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Level 3 Getting Bigger; Better Remains To Be Seen
Investors who have supported Level 3 (Nasdaq:LVLT) through thick and thin have seen at least half of the investment thesis play out. Demand for bandwidth has indeed exploded, and broadband connectivity is everywhere. On the other hand, the profitability side of the thesis has just never worked out, and it has been a perennial question as to whether Level 3 will ever reap profits from its impressive fiber network.
Level 3 is taking another big step in trying to drive profitability and free cash flow out of its assets, announcing on Monday that it would acquire rival Global Crossing (Nasdaq:GLBC) in a $3 billion stock deal. Assuming that the deal goes through, Level 3 should be able to drive some meaningful synergies, but it is an open question as to whether even this combined company will produce compelling returns on its huge asset base.
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Terms of the Deal
Level 3 will be paying 16 of its own shares for every share of Global Crossing, a deal that valued Global Crossing at just a bit over $23 based on Friday's close. Level 3 will also be taking on $1.1 billion in Global Crossing debt, bringing the total value of the deal to $3 billion.
At those prices, Level 3 is paying almost eight-times trailing EBITDA, and valuing Global Crossing at about 1.2-times on an EV/revenue basis. So even though Level 3 is paying a 55% premium to acquire Global Crossing, it is still valuing its target at a lower multiple that it itself trades for currently.
Although not part of the deal itself per se, Level 3 has also announced a shareholder rights plan in conjunction with the deal. Now, this is not a run-of-the-mill rights plan; the sort that companies will issue in the name of "protecting" shareholders while actually only protecting their cushy seats. This plan is about limiting ownership stakes in Level 3 that could imperil the company's considerable tax loss carryforwards or net operating losses (NOL). (For related reading, check out A Sticky Fight Between Comcast And Level 3 Over The Web.)
Those NOLs amount to about $5.9 billion right now, against a pre-open enterprise value of $8.4 billion for Level 3 in its entirety, so it stands to good reason that the company would protect their value. Moreover, it seems like there are some fairly clear guidelines as to how/when the rights plan will expire, so this looks like a shareholder-friendly move.
What Level 3 is Getting
Assuming the deal goes through, Level 3 will become own a network that stretches across three continents and 50 countries. The combined entities will have over $6 billion in revenue, and could see upwards of $300 million in synergies flowing through to the EBITDA line.
Will This Deal Work?
Of course, those synergies only matter if the deal goes through. Given the price that Level 3 is apparently willing to pay, an outside rival bid seems unlikely. It is possible, though, that there could be some antitrust concerns. (For more, see Mergers And Acquisitions: Understanding Takeovers.)
It would seem that there is enough competition from the likes of AT&T (NYSE:T), Verizon (NYSE:VZ), Akamai (Nasdaq:AKAM) and Limelight (Nasdaq:LLNW) in their respective and relevant businesses. Nevertheless, it is hard to see this deal making sense unless it drives up prices - neither company has been able to produce attractive free cash flow on its own, and many mergers have failed to deliver the presumed synergies. All of that said, the fact that both stocks are up so strongly after the announcement suggests that the Street is pretty confident that the deal will go through and that it will deliver on its potential.
The Bottom Line
From a top-line perspective, there are reasons to be optimistic on Level 3. Streaming media, software as a service and wireless backhaul are all gobbling up bandwidth, and deals with companies like Netflix (Nasdaq:NFLX) could drive that even further for Level 3.
The question still outstanding, though, is whether Level 3 can really produce an attractive economic return on its asset base. Even with so much installed capacity, the company still has hundreds of millions of ongoing capex needs and that consumes a lot of capital. There is likely a tipping point here where demand growth will finally improve the pricing environment, and the operating leverage at that point will likely be quite compelling. The problem with that scenario is the "when" and whether investors will be suitably rewarded for the time spent waiting.
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Level 3 is taking another big step in trying to drive profitability and free cash flow out of its assets, announcing on Monday that it would acquire rival Global Crossing (Nasdaq:GLBC) in a $3 billion stock deal. Assuming that the deal goes through, Level 3 should be able to drive some meaningful synergies, but it is an open question as to whether even this combined company will produce compelling returns on its huge asset base.
Tutorial: Investing Concepts
Terms of the Deal
Level 3 will be paying 16 of its own shares for every share of Global Crossing, a deal that valued Global Crossing at just a bit over $23 based on Friday's close. Level 3 will also be taking on $1.1 billion in Global Crossing debt, bringing the total value of the deal to $3 billion.
At those prices, Level 3 is paying almost eight-times trailing EBITDA, and valuing Global Crossing at about 1.2-times on an EV/revenue basis. So even though Level 3 is paying a 55% premium to acquire Global Crossing, it is still valuing its target at a lower multiple that it itself trades for currently.
Although not part of the deal itself per se, Level 3 has also announced a shareholder rights plan in conjunction with the deal. Now, this is not a run-of-the-mill rights plan; the sort that companies will issue in the name of "protecting" shareholders while actually only protecting their cushy seats. This plan is about limiting ownership stakes in Level 3 that could imperil the company's considerable tax loss carryforwards or net operating losses (NOL). (For related reading, check out A Sticky Fight Between Comcast And Level 3 Over The Web.)
Those NOLs amount to about $5.9 billion right now, against a pre-open enterprise value of $8.4 billion for Level 3 in its entirety, so it stands to good reason that the company would protect their value. Moreover, it seems like there are some fairly clear guidelines as to how/when the rights plan will expire, so this looks like a shareholder-friendly move.
What Level 3 is Getting
Assuming the deal goes through, Level 3 will become own a network that stretches across three continents and 50 countries. The combined entities will have over $6 billion in revenue, and could see upwards of $300 million in synergies flowing through to the EBITDA line.
Will This Deal Work?
Of course, those synergies only matter if the deal goes through. Given the price that Level 3 is apparently willing to pay, an outside rival bid seems unlikely. It is possible, though, that there could be some antitrust concerns. (For more, see Mergers And Acquisitions: Understanding Takeovers.)
It would seem that there is enough competition from the likes of AT&T (NYSE:T), Verizon (NYSE:VZ), Akamai (Nasdaq:AKAM) and Limelight (Nasdaq:LLNW) in their respective and relevant businesses. Nevertheless, it is hard to see this deal making sense unless it drives up prices - neither company has been able to produce attractive free cash flow on its own, and many mergers have failed to deliver the presumed synergies. All of that said, the fact that both stocks are up so strongly after the announcement suggests that the Street is pretty confident that the deal will go through and that it will deliver on its potential.
The Bottom Line
From a top-line perspective, there are reasons to be optimistic on Level 3. Streaming media, software as a service and wireless backhaul are all gobbling up bandwidth, and deals with companies like Netflix (Nasdaq:NFLX) could drive that even further for Level 3.
The question still outstanding, though, is whether Level 3 can really produce an attractive economic return on its asset base. Even with so much installed capacity, the company still has hundreds of millions of ongoing capex needs and that consumes a lot of capital. There is likely a tipping point here where demand growth will finally improve the pricing environment, and the operating leverage at that point will likely be quite compelling. The problem with that scenario is the "when" and whether investors will be suitably rewarded for the time spent waiting.
Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!
by
Stephen D. Simpson, CFA
Stephen D. Simpson, CFA, is a freelance financial writer, investor, and consultant. He has worked as an equity analyst for both sell-side and buy-side investment companies in both equities and fixed income. Stephen's consulting work has focused primarily upon the healthcare sector, while he has also written extensively for publication on topics pertaining to investments, security analysis, and healthcare. Simpson operates the Kratisto Investing blog, and can be reached there.
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