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LEVEL 3 COMMUNICATIONS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations
(Edgar Glimpses Via Acquire Media NewsEdge)
The following discussion should be read in conjunction with the Level 3
Communications, Inc. and its subsidiaries ("Level 3" or the "Company")
consolidated financial statements (including the notes thereto), included
elsewhere herein and the Company's Form 10-K, as amended, for the year ended
December 31, 2011 filed with the Securities and Exchange Commission.
This document contains forward looking statements and information that are based
on the beliefs of management as well as assumptions made by and information
currently available to the Company. When used in this document, the words
"anticipate", "believe", "plan", "estimate" and "expect" and similar
expressions, as they relate to the Company or its management, are intended to
identify forward-looking statements. Such statements reflect the current views
of the Company with respect to future events and are subject to certain risks,
uncertainties and assumptions. Should one or more of these risks or
uncertainties materialize, or should underlying assumptions prove incorrect,
actual results may vary materially from those described in this document. For a
more detailed description of these risks and factors, please see the Company's
Form 10-K, as amended, for the year ended December 31, 2011 filed with the
Securities and Exchange Commission and Item 1A in Part II of this Form 10-Q.
Executive Summary
Overview
The Company is a facilities-based provider of a broad range of communications
services. Revenue for communications services is generally recognized on a
monthly basis as these services are provided. For contracts involving private
line, wavelength and dark fiber services, Level 3 may receive up-front payments
for services to be delivered for a period of generally up to 20 years. In these
situations, Level 3 defers the revenue and amortizes it on a straight-line basis
to earnings over the term of the contract.
On October 4, 2011, a wholly owned subsidiary of Level 3 completed its
amalgamation with Global Crossing and the amalgamated entity became an indirect
wholly owned subsidiary of the Company through a tax free, stock for stock
transaction (the "Amalgamation"). In addition, after the close of business on
October 19, 2011, Level 3 completed a 1 for 15 reverse stock split as previously
approved by the Company's stockholders in connection with its announcement to
transfer the listing of its common stock to the New York Stock Exchange on
October 20, 2011. The reverse stock split automatically combined every fifteen
shares of issued and outstanding Level 3 common stock into one share of common
stock without any change in the par value per share. All share and per share
references for all periods presented have been adjusted to give effect to the
reverse stock split.
Level 3, through its two 50% owned joint-venture surface mines, one each in
Montana and Wyoming, sold coal primarily through long-term contracts with public
utilities. In November 2011, Level 3 completed the sale of its coal mining
business to Ambre Energy Limited as part of its long-term strategy to focus on
core business operations. As a result of the transaction, all of the assets and
liabilities associated with the coal mining business have been removed from
Level 3's balance sheet. The financial results of the coal mining business are
included in the Company's consolidated results of operations through the date of
sale, and all periods presented have been revised to reflect the presentation
within discontinued operations.
Business Strategy and Objectives
The Company pursues the strategies discussed in Item 1. Business, "Business
Overview and Strategy" as discussed in its Form 10-K, as amended, for the year
ended December 31, 2011. In particular, with respect to strategic financial
objectives, the Company focuses its attention on the following:
• growing Core Network Services revenue by increasing sales;
• continually improving the customer experience to increase customer
retention and reduce customer churn;
• completing the integration of acquired businesses;
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• reducing network costs and operating expenses;
• achieving sustainable generation of positive cash flows from operations in
excess of capital expenditures;
• continuing to show improvement in Adjusted EBITDA (as defined in this Item
below) as a percentage of revenue;
• concentrating its capital expenditures on those technologies and assets
that enable the Company to develop its Core Network Services;
• managing Wholesale Voice Services for margin contribution; and
• refinancing its future debt maturities.
The Company's management continues to review all existing lines of business and
service offerings to determine how those lines of business and service offerings
enhance the Company's focus on delivery of communications services and meeting
its financial objectives. To the extent that certain lines of business or
service offerings are not considered to be compatible with the delivery of the
Company's services or with meeting its financial objectives, Level 3 may exit
those lines of business or stop offering those services in part or in whole.
The successful integration of acquired businesses into Level 3, including Global
Crossing, is important to the success of Level 3. The Company must identify
synergies and integrate acquired networks and support organizations, while
maintaining the service quality levels expected by customers to realize the
anticipated benefits of any acquisition. Successful integration of any acquired
businesses will depend on the Company's ability to manage the operations,
realize opportunities for revenue growth presented by strengthened service
offerings and expanded geographic market coverage, and eliminate redundant and
excess costs to fully realize the expected synergies. If the Company is not able
to efficiently and effectively integrate any businesses or operations it
acquires, the Company may experience material negative consequences to its
business, financial condition or results of operations.
The Company has also been focused on improving its liquidity, financial
condition, and extending the maturity dates of certain debt.
In October 2012, Level 3 Financing, Inc. refinanced its existing $650 million
Tranche B II and $550 million Tranche B III Term Loans under its existing senior
secured credit facility through the creation of a new term loan in the aggregate
principal amount of $1.2 billion (the "Tranche B-II 2019 Term Loan"). The
Company used the net proceeds from the Tranche B-II 2019 Term Loan, along with
cash on hand, to repay Level 3 Financing, Inc.'s $650 million Tranche B II and
$550 million Tranche B III Term Loans under the existing credit agreement
maturing in September 2018. See Note 13 - Subsequent Events in the notes to the
consolidated financial statements for additional information.
In September 2012, the Company fully repaid the outstanding principal of its
Commercial Mortgage due 2015 along with accrued interest which was approximately
$63 million. See Note 8 - Long-Term Debt in the notes to the consolidated
financial statements for additional information.
In August 2012, the Company completed the offering of $300 million aggregate
principal amount of its 8.875% Senior Notes due 2019 in a private offering. The
net proceeds from the offering of the notes will be used for general corporate
purposes, including the potential repurchase, redemption, repayment or
refinancing of the Company's and its subsidiaries' existing indebtedness from
time to time. See Note 8 - Long-Term Debt in the notes to the consolidated
financial statements for additional information.
Also in August 2012, Level 3 Financing, Inc. completed the offering of $775
million aggregate principal amount of its 7% Senior Notes due 2020 in a private
offering. The net proceeds from the offering of the notes, along with cash on
hand, were used to redeem all of the Company's outstanding 8.75% Senior Notes
due 2017, including the payment of accrued interest and applicable premiums. See
Note 8 - Long-Term Debt in the notes to the consolidated financial statements
for additional information.
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Level 3 Financing, Inc. refinanced its existing $1.4 billion Tranche A Term Loan
under its existing senior secured credit facility through the creation of new
term loans in the aggregate principal amount of $1.415 billion (the "New Term
Loans") in August 2012. The Company used the net proceeds from the New Term
Loans, along with cash on hand, to repay Level 3 Financing, Inc.'s $1.4 billion
Tranche A Term Loan under the existing credit agreement maturing in March 2014
and used remaining net proceeds to repay $15 million in principal amount plus
premium for existing vendor financing obligations. See Note 8 - Long-Term Debt
in the notes to the consolidated financial statements for additional
information.
In March 2012, the Company exchanged approximately $100 million aggregate
principal amount of its outstanding 15% Convertible Senior Notes due 2013 for
approximately 3.7 million shares of Level 3's common stock into which the notes
were convertible plus an additional 1.7 million shares for a total of
approximately 5.4 million shares. See Note 8 - Long-Term Debt in the notes to
the consolidated financial statements for additional information.
In January 2012, Level 3 Financing, Inc. issued $900 million aggregate principal
amount of its 8.625% Senior Notes due 2020 in a private transaction. A portion
of the net proceeds from the offering were used in February 2012 to redeem all
of Level 3 Financing's outstanding 9.25% Senior Notes due 2014 in aggregate
principal amount of $807 million. See Note 8 - Long-Term Debt in the notes to
the consolidated financial statements for additional information.
The Company will continue to look for opportunities to improve its financial
position and focus its resources on growing revenue and managing costs for the
business.
Revenue and Service Offering
Three Months Ended September 30, Nine Months Ended September 30,
(dollars in millions) 2012 2011 2012 2011
Core Network Services:
North America - Wholesale
Channel $ 381 $ 334 $ 1,144 $ 993
North America - Enterprise
Channel 627 341 1,858 995
EMEA - Wholesale Channel 89 51 272 152
EMEA - Enterprise Channel 80 31 240 87
EMEA - U.K. Government
Channel 41 - 131 -
Latin America - Wholesale
Channel 36 1 103 3
Latin America - Enterprise
Channel 141 - 415 1
Total Core Network Services $ 1,395 $ 758 $ 4,163 $ 2,231
Wholesale Voice Services and
Other 195 169 599 523
Total Revenue $ 1,590 $ 927 $ 4,762 $ 2,754
Total revenue consists of:
• Core Network Services revenue from colocation and data center services,
transport and fiber, IP and data services, and voice services.
• Wholesale Voice Services and Other revenue from long distance voice services,
revenue from managed modem and its related intercarrier compensation services
and revenue from the "SBC Master Services Agreement," which was obtained
through an acquisition in 2005.
Core Network Services revenue represents higher margin services and Wholesale
Voice Services and Other revenue represents lower margin services. Core Network
Services revenue requires different levels of investment and focus and provides
different contributions to the Company's operating results than Wholesale Voice
Services and
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Other revenue. Management of Level 3 believes that growth in revenue from its
Core Network Services is critical to the long-term success of its business. The
Company also believes it must continue to effectively manage gross margin
contribution from the Wholesale Voice Services component and the positive cash
flows from the Other revenue component of Wholesale Voice Services and Other
revenue. The Company believes that trends in its communications business are
best gauged by analyzing revenue changes in Core Network Services.
Core Network Services
Growth in transport and fiber revenue is largely dependent on increased demand
for bandwidth services and available capital of companies requiring
communications capacity for their own use or in providing capacity as a service
provider to their customers. These expenditures may be in the form of monthly
payments or up-front payments for private line, wavelength or dark fiber
services. The Company is focused on providing end-to-end transport and fiber
services to its customers to directly connect customer locations with a private
network. Pricing for end-to-end metropolitan transport services have been
relatively stable. For intercity transport and fiber services, the Company
continues to experience pricing pressure in locations where a large number of
carriers co-locate their facilities. An increase in demand may be offset by
declines in unit pricing.
Colocation and data center services allow customers to place their network
equipment and servers in suitable environments maintained by the Company with
high-speed links providing on net access to more than 45 countries. These
services are secure, redundant and flexible to fit the varying needs of the
Company's customers. Services include hosting network equipment used to
transport high speed data and voice over Level 3's global network; providing
managed IT services (hosting), installation, maintenance, storage and monitoring
of enterprise services; and providing comprehensive IT outsource solutions.
IP and data services primarily include the Company's high speed Internet
protocol service ("IP"), dedicated Internet access ("DIA") service, virtual
private network ("VPN") services, content delivery network ("CDN") service,
media delivery service, Vyvx broadcast service, Converged Business Network
service, Asynchronous Transfer mode ("ATM") and frame relay services. Level 3's
IP and high speed IP service is high quality and is offered in a variety of
capacities. The Company's VPN service permits businesses of any size to replace
multiple networks with a single, cost-effective solution that greatly simplifies
the converged transmission of voice, video, and data. This convergence to a
single platform can be obtained without sacrificing the quality of service or
security levels of traditional ATM and frame relay offerings. VPN service also
permits customers to prioritize network application traffic so that high
priority applications, such as voice and video, are not compromised in
performance by the flow of low priority applications such as email.
The Company believes that one of the largest sources of future incremental
demand for the Company's Core Network Services will be from customers that are
seeking to distribute their feature rich content or video over the Internet.
Revenue growth in this area is dependent on the continued increase in demand
from customers and the pricing environment. An increase in the reliability and
security of information transmitted over the Internet and declines in the cost
to transmit data have resulted in increased utilization of e-commerce or web
based services by businesses. Although the pricing for data services is
currently relatively stable, the IP market is generally characterized by price
compression and high unit growth rates depending upon the type of service. The
Company experienced price compression in the high-speed IP and voice services
markets in 2011, which has continued in 2012.
The following provides a discussion of the Company's Core Network Services
revenue in terms of the enterprise and wholesale channels.
• The enterprise channel includes large, multi-national enterprises
requiring large amounts of bandwidth to support their business operations,
such as financial services companies, healthcare companies, content
providers, and portal and search engine companies. It also includes medium
enterprises and regional service providers who buy services regionally or
locally, as well as government markets, including the U.S. federal
government, the systems integrators supporting the U.S. federal
government, U.S. state and local
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governments, academic consortia, and certain academic institutions. Included in
the enterprise channel, but broken out separately in the table above, is the
U.K. government channel, which includes revenue primarily from the government
sector in the U.K.
• The wholesale channel includes revenue from incumbent and alternative
carriers in each of the regions, global carriers, wireless carriers, cable
companies, satellite companies, and voice service providers.
The Company believes that the alignment of Core Network Services around channels
should allow it to drive growth while enabling it to better focus on the needs
of its customers. Each of these channels is supported by dedicated employees in
sales. Each of these channels is also supported by non-dedicated, centralized
service delivery and management, product management and development, corporate
marketing, global network services, engineering, information technology, and
corporate functions, including legal, finance, strategy and human resources.
Wholesale Voice Services and Other
The Company offers wholesale voice services that target large and existing
markets. The revenue potential for wholesale voice services is large; however,
the pricing and margins are expected to continue to decline over time as a
result of the new low-cost IP and optical-based technologies. In addition, the
market for wholesale voice services is being targeted by many competitors,
several of which are larger and have more financial resources than the Company.
The Company also has other revenue derived from mature services that are not
critical areas of emphasis for the Company, including revenue from managed modem
and its related intercarrier compensation services and SBC Contract Services,
which includes revenue from the "SBC Master Services Agreement," which was
obtained in the December 2005 acquisition of WilTel Communications Group, LLC.
The Company and its customers continue to see consumers migrate from narrow band
dial-up services to higher speed broadband services as the narrow band market
matures. The Company expects ongoing declines in the other revenue component of
Wholesale Voice Services and Other similar to what has been experienced over the
past several years.
The Company receives compensation from other carriers when it terminates traffic
originating on those carriers' networks. This intercarrier compensation is based
on interconnection agreements with the respective carriers or rates mandated by
the Federal Communications Commission ("FCC"). The Company has interconnection
agreements in place for the majority of traffic subject to intercarrier
compensation. Along with addressing other matters, on November 18, 2011, the FCC
established a prospective intercarrier compensation framework for terminating
switched access and Voice Over Internet Protocol ("VoIP") traffic, with elements
of it becoming effective beginning on December 29, 2011. Under the framework,
most terminating switched access charges and all intercarrier compensation
charges are capped at current levels, and will be reduced to zero over, as
relevant to Level 3, a six year transition period beginning July 1, 2012.
Several states, industry groups, and other telecommunications carriers filed
petitions in federal court for reconsideration of the framework with the FCC,
although the outcome of those petitions is unpredictable. A majority of the
Company's existing intercarrier compensation revenue is associated with
agreements that have expired terms, but remain effective in evergreen status. As
these and other interconnection agreements expire, the Company will continue to
evaluate simply allowing them to continue in evergreen status (so long as the
counterparty allows the same) or negotiating new agreements. The Company earns
intercarrier compensation revenue from providing managed modem services, which
are declining. The Company also receives intercarrier compensation from its
voice services. In this case, intercarrier compensation is reported within Core
Network Services revenue.
For a detailed description of the Company's broad range of communications
services, please see Item 1. Business - "Our Services Offerings" of the
Company's Form 10-K, as amended, for the year ended December 31, 2011 filed with
the Securities and Exchange Commission.
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Hurricane Sandy
Level 3's business has been affected by Hurricane Sandy in the Northeast region
of the United States during the fourth quarter of 2012. Level 3 continues to
address issues affecting its network and to restore services to customers
affected by the storm. In addition, revenue from Level 3's usage-based services
may be adversely affected by storm-related business interruptions affecting its
customers. The timing of the installation of services ordered by customers and
Level 3's resulting revenue may also be adversely affected by limitations on the
ability of third party access providers to provision services in the region on a
timely basis. It is not possible at this time to estimate the effect that the
storm may have on Level 3's operating results in the fourth quarter of 2012.
Based on information that is available to management on the date of this report,
Level 3 does not expect that the direct and indirect effects that the storm has
on its operating results in the fourth quarter of 2012 will be significant;
however, it is possible that this expectation could change once additional
information regarding the effect of the storm damage is available.
Critical Accounting Policies
Refer to Item 7 of the Company's Form 10-K, as amended, for the year ended
December 31, 2011 for a description of the Company's critical accounting
policies.
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Results of Operations for the Three and Nine Months Ended September 30, 2012 and
2011:
Three Months Ended September 30, Nine Months Ended September 30,
Change Change
(dollars in millions) 2012 2011 % 2012 2011 %
Revenue $ 1,590 $ 927 72 % $ 4,762 $ 2,754 73 %
Cost of Revenue 642 342 88 % 1,947 1,046 86 %
Depreciation and
Amortization 185 203 (9 )% 563 612 (8 )%
Selling, General and
Administrative 619 375 65 % 1,851 1,089 70 %
Restructuring Charges 6 - NM 14 - NM
Total Costs and Expenses 1,452 920 58 % 4,375 2,747 59 %
Operating Income 138 7 NM 387 7 NM
Other Income (Expense):
Interest income - - NM 2 - NM
Interest expense (188 ) (178 ) 6 % (558 ) (495 ) 13 %
Loss on extinguishment
of debt, net (49 ) (30 ) 63 % (110 ) (73 ) 51 %
Other, net (54 ) (1 ) NM (52 ) 5 NM
Total Other Expense (291 ) (209 ) 39 % (718 ) (563 ) 28 %
Loss Before Income Taxes (153 ) (202 ) (24 )% (331 ) (556 ) (40 )%
Income Tax Expense (13 ) (6 ) 117 % (35 ) (36 ) (3 )%
Loss from Continuing
Operations (166 ) (208 ) (20 )% (366 ) (592 ) (38 )%
Income (Loss ) from
Discontinued Operations,
Net - 1 (100 )% - (1 ) (100 )%
Net Loss $ (166 ) $ (207 ) (20 )% $ (366 ) $ (593 ) (38 )%
NM - Not meaningful
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Discussion of all significant variances:
Total Revenue by Service Offering
Three Months Ended September 30, Nine Months Ended September 30,
(dollars in millions) 2012 2011 Change % 2012
2011 Change %
Core Network Services $ 1,395 $ 758 84 % $ 4,163 $ 2,231 87 %
Wholesale Voice
Services and Other 195 169 15 % 599 523 15 %
Total Revenue $ 1,590 $ 927 72 % $ 4,762 $ 2,754 73 %
Revenue increased 72% to $1.590 billion in the three months ended September 30,
2012 from $927 million in the same period of 2011 and increased 73% to $4.762
billion in the nine months ended September 30, 2012 from $2.754 billion in the
same period of 2011. The increase is primarily driven by the additional revenue
associated with the Global Crossing acquisition completed in the fourth quarter
of 2011. Excluding revenue from the Global Crossing acquisition, revenue from
enterprise customers contributed to the growth in Core Network Services revenue.
The Company experienced growth in each of its service offerings during the three
and nine months ended September 30, 2012 compared to the same periods in 2011 as
a result of the Global Crossing acquisition. Excluding revenue from the Global
Crossing acquisition, revenue growth in IP and data services and voice services
during the three and nine months ended September 30, 2012 was driven primarily
by end customer demand for content delivery over the internet and enterprise
bandwidth, as well as increased usage for voice services. Growth in transport
and fiber services and colocation and data center services was more modest
during the three and nine months ended September 30, 2012.
Core Network Services revenue increased in the North America, EMEA and Latin
America regions during the three and nine months ended September 30, 2012
compared to the same periods of 2011 primarily as a result of the Global
Crossing acquisition. Excluding revenue from the Global Crossing acquisition,
revenue increased in the North America region during the three and nine months
ended September 30, 2012 compared to the same periods of 2011.
Wholesale Voice Services and Other revenue increased in the three and nine
months ended September 30, 2012 compared to the same periods in 2011 as a result
of the Global Crossing acquisition. Excluding revenue from the Global Crossing
acquisition, Wholesale Voice Services and Other revenue decreased in the three
and nine months ended September 30, 2012 due to declines in usage. The Company
continues to manage its combined wholesale voice services platform for margin
growth, and expects continued volatility in revenue as a result of this
strategy. In addition, the Company expects managed modem and SBC Contract
Services revenue to continue to decline due to an increase in the number of
subscribers migrating to broadband services and as a result of the migration of
the SBC traffic to the AT&T network, respectively.
Cost of Revenue includes leased capacity, right-of-way costs, access charges,
satellite transponder lease costs, and other third party costs directly
attributable to the network, but excludes depreciation and amortization and
related impairment expenses.
Cost of revenue as a percentage of total revenue was 40% and 41% for the three
and nine months ended September 30, 2012 compared to 37% and 38% in the same
periods of the prior year. The increase is due to inclusion of costs associated
with the Global Crossing business, which has lower gross margins, in the current
year periods compared to the same periods of 2011. This increase was partially
offset by an improving gross margin mix from higher margin on-net Core Network
Services and a decrease in lower margin Wholesale Voice Services and Other.
Additionally, the Company continues to implement initiatives to reduce both
fixed and variable network expenses.
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Depreciation and Amortization expense decreased 9% to $185 million in the three
months ended September 30, 2012 from $203 million in the same period in 2011 and
decreased 8% to $563 million in the nine months ended September 30, 2012 from
$612 million in the same period in 2011. The decrease is attributable to a
change in the estimated useful lives of certain of the Company's property, plant
and equipment that resulted in a reduction of depreciation expense in the three
and nine months ended September 30, 2012 compared to the same periods of 2011.
The change in accounting estimate was applied on a prospective basis effective
October 1, 2011 as required under the accounting standard related to changes in
accounting estimates. This decrease was partially offset by additional
depreciation and amortization as a result of the Global Crossing acquisition and
property, plant and equipment additions since September 30, 2011.
Selling, General and Administrative ("SG&A") expenses include salaries, wages
and related benefits (including non-cash, stock-based compensation expenses),
property taxes, travel, insurance, rent, contract maintenance, advertising,
accretion expense on asset retirement obligations and other administrative
expenses. SG&A expenses also include certain network related expenses such as
network facility rent, utilities and maintenance costs.
SG&A expenses increased 65% to $619 million in the three months ended
September 30, 2012 compared to $375 million in the same period of 2011 and
increased 70% to $1.851 billion in the nine months ended September 30, 2012 from
$1.089 billion in the same period in 2011. The increase is primarily due to SG&A
expenses associated with the Global Crossing acquisition, including integration
costs of approximately $18 million and $50 million for the three and nine months
ended September 30, 2012, higher employee compensation and related costs as the
Company continued to increase its sales, support and customer service delivery
headcount, and merit increases effective in the first quarter of 2012. These
increases were partially offset by cost synergies achieved as a result of the
Global Crossing acquisition in the three and nine months ended September 30,
2012.
Also included in SG&A expenses in the three and nine months ended September 30,
2012 were $49 million and $102 million, respectively, and in the three and nine
months ended September 30, 2011, $26 million and $68 million, respectively, of
non-cash, stock-based compensation expenses related to grants of outperform
stock options, restricted stock units, accruals for the Company's discretionary
bonus, incentive and retention plans and shares issued for the Company's
matching contribution for the 401(k) plan.
Restructuring Charges in the three and nine months ended September 30, 2012 were
$6 million and $14 million, respectively, compared to less than $1 million in
the same periods of 2011. The increase in the three and nine months ended
September 30, 2012 compared to the same periods of 2011 was primarily due to
reductions in headcount associated with the Global Crossing acquisition, as the
Company had not initiated any significant new workforce reduction plans in 2011.
The Company may initiate additional restructuring activities in future periods
in connection with the efforts to optimize its cost structure or in connection
with the Amalgamation of Global Crossing. Additional restructuring activities
could result in additional headcount reductions and related charges.
Adjusted EBITDA, as defined by the Company, is net income (loss) from the
consolidated statements of operations before (1) income tax benefit (expense),
(2) total other income (expense), (3) non-cash impairment charges included
within restructuring charges, (4) depreciation and amortization expense,
(5) non-cash stock compensation expense included within selling, general and
administrative expenses and (6) discontinued operations.
Adjusted EBITDA is not a measurement under generally accepted accounting
principles ("GAAP") and may not be used in the same way by other companies.
Management believes that Adjusted EBITDA is an important part of the Company's
internal reporting and is a key measure used by management to evaluate
profitability and operating performance of the Company and to make resource
allocation decisions. Management believes such measurement is especially
important in a capital-intensive industry such as telecommunications. Management
also uses Adjusted EBITDA to compare the Company's performance to that of its
competitors and to eliminate certain non-cash and non-operating items in order
to consistently measure from period to period its ability to fund capital
expenditures, fund growth, service debt and determine bonuses.
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Adjusted EBITDA excludes non-cash impairment charges and non-cash stock
compensation expense because of the non-cash nature of these items. Adjusted
EBITDA also excludes interest income, interest expense and income tax benefit
(expense) because these items are associated with the Company's capitalization
and tax structures. Adjusted EBITDA also excludes depreciation and amortization
expense because these non-cash expenses reflect the effect of capital
investments which management believes are better evaluated through cash flow
measures. Adjusted EBITDA excludes net other income (expense) because these
items are not related to the primary operations of the Company.
There are limitations to using non-GAAP financial measures, including the
difficulty associated with comparing companies that use similar performance
measures whose calculations may differ from the Company's calculations.
Additionally, this financial measure does not include certain significant items
such as interest income, interest expense, income tax benefit (expense),
depreciation and amortization expense, non-cash impairment charges, non-cash
stock compensation expense and net other income (expense). Adjusted EBITDA
should not be considered a substitute for other measures of financial
performance reported in accordance with GAAP.
The following information provides a reconciliation of Net Loss to Adjusted
EBITDA as defined by the Company (dollars in millions):
Three Months Ended September 30, Nine Months Ended September 30,
2012 2011 2012 2011
Net Loss $ (166 ) $ (207 ) $ (366 ) $ (593 )
Income Tax Expense 13 6 35 36
Total Other Expense 291 209 718 563
Depreciation and
Amortization Expense 185 203 563 612
Non-Cash Compensation
Expense 49 26 102 68
Discontinued Operations
of Coal Mining Business - (1 ) - 1
Adjusted EBITDA $ 372 $ 236 $ 1,052 $ 687
Consolidated Adjusted EBITDA was $372 million in the three months ended
September 30, 2012 compared to $236 million in the same period of 2011 and was
$1.052 billion in the nine months ended September 30, 2012 compared to $687
million in the same period of 2011. The increase in Adjusted EBITDA in the three
and nine months ended September 30, 2012 is primarily attributable to Adjusted
EBITDA associated with the Global Crossing acquisition and growth in the
Company's higher incremental margin Core Network Services revenue and continued
improvements in cost of revenue.
Interest Expense increased 6% to $188 million in the three months ended
September 30, 2012 from $178 million in the same period of 2011 and increased
13% to $558 million in the nine months ended September 30, 2012 from $495
million in the same period of 2011. Interest expense increased as a result of
higher average debt balance for 2012 compared to 2011, including financing
associated with the Global Crossing acquisition, partially offset by lower cost
of borrowing on refinanced debt.
The Company expects annual interest expense in 2012 to be approximately $740
million based on the Company's outstanding debt as of September 30, 2012, and
taking into consideration the current interest rates on the Company's variable
rate debt and the October 2012 incurrence of the $1.2 billion Tranche B-II 2019
Term Loan under the amended and restated credit agreement (along with the
repayment of the existing $650 million Tranche B II and $550 million Tranche B
III Term Loans). See Note 8 - Long-Term Debt and Note 13 - Subsequent Events of
the Notes to Consolidated Financial Statements for more details regarding the
Company's financing activities.
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Loss on Extinguishment of Debt, net was $49 million and $110 million in the
three and nine months ended September 30, 2012, compared to a loss of $30
million and $73 million in the three and nine months ended September 30,
2011. The loss recorded during 2012 was related to a charge of approximately $9
million related to the refinancing of the $1.4 billion Tranche A Term Loan in
August 2012 and the repayment of existing vendor financing obligations, a charge
of approximately $40 million as a result of the redemption of the 8.75% Senior
Notes due 2017 in August 2012, a charge of approximately $22 million related to
the redemption of the 9.25% Senior Notes due 2014 in February 2012 and a charge
of approximately $39 million as a result of the exchange of a portion of the 15%
Convertible Senior Notes due 2013 for approximately 5.4 million shares of Level
3 stock in March 2012. The loss recorded during 2011 was related to a charge of
approximately $29 million recognized for the July 2011 conversion of the 15%
Convertible Senior Notes due 2013, a charge of less than $1 million for the 3.5%
Senior Notes due 2012 repurchased in August 2011, a $23 million charge
recognized for the portion of the 9.25% Senior Notes due 2014 redeemed in April
2011 and a $20 million charge recorded in the first quarter of 2011 resulting
from the redemption of the 5.25% Convertible Senior Notes due 2011 in February
2011 and the exchange of the 9% Convertible Senior Discount Notes due 2013 in
January 2011. See Note 8 - Long-Term Debt, of the Notes to the Consolidated
Financial Statements for more details regarding the Company's financing
activities.
The Company may enter into additional transactions in the future to repurchase
or exchange existing debt that may result in gains or losses on the
extinguishment of debt.
Other, net was $54 million and $52 million of expense in the three and nine
months ended September 30, 2012, respectively compared to $1 million of expense
and $5 million of income in the same periods of the prior year. Other, net is
primarily comprised of foreign currency gains and losses, gains and losses on
the sale of non-operating assets and other income. Other, net in the three and
nine months ended September 30, 2012 was driven by a non-cash loss on the
Company's interest rate swaps agreements of approximately $60 million that were
deemed "ineffective" under GAAP in connection with the refinancing of the $1.4
billion Tranche A Term Loan. See Note 8 - Long-Term Debt, of the Notes to the
Consolidated Financial Statements for more details regarding the Company's
financing activities.
Income Tax Expense was $13 million and $35 million in the three and nine months
ended September 30, 2012 compared to $6 million and $36 million in the same
periods of 2011. The income tax expense in 2012 was primarily related to income
taxes for Latin American entities acquired as part of the Global Crossing
acquisition. The income tax expense during the nine months ended September 30,
2011 is primarily related to an out of period adjustment due to taxable
temporary differences associated with certain indefinite-lived intangible assets
that the Company is unable to offset with deductible temporary differences.
The Company also incurs income tax expense attributable to income in various
Level 3 subsidiaries that are required to file state or foreign income tax
returns on a separate legal entity basis. The Company also recognizes accrued
interest and penalties in income tax expense related to uncertain tax benefits.
Income (Loss) from Discontinued Operations was income of $1 million and a loss
of $1 million in the three and nine months ended September 30, 2011,
respectively. Level 3 sold its coal mining business in the fourth quarter of
2011, and accordingly, reflected the coal mining business as discontinued
operations in 2011.
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Financial Condition - For the nine months ended September 30, 2012 and 2011
Cash flows provided by operating activities, investing activities and financing
activities for the nine months ended September 30, 2012 and 2011, respectively,
are summarized as follows:
Nine Months Ended September 30,
(dollars in millions) 2012 2011 Change
Net Cash Provided by Operating
Activities of Continuing
Operations $ 178 $ 199 $ (21 )
Net Cash Used in Investing
Activities of Continuing
Operations (538 ) (405 ) (133 )
Net Cash Provided by Financing
Activities of Continuing
Operations 234 54 180
Net Cash Used in Discontinued
Operations - (4 ) 4
Effect of Exchange Rates on Cash
and Cash Equivalents 1 1 -
Net Change in Cash and Cash
Equivalents $ (125 ) $ (155 ) $ 30
Operating Activities of Continuing Operations
Cash provided by operating activities of continuing operations decreased to $178
million in the nine months ended September 30, 2012 compared with $199 million
in the same period in 2011 primarily due to higher interest paid and an increase
in the use of cash for working capital items.
Investing Activities of Continuing Operations
Cash used in investing activities of continuing operations increased in the nine
months ended September 30, 2012 compared to the same period of 2011 primarily as
a result of additional capital expenditures, which totaled $545 million in the
nine months ended September 30, 2012 compared to $346 million in the same period
of the prior year. The increase was primarily driven by the inclusion of Global
Crossing in the Company's results since the acquisition date. The increase was
partially offset by a decrease of $15 million in restricted cash and securities,
net in the nine months ended September 30, 2012 compared to a $63 million
increase in the same period in 2011.
Financing Activities of Continuing Operations
Cash provided by financing activities of continuing operations increased in the
nine months ended September 30, 2012 compared to the same period of 2011 as a
result of greater borrowings net of payments on and repurchases of debt and
capital leases during 2012. See Note 8 - Long-Term Debt of the Notes to the
Consolidated Financial Statements for more details regarding the Company's debt
transactions during 2012.
Cash Flows of Discontinued Operations
Net cash used in discontinued operations was $4 million in the nine months ended
September 30, 2011. The Company completed the sale of its coal mining business
on November 14, 2011.
Liquidity and Capital Resources
The Company incurred a net loss of $366 million in the nine months ended
September 30, 2012 and $593 million in the same period of 2011. In connection
with its continuing operations, the Company used $545 million for capital
expenditures and $234 million of cash was provided by financing activities in
the nine months ended September 30, 2012. This compares to $346 million of cash
used for capital expenditures and $54 million of cash flows provided by
financing activities in the same period of the prior year.
Net cash interest payments are expected to increase to approximately $695
million in 2012 from the $576 million made in 2011 based on forecasted interest
rates on the Company's variable rate debt outstanding as of September 30, 2012
and the October 2012 incurrence of the $1.2 billion Tranche B-II 2019 Term Loan
under the
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amended and restated credit agreement (along with the repayment of the existing
$650 million Tranche B II and $550 million Tranche B III Term Loans).
Capital expenditures for 2012 are expected to remain relatively consistent as a
percentage of revenue with 2011, as the Company invests in base capital
expenditures (estimated capital required to keep the network operating
efficiently and support new service development) with the remaining capital
expenditures expected to be partly success-based, which is tied to a specific
customer revenue opportunity, and partly project-based where capital is used to
expand the network based on the Company's expectation that the project will
eventually lead to incremental revenue. As of September 30, 2012, the Company
had debt contractual obligations, including capital lease and commercial
mortgage obligations, and excluding interest, premium and discounts on debt
issuance and fair value adjustments, of $11 million that mature in the remainder
of 2012, $210 million in 2013 and $16 million in 2014.
In October 2012, Level 3 Financing, Inc. refinanced its existing $650 million
Tranche B II and $550 million Tranche B III Term Loans under its existing senior
secured credit facility through the creation of a new Tranche B-II 2019 Term
Loan in the aggregate principal amount of $1.2 billion. The Company used the net
proceeds from the Tranche B-II 2019 Term Loan, along with cash on hand, to repay
Level 3 Financing, Inc.'s $650 million Tranche B II and $550 million Tranche B
III Term Loans under the existing credit agreement maturing in September 2018.
In September 2012, the Company fully repaid the outstanding principal of its
Commercial Mortgage due 2015 along with accrued interest which was approximately
$63 million.
In August 2012, the Company completed the offering of $300 million aggregate
principal amount of its 8.875% Senior Notes due 2019 in a private offering. The
net proceeds from the offering of the notes will be used for general corporate
purposes, including the potential repurchase, redemption, repayment or
refinancing of the Company's and its subsidiaries' existing indebtedness from
time to time.
Also in August 2012, Level 3 Financing, Inc. completed the offering of $775
million aggregate principal amount of its 7% Senior Notes due 2020 in a private
offering. The net proceeds from the offering of the notes, along with cash on
hand, were used to redeem all of the Company's outstanding 8.75% Senior Notes
due 2017, including the payment of accrued interest and applicable premiums. The
Company recognized a loss on extinguishment of debt of $40 million in the third
quarter of 2012 as a result of the redemption of the 8.75% Senior Notes due
2017.
Level 3 Financing, Inc. refinanced its existing $1.4 billion Tranche A Term Loan
under its existing senior secured credit facility through the creation of new
term loans in the aggregate principal amount of $1.415 billion in August 2012.
The Company used the net proceeds from the New Term Loans, along with cash on
hand, to repay Level 3 Financing, Inc.'s $1.4 billion Tranche A Term Loan under
the existing credit agreement maturing in March 2014 and used remaining net
proceeds to repay $15 million in principal amount plus premium for existing
vendor financing obligations. The Company recognized a loss on the
extinguishment of debt of $9 million in the third quarter of 2012 as a result of
refinancing the $1.4 billion Tranche A Term Loan and repayment of existing
vendor financing obligations. In addition, in connection with the refinancing of
the Tranche A Term Loan, the Company recognized a $60 million non-cash loss on
two interest rate swaps that had previously hedged changes in the interest rate
on a portion of the Tranche A Term Loan. See Note 7 - Derivative Financial
Instruments of the Notes to Consolidated Financial Statements.
In March 2012, the Company entered into an exchange agreement for a portion of
its 15% Convertible Senior Notes due 2013. Pursuant to the agreement,
approximately $100 million aggregate principal amount of Level 3's outstanding
15% Convertible Senior Notes due 2013 were exchanged for approximately 3.7
million shares of Level 3's common stock into which the notes were convertible
plus an additional 1.7 million shares for a total of approximately 5.4 million
shares. The consideration was based on the market price for these notes which
included an inducement premium and included a payment for accrued and unpaid
interest from January 15, 2012 through March 15, 2012 of approximately $2
million. This transaction did not include the payment by the Company of any
cash. The Company recognized a loss on extinguishment of $39 million in the
first quarter of 2012 as a result of this exchange of the 15% Convertible Senior
Notes due 2013. The transaction will reduce cash interest expense by
approximately $15 million on an annual basis.
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In January 2012, Level 3 Financing, Inc. issued $900 million aggregate principal
amount of its 8.625% Senior Notes due 2020 in a private transaction. A portion
of the net proceeds from the offering were used to redeem all of Level 3
Financing's outstanding 9.25% Senior Notes due 2014 in aggregate principal
amount of $807 million. The Company recognized a loss on extinguishment of $22
million in the first quarter of 2012 as a result of the redemption of the 9.25%
Senior Notes due 2014. The remaining proceeds constitute purchase money
indebtedness under the existing senior secured credit agreement and indentures
of Level 3 and will be used solely to fund the cost of construction,
installation, acquisition, lease, development or improvement of any
Telecommunications/IS Assets (as defined in the existing senior secured credit
agreement and indentures of Level 3), including the cash purchase price of any
past, pending or future acquisitions.
For information related to financing activities that occurred during 2011, see
Item 7 of the Company's Form 10-K, as amended, for the year ended December 31,
2011.
Level 3 had $793 million of cash and cash equivalents on hand at September 30,
2012. In addition, $47 million of current and non-current restricted cash and
securities are used to collateralize outstanding letters of credit, long-term
debt, and certain operating obligations of the Company. Based on information
available at this time, the Company believes that its current liquidity and
anticipated future cash flows from operations will be sufficient to fund its
business for at least the next twelve months.
The Company may need to refinance all or a portion of its indebtedness at or
before maturity and cannot provide assurances that it will be able to refinance
any such indebtedness on commercially reasonable terms or at all. In addition,
the Company may elect to secure additional capital in the future, at acceptable
terms, to improve its liquidity or fund acquisitions. In addition, in an effort
to reduce future cash interest payments as well as future amounts due at
maturity or to extend debt maturities, Level 3 or its affiliates may, from time
to time, issue new debt, enter into debt for debt, debt for equity or cash
transactions to purchase its outstanding debt securities in the open market or
through privately negotiated transactions. Level 3 will evaluate any such
transactions in light of the existing market conditions and the possible
dilutive effect to stockholders. The amounts involved in any such transaction,
individually or in the aggregate, may be material.
In addition to raising capital through the debt and equity markets, the Company
may sell or dispose of existing businesses, investments or other non-core
assets.
Consolidation of the communications industry may continue. Level 3 will continue
to evaluate consolidation opportunities and could make additional acquisitions
in the future.
Off-Balance Sheet Arrangements
Level 3 has not entered into off-balance sheet arrangements.
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