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LVLT > SEC Filings for LVLT > Form 10-Q on 6-Aug-2013All Recent SEC Filings

Show all filings for LEVEL 3 COMMUNICATIONS INC

Form 10-Q for LEVEL 3 COMMUNICATIONS INC


6-Aug-2013

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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 for the year ended December 31, 2012, 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 for the year ended December 31, 2012, 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 25 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.

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 for the year ended December 31, 2012. 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;

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 or expand its addressable market;

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 the 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 is important to the success of Level 3. The Company must identify synergies and integrate acquired networks and support organizations, while maintaining the


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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 and financial condition, and extending the maturity dates of certain debt, as described below and in greater detail in Note 6 - Long-Term Debt in the notes to the consolidated financial statements.

In January 2013, the Company repaid at maturity approximately $172 million of its 15% Convertible Senior Notes due 2013.

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 by Channel:
                                        Three Months Ended June 30,         Six Months Ended June 30,
(dollars in millions)                      2013              2012             2013             2012
Core Network Services:
North America - Wholesale Channel    $           367     $       382     $         739     $       763
North America - Enterprise Channel               603             574             1,198           1,135
EMEA - Wholesale Channel                          88              94               177             190
EMEA - Enterprise Channel                         99              91               196             179
EMEA - U.K. Government Channel                    33              43                70              91
Latin America - Wholesale Channel                 40              37                80              75
Latin America - Enterprise Channel               149             136               291             274
Total Core Network Services                    1,379           1,357             2,751           2,707
Wholesale Voice Services and Other               186             229               391             465
Total Revenue                        $         1,565     $     1,586     $       3,142     $     3,172

Total revenue consists of:

Core Network Services revenue from colocation and data center services; transport and fiber; IP and data services; and local and enterprise voice services.

Wholesale Voice Services and Other revenue from sales of 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 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. The Company believes that trends in its communications business are best gauged by analyzing revenue changes in Core Network Services.


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Core Network Services

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 55 countries. These services are secure, redundant and flexible to fit the varying needs of the Company's customers. Services, which vary by location, include hosting network equipment used to transport high speed data and voice over Level 3's global network; providing managed IT services, installation, maintenance, storage and monitoring of enterprise services; and providing comprehensive IT outsource solutions.

Growth in transport (such as private line and wavelengths) 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, in the case of private line, wavelength or dark fiber services, either monthly payments or up-front payments. 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.

IP and data services primarily include the Company's high speed Internet Protocol ("IP"), dedicated Internet access ("DIA"), virtual private network ("VPN"), content delivery network ("CDN"), media delivery, Vyvx broadcast, Converged Business Network, 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.

Voice services comprise a broad range of local and enterprise voice services using VoIP and traditional circuit-switch based technologies, including VoIP enhanced local service, SIP Trunking, local inbound service, Primary Rate Interface service, long distance service and toll-free service. The Company's voice services also include its comprehensive suite of audio, web and video collaboration services.

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 2012, which has continued in 2013.

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 sized enterprises, 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 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.


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The wholesale channel includes revenue from incumbent and alternative carriers in each of the regions, global carriers, wireless carriers, cable companies, satellite companies, regional service providers 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, pricing is 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," 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 is in the process of discontinuing managed modem services and has notified all current managed modem customers of this decision. 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 which began 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 for the year ended December 31, 2012, filed with the Securities and Exchange Commission.

Critical Accounting Policies

Refer to Item 7 of the Company's Form 10-K for the year ended December 31, 2012, for a description of the Company's critical accounting policies.


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Results of Operations for the Three and Six Months Ended June 30, 2013 vs. 2012

                            Three Months Ended June 30,                     Six Months Ended June 30,
(dollars in                                            Change                                        Change
millions)                2013             2012            %             2013            2012            %
Revenue             $     1,565       $    1,586           (1 )%   $     3,142      $    3,172           (1 )%
Cost of Revenue             616              648           (5 )%         1,245           1,305           (5 )%
Depreciation and
Amortization                199              191            4  %           393             378            4  %
Selling, General
and
Administrative              610              614           (1 )%         1,209           1,240           (3 )%
Total Costs and
Expenses                  1,425            1,453           (2 )%         2,847           2,923           (3 )%
Operating Income            140              133            5  %           295             249           18  %
Other Income
(Expense):
Interest income               -                1         (100 )%             -               2         (100 )%
Interest expense           (167 )           (181 )         (8 )%          (336 )          (370 )         (9 )%
Loss on
extinguishment of
debt, net                     -                -            -  %             -             (61 )       (100 )%
Other, net                   14               (7 )         NM              (36 )             2           NM
Total Other
Expense                    (153 )           (187 )        (18 )%          (372 )          (427 )        (13 )%
Loss Before
Income Taxes                (13 )            (54 )        (76 )%           (77 )          (178 )        (57 )%
Income Tax
Expense                     (11 )             (8 )         38  %           (25 )           (22 )         14  %
Net Loss            $       (24 )     $      (62 )        (61 )%   $      (102 )    $     (200 )        (49 )%


___________________
NM - Not meaningful

Discussion of all significant variances:

Revenue by Service Offering:
                                          Three Months Ended June 30,                    Six Months Ended June 30,
(dollars in millions)                  2013          2012        Change %            2013            2012        Change %
Core Network Services Revenue      $     1,379     $ 1,357            2  %     $    2,751          $ 2,707            2  %
Wholesale Voice Services and

Other Revenue                              186         229          (19 )%            391              465          (16 )%
Total Revenue                      $     1,565     $ 1,586           (1 )%     $    3,142          $ 3,172           (1 )%




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Revenue by Product Offering:
                                     Three Months Ended June 30,                    Six Months Ended June 30,
(dollars in millions)             2013           2012        Change %           2013             2012        Change %
Colocation and Data Center
Services                      $       145     $    139           4  %     $      287          $    277           4  %
Transport and Fiber                   488          485           1  %            972               965           1  %
IP and Data Services                  514          497           3  %          1,024               988           4  %
Voice Services (local and
enterprise)                           232          236          (2 )%            468               477          (2 )%
Total Core Network Services         1,379        1,357           2  %          2,751             2,707           2  %
Wholesale Voice Services
and Other                             186          229         (19 )%            391               465         (16 )%
Total Revenue                 $     1,565     $  1,586          (1 )%     $    3,142          $  3,172          (1 )%

Revenue decreased 1% to $1.565 billion in the three months ended June 30, 2013 compared to $1.586 billion in the same period of 2012 and decreased 1% to $3.142 billion in the six months ended June 30, 2013, from $3.172 billion in the same period of 2012. The decrease was driven by declines in Wholesale Voice Services and Other revenue partially offset by growth in Core Network Services revenue from enterprise customers.

The Company experienced growth in its IP and data services and colocation and data center services during the three and six months ended June 30, 2013 compared to the same period of 2012 driven primarily by end user customer demand for content delivery over the Internet and enterprise bandwidth. The Company also experienced modest growth in transport and fiber services during the first half of 2013. Core Network Services revenue for voice services declined during the three and six months ended June 30, 2013, primarily due to the anticipated attrition of certain U.K. Government channel voice services.

Core Network Services revenue increased in the North America and Latin America regions during the three and six months ended June 30, 2013 compared to the same period of 2012, as a result of growth in services provided to the existing enterprise customer base and the acquisition of new customers in the enterprise channel. These increases were partially offset by (i) a decrease in the EMEA region's Core Network Services revenue primarily as a result of lower U.K. Government and wholesale channel revenue and (ii) a decrease in wholesale channel revenue in the North American region.

Wholesale Voice Services and Other revenue decreased in the three and six months ended June 30, 2013 compared to the same period of 2012 primarily as a result of declines in usage. The Company continues to manage its combined wholesale voice services platform for margin contribution. 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. The Company is in the process of discontinuing managed modem services and has notified all current managed modem customers of this decision.

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 39% in the three months ended June 30, 2013 compared to 41% in the same period of 2012 and was 40% in the six months ended June 30, 2013 compared to 41% in the same period of 2012. The decreases are primarily due to an improving gross margin mix of 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.

Depreciation and Amortization increased 4% to $199 million in the three months ended June 30, 2013, from $191 million in the same period of 2012 and increased 4% to $393 million in the six months ended June 30, 2013,


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from $378 million in the same period in 2012. The increase is primarily attributable to incremental capital expenditures.

Selling, General and Administrative ("SG&A") includes 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 decreased 1% to $610 million in the three months ended June 30, 2013 compared to $614 million in the same period of 2012 and decreased 3% to $1.209 billion in the six months ended June 30, 2013, from $1.240 billion in the same period in 2012. The decreases are primarily due to lower employee cash compensation and other employee related costs, professional fees and vendor services and other discretionary costs. Employee cash compensation and other employee related costs decreased as the Company continued to integrate the Global Crossing business and achieve cost synergies through the reduction of headcount as well as the higher capitalization of labor costs related to the implementation of information technology systems, network deployment and customer installation activities. Professional fees and vendor services and other discretionary costs decreased primarily due to the rationalization and renegotiation of vendor services and lower travel and entertainment costs. In addition during the first quarter of 2012, the Company incurred approximately $15 million of integration costs related to the Global Crossing acquisition. The integration was substantially complete by the end of 2012.

Also included in SG&A in the three and six months ended June 30, 2013, were $48 million and $85 million, respectively, and in the three and six months ended June 30, 2012, $29 million and $53 million, respectively, of non-cash, stock-based compensation expenses related to grants of outperform stock options, restricted stock units, accruals for the Company's annual discretionary bonus, incentive and retention plans and shares issued for the Company's matching contribution for the 401(k) plan. The increase in non-cash, stock-based compensation expense is primarily due to additional stock grants subsequent to March 31, 2012 and accruing the annual discretionary bonus at a higher target rate in 2013 than in 2012, as well as the vesting of long term incentive awards in connection with James Q. Crowe's departure from the Company, as described below.

On April 11, 2013, the Company announced that Jeff K. Storey had been appointed by the Board of Directors, effective immediately, to be the Company's president and Chief Executive Officer. As a result of the departure of James Q. Crowe, the Company incurred an SG&A charge of approximately $23 million in the second quarter of 2013, consisting of $6 million of additional cash compensation expenses and $17 million in non-cash compensation expenses related to the vesting of certain of Mr. Crowe's long term incentive awards payable under the terms of his employment agreement.

Adjusted EBITDA, as defined by the Company, is net income (loss) from the . . .

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