Level 3's longer convertibles offer play on improving fundamentals, credit, Barclays says

By Rebecca Melvin

New York, May 11 -Level 3 Communications Inc.'s longer-dated convertibles are an attractive way to capitalize on the communications infrastructure provider's improving outlook expected over the next year, according to Barclays Capital convertibles and equity-linked strategies research.

Level 3's 3.5% convertibles due June 2012 and its 5.25% convertibles due December 2011 are longer dated than the company's 2.875% paper due July 2010, 6% convertibles due March 2010, and 6% convertibles due September 2009.

Level 3's leverage is falling, down from 10.5x in 2005 to 6x in 2008, and its liquidity has improved enough to cover debt maturities for the next two years, Barclays research analysts Venu Krishna and Kannan Venkateshwar wrote in a note Monday.

In addition, fundamental performance is expected to improve on potentially higher demand growth, they said.

The company has roughly $908 million of cash, enough to cover debt maturities for the next two years, as well as a forecasted positive free cash flow position for the first time in more than 11 years.

The free cash flow forecast is estimated at $102 million in 2009.

Improving fundamental performance is expected due to better management of costs, which should incrementally benefit if demand growth picks up.

"While demand growth has been elusive in the past, it may become more realistic going forward on the back of increasing volume of video on the internet as well as popularity of user-friendly interfaces like the iPhone and Kindle," the Barclays analysts said.

Barclays recommends going long the Level 3 3.5% convertibles due 2012 which have a 25% yield to their maturity in 3.1 years; and long the 5.25% convertibles due 2011 which have about a 21% yield to their maturity in 2.6 years.

Level 3 has grown into one of the largest communications infrastructure providers over the last few years through aggressive expansion and acquisitions, Barclays said.

But integration issues with these acquisitions, high leverage as well as demand growth falling short of expectations have resulted in the entire capital structure of the company being under pressure over the last couple of years.

"Going forward, developments at the sector and company levels make us believe that the long-term outlook on the name may begin to change during the year," the Barclays analysts wrote.

Fundamental performance has had steadily improving margins over the last couple of years despite often disappointing top line growth. It has surprised on margins on account of better control on cost.

This margin improvement has helped the company meet its target of achieving a free cash flow breakeven position in 2008 for the first time in eight years. The company expects to have a modest positive free cash flow in 2009.

Level 3 is a Broomfield, Colo.-based provider of internet protocol services, broadband transport and infrastructure services, collocation services and voice-over-internet-protocol services.

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