Level 3 Communications (LVLT) will produce double digit FCF (free cash flow) and eps growth over the next several years. So why does it seem there is little interest in the stock. The stock has languished over the past year. The problem lies with market apprehension about top line growth; close to zero this year and low single digit next year. Refer to “Level 3 Communications - The Bad And The Good” to see how low top line growth leads to double digit bottom line growth rates over the next few years.
There is an event that could lead to increased top line growth going forward. The effect would not be felt immediately but over the course of the next few years should it take effect. What is this event? The ongoing FCC investigation into BDS (Business Data Services) also known as “special access”. Yes, I know boring stuff but could have a major impact on LVLT’s revenue growth pushing bottom line and FCF growth already at double digits higher.
There are also catalysts within managements control such as returning cash to shareholders or M&A we’ll look at, but first the FCC situation.
FCC Investigation Background
On October 15, 2015, the FCC opened an investigation into the incumbent LEC AT&T (T), CenturyLink (CTL), Frontier (FTR), and Verizon (VZ) business data services tariff pricing plans that incorporate a complicated web of all-or-nothing bundling, loyalty and term commitments, complex enforcing penalties, circuit migration rules and other provisions that in effect lock up substantial proportions of carrier and end-user demand, which locks out competition. CEO Jeff Storey had this to say about it on the Q3 2015 conference call:
"Today, many of the incumbents have what we consider demand lock-up agreements. It prevents customers from going to somebody else, because they lose discounts on all of their services if they put a little bit of their service with some other provider. That constrains trade. That constrains the ability of customers to move their traffic to Level 3... if they were to decide to eliminate those demand lock-up agreements, then there's a lot of opportunity for us that today is not really addressable... Even though companies want to move services to us, even though we can provide a better solution for them, they don't have the ability to move because they lose their discounts on their embedded base of services if they do. So we think it's a very positive event. We look forward to the FCC making final rulings, and we'll be very actively participating in their process to provide them with our insight and our input in the process."
In letters to the FCC, Level 3 states that "the incumbents use a combination of devices to lock up the market for special access services, shrinking the addressable market for any carrier that wishes to provide service in competition with the incumbent LECs. Level 3 further states that, "regrettably, left largely unchecked, many price cap LECs have been able to use their market dominance to force nearly all of their major customers (many of which are also their competitors) to 'lock-up' 85% to 100% of their existing special access purchases with the price-cap LEC." The Government Accountability Office observed that "these types of contracts may inhibit choosing competitive alternatives... Unless a competitor can meet the customer's entire demand, the customer has an incentive to stay with the incumbent... even if the competitor is less expensive."
There are more examples and issues under investigation in the FCC order but you get the idea; if businesses must use one provider for all their services it makes it difficult to impossible to shop around for individual services no matter how low a competitor’s price. Reminds me of how cable and satellite TV was offered for many years; hundreds of channels with little choice, i.e., all or nothing. It appears that model is being disrupted with Netflix, Hulu, Amazon and a host of other competitors.
FCC Recent Events
FCC Chairman Tom Wheeler’s proposal would prevent Carriers from forcing customers (defined as businesses) to use all-or-nothing pricing plans allowing them to use the services of various carriers vs. love it or leave it as it presently exists.
Mandating fair terms and conditions based on the findings in the FCC’s May2,2016 Tariff Investigation Order, including:
Barring new “all-or-nothing” plans that force users to make all of their purchases under one plan rather than split them among more tailored and cost-effective options
Reining in excessive penalties for early termination or failure to purchase a set minimum amount of capacity
The BDS item is not on FCC’s meeting agenda before the election for obvious reasons. A Democratic win would seal the deal while a Republican win may not. That said I believe it’s only a matter of time as it is for bundled TV services. You can slow change but you can’t stop it.
If the final order becomes reality Level 3 will be in a stronger position to take market share from the LEC’s.
Returning Cash To Shareholders
Management has spoken on several occasions about what to do with their growing cash pile. Past CEO comments:
Q2 2016 Conference call:
"Beyond investing in the business, I want to take a minute to address the topic of capital allocation. We don't have an update at this time, but I wanted to note that we've heard your suggestions on our options for deploying any excess cash. We continue to work closely with our board of directors on the best and highest use of that cash, including M&A and the potential return of cash to stockholders."
Q1 2016 Conference call:
"returning cash to stockholders makes perfect sense to us."
Q4 2015 Conference call:
"returning capital to stockholders is an appropriate consideration. Keeping in mind that 2015 was only the second year we generated substantial free cash flow, we will continue to be very disciplined in our efforts to drive revenue growth, adjusted EBITDA growth and consistent growth in free cash flow per share. All of our capital allocation decisions are evaluated through the lens of providing the best return for our stockholders."
Low top line growth generates approximately $6.6 Billion in FCF thru 2020 so returning cash to shareholders should not be a problem. So, what are they waiting for? They want to get to the low end of their target leverage range of three to four times. They exited Q2 2016 with net debt to adjusted EBITDA ratio of 3.5. Q1 2016 was 3.7 and Q4 2015 was 3.8. Given this countdown we are probably within two quarters for a decision.
Market perception is for continued anemic top line growth going forward. The long-term risk is small and the potential long-term reward large should growth start to improve pushing the estimated $6.6 Billion in FCF thru 2020 much higher. I expect the next earnings report (11/3/16) to show little to no improvement in top line growth but expect FCF to exceed $1 Billion in 2016 and grow going forward.
M&A
The only scenario that would prevent returning cash to stockholders would be an M&A event which was mentioned in the Q2 2016 conference call noted above. There have also been rumors of LVLT being acquired. Past price estimates have been in the $70 range. These rumors have been raised in the past first with Comcast and recently with CenturyLink. Whether any M&A occurs is anyone's guess.
I have no crystal ball so I can’t say what will be announced but am confident one of the three events will occur within the next six months changing the market perception from ignoring this stock to taking notice again.
Either way LVLT is undervalued at this point as modeled here. The model is interactive and allows you to perform what ifs by changing growth rates, ratios, etc.
