Question: You have been a long-term investor of Level 3. The company has been doing poorly and in a lot of financial stress. What is your thesis in investing in Level 3 (LVLT)? Isn’t it a value trap?
Level 3 is among the world’s largest internet backbone service companies offering a unique combination of long-haul and metropolitan fiber routes spanning 45 countries on 3 continents. No other single provider offers the same range of global coverage. Demand is rapidly growing aided by the increase in mobile and cloud computing as well as growth from voice, data and video traffic across the internet. Over the last ten years, rising demand combined with industry consolidation have enabled pricing strength as excess capacity from overbuilding in the dot.com era has declined. Because of the high contribution margins in this largely fixed cost business, revenue increases will drive large free cash flow and value growth. The current top line value growth makes Level 3 one of our most compelling investments.The company sells far below our appraisal for several reasons including the perception of “financial stress” echoed in your question. While Level 3 has a history of being highly levered, the company has successfully managed its capital structure even through the challenge of the financial crisis. Last year’s acquisition of Global Crossing essentially removed the company’s debt strain as EBITDA to Net Debt greatly improved. The acquisition also added three board members from Temasek, the Singaporean fund, who will bring additional focus on successful sales execution. While some would argue that the company sells near industry EBITDA multiples, those views do not account for Level 3’s lower required capex and a substantial tax advantage relative to competitors.
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