by David Dixon of FBR Telecom Services (edited by Alan J Weissberger)

Executive Summary:

Level 3 delivered solid 1Q15 results in its first quarter with full TWTC (tw telecom inc. which they acquired last year) results. Management is executing well and should continue to leverage the global asset platform this year.

Looking into 2016, we believe the advent of a shift to 25G/100G metro networks will reduce the number of optical network elements, lower costs, and be and enabler for direct private networking relationships between content owners and access networks as an alternative to peering and IP transit services on the public Internet.

We think this will create greater pricing pressure for transport services in 2016 and increase disintermediation risk. For the quarter, we were pleased with:

(1) EBITDA  (earnings before interest, taxes and amortization) beat analyst estimates,

(2) increase in FY15 adjusted EBITDA and free cash flow guidance, and

(3) achievement of $95M of annualized run-rate adjusted EBITDA synergies since the close of the tw telecom transaction.

Overall company revenue continues to be driven by IP and data services (~45.7% of total CNS revenues), which grew 9.0% Year over Year in constant currency.

Management believes CDN (Content Delivery Network) will see further growth later this year as more capacity is added. Although we welcome continued margin expansion and CDN momentum, we believe these may be affected by the current shift to a paid peering model₁ and further architecture shifts from 2016. We think the FCC believes that the paid interconnection model from a decade ago (where voice traffic was 96% versus data traffic of 4%) worked well then and could provide a roadmap for today’s data-biased traffic. Therefore, content companies and intermediary network providers such as LVLT may see higher interconnection rates going forward, provided that rates are “just and reasonable.” The argument today is in terms of which party should set the interconnection rate.

Note 1.  Paid Peering is the business relationship whereby service providers (Internet Service Providers (ISPs), Content Distribution Networks (CDNs), Large Scale Network Savvy Content Providers) reciprocally provide access to each others’ customers, but with some form of compensation or settlement fee.

Internet traffic flows between different networks generally in one of two ways, through transit, in which a smaller network passes its traffic through a larger one to connect to the broader Internet; and peering, in which large networks connect with each other. Traditionally, smaller networks paid larger ones for transit services, but peering didn’t require any kind of payment from one company to another. Instead, both networks are responsible for their own costs of interconnecting.

Reference:  

Highlights of Peer 2.0 Conference: Aug 3-4, 2014 in Palo Alto, CA

Key Points:

■ 1Q15 results recap. Consolidated revenue of $2.05B was just shy of the consensus estimate of $2.06B. The adjusted EBITDA margin expanded by 130 bps YOY on a pro forma basis to 30.9%, compared with the consensus of 30.4%, and adjusted EBITDA were $635.0M, versus the consensus of $626.1M. Margins benefited from increased synergies associated with the TWTC acquisition.

■ FY15 adjusted EBITDA and Free Cash Flow guidance raised. Management raised full-year 2015 adjusted EBITDA growth guidance to a range of 14% to 17% from 12% to 16% previously. Free cash flow is now anticipated to be in a range of $600M to $650M, up from $550M to $600M.

■ Adjusting estimates: We are lowering our FY15 revenue estimate to $8.6B from $8.7B to account for U.S. dollar strength. Our FY15 adjusted EBITDA estimate increases to $2.6B from $2.5B, as the company should achieve further cost synergies. Our FY15 EPS estimate declines modestly to $1.57 from $1.59. Our estimates remain conservative given the unclear longer-term impact from the likely shift in the peering model, greater price compression from the move in 2016 to 25 GB/100 GB transport services, and adverse demand implications from a shift toward simpler, lower-cost metro networks (a net new build for the industry in 2016) that could raise disintermediation risks for Level 3. 

Q &A:

1. What is the real benefit of the tw telecom merger?

CDN services are becoming commoditized, but the LVLT/TWTC combination will allow LVLT to improve scale and scope by leveraging the domestic and global long-haul footprint and TWTC s dense urban fiber network. TWTC s higher-margin enterprisecentric business should benefit from greater scale. LVLT has a network backbone that includes 180,000 miles of fiber across 60 countries. A long-haul and metro network provider makes sense against a backdrop of increasing competitive pressures, but the move by access networks to create their own distributed datacenters and connect directly to regional agnostic datacenters suggests that the outlook for CDN providers is unclear. We think online content relationships will continue to evolve. 12 to 18 Months time frame.

2. Will network changes amid heavy traffic demands trigger greater disintermediation risk for Level 3?

The Internet architecture, traffic flows, and content relationships are changing fast. Many application service providers are leveraging Level 3 utility services to capture network ownership economics as the value continues to move higher up the stack from the networking layer to the application layer.

The telecom industry is migrating to improved utilization through:

(1) SDN and NFV (following Google’s lead) and

(2) application development with Docker that enables coding and linux containers (i.e., applications, storage resources) to work together more easily and be extracted out to a virtual linux container edge.

Utilization is much improved on common processing platforms with simplified routing protocols, thus shifting the demand curve for network traffic as application flows move on private networks from source origination to destination.

The migration to 25 GB/100 GB metro networks could be the enabler for direct private networking agreements in regional datacenters offering greater security and performance attributes relative to public Internet traffic interconnections.

We believe the migration to paid peering agreements and a rationalization of peering agreements is well underway and should continue to affect Level 3 cost structure.

The key driver is mature broadband penetration that has operators focused on incremental costs. We expect this transition to be implemented methodically as the industry migrates to major private interfaces over the next few years.

Today, traffic ratios increasingly determine the nature of the interconnection relationship to a greater extent than traffic volumes. We believe de-peering risk is significant and/or could create a higher cost structure as the eyeball network operators become more disciplined with traffic ratio imbalances above 2:1.  12 to 24 Months time frame.