Level 3’s Resurgence Does Have Teeth

I was asked recently why I haven’t offered another predictive model for Level 3 Communications (NYSE:LVLT, news, filings) in light of the Global Crossing deal and the dramatic resurgence of their stock over the past eight months.  For what it’s worth, I think there are indeed very good reasons supporting the TTID thesis this time around.  TTID for the uninitiated, is Level 3 investor shorthand for This Time It’s Different – which it wasn’t the last few times.  But those same reasons are making analysis rather challenging in my view, in that past performance is rapidly becoming less relevant and we seem to be approaching a singularity of sorts.  The company has earned itself many detractors over the years, but for the first time all the pieces seem to be coming together simultaneously.

Overall demand trends – The economy may not be surging, but bandwidth demand is showing little if any parallel softness.  Over-the-top video traffic growth is probably unstoppable.  More functionality moving into clouds of various types can’t mean anything other than more traffic to and from all those data centers.  Traffic growth across the board is finally reaching the tipping point at many off-net sites, making them economically attractive to bring on-net.   LTE and WiMAX are making fiber-to-the-tower viable and beyond as well.  To put it simply, it’s a good time to own fiber across the sector and the more you have the happier you are right now.

The Global Crossing purchase – The synergies and the scale brought by this combination are very real, to the extent that a deal seemed virtually inevitable for several years.  Now that it is about to come to fruition, analysts are finally taking a very close look and they just aren’t finding the downside.  Frankly, the $300M in synergies they have projected is conservative, which is as it should be of course.  The integration looks straightforward, unmeasured but obvious revenue synergies abound, and the path not just to positive cash flow but to positive earnings looks decidedly downhill.  The deal alone wouldn’t make the future hard to predict, but it changes the rules in enough ways that things start to get very complex.

Internal cohesion – When Level 3’s last M&A binge ended in integration disarray, a lot of people underestimated just how wounded the company was internally.  It took years not just to merely repair the back office systems but to restore intangibles like confidence in execution, trust between management and the trenches, and of course reputation with customers.  The financial crisis and recession didn’t help but even if it hadn’t happened they simply weren’t ready to rumble operationally yet.  But they are now.  Everything I hear now says that their operations are back in every sense.  Finally.  You can’t sustain organic growth without that internal cohesion, which is why Level 3 hasn’t been able to do so until recently even while many other fiber operators (TW Telecom, AboveNet, Cogent, many private operators) were racking up solid gains.

Enterprise Momentum – One can see this in the success they are finally having in addressing the enterprise business.  Their approach no longer looks like a wholesale machine with a new sticker.  Mid-Market revenue growth led the way in the first quarter on the strength of those metro and regional assets and the decentralized decision-making power they finally put in place around them.  They have never had this before.  Anecdotal evidence has been cropping up of a dramatically improved presence in enterprise RFPs all year.

CDN Momentum – The other big driver pushing Level 3’s train forward is that its CDN business is now big enough to start really contributing to both the top and bottom lines, both directly and indirectly through bundling other services where the competition can’t.  Whatever happens to the economy from here, it seems unlikely to make any sort of dent at all in the trend to more and more video online.  While the CDN business is competitive, the pricing pressures that seem to characterize it still just don’t seem likely to deteriorate into the sort of self destructive cycle that hit the wholesale IP transit business a decade ago.  There is no capacity glut, only more business to compete for or not.

Singularities are inherently un-modelable.  There are too many moving parts here, too many variables for whom small perturbations yield big changes.  When I build a spreadsheet to try and model it (yes I’ve tried), I can make it say almost anything I want to, from certain doom all the way to bell-busting nirvana.  I suppose I could lump everything into one or two well-named variables and pretend it’s simple, but to put a comprehensive model out there and claim to understand it would require hubris I can’t yet manage.   Maybe later… 🙂

The surge in the company’s stock price reflects the fact that so many favorable trends seeming to point in the right direction.  In the end though, Level 3 has to prove it all out and actually show us the money before we will really be able to put a valuation on it that will stick.  Such proof, if they manage it, will of course take longer than the market wants it to because in today’s world of short attention spans and instant media response that’s just the way it is.  But so be it.

Additional news just in this morning:  Level 3 has upgraded its low latency route between London and Frankfurt, targeting the financial vertical.  I don’t know who is on top in that profitable game of leapfrog these days, I’ll have to look into it.  They also just unveiled SIP trunking with Nomadic E-911 for MicroSoft Lync – further evidence of their expanding enterprise focus.

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Categories: Financials · Internet Backbones · Mergers and Acquisitions