(This is a highly-abbreviated version of a full SumZero report republished with the author's consent)
Contributor: Fionn Gibbons.
Firm: Cluain Ard. Hedge Fund.
Location: New York, NY.
Recommendation: Short Unsecured Debt of Level 3 Communications (Nasdaq: LVLT)
Timeframe: 2 Years and Beyond
Recent Price: $20.47
Target Price: $0.01
Disclosure: The author of this report had an active position in this security at the time of its posting.
Level 3 Communications did a bond deal at the Communications Inc. entity (which is the Holdco) last week pricing $300mm @8.875%. The stock was up 6% that day as the market celebrated a 1% ROIC business locking in a near 9% liability. The market should have looked at this bond deal and run for the hills.
To most people things seem fine today at Level 3 Communications (LVLT), with the acquisition of Global Crossing (GLBC) they have been able to significantly lower leverage on a pro forma basis.
It's time to put on a trade cheaply that you will be glad of later. Management has made this trade even more potent by using their synergy add-back to refinance Inc.(Holdco) converts into lower cost Finco (structurally senior) unsecured debt under the 3.75x Finco incurrence test, so that when the bow breaks the cradle will fall further and harder. Today's deal at the holdco Inc. level means, I suppose, that the cannon is packed at the Finco level.
Buy LVLT 8.125% bonds due 2019 (or equivalent CDS) at the Finco level and short the structurally subordinate 8.875% bonds due 2019 at the Communications Inc. (Holdco) entity (or equivalent CDS) on an 1:1 ratio paying roughly ~100bps.
I dont think we are going to have a real recovery in the US because that would require, first, the bitter medicine of a restructuring, which we have no stomach for (which would blow up LVLT), so what we will get is inflation. I believe that pricing will continue to march down in LVLT's offerings (no scarcity there) and wages will increase, this plus the elevated cost of capital and capital equipment will cause this business to implode eventually. The question for me is how long can they use their overpriced stock to overpay for acquisitions.
In buying GLBC, Level(3) went against what it had been preaching for the past couple years namely it overpaid for a Long-haul competitor in the most commoditized part of its value chain rather than focusing on the CLEC arena where there are fewer competitors per enterprise building and less price erosion.
Level (3) operates in an industry that does not quote its capacity or its volumes and therefore its capacity utilization is not known. The industry has been characterized by large volume growth and very significant pricing declines. Most of level (3) business is in longhaul which has exhibited the pricing characteristics of a commodity.
Guidance for LVLT is interesting, "from the starting point of company's $1.216bn of consolidated Adjusted EBITDA in 2011, we expect Adjusted EBITDA to grow 20-25% for the full year 2012." GLBCs Q4'11 contribution to this starting point amounts to $40mm even though in Q4'10 they did a record ~$126mm of OIBDA. GLBC have clearly been window dressing with that Q4'10 number, but at a $326mm 2011 EBITDA LVLT are now sandbagging. In those terms LVLT paid 10.4x for GLBC. [I got the $40mm from: $326mm OIBDA (Q4 press release) - Q1'11 $88mm (GLBC), - Q1'11 $96mm (GLBC), - Q3'11 $102mm (GLBC).] Shameful.
This is a shockingly poor business, or a shockingly poorly run business, or both; I cant stress enough to you how bad this business is. Spend some time on Glassdoor.com reading the of LVLT employees and you will get a glimpse and then consider that the business has generated a sub 1% return on Invested Capital for as long as I can "Crtl-v" the formula back, all the while borrowing money at high single digit weighted average costs. LVLT is where capital has gone to die!
This is an over indebted business selling a commodity product. This business needs regular access to capital and so will so many other better businesses in the in 2013-15 time frame which is when these guys will be coming to market to refinance Parent debt that will then mature behind a ton of structurally senior Finco debt; it is also when lots of other 2006-07 vintage bond tranches need to be addressed. Those loyal partners that have rolled converts and exchanged converts in the past (and likely lost money) have a few more years of data where the bridge to enormous value realization that they thought they were financing never materialized. Pricing didn't turn indeed pricing nirvana may be further away than ever.
This idea can be diligenced; one can get bandwith buyers on the phone and build datapoints which if it drives increased conviction could lead to a better timed trades. The data points that I have uncovered to this point have backed up the thesis that long haul (and to a lesser extent Metro(CLEC))bandwith is a commodity. If things change, it's possible to get ahead of it.
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