Level 3 makes opportunistic acquisition with Genuity purchase, but converts lag in market

By Ronda Fears

Nashville, Dec. 2 - Level 3 Communications Inc. followed through on a plan to make opportunistic acquisitions outlined six months ago when it scored a capital infusion of $500 million with the private sale of convertible notes.

The private placement with Berkshire Hathaway, Legg Mason and Longleaf Partners was seen as a major coup in July, and the company said its purchase of Genuity Inc. out of bankruptcy for roughly $242 million in cash is equally a major score.

"It is particularly true that Genuity is a compatible organization" with Level 3, said Level 3 CEO Jim Crowe on a company conference call Monday.

"Genuity, which is a successor to BBN, the company that helped invent the Internet, shares a common technical heritage with Level 3."

Traders said that Level 3 was very active Monday on the event, which was announced last week just before the Thanksgiving holiday, but suffered from the gyrations in the broader market.

The Level 3 6% convertible due 2009 was quoted up 0.375 point to 39.625 bid, 41.625 asked and the 6% convertible due 2010 up 0.75 point to 39.875 bid, 41.875 asked.

Level 3 shares ended down 39c to $5.71.

"I think the attitude is very positive toward Level 3 and particularly the news," said one convertible dealer.

"The converts have not had the pop that a lot of people would've like to have seen, though, not like the stock. Today, there was a mix of bargain hunting going on as well as some profit taking in the converts."

Level 3 shares were at $4.36 in July when the private placement convertible transaction took place. At that time, the 2009 convert was at 29 bid and the 2010 issue at 28 bid.

Some analysts are still negative on Level 3, however, particularly equity analysts.

"While Level 3 has clearly made strides in adapting to the challenging market place, we continue to believe that it needs to further restructure its balance sheet. Although with no major obligations coming due until 2007, it has 2-3 years of grace on our projections," said Merrill Lynch & Co. equity analyst Adam Quinton in a report, who also said he has a "negative view on the equity."

Pro forma financial details were sketchy, since the deal hasn't closed.

But, Sureel Choksi, Level 3 CFO, said the company expects to get cash-on-cash payback of its investment in Genuity within three years.

Initially, he said the deal will hamper Level 3's overall revenue run rate because of the price of previous contracts Genuity has with AOL and Verizon, as they step down in price, and some rise in churn rates is expected due to the bankruptcy.

But gross margins, costs and capital expenditures are expected to decline as a result of the acquisition, he said.

"In terms of incremental revenue provided by Genuity, a useful starting point might be the $223 million of revenue that Genuity reported during the third quarter, which equates to about $890 million on an annualized basis," Choksi said.

A big benefit of the transaction, he said, is that Level 3's business plan is not jeopardized.

"This transaction accelerates the point at which we achieve free-cash break-even," Choksi said.

"It serves to effectively delever our balance sheet through the addition of projected positive free cash flow with out having to take on additional debt."

Crowe said the deal is expected to close in first quarter 2003, subject to bankruptcy court and regulatory approvals.

All but one of Genuity's nine banks involved have approved the sale, he said, along with Genuity's two largest customers and its largest vendor. The two customers, America Online and Verizon, account for over 60% of Genuity's revenues, he noted.

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