Off topic -- WSJ article on Level 3 Communications Inc.
November 19, 2002
HEARD ON THE STREET
Level 3 Fights Telecom Crash By Investing in Software Units
Analysts and Investors Scramble to Define Firm Since Most Revenue Isn't From Telecom Business
By DENNIS K. BERMAN
Staff Reporter of THE WALL STREET JOURNAL
Hearing actor Sean Connery extol Level 3
Communications Inc. in James Bond-type tones,
investors may think they are buying a rare survivor in
the beleaguered high-tech realm of fiber optics.
But Mr. Connery's new television ads tell less than half
the story. The Broomfield, Colo., company has quietly
undergone a "radical transformation" over the past eight
months, in the words of one analyst. The results of this
makeover? For the three months ended Sept. 30, Level
3 derived 72% of its $1.07 billion in revenue from two
low-margin software-distribution businesses it acquired
earlier this year. It is, in fact, the nation's largest
software distributor to corporations in charge of the
humdrum task of selling and looking after the software
applications used on office personal computers.
Moving and manipulating electronic data over long-haul
fiber optics -- what was widely considered the
company's primary growth business prior to this year --
accounted for about 16% of the past quarter's revenue,
or $164 million, according to a Bear Stearns report. And
there is no uptick in sight. With corporate customers
continuing to delay spending on new, high-margin,
telecommunications services, there is "increased
uncertainty" about the company's ability to project its
business outlook, Level 3 Chief Executive James Q.
Crowe said in a statement last month.
Level 3's new software business shows how the
telecom sector has had to creatively adapt -- for better
and for worse -- through the most difficult market in
history. And it underscores how even those companies
that are considered the market's survivors still face
large execution risks on the strategies they pursue.
Qwest Communications International, Inc., for
instance, is abandoning wireless and some of its data
business and is concentrating on local phone service,
which is shrinking for the first time since the
Depression.
Along
with
many
telecom
stocks,
Level 3
shares
have recovered from a midsummer low of $2.89, to trade at
$4.59 Monday at 4 p.m. on the Nasdaq Stock Market. The
52-week high is $7.39, a far cry from the days of the bull
market, when Level 3 was a $130-a-share highflier at its peak in
March 2000.
This isn't the first time Level 3 has changed its stripes. It traces
its roots to a 114-year-old construction and mining company,
and still holds small interests in coal mines and an Orange
County, Calif., toll road. But the latest moves have flummoxed
some investors and analysts. They aren't sure how to classify
the company. This is no academic question, for it affects how
the company's operations are benchmarked, and eventually,
what kind of investors are willing to hold its shares.
Goldman Sachs' Frank Governali, for instance, wondered in a
recent report whether Level 3 should be "known as a
communications company with a significant
software-distribution business or vice versa?" At French
investment bank Credit Lyonnais, analysts are now debating
who should track the company, which now has more than half
of its 6,100 employees working in the software subsidiaries.
"We classify companies based on revenue," says telecom
watcher Rick Grubbs, "From that point of view, it would be a
software company."
Ratings firm Standard & Poor's said it is reviewing the
company's official industry classification, and could either keep
it lumped with other start-up telecom carriers or move it to the "electronic equipment and instruments"
category that houses software distributors. The classification matters greatly: Stacked up against telecom
companies, Level 3's revenue per employee over the past 12 months was the highest of 16 peer companies that
have more than $100 million in sales. When compared with software distributors, however, it sits behind five
competitors.
To Level 3's Mr. Crowe, the company's direction is clear. "We are a company which moves information," he
says. "We're a backbone network company." Mr. Crowe, in fact, has been avidly bidding on distressed
telecom assets, which, if they generate enough sales, may change the revenue mix back in favor of telecom.
When Level 3 spent $211 million in stock and cash to buy the two software firms CorpSoft Inc. and Software
Spectrum Inc., many institutional investors labeled it a brazen attempt to avoid violating loan covenants. Those
loan covenants specified that Level 3 have $2.3 billion in annual sales by the end of the fourth quarter. Mr.
Crowe acknowledged that the covenants factored into the purchases. He adds, however, that there are
long-term opportunities in putting software distribution together with a fiber-optic network. Instead of shipping
boxed software on trucks, Mr. Crowe believes that the computer code one day will arrive via telecom
networks.
Just when will this synergy kick in? Mr. Crowe says it will be three to five years before significant numbers of
corporations start moving their software via telecom networks. Level 3's customers include Microsoft Corp.,
whose network-computing effort, called .Net, is off to a slow start.
Mr. Crowe's long-term vision is attractive to some investors. Jerry Bruni, who controls 1.6 million Level 3
shares at Colorado investment-advisory firm J.V. Bruni & Co., concedes that Level 3 "is not an investment one
can justify based on current operations," saying the appeal is "the promise of the future." Among the current
drawbacks: The company's software-distribution unit returned gross margins of only 1.8% in the quarter
ended Sept. 30, compared with 81% for the telecommunications side of the company. With those margins, the
distribution business is "like a grocery chain," Mr. Bruni says.
Tim Gleeson, a portfolio manager at Toronto's Mackenzie Financial Corp., which owns 630,000 Level shares,
regards the distribution business as a kind of low-cost warrant -- something that may pay off in the future.
"It's a smart strategic entree'' into electronic delivery, he adds. As it is, what he likes about Level 3 is that its
telecom margins are some of the industry's best, so it is poised to do well if network traffic increases.
Level 3 does appear to have dodged the bullet that has sent the likes of Global Crossing Ltd. and Williams
Communications Group Inc. into bankruptcy-court protection. Level 3 received an invaluable endorsement this
summer, when famed investor Warren Buffett's Berkshire Hathaway Inc. pumped in $100 million of a $500
million convertible-security offering in July.
That said, Level 3 and other such upstart telecom concerns "still aren't making money," complains Naima
Hoque, telecom analyst at Columbia Management Group, the $145 billion asset-management arm of Fleet
Boston Financial Corp. Columbia's Stein Roe mutual-fund unit dumped 445,000 Level 3 shares in the first six
months of 2002. Many investors say they want the company to find a way to conserve cash; it must repay
about $1.2 billion in debt by 2007. Level 3 lost $299 million last quarter, and most investors expect losses to
persist through 2004.
Level 3's best-performing business has been its managed-modem unit, which manages thousands of
low-speed, dial-up Internet connections for the likes of the America Online Internet unit of AOL Time Warner
Inc. and Microsoft's MSN online service. Third-quarter revenue for this unit climbed to $82 million from $57
million in the year-earlier period, largely because of the acquisition of a rival McLeodUSA unit, according to
Bear Stearns.
Level 3 has developed strong margins from the work because it uses proprietary software that runs at a lower
cost than its competitors. "It's a great business for us," Mr. Crowe says. The company hopes to expand this
line by acquiring large contracts owned by telecom-services provider Genuity Inc.
That Level 3 likely will book the bulk of its 2003 sales from two stodgy businesses -- software distribution and
dial-up modems -- is a tale of the times to some. While the company has spent $13 billion on its broadband
vision of the world, "what's paying the bills is 1980s and 1990s kind of technology," Credit Lyonnais' Mr.
Grubbs says.
Write to Dennis K. Berman at dennis.berman@wsj.com
Updated November 19, 2002
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