Level 3 Communications (2nd largest ISP after Google) earnings miss & FBR Commentary

Level 3 Communications (NYS: LVLT) reported earnings on April 25. For the quarter ended March 31 (Q1), Level 3 Communications missed slightly on revenues and missed expectations on earnings per share.  Margins expanded across the board.  Level 3 Communications tallied revenue of $1.58 billion. The 14 analysts polled by S&P Capital IQ hoped for revenue of $1.61 billion on the same basis. GAAP reported sales were the same as the prior-year quarter’s.

Source: S&P Capital IQ. Quarterly


Level 3 Communications’ (NYSE: LVLT) first-quarter revenues declined sequentially and year-over-year to $1.58 billion due to the expected termination of various North America and UK government contracts.
During the first quarter, the company’s net loss was $0.36 per share, including $0.11 in foreign exchange losses in EMEA and Latin America.

“In the first quarter, we saw the effects of the near-term revenue pressures we cited last quarter, due to the typical reversal in seasonally strong fourth quarter revenue and some known contract disconnects in North America and UK Government,” said Sunit Patel, CFO of Level 3.  Patel said that “our gross margin is now back above 60 percent for the first time since acquiring Global Crossing.”

Despite these initial revenue challenges, Level 3′s total Enterprise Core Network Services (CNS) revenue grew 2.2 percent year-over-year to $1.37 billion. Taking out the impact of UK government revenue, Enterprise CNS revenue grew 6.8 percent year-over year. Wholesale revenue, meanwhile, declined to $501 million, while wholesale voice and other revenue declined to $205 million.

On a regional basis, North America was the clear leader with $967 million in revenue, while EMEA and Latin America posted revenues of $223 and $182 million, respectively.


David Dixon of FBR wrote:  

“While Level 3 continues to generate benefits from the Global Crossing merger, and we welcome incoming CEO Jeff Storey, our concerns about weak top-line trends and cost structure continue to be borne out. In the retail enterprise segment, a tough macro environment is coupled with a challenging pricing environment for connectivity services, which are largely commoditized. Furthermore, generationally challenged Ethernet equipment is an issue. Level 3 has avoided significant capex over the past two years by using Huawei engineers under contract to tune lasers on older fiber on a hop-by-hop basis to increase capacity and avoid network upgrades; however, excess capacity is unclear. In the wholesale segment, wireless backhaul demand is a potential bright spot, as demand for backhaul is increasing.

Cable companies are focused on offering lit fiber versus dark fiber to maintain owner economics. For Level 3, it is unclear to what extent the company would sell metro dark fiber circuits to wireless companies seeking fiber-based backhaul and feeder fiber from IXC hubs. While Level 3 gives up owner economics in this case, it may be the preferred approach, as wireless carriers are reluctant to use Level 3 to source lit fiber because of concerns regarding a lack of a capacity upgrade path —i.e., Level 3 can provide 100 Mbps today, but carriers need substantially higher capacity going forward. And our checks confirm that customer confidence is low regarding the company’s ability to increase investment levels to meet growing capacity requirements (particularly in a virtualized network context), primarily due to balance sheet concerns.

■ CNS* revenues weaker than expected, but EBITDA beat expectations as margins rebound—a flip from results last quarter. CNS revenue of $1,372M in 4Q12, up 1.6% YOY, was below our $1,418M estimate and consensus of $1,390M. One of the primary growth drivers was Latin America (13% of CNS revenues). Adjusted EBITDA were $386M, above our $378M estimate and consensus of $378M. The 24.5% EBITDA margin was ahead of consensus and our estimate of 23.5%, the first margin above 24% since the merger closed in 4Q11.

* Editors Note:  We don’t know if Core Network Services (CNS) also includes Content Delivery Networks (CDNs), which Level 3 provides to other service providers.  Their CDN is said to “support some of the largest video, software and web properties. The Level 3® Network is connected with direct, private connections to almost every major ISP and Telco, which allows traffic to flow directly to end users without traversing public peering points.”


■ Reiteration of weak EBITDA guidance. For the second-largest ISP after Google, modest revenue growth, low-double-digit EBITDA guidance, and what we interpret as modestly positive FCF growth (i.e., positive FCF, excluding $56M
in interest rate swap liabilities) are weak. Capex spending remains moderate, tracking below expectations, and a 4% head-count reduction taken late in the fourth quarter may provide a boost to EBITDA by $40M but will likely challenge
top-line growth in FY13.”

by David Dixon and Neil Macker, CFA

FBR Technology, Media & Telecom