable to figure that LVLT is destined to be a poor, price-driven business.

    A final couple opinions:
    1) LVLT bulls that I know dismiss the relevance of comparable companies seeing their bonds trade for pennies on the dollar (reflecting the poor liquidation prospects of telecom assets, especially FO assets), and they dismiss the idea that better financed competitors with lower costs of capital who will ultimately buy assets for pennies on the dollar of debt out of bankrupcy will have any cost advantage, price advantage, or profitability advantage in the future. Seems that in capital-intensive industries characterized by price competition, the better financed competitor with the lower cost of capital will have the edge in being able to set low prices and take share, barring incredibly massive differences among other components of cost, such as labor, indirect government subsidies, etc.

    2) The significance of this software company buy is key. If LVLT had any flexibility at all with creditors, it should have been able to get a covenant amendment, especially when the alternative is spending a truckload of money for a <1% business. Then again, this has been LVLT management's MO.

    IMO, the massive premium offered for SSPE and the fact that they even had to do this reflects 1) the urgency of the buy (how many times do you want to invest with/side with a 'desperate buyer'?) and 2) the severe lack of credibility management holds with creditors, who have access to more information than most of us do.

    Just my two cents. Mike






    SubjectCommodity business
    Entry05/27/2002 03:53 PM
    Memberbowd57

    Hi, Mike --

    As I understand, the argument is that switching costs and declining costs of production will allow LVLT to capture rent from existing customers. The first taste is free, and the 2d-Nth tastes are still free, but LVLT makes money because economies of scale and advancing technology in effect subsidize the subsequent transactions. Kind of reminds me of a certain online retailer....

    I may be mangling the argument, and if not, I'm sure someone has expressed it more clearly. Anyway, good to see you around again.

    Yours,
    Bowd

    SubjectReply to Michael - Invocations
    Entry05/27/2002 05:08 PM
    Membernish697
    Michael:

    There are clearly two schools of thought on LVLT bonds and we are on opposite sides. Time will be the decisive judge.

    I generally agree that most investments in telecom companies today are a bad investment. The specific dynamics of an investment in LVLT bonds is distinctly different.

    I agree that Miller, Mason, Cates and Lawson have all been wrong before. Even Buffett has been wrong before. Just out of curiosity have all of them had a common holding in the past and been wrong on the investment?

    Crowe has mentioned in past calls that they frequently talk to the secured lenders and have a good relationship with them and that he anticipates being able to work through the violation with them. If you calculate what a covenant violation would cost the company (50-200 basis points additional, for example) over the life of the loan and weigh the acquisition cost, you'll arrive at the same conclusion as management. These are smart buys. Cheap relative to revenues they generate and even cheaper when you deduct the cost of additional interest. One of them got paid for by the unexpected IRS refund.

    Between LVLT SEC filings, OID's discussion and all the discussion on VIC, there is ample data for anyone to make an independent judgement.

    In a few years we'll have a definitive answer on the results of the investment.

    SubjectHate to Butt In...
    Entry05/28/2002 05:49 PM
    Memberround291
    I hate to but into others threads, let along Michael's (since we tend to disagree so often) but the lot you revere blew it on USG.

    No one is infallible.

    SubjectReply to Round - USG
    Entry05/29/2002 03:02 PM
    Membernish697
    I know that Buffett did not do well with the USG investment. However, Marty Whitman did very well on the USG bonds. I checked Portfolio Reports and can find no reference to Longleaf, Legg Mason or Weitz owning USG. What source indicates that Longleaf, Weitz and Legg Mason had/have positions in USG?

    The USG bonds were a terrific investment - just like LVLT bonds will prove to be.

    SubjectCheck USG Post
    Entry05/29/2002 03:46 PM
    Memberround291
    Check a comment titled "Ownership Round-Up" I posted on this board under a USG thread back in March 2001. Although Legg Mason is not listed, I'm pretty sure that they were in on the equity and/or the bonds. Weitz I'm not as sure about. Nygren was also on board and I included a Morningstar interview snippet in which he described his mistaken analysis, also under the USG thread.

    Bottom line...even the big boys get it wrong from time to time.

    SubjectQuote from Crow
    Entry06/07/2002 09:03 AM
    Memberjay347
    I'm late to the game in this thread, but have looked at Level 3 and wanted to add my 2 pennies.

    The difficulty of the task at hand is summed up by Crow himself in the OID interview. "If we build the internal systems that allow us to scale (which is hard), build the supply chain relationships, both with technology partners and with customers who build your pricing and service into their services -- business providers and residential providers so that they stimulate demand -- yeah, I think that's the company that's going to break away."

    In this quote is an important distinction about the relationship of supply and demand in this industry. Lower prices don't stimulate demand for bandwith. Lower prices make new applications feasible, and new applications stimulate demand. So although Level 3 would like to believe that fostering new applications is part of the "supply chain" I would argue that they have little or no control over this vital aspect of the business plan. Another factor to consider is the large zone of usability that a given bandwith provides to a corporate customer. New applications may indeed soak up more bandwith, and a network may slowdown but the customer may opt to grin and bear it.

    When one can't quantify the timing of needed events nor their likelihood, I just don't see how you can make an informed investment decision.

    SubjectReply to Jay - Crowe Comments
    Entry06/07/2002 06:07 PM
    Membernish697
    The LVLT bond investment thesis is fundamentally not based on big declines in prices and bigger increases in demand over the next 2-3 years.

    The bond investment is based on the thesis that there is a massive cash cushion and over 80% of future capex is tied to revenue. In addition, the company expects to get to cash flow break even within 2 years with no improvement in business fundamentals. When you look at cash used in the next 2 years, they have a big cushion.

    Crowe's comments are more relevant in looking at whether the stock can go to $10, 20 or higher. The bond investment is based on a very different set of criteria.

    Where the stock ends up in a few years is speculative. Whether the bonds are a good investment is a no brainer after one understands the company's specicfic cash position and cash utilization going forward.

    SubjectReply to Nish
    Entry06/13/2002 02:07 PM
    Memberjay347
    Point taken.

    It was my observation that this thread had morphed into a more general discussion of Level 3's business plan. My comments do pertain more to the equity than the debt. However, for the debt to be paid back the business does have to be viable.

    In this regard let me point out that according to your Crow quote the business is funded to break even if the current "RATE of sales" does not improve. That is fundamentally different from "no improvement in business."


    SubjectAlrighty Then...
    Entry06/27/2002 07:36 PM
    Memberround291
    The callable bonds maturing in 2008 have traded off about $10 per bond post-Worldcom. Any second thoughts? Or are you putting more money to work?

    Given your thesis (ie..."all that really matters is the cash on hand" and "fully funded to free cash flow breakeven" and "high upfront fixed cost, low marginal cost to service incremental customers"), you've probably backed the truck up on this bad boy.

    Any progress with regards to substantiating Buffett's involvement?

    SubjectReply to Round
    Entry06/28/2002 11:34 PM
    Membernish697
    Unless WCOM was a big customer, the events at WCOM are a nonevent for LVLT. Classical market panic at work and buying the 2008 bonds at present prices is an even better deal than pre-WCOM prices.

    SubjectSpeaking of Buffet catalysts..
    Entry07/08/2002 07:14 AM
    Memberbowd57


    Hi, guys --

    Buffet is in:

    http://biz.yahoo.com/djus/020708/200207080405000100_2.html

    Yours,
    Bowd


    Subject$100 m
    Entry07/08/2002 09:30 AM
    Memberduff234
    He's in for very little. I'm surprized he's doing it at all for such a small amount. He's certainly not the type to lend his name to something without his money, but it seems that way.

    SubjectFunding virtuous circle
    Entry07/08/2002 10:46 AM
    Memberraf698
    I think it's important to remember a few things on this Buffett deal. First is that he is well aware of the tenuousness of the operations of a business like LVLT--not the technology, but the financing end.

    GEICO had a similar experience in which they were raising money in a bond deal with Solly. If they could raise the money, they were fine and completely solvent--if they couldn't, they were bankrupt. I believe that Buffett later explained the terms of the deal to be such that given the minimum issuance size--enough to assure solvency, or the deal was off--it was a bit of a free option for any subscriber. The subscriber to the offering would be fine given that the bond issue would only go through at the successful hurdling of the regulatory capital needs, etc. (I'm not a historian, I'm recalling the gist of the thing).

    Anyway, my point is that this deal reflects the purchaser's collective awareness of the impact of such a funding statement, and hence their desire to have it be convertible at a near-market strike price. Other than that, it's nothing new--although quite more emphatic than Legg Mason's and Longleaf's earlier commentary given Buffett's now announced involvement.

    Finally, for the few who have read this far...more important commentary on the state of all of these companies and their debt structures is Paul McCulley's Fed Focus at www.pimco.com. His comments on Minsky and debt structures are phenomenal, and very informative in light of the importance that debt structure has increasingly become in the market.

    SubjectLongleaf Partners Funds, Berks
    Entry07/08/2002 11:23 AM
    Membernish697
    I believe Buffett has held the bonds for a while. Thus his token investment here is not the end of the story, but adding to a previous position.

    I agree with the analogies with GEICO. The capital behind Level 3 makes it a no brainer - if it wasn't one before. Not sure where the bonds are at, but they should be climbimg.

    SubjectTelecom=Paper=Airline Industry
    Entry07/09/2002 10:34 AM
    Memberround291
    The similarities :

    Commodity products/services
    Cost based competition
    Broadly dispersed technologies
    High barriers to exit (capacity is never really retired)
    Customers have the power and eventually receive 100% of any productivity improvements

    Market share or "unique asset" based acquisition strategies rarely work in these types of industries. Competitors and customers eventually copy and dissipate any temporary advantage (usually higher product/service prices) gained through a business consolidation.

    For these reasons, I question the reasonableness of acquiring a competitor and therefore the stated rationale for the extension of debt by these investment luminaries. I am particularly struck by Buffett's involvement given his prior mistakes both in paper (Champion) and airlines (USAir). If I'm not mistaken, both investments were structured as convertible preferreds with the USAir results being particularly poor.

    Furthermore, given the "completed infrastructure" and the ability of the company to pick off customers running for cover into the arms of a more financially solid competitor, LVTL's presumed acquisition strategy is a contradiction and yet another strategic flip-flop. Kind of reminds me of Netscape's lack of strategy and eagerness to be anything to anyone with capital...but there are few apparent bigger fools among the telecom survivors to bail out LVTL.

    On the other hand, since the majority of existing bonds will either be purchased at a discount by the company or swapped for equity anyway, a convertible subordinated note yielding 9% and in the money ain't all that bad, particularly for Legg Mason (already in the stock) and Longleaf (already in the callable bonds). Both have already presumably gotten comfortable with the industry issues. But Buffett...that's the shocker for me. I guess he bears some of the same pressures faced by money managers to put capital to work after all. He also seems to be succeptible to falling in love with business managers. To wit: "We only want to link up with people whom we like, admire and trust. John Gutfreund at Salomon, Coleman Mockler, Jr. at Gillette, Ed Colodny ay USAir, and Andy Sigler at Champion meet this test in spades" (Berkshire Hathaway 1989 Annual).

    Buffett is my man! I learn a tremendous amount from his writings and admire him emensely. I'm just confused on this one.

    SubjectReply to Round
    Entry07/09/2002 10:55 AM
    Membernish697
    I
    disagree with the airline/paper analogy. All airlines have similar safety/risk characteristics
    and are clones of each other on given routes. LVLT and its competitors are not
    clones. Network health and quality matters a lot as does management and technology
    competence. When carriers choose service providers they don't make the choices like consumers. Network design, topography, technology, uptime, engineering skills, management team and financials all matter a lot.

    Level 3's moat just got a lot bigger and deeper. They'll have an easier time making sales and the extra capital means beng able to buy revenue on the cheap.

    This is not a commodity business.

    Subjectbond prices
    Entry07/09/2002 11:06 AM
    Membergophar571

    For those that are curious as to how the bonds have reacted:

    Mid-market on the 9.125% is now 51 which is a 25.86% to maturity.

    SubjectFollow Up
    Entry07/09/2002 12:27 PM
    Memberround291
    If the capital markets are at least reasonably efficient, having extra capital does not create a durable moat. The experience of the past five years (overfunding of dot coms, telecoms, etc) should make this point painfully clear. Capital will find presumably desirable opportunities and be drained from those that offer returns below cost. The knife now cuts the other way as it is being withdrawn from the corpses of dot com/telco/technology loosers.

    I see no moat whatsoever. Were we talking about the Baby Bells that might be an entirely different matter.

    Please address the apparent repeated strategic flip-flopping of LVTL management. Either their network is somehow inherently superior and underutilized or it ain't. If it is the former, and this creates an economic and/or other customer benefit, why not just stand there and collect tolls. Acquiring customers that you would otherwise attract because of your superior value proposition is foolish. Acquiring "inferior" capacity in a glutted market is even more stupid.


    SubjectReply to Round - The Moat
    Entry07/10/2002 02:15 AM
    Membernish697
    LVLT is not planning to buy capacity. They are planning to buy customers. They made that clear on the call. I'd give the company some leeway to see what the first deal looks like. Let's say that getting $1B in annual recurring revenue with 80+% margins has a sales cost of $200 Million (totally theoretical numbers). In addition, it might take a year or 2 to spend the $200 Million to get the revenue. But let's say $100 Million buys a billion in revenue immediately. In that case it makes total sense to buy customers in bulk vs. acquiring them one at a time.

    Telecom customers are "sticky". Switching leased pipes is not as simple as switching your long distance. If they can move WCOM or Global Crossing customers in bulk over to their cheaper network at a low acquisition price, that's great. Many are locked in long term contracts etc.

    As I mentioned before there are 2 schools of thought - The Buffett View and The Street View. Look at all thr facts and decide which school of thought you subscribe to.

    At this point LVLT has over $2 Billion of liquidity. They don't run out of cash even with the most dire circumstances for 4-5 years - by which time you've gotten all your $$$ back as interest. No brainer.

    .

    SubjectHow in the World?
    Entry07/10/2002 03:21 PM
    Memberround291
    How in the world can LVTL buy customers and not capacity? You said yourself : "Switching leased pipes is not as simple as switching your long distance". Customers and the productive assets that serve them don't seem to be seperable to me. Creditors of a bankrupt company would be foolish to let this happen! To come out of the process without customers ensures the destruction of whatever value might exist.

    Were not talking about real estate or airplanes here. The asset here is the capacity AND the customer relationships.

    I'm still scratching my head on this latest strategic flip-flop.

    SubjectReply to Round - Customers vs.
    Entry07/11/2002 10:28 AM
    Membernish697
    Its pretty simple to buy customers and not capacity.

    Let's say IBM has leased 10 T3 lines from Armonk to Raliegh. NC from Worldcom. Typically this is a multi-year contract. LVLT buys the IBM contract and perhaps rents WCOM circuits for a few weeks. It gets its circuits ready and then at 3:00 AM on a Sunday morning does the cutover.

    In bankruptcy, the creditors don't have much choice. Customers like IBM are likely to leave a bankrupt company anyway.

    LVLT mentioned on the call that they don't plan to buy one contract at a time. They'll go to someone like WCOM and buy say 10000 customer contracts. They'll assume, for example, that 25-30% of customers might not switch over to LVLT and pay accordingly.

    Creditors don't have much choice. There aren't a lot of buyers out there.
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