Beyond the obvious

Almost immediately after Level 3 Communications announced last week it had signed an agreement with Verizon Communications to provide co-location services and bandwidth capacity to the carrier's Global Solutions unit, the company's stock spiked.

It wasn't much of a spike — only about 40¢ — but considering the stock trades at just above $4 per share, it was enough to spark investor interest. And the Verizon contract wasn't much of a deal — analysts estimate the value between $10 million and $20 million, a pittance for a company that projects 2001 revenues of $2.1 billion.

But the power of the Verizon deal stems from what it symbolizes, said Vik Grover, senior vice president of equity research for Kaufman Brothers.

“The Verizon deal is a sign that supports their claim that they're going to focus on the 300 largest bandwidth consumers, which is the most recent revision to their model,” he said.

At first glance, shifting marketing focus to large stable companies might not seem like a thinking-outside-the-box breakthrough. But for Level 3, the shift, announced about a month ago, and its timing are critical.

The company last week posted a net loss for second quarter 2001 of $731 million, or $1.99 per share, including a one-time charge of $136 million related primarily to a restructuring announced earlier in the quarter. This compares with a net loss of $281 million and 77¢ per share year over year.

However, revenues for the second quarter were $389 million, a 66% increase over the $234 million posted the year before. According to CEO James Crowe, the company continues to pick up meaningful new business, but disconnects from failing customers have become an enormous drain on Level 3's bottom line.

“Since March, we have seen a ramp-up in the rate of disconnects and a commensurate slowing in the rate of increase of recurring revenue,” Crowe said. “And while we saw solid growth in the second quarter, we continue to project cancels and disconnects from financially weaker companies are approximately equal to installs from stable customers with growing needs.”

Level 3 estimates that “financially distressed” companies account for 90% of the disconnect notices it receives.

The early returns from the strategy shift are positive. But James Friedland, principal telecom service analyst for Robertson Stephens, thinks the company might be joining the game a little too late.

“They're focusing on what they need to be doing, but there are 14 backbones in the U.S. and 14 in Europe addressing a smaller group of customers, given the fact that a lot of the other players have gone out of business,” he said. “There's only so much to go around.”

Grover concurred. “They need an anchor tenant or some significant tenants with long-term contract agreements, and they don't really have those right now,” he said. The RBOCs are likely candidates for this, but most of them have already chosen their sides.”

That's not something that concerns Crowe, who believes new opportunities are about to develop.

“Over time carriers will need to choose whether they want to focus on selling services to customers or being network providers,” he said. “Many carriers have already signaled their intent and… tens of billions of dollars of demand are going to go to third parties. We are uniquely positioned… to get a substantial percentage of that demand.”

Crowe added that this phenomenon would be fueled in part by the “disaggregation of the traditional, very large interexchange carriers.” He pointed to AT&T as an example of how the new order might look.

“The parts and pieces of AT&T as they become publicly held and subject to scrutiny will no doubt look to buy from the most cost-effective sources to meet their needs,” Crowe said. “That's already starting. So the real question is: ‘How rapidly will it continue?’ Two or three years from now, you'll look back and see substantial amounts of network capacity — that traditionally would have been built internally — bought from third parties by major players.”

Frying the big fish

While losing $731 million in Q2 2001, Level 3 Communications also scored deals it believes are significant mileposts for its new direction

April 23	Yahoo Broadcast	Makes Level 3 primary bandwidth provider for multimedia site
May 10	France Telecom	Leases 2.5 Gb/s circuit between New York and L.A.
June 13	France Telecom	First to lease bandwidth on undersea cable connecting Hong Kong and Japan
June 25	EarthLink	Contracts for Internet access services
June 26	Microsoft	Signs three-year Internet access deal for MSN unit
June 28	Time Warner Telecom	Purchases intercity transmission capacity for $1.3 million over one year
July 16	Verizon Communications	Leases 7000 sq. ft. of co-location space and dedicated bandwidth
Source: Level 3