Wholesale consolidation moves to the next Level

Level 3 Communications last week made its latest move — and maybe its last for a while — in a flurry of acquisitions with its $1.4 billion purchase of Broadwing Communications. In the process, the company not only eliminated a major competing national backbone provider but also significantly boosted its own emerging business markets group, improved its margins, reduced its debt level and raised its stock price, even though it is issuing more stock to make the Broadwing purchase, thus diluting existing investments.

Level 3 also dropped a significant pebble into the U.S. wholesale pond that is expected to have major ripple effects.

The Broadwing buy could well complete what is a remarkable transformation of Level 3 from a debt-ridden wholesale provider in a commodity market to a more financially stable provider of both enterprise and wholesale services on an end-to-end basis in the U.S. And while its mass doesn't approach that of mega-carriers AT&T and Verizon, Level 3 has clearly set itself apart from the rest of the competitive backbone players, including Global Crossing, Qwest, Savvis and XO Communications.

Level 3's management “gets an A-plus for dealing with their financial situation,” said Donna Jaegers, financial analyst with Janco Partners.

By acquiring Broadwing, Level 3 actually reduced its debt level from 9.7 times EBITDA (earnings before interest, taxes, depreciation and amortization) to about 7.7 times EBITDA, based on the fact that, as of June 30, Broadwing had $350 million in cash and only $200 million in debt.

In addition, Jaegers said, Broadwing's rising stock price makes its $170 million in convertible debt transformable into equity, and other Level 3 convertible debt is already “in the money” and could be converted to equity in 2008, under the debt covenants.

Wall Street acknowledged Level 3's savvy with a rising stock price. In heavy post-announcement trading, the stock jumped 13% to $6.02 before settling at $5.70 later in the week, still above the pre-Broadwing mark.

Level 3 clearly becomes the bully on the wholesale block, said Brian Washburn, industry analyst with Current Analysis. But he and Jaegers agree that there is still some turmoil ahead for remaining wholesale players.

“Level 3 has consolidated WilTel and now Broadwing — it has sucked a lot of the wholesale and nationwide fiber network into itself,” Washburn said. And just as it took large chunks of WilTel's fiber-optic capacity out of service, Level 3 is likely to do the same thing with Broadwing's 19,000 route-mile fiber network in places where it overlaps with existing Level 3 facilities, he added.

“Some of the routes that are not redundant, they will keep,” he said. “But the rest of it will be shut down.”