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Company Focus
Can Level 3 ever be a No. 1 telecom?
Expectations that Level 3 Communications has the strategy and genetics to become a global giant has sent shares surging to extremes. But most revenues now come from coal-mining -- and analysts wonder if earnings will ever justify the current price.
By Barbara Grady
Here's one for those who invest on faith: Level 3 Communications.
The new long-distance telecommunications company signed up its first telephone customers only six months ago, faces construction costs of $8 billion to $10 billion and must compete with long-distance rivals that own tens of millions of customers and networks paid for long ago.L I V E V O T E
Voting ends 6/14/99
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Yet Level 3 (LVLT) sports a market capitalization of $29.9 billion -- about a third of AT&T (T) and half of Sprint (FON) -- as its stock has soared 116% already this year. And most of its revenues come today from coal mining.
What's going on? Let's go through both the bull and bear cases for this unusual story.
The bulls' case
Investors who are optimistic about Level 3's prospects note that it's among the leaders of a revolution in telecommunications in which the century-old method of transmitting voices, called circuit switching, is being replaced by a much cheaper and more efficient technology called Internet-protocol packet switching. Circuit switching is done mostly on the type of copper wires you've got in your home telephone; packet switching is primarily and most efficiently done on fiber-optic lines.
Level 3 and a handful of other network builders are laying the groundwork for fiber-based packet switching around the world. It's a big job, but so is their goal: to offer high-quality voice and data communications in the future at a fraction of today's costs. Cool stuff like home video conferences ("Hi Grandma, see my new puppy?") that are slow and expensive today would be cheap and attractive on these new lines.
Says Jack Grubman, senior telecom analyst at Salomon Smith Barney: "We think these companies are, simply put, the plumbing for what is going to be the single biggest contributor of growth for the entire economy." Naming Level 3, Qwest Communications (QWST), Frontier (FRO) and Metromedia Fiber Network (MFNX) as the top beneficiaries, he adds: "Frankly, we would argue that bandwidth has replaced memory and microprocessing as the gating factor in growth."
Level 3 has ambitious plans to build a 16,000-mile U.S. long-distance network and local loop networks in 50 cities. It's also stretching an IP-packet-switched cable under the Atlantic Ocean to attach to a 3,500-mile network it's building in Europe. It has completed 10% of the project and has $6 billion in hand to do the rest.
James Henry of Bear Stearns considers the plan "incredibly logical -- that is exactly where industry is going." And, he says, the firm's management team "has a track record essentially unmatched in the telecom industry in creating shareholder value and operational success."
The bears' case
All right, enough of the good news. The bears note that despite these gushes of praise, Grubman maintains a target price of $70 on the stock, even though it's trading at $89. And Henry will not rate the stock, citing its "extreme" valuation. "Its market cap reflects fairly buoyant enthusiasm for their near-term prospects without any solid near-term indicators for ability to execute," he said.
"This is an industry where you bet on the jockey and not on the horse. Management is the single most important ingredient here."
-- James Henry,
Bear Stearns
In fact, although Wall Street is swarming with telecommunications analysts, only five rate Level 3, according to Zack's Investment Research, four with a "moderate buy" and one a "strong buy."
How extreme is the valuation? Shares go for a price-to-sales multiple of 73 -- compared with the average S&P 500 stock's price-to-sales multiple of 2. Even popular growth stocks such as Microsoft (MSFT) and Cisco Systems (CSCO) only have price-to-sales multiples of 23 and 18, respectively. (Editor's note: Microsoft is the publisher of MSN MoneyCentral.)
The disconnect comes largely from the fact that Level 3 doesn't plan to sell full long-haul communications services until early 2001, when its U.S. network is scheduled to be done. Until then, it gets its revenues mostly from coal mining (a business left over from when it was a diversified construction company) and some from local telecommunications operations in 17 cities where it has completed construction or leased lines.
"You're buying a story and future growth," with Level 3, said analyst Jessica Reuss of Kirkpatrick Pettis, who rates it a "buy."
Cheaper calls in the future
Why should Level 3's network be the Holy Grail of telecommunications, or any better than the telecommunications networks that exist? Level 3 vice president Scott Roberts cites the 13-to-1 cost advantage of packet-switching networks over circuit-switched networks. Calls to Europe from San Francisco that cost 30 cents a minute today might cost less than a penny five years from now.
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Level 3 Communications
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Level 3 initially is promising prices 20% lower than today's rates from the major carriers, and ongoing 20% to 35% annual rate reductions over the next few years as capacity grows.
The reason packet switching is so much cheaper:
It allows hundreds of conversations or data transmissions to travel over a single line simultaneously. The switch translates voice into computer data, labels each bit for its destination and then stuffs the data into packets. Those packets travel along the transmission line like subway cars stuffed with passengers, all with different places to stop. When the bits get to their destination, they are pulled from the packet and rapidly reassembled.
In circuit switching, a network opens a circuit when a call is placed and then dedicates that entire line to the call, even if there's no traffic, such as when voices pause in conversation. It's like dedicating an entire subway car to one person.
Packet switching is not new nor is the IP addressing system. But while they have proved efficient for data such as e-mail and fax, they haven't been very successful at moving voice traffic on the Internet. Level 3 believes its new high-capacity network -- which benefits from a new technology called dense wavelength division multiplexing -- will fix the voice quandary. The company will also benefit from new equipment rolling out of Nortel Networks (NT), Cisco and Lucent Technologies (LU).
Getting enough customers
Even if it all works, it's still unclear whether Level 3 and rivals like Qwest will ever grab enough business away from AT&T, Sprint and MCI WorldCom to cover their costs and justify their current stock prices.
"These companies are going to have much better networks than the Big 3 carriers, but the challenge is they have to find customers," says Scott Cleland of Legg Mason Precursor Group. Adds analyst Amanda McCarthy of Forrester Research: "These newcomers don't have a hook into the business market the way an AT&T or MCI WorldCom does. And breaking into that market will be an uphill battle."
McCarthy believes selling voice over IP services will be an uphill battle anyway, based on a survey she conducted recently. Forrester found that only 4% of businesses surveyed had implemented voice over IP, although virtually all of them had been approached by marketers. "They found no compelling reason to migrate from a perfectly capable system of circuit switching," McCarthy said.
The X-factor: strong management
The bulls' final arguments in favor of Level 3: blood lines. "This is an industry where you bet on the jockey and not on the horse," Bear Stearns' Henry said. "Management is the single most important ingredient here."
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Jim Crowe, Level 3's founder and chief executive, started MFS Communications in 1988 and led a revolution in telecommunications before by taking on the Baby Bells and winning big swaths of market share in regions around the United States. MFS grew to be worth $14.3 billion when it was sold to MCI WorldCom in 1996.
Crowe is now extending that battle, with his new company, to long-distance carriers. But he isn't worried by the fact that many others are also building competitive long-distance networks. The company argues there will always be demand for cheap capacity. "If you locked in today's prices, you might get a glut," says the management discussion of its annual report. "We and others believe that as you drop the price of communicating, demand increases even faster. At the right price, you can't have too much bandwidth."
Most telecom analysts agree with that assessment. Says Reuss: "I kind of look at bandwidth like Intel chips. No matter how much more processing speed Intel puts out, software developers always find ways to use it up," she said.
And if all else fails, Level 3 has a safety net, argue bulls. It could always sell itself to an established carrier who can't build fast enough to catch up with the revolution.
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Last week, we asked users to rate Guidant (GDT), a cardiac-device maker. Here are the results to date. To learn more about Guidant and cast your own vote, check out:
Guidant doesn't miss a (heart) beat
Rate Guidant -- Total Votes: 737*
Buy.
76%
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9%
Hold.
15% * Through 5/13/99
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