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Level 3 Regains Luster Amid Web-Video Boom
By Li Yuan and Gregory Zuckerman
The Wall Street Journal
Thursday, December 21, 2006

Fiber-optic network operator Level 3 Communications Inc., a high-flyer during the telecommunications bubble, almost went bankrupt after the sector burst in 2000.

Now, it is back, with a stock price that has almost doubled in the past year and bond prices that have risen about 20%.

Behind the gains:  Explosive growth in video viewing over the Internet, which requires high-speed networks of the sort Level 3 offers.  At the same time, a hearty appetite by investors for risky debt has enabled the company to put itself on firmer footing by refinancing its debt at lower rates.  There also are good reasons to believe that Level 3 might be an acquisition candidate, though many feel such speculation is overblown.

But there are reasons to be wary:  The company remains saddled with debt, it is in a business that still has excess capacity, and it has reported a quarterly profit just once in its more than 20-year history.  With the stock and bonds at lofty levels, it could be that any future possible good news already is priced in.

Even bullish analysts acknowledge that to keep the stock climbing, demand for video and voice over the Internet will have to be strong enough to allow Level 3 to increase what it charges big telecommunications, cable and other businesses for access to its fiber network, one of the world's largest.  Level 3 also will have to demonstrate that it can skillfully integrate a series of recent acquisitions.  The company will also have to show that it is getting closer to pulling more cash out of its business than it is putting in.

Level 3 shares, which traded above $120 in the Internet boom, closed yesterday at $5.65 on the Nasdaq Stock Market, down 1.7%.

By one measure, Level 3 stock and bonds are a bit pricey.  Its enterprise value, or the value of shares plus debt, is about 13 times the company's expected earnings before interest, tax, depreciation and amortization for 2009.  Time Warner Telecom Inc., which sells telecom services to business customers, trades at well under 10 times its expected Ebitda, though the two companies may not have the same growth potential.

Level 3's bonds, which sported yields of about 18% a year ago, now have yields as low as 8.5%, thanks to their increased prices.  That rate isn't especially generous for a junk-bond-rated company that isn't expected to turn a profit soon.

Level 3 has been refinancing its debt and extending some maturities to at least 2010, giving it more breathing room. This month, the Broomfield, Colo., company sold about $650 million of bonds with interest rates of 9.25% to pay off debt with a 10.75% coupon.  Still, the company is burdened with $6.8 billion in debt.  It needs to repay $2.3 billion of debt in 2010 and another $2.9 billion in 2011.

If the financial market shuts the door and refuses to refinance that debt, it could ramp up pressure on the company.  For now the debt markets are willing to buy Level 3's debt and the company is upbeat.  "Something will have to go very wrong both at Level 3 and the market" for the company not to be able to refinance its existing debt, a Level 3 spokeswoman says.

Level 3 says more than half the traffic on its network is from Internet video, up from no such traffic in 2000, and it is increasing its capacity.  "Video has exploded as a generator of traffic for them," says Michael Mahoney, a partner at EGM Capital, an investment management firm that has owned Level 3 shares for about nine months.  "All of a sudden, the pipe Level 3 built in the late 1990s looks attractive."

But Level 3's management acknowledged to a group of investors last week that even though traffic from Internet video is huge and growing fast, it is at least two years away from becoming a large revenue contributor.  Analysts say it needs more YouTubes to emerge to make this a big business.

And prices for access to networks have fallen about 15% this year.  While much slower than the 50% rate of 2004, that still is a troubling sign in a market where demand for network capacity has increased at a rate of about 60% a year in the past two years.  The capacity glut is so huge that it could take years before it is filled up.

Since late 2005, "we started to see a change in the pricing environment," says Kevin O'Hara, president and chief operating officer of Level 3, who says still-falling prices for the use of Level 3's network are being more than offset by strengthening demand for its high-speed networks.  The company projects revenue will rise about 20% this year, but it will remain unprofitable, due to its high debt level.  In 2005, revenue rose 18% to $3.61 billion.

The market also is upbeat because of the six acquisitions Level 3 made in the past year that help distinguish it from its competitors, analysts say.  Those acquisitions enable Level 3 to offer higher-profit phone and data-communications services directly to business customers, encroaching on the turf of regional phone companies like AT&T Inc. and Verizon Communicatons Inc.

Some investors have been looking at Level 3 as a possible acquisition target for providers of Internet video, including Google, which acquired YouTube last month.  The logic:  With bandwidth prices stabilizing, owning their own networks could help Internet video sites and other heavy users of data protect against possible pricing pressure down the line.

It remains likely, however, that the high price tag and hefty debt burden of Level 3 would deter any Google interest.  A Google spokesman said, "We don't comment on rumor or speculation."

Qwest, whose share price is up more than 40% this year, is looking at potential deals, and Level 3 is rumored to be one of several possibilities.  A spokesman for Qwest declined to comment.

-- Kevin J. Delaney and Amol Sharma contributed to this article.

Write to Li Yuan at and Gregory Zuckerman at