Telecosm - Ike Elliott

Dial-up Refuses to Die

The new Pew Internet report paints a not-so-rosy picture of broadband adoption in the U.S., including a stubborn dial-up Internet access market that just refuses to die, and contrary to what you might think, that's good news for broadband leader Level 3 Communications. 

According to the Pew survey,

"62% of dial-up users say they are not interested in giving up their current connection for broadband."

When asked what it would take for them to switch, here's what the reluctant dial-up users said:

Criteria for Switching to Broadband	% responding
Price of broadband needs to fall	35%
Nothing can convince me to move	19%
Broadband needs to become available	14%

19% refuse to move, for any reason!  So, like the plague victim in Monty Python's Holy Grail, dial-up is "not dead yet."  However, dial-up internet access is certainly ill:

Dial-up is down to about 10% of the population, but the curve is flattening out somewhat.  One thing you have to watch out for in this chart, which is directly from the Pew report, is that the time scale on the X-axis is not constant, with the last three data points separated by 5 months and 9 months, and the prior data points separated by about 12 months each on average.  That means that the curve is not actually flattening as much as the chart seems to imply. But, the curve IS flattening.   

Why is this good to Level 3 Communications?  Because Level 3 owns most of the wholesale dial-up Internet access market, and it is a high-margin product for them.  In the company's first quarter earnings report, they reported $51M in "Other Communications Revenue", which is mostly from their managed modem wholesale dial-up Internet access product.  This $51M was a 39% decline from 1st quarter 2007.  The flattening dial-up defection curve as shown in the Pew report would indicate a smaller decline in the coming year than what was seen in 2007.

If Level 3 were to see a 39% decline in "Other Communications Revenue" in 2008, then the $51M per quarter would drop to about $35M in 1st quarter of 2009.  I think the Pew report is showing that Level 3 will lose less than 39% in the coming year in "Other Communications Revenue."  This might turn into a small up-side surprise for Level 3 over the next few quarters.

"Level 3 is Back"

The world is starting to wake up to Level 3 again. In an article from Telephony Online, Janco Partners analyst Donna Jaegers says "Level 3 is back," referring to reports that Cogent is feeling pricing pressure for wholesale Internet access, and noting that the pressure is coming directly from Level 3. 

This is great news for Level 3, and the first market evidence I have seen reported in the press that Level 3 is once again aggressively ramping its sales efforts.  Go get 'em!

Level 3 on the Hunt Again?

Rob Powell has a couple of interesting posts over on the Telecom Ramblings blog about Global Crossing's UK unit being up for sale.  Rob speculated about potential buyers in a post the next day, including the possibility that Level 3 Communications might buy the unit, or the whole company, but worried that LVLT isn't operationally or financially ready to make that purchase yet.

Then came yesterday's Level 3 Annual Stockholders Meeting, in which CEO James Crowe said that Level 3 is open to doing the right acquisitions in Europe or in content delivery networks.  Could it be the Level 3 is on the hunt again, and this time the prey is Global Crossing UK?  Or is Limelight in the crosshairs?

Level 3 Annual Meeting Report

I have just returned from the Level 3 Communications Annual Meeting, held here in Broomfield, Colorado.  CEO James Crowe and CFO Sunit Patel hosted a meeting that was in some ways surprisingly tame, given the company's most recent twelve month history, including the announcement of the Big Miss in October and the resignation of the President and COO in March.  We seem to be far enough removed from these events that the shareholders are optimistic, once again.

I'll skip all the formalities in this report...yes, they re-elected the board and approved a motion to maybe do a reverse stock split, and a few other odds and ends.  Not a lot of suspense there.

Instead, I'll skip right to the fun part: the presentation by Jim and Sunit on the company's results and prospects, and then the Q&A.  Jim was his usual eloquent self, reminding me once again of why he inspires such loyalty.  His presentation was full of worthy Crowe-isms, including these:

"Make no mistake about it, at the end of the day the problem is management, meaning myself and the other top managers of the company." (referring to the company's widely-reported provisioning issues announced in the 2nd half of 2008).

"We screwed up, and I assure you it won't be the last time.' (in the apology to shareholders that Jim issued at the end of the meeting)

"Only two?" (answering a question about two complaints from former employees about "fear management": a lack of management by walking around and a perception of an old boys network more interested in self-preservation than the best interests of the company.  Of course, Jim went on to say that the company is now focused on reaching out to all employees).

Jim has an honesty, humility, and buck-stops-here mentality that is all too rare among chief executives and is refreshing to see.

Jim and Sunit gave the standard Level 3 pitch (here), and then took questions.  Here are some paraphrased highlights from the Q&A:

Q: Are WiFi networks and mobile phone networks a threat to Level 3?

A: A good part of our business is connecting anntenas together.  Today, most antenna towers don't drive enough traffic to justify fiber connectivity, but over time, that is changing.  It's a future opportunity for us.

Q: When will Level 3 be operationally ready to do more acquisitions?

A: "If business plagiarism were a crime, we'd have to go to jail, because we want to be the UPS or FedEx of our industry."  Project Unity (the project to integrate and automate the operational systems of the most recent six acquisitions) should be 2/3rds complete by the end of the year, meaning 2/3rds of orders should flow through Unity by then.  Our operational problem, though, wasn't in Content Distribution or in Europe.  If we had an opportunity in Content or in Europe, we might do it.

Q: (Ike made a thinly-veiled attempt to settle his bet with Dan Caruso by asking) Is Level 3's 75-80% growth in IP traffic representative of the industry or is the industry growing more slowly, meaning Level 3 is taking market share by growing more quickly?

A: (Jim refused to take the bait, and confessed he reads this blog by way of saying he had to be careful with his answer) Level 3 can only speak for traffic on our own backbone.  We grew, what, 90% last year, is that right, Jack? (CTO Jack Waters confirmed from the audience) We're projecting 75%-80% this year.  The industry lacks good third-party measurements of Internet growth.  We believe that 70% of demand comes from individuals, now, people with broadband in the home.  We expect more video traffic to continue to move to the Internet, because it is cheaper.  Standard-definition TV became cheaper to distribute on the Internet back in 2003, and HDTV became cheaper in 2006.  We think the Internet will grow in the range of 60%-110%, and we see no end to that.  And whether it is 60% or 110%, it is extraordinary unit growth.

Ah well...I was hoping Jim could get me off the hook from buying Caruso dinner, along with some outrageously overpriced wine.  No such luck, yet.

If you are not familiar with my bet with Dan, click the continuation link below to learn more.

"Toes" Starts a Blog!

I have just discovered that Rob Powell started a blog last week, and for those that track Level 3 Communications, this is big news.  That's because Rob Powell is one of the best of the "anonymous analysts" that haunt the Level 3 Investor Village message board, where he goes by the alias "toes_that_twinkle." 

In my occasional trips to the Level 3 Investor Village message board, I have learned to scan for posts from "toes," because they are almost always thoughtful, never ranting, and most importantly, on the mark.  He really digs through the SEC reports, and as a result has very deep and informed perspective on Level 3.  If you track Level 3, you are going to want to add Rob's new blog to your RSS reader. 

To start, I highly recommend Rob's post on the "Virtuous Circle" that awaits Level 3 if the stock rises enough to start calling their convertible debt. 

Rob, welcome to my blogroll!  I will be an avid reader of your posts.

How Level 3 Gets to Positive Cash Flow

Yesterday I posted about how Level 3's positive earnings report, and their forecast of positive cash flow before the end of the year, could be due to couple of things:

• Cost reductions in both capital expenditures and SG&A
• More rapid growth in wholesale Internet access utilization and revenue

Meanwhile, I've been picking through the posts from the "anonymous analysts" over on the Investor Village Level 3 message board, and have discovered some additional factors that should figure in to an outstanding year for Level 3.  You've got to hand it to this particular message board: it has a number of very talented and thoughtful posters, and they turn over a lot of rocks, and they share their findings.  I often learn from them.

• Gross margin improvement: The company forecast a slight improvement in gross margins this year, but since gross margins came down a little bit in the first quarter, the company must be counting on improving gross margins more in the remaining three quarters.  This margin improvement should come from additional transitioning of services to on-net fiber, and from slight increases in wholesale voice pricing.  This could add on the order of $20M or so per quarter in additional free cash flow.
• Lower interest expense:  Level 3's bond interest expenses are seasonally concentrated in the 1st, 2nd, and 3rd quarters.  Less interest expense in the 4th quarter equals more free cash flow at that time.

Add these factors to continued improvements in SG&A forecast by the company, and you could get enough cash flow improvement to meet or beat guidance even without increasing sales much at all.  Meanwhile, the company is adding 100 salespeople in the first half of this year, so we should see some of those new hires begin to hit their stride in the 4th quarter.

Many thanks to a certain members of the Investor Village gang for this info!

Level 3's Wholesale Internet Business Turning the Corner

Listening to the Level 3 Communications quarterly earnings conference call this morning, CEO Jim Crowe offered the following forecast for the company's IP business for 2008:

Bandwidth Growth: 75-80%
Pricing Decline: 25-30%

Taking these two data points and plotting them on the table I published last week in my post on "Is An Internet Industry Resurgence Coming?", we can now plot a range for Level 3's IP and Data Services revenue growth for 2008:

Industry Internet Year over Year Revenue Growth
	Rate of Price decline in price per Mbps
Rate of Bandwidth Growth	20%	22%	24%	26%	28%	30%	32%	34%	36%	38%	40%	42%	44%
50%	20%	17%	14%	11%	8%	5%	2%	-1%	-4%	-7%	-10%	-13%	-16%
55%	24%	21%	18%	15%	12%	9%	5%	2%	-1%	-4%	-7%	-10%	-13%
60%	28%	25%	22%	18%	15%	12%	9%	6%	2%	-1%	-4%	-7%	-10%
65%	32%	29%	25%	22%	19%	16%	12%	9%	6%	2%	-1%	-4%	-8%
70%	36%	33%	29%	26%	22%	19%	16%	12%	9%	5%	2%	-1%	-5%
75%	40%	37%	33%	30%	26%	23%	19%	16%	12%	9%	5%	1%	-2%
80%	44%	40%	37%	33%	30%	26%	22%	19%	15%	12%	8%	4%	1%
85%	48%	44%	41%	37%	33%	30%	26%	22%	18%	15%	11%	7%	4%
90%	52%	48%	44%	41%	37%	33%	29%	25%	22%	18%	14%	10%	6%
95%	56%	52%	48%	44%	40%	37%	33%	29%	25%	21%	17%	13%	9%
100%	60%	56%	52%	48%	44%	40%	36%	32%	28%	24%	20%	16%	12%
105%	64%	60%	56%	52%	48%	44%	39%	35%	31%	27%	23%	19%	15%
110%	68%	64%	60%	55%	51%	47%	43%	39%	34%	30%	26%	22%	18%
115%	72%	68%	63%	59%	55%	51%	46%	42%	38%	33%	29%	25%	20%

It looks like 23-33% revenue growth for Level 3's IP and Data Services Business this year, thanks to a small reduction in the rate of price compression, and an uptick in traffic growth at Level 3. This is much better than 2007, when the company's IP and Data Services revenue grew at about 8 or 9%.  A higher IP and Data Services growth rate could be a big part of why Level 3 is comfortable reiterating its forecast of 8-13% growth in Core Communications Services revenue for 2008. 

If Level 3 is representative of the Internet industry as a whole, then maybe we are seeing the beginning of a "resurgence," as Dan Caruso calls it, in the wholesale Internet industry, here in 2008, in revenue terms.  Does Level 3's traffic growth of 75-80% match the industry, or is Level 3 expecting to take market share and grow faster than the industry?  I suspect that Level 3 is growing faster than the industry, but that we may actually be seeing an uptick on overall industry growth rates from the 50-60% we saw last year.

Jim Crowe pointed to video delivery over the Internet as the big driver, citing a stat from Comscore that 10 billion videos were viewed over the Internet in February, a 65% year-over-year increase.  A continuation or acceleration of that growth rate in 2008 could nudge the overall Internet's traffic growth above 60%, since video files are so large.

It's going to use data from Level 3 to track this in the future, though, because Level 3 has stopped reporting revenue by product group and is now reporting revenue by customer segment instead. 

LVLT: Crowe Predicts CFBE For Remaining Three Quarters of 2008

Level 3 Communications released a promising earnings report this morning, with the highlight being this statement from CEO James Crowe:

"...we expect to be free cash flow breakeven for the remaining three quarters of this year."

That's big news, even though Crowe only meant that the next three quarters would cash flow breakeven on a cumulative basis.  Prior to today, the company had only predicted positive cash flow, on a run rate basis, by the end of 2008.   Today's statement accelerates the march to positive cash flow by at least one quarter, and maybe by two quarters three quarters.

It appears that the company is achieving this milestone by managing its SG&A and capital expenditures downward.  SG&A for 1Q08 was $418M, a cut of $21M from the $439M in 4Q07.  Capital expenditures were down to $113M in 1Q08, compared with $153M in 4Q07, a drop of $40M. 

Cost-cutting your way to profitability by itself would not inspire celebration, but there was other good news in the report:

• CFO Sunit Patel reaffirmed EBITDA guidance of $950M - $1.1B for 2008
• Patel also reaffirmed the company's projection "that Core Communications Services revenue will grow 8 to 13 percent for the full year 2008."

There had been speculation that the company would need to cut its sales forecast for 2008, due to a worsening economy and lack of demonstrated sales momentum, so a reaffirmation of revenue guidance is a very good sign.  Growing sales for the remainder of the year is key for Level 3.

The only dark lining on this silver cloud was that 1st quarter results in core network services revenue were sequentially lower than 4th quarter 2007.  This high-margin segment declined to $774M in 1Q08 from $783M in 4Q07.  The company telegraphed that revenue would be down a bit in the 1st quarter on their last quarterly earnings call.

Overall, though, things seem to be heading in the right direction, and the market likes the news, too.  The stock is trading at $2.69, up 13.5% on the day, so far.

I may post more after the conference call.

Full disclosure: I own Level 3 Communications stock.

The Bear Strikes Back

Interesting post today from Dan Caruso over on the Bear on Business blog, regarding my contention that the wholesale Internet access business isn't growing quickly, at least in revenue terms, due to price compression.  I used data from Level 3's quarterly reports, and from Qwest's quarterly reports to support the hypothesis, showing that neither company's revenue line for the business grew much in 2007. 

Now Dan raises the possibility that Level 3's Internet and Data Services revenue line is sufficiently corrupted by other revenue items that it isn't a reliable indicator of the growth of the wholesale Internet access business.  Dan's hypothesis is that revenue from discontinued or de-emphasized businesses is included in the Internet and Data Services revenue line item...revenue from things like IP-VPN services.  He even speculates there might be some retail VoIP revenue in there.  Dan's hope is that these businesses are shrinking at a rate that offsets and masks the true growth rate of Level 3's wholesale Internet acccess business.

Dan might be right on this point (gasp!), Level 3 might have a bunch of other businesses cluttering up their IP and Data services revenue line item.  Even so, the burden of proof is still on Dan to show how much of that revenue isn't related to Level 3's wholesale Internet access business.  And, keep in mind, that it is not only Level 3 who is showing slow growth in wholesale Internet access.

I told Dan I'd buy him dinner if he can prove that the wholesale Internet access business grew quickly, in revenue terms, in 2007, and that is no small bet, given Dan's expensive taste in wine!  I'm ready to pay up, though, if I must, just for the joy of getting to tell Dan to go find a rock, for once in my life!

Triangulating Internet Growth

In yesterday's post, we saw that the big Internet backbone providers like Level 3 Communications really want to see a boom in the rate of Internet bandwidth consumption, and would be thrilled if that boom was accompanied by a sudden reduction in the rate of bandwidth price declines.  More units sold for more money per unit equals bigger profits.

So, are we heading for a boom?  To get a read on that, I looked at Level 3's "IP and Data Services" revenue for 2007 to see if I could spot a trend.   Now, looking at a single company, like Level 3, is kind of dangerous when trying to extrapolate a trend for an entire industry, so take this analysis along with a disclaimer that, well, it could be wee bit speculative!

Here was Level 3's IP and Data Services revenue:

	1Q07	2Q07	3Q07	4Q07
Level 3 IP and Data Services Revenue ($millions)	$     144	$     143	$     144	$     153

You can see that revenue was really very flat until the fourth quarter, when it saw a 6% quarter-over-quarter jump.  You can interpret this data in one of two ways:

• Look at the entire year, which gives you an 8% annual revenue growth rate, supporting the hypothesis that price compression is eating most of the revenue you would otherwise achieve from bandwidth growth, or
• Look at just at the fourth quarter, and assume every quarter thereafter will grow just as much, and you get a much prettier 25% annual revenue growth rate.

Okay, assuming 2007 is a good guide for 2008, that gives us a range of 8-25% revenue growth in 2008.  So, how much bandwidth growth does that imply?  To find that, we need an assumption on how much prices will decline in 2008. 

Again, looking at 2007 as a guide, if you assume that Level 3's 2007 bandwidth growth matched the overall Internet's bandwidth growth, then you would have to assume that Level 3 grew 50-60% in bandwidth in 2007.  Some sources think that Level 3 officials have dropped hints that the actual bandwidth growth at Level 3 was more like 90% in 2007.  So, we have a range of 50% to 90% bandwidth growth in 2007.  This much bandwidth growth, combined with what we know about Level 3's Internet revenenue, results in a range of price compression between 28% (if bandwidth grew 50%) and 40% (if bandwidth grew 90%), year over year, for 2007.

What does all this mean for bandwidth growth in 2008?  Well, if 2008 is similar to 2007 in terms of revenue growth (8 to 25%) and price compression (28 to 40%), then you get a range of potential Level 3 bandwidth growth as follows:

Likely Level 3 2008 Internet Bandwidth Growth Range
	Price Compression
Revenue Growth	28%	40%
8%	50%	80%
25%	74%	108%

So, you're probably thinking "Thanks a lot, Ike.  So we know it should be somewhere between 50% and 108% bandwidth growth in 2008.  Thanks for narrowing it down!" 

I know this isn't much of a prediction, but I wanted to take you through the calculation of how you end up with this range of performance, because the analysis might indicate that an acce