The Last Supper?

Level 3 Communications Inc.s hunger for M&A seems to be satisfied with the $1.4 billion purchase of Broadwing Corp., with CEO James Crowe admitting as much in an October investor conference call. Were going to work hard to do what we have already taken on, he said, adding the companys appetite for further acquisitions is pretty low. Now, with six new companies under its belt, Level 3 has transformed itself from a wholesaler to a carrier simultaneously focused on metro and retail markets, and agent channel partners. Analysts, overall, view the companys strategy as viable and positive a view shared by Level 3s agent partners.

The combined companies will enjoy an enhanced competitive position, says Geoff Shepstone, president of Telecom Brokerage Inc. (TBI), which was Broadwings largest partner in 2005. I believe they will create additional long-term value to customers, employees and investors, he says, adding hes sure customer experience will remain top priority.

Thanks to its acquisitions over the past year, Level 3 once again runs an agent program, this after its 3Tone VoIP reseller program was discontinued in 2003. The Level 3 Business Partner Program targets master agents who are selling the companys metro Ethernet, private line, dedicated Internet access, MPLS, VPN, disaster recovery and business continuity services. The acquisition of Broadwing left a number of questions unanswered at press time (Level 3 had just begun closing the deal, a process that was not expected to be complete until the end of December, at the earliest). Among the most pressing concerns was how the carrier planned to integrate Broadwings agent operations and focus. However, Shepstone, along with MicroCorp President and CEO Brad Miehl master agents working with Level 3 and Broadwing feel sure Level 3 will do right by all parties involved. Miehl calls the deal with Broadwing a good thing for Level 3 because it increases the carriers portfolio and its commitment to the alternate channel. The industry can use another competitor out there right now, he says.

Craig Clausen, senior vice president and COO of research firm New Paradigm Resources Group Inc. (NPRG), also predicts the indirect channel will only benefit from Level 3s purchase of Broadwing. Agents will be able to sell more services as Level 3 moves away from just transport longhaul to reaching the end user, Clausen says.So thats what this whole current frenzied activity by Level 3 is about purchasing into the metro, gaining access to the end users and then, down the road, being able to pump additional applications services, the real premium stuff, over those pipes, he explains. They cant do that effectively by reselling the loop and paying someone else for access to the customer thats not a solid, long-term strategy.

Other analysts concur that Level 3 is planning for the future, not just trying to boost profits or add services to its portfolio by buying smaller companies. By absorbing Broadwing, Level 3 has taken one of the few remaining nationwide long-haul carriers out of the mix, writes Fedor Smith of ATLANTIC-ACM, a firm that studies wholesale carriers, in a research note. There are almost no little guys left to compete with the Tier 1 carriers for longdistance contracts, which should help stabilize prices for long-haul services, and drive stronger margins for the remaining carriers.

The outlook remains mixed on whether Level 3s acquisitions will pay off. The company has done very well at raising money, says Clausen, but whether there are profitable returns is an unknown. Clausen is waiting to see whether revenue exceeds total cost without Level 3 resorting to non-GAAP principles such as presenting EBITDA and other metrics to obscure the real picture of profitability, he says. So thats where the companys real mettle will be tested. How fast can they ramp up revenues so they become truly profitable and not just mythically profitable? They are strong financially, theyve got plenty of funds to execute their plan, at least the initial phases. Now can they then turn that into real dollars for shareholders?

Level 3 executives believe they can. The carrier was in the red just a few years ago, but now Crowe foresees free cash flow breakeven not far in the future. Thats in spite of overpaying for Broadwing. In a research note, Current Analysis analysts Brian Washburn and Cindy Whelan say Level 3 paid 15 percent more for Broadwing than the companys value. (Level 3 has admitted it was in a competitive bidding situation for Broadwing, for which it ostensibly overpaid to keep the company out of the hands of carriers such as XO Communications or Global Crossing, Washburn and Whelan explain.) Level 3 also has said it will spend up to $130 million on integration. It expects the Broadwing acquisition to generate positive free cash flow in 2008 and rise to $200 million in free cash flow in 2009, which indicates a substantially lengthy period to get a full return on its investment, Washburn and Whelan write.

Nevertheless, Washburn tells PHONE+, Level 3 so far seems to be able to justify each of its acquisitions with relatively fast paybacks, although Broadwings a little bit more long-term. That is partly because Broadwing does not increase Level 3s metro footprint or significantly expand its backbone distribution, as ATLANTIC-ACMs Smith points out. Still, Smith adds, If the objective is to further build the retail long-haul business, then Broadwing is a logical choice. Level 3 gets more than that, Washburn says, it gets customers. Broadwing has lots of enterprise customers, they have a nationwide sales force, and those are two things that Level 3 can use as its building its enterprise base further.

Level 3 executives are acutely aware of concerns about how much the company is spending on acquisitions. During the October conference call with analysts, Crowe assured participants Level 3 enters deals knowing more than half of all acquisitions destroy value for the acquiring companys shareholders. Level 3 heads, he said, have worked very hard not to ever forget that not only is it important to buy at a fair price, it is important to have all of the questions, as well as you can about integration, answered before you sign. Now youre going to make mistakes, but you have to do the planning. And I would assure all of our investors that were not going to forget that, and were going to continue to have a very, very high hurdle before we acquire any company.

In the meantime, Level 3 is getting the most out of its five closed buyouts. The metro acquisitions already are growing in the teens to 20-percent range, said Kevin OHara, Level 3s president and COO, in October. Helping growth, Level 3 will eliminate redundant routes as it integrates Broadwing into its operations. We would certainly expect that a good number of the route miles, 19,000, would be eliminated in aggregate, OHara said. Whether that comes from the Level 3 network or the Broadwing network is less relevant than the fact that a good number of the network miles will be coming out because they are connecting redundant city pairs. And, added Sunit Patel, Level 3s CFO, Broadwing has been experiencing 4 percent to 5 percent growth. He predicted that by 2009, the acquisition will be paying off to the tune of $1 billion in revenue.