Will Level 3 with GC Be Able to Compete in the Business Services Market?

Level 3 Communications Inc. announced today that it would buy Global Crossing (GC) in an all stock-for-stock transaction valued at US$1.9 billion (after assumed debt). As part of the deal, which is expected to close by year end, Level 3 will assume $1.1 billion of GC’s debt. The two companies had combined 2010 revenues of $6.26 billion.

The new Global Crossing will continue selling its fiber optic network to other carriers, but also intends to offer a menu of transport, IP and data services, content delivery, data center, collocation and voice services to business customers. Global Crossing will provide capabilities such as managed services, Communications as a Service (CaaS), and inter-continental virtual private networking capabilities.

The combined entity would be a huge fiber optic network operator. It would own thousands of miles of fiber optic cable across 70 countries. Level 3 is strong in North America and Europe, while Global Crossing has a robust presence in Latin America. Global Crossing’s enterprise customers will help Level 3 increase its current client base, which includes major telecommunications, cable and Internet business customers.

The press release announcing the deal makes several bold claims up front:

  • Combination creates a premier global communications provider with extensive network reach, global scale and a comprehensive service portfolio to deliver enhanced capabilities to customers
  • Transaction creates significant value through synergies; results in substantial improvement to balance sheet and credit profile
  • Expected to be Accretive to Level 3 on a free cash flow per share basis in 2013
  • Combination will position Level 3 to better address expansion opportunities in key global markets

For more information, please see: Level 3 to Acquire Global Crossing

Comment:

Level 3 and Global Crossing are two fallen stars of the optical networking boom and bust. Both have been on a steep decline since mid 2000 when the fiber optic bubble burst. Bermuda based Global Crossing filed bankruptcy in 2002, but re-emerged two years later with a new financial backer — Singapore Technologies Telemedia -which currently owns about 60 percent of the company. Level 3 avoided a similar fate with a cash infusion from Warren Buffett’s Berkshire Hathaway. Yet it too has struggled to grow revenue and profits. Last year, losses at Level 3 hit $622 million and reached $176 million at Global Crossing. As profits have eroded, Level 3’s financial situation has grown more precarious. The company’s debt stood at approximately $6 billion in December, 2010 and $1.1B more with this acquisition.

Global Crossing has been moving more into the content delivery market in recent years. It signed a deal in 2009 with CDN vendors Limelight and EdgeCast that gave Global Crossing customers access to their services. Last year, GC purchased Genesis Networks, a video fiber network operator that specialized in providing end-to-end IP video transmission services for major networks.

In North America, the biggest impact would likely be to give Global Crossing’s enterprise and multinational customer base access to Level 3’s metro networks. The combined entity would also participate in the faster growing Latin American market. Given the growth of networked video, e.g. over-the-top (OTT) video and telepresence/ high quality video conferencing, a broader customer base would be a big positive. Netflix uses Level 3’s network to deliver its OTT streaming video to its subscribers. The acquisition may also improve its balance sheet by cutting overall costs.

Level 3 already has significant shareholder support since Global Crossing’s largest investor -ST Telemedia- has agreed to vote in favor of the acquisition. Once the deal closes, ST Telemedia is to nominate directors to the board, relative to the size of its stake.

Analysis:

Will the combination of two struggling tier 2 carriers enable the combined entity to compete successfully with AT&T, Verizon Business (in the U.S.) and large global carriers like Telefonica (Latin America) and Deutsche Telekom (Europe)? We are skeptical while others are more sanguine.

“This is the start of consolidation,” said Donna Jaegers, an analyst with the research firm, D.A. Davidson & Co. “It’s not enough to firm up pricing overnight, but it’s a step in the right direction.”

Level 3 CEO James Crowe is calling this deal “transformational” for both companies. On the analyst call to discuss the deal, Mr. Crowe was most excited about new sales possibilities for both companies, considering the greater reach of their combined networks. Global Crossing would provide 33,000 fiber route miles outside the U.S. that Level 3 could sell to its global customers, while Level 3 would offer more metro connections for Global Crossing’s North American customers. “What we’ve all been trying to do is get more deals in front of more customers, and the combined set of assets with many more [sales] people touching customers will accomplish that,” Crowe said.

Mr. Crowe told the NY Times in a phone interview, “This will be a company with modern Internet infrastructure, across three different continents, connected by undersea cables that we control.” He also said the potential cost savings could amount to $2.5 billion, with $200 million in the first 18 months. With an improved balance sheet, analysts believe Level 3 could refinance its debt to cut its interest rates $100 million to $200 million per year.

Brian Washburn, research director, network services, for Current Analysis , says the deal is a chance for Global Crossing and Level 3 to reverse the recent negative trends in their financial performance. “All lines of Level 3 business are declining or stagnant and the net losses are not improving,” Washburn said. “Their numbers are trending in the wrong direction. The Global Crossing acquisition is a good move — because they get all the assets, and yes, assume some debt, in a stock swap. But more importantly, Level 3 gets a to-do project — they will spend the next several months shaving costs out of their internal business to increase profitability and get the numbers heading in the right direction, even if overall top-line revenue remains stagnant.”

Arthur Gruen, Chief Economist of Wilkofsky and Gruen thinks that most telecom mergers and acquisitions provide much less “bang for the buck” than industry pundits believe. For sure, the investment banks that arranged the deal make money, but shareholders may not come out ahead. While Mr. Gruen didn’t specifically comment on this Level 3-GC deal, he recently told me that mergers in the media, telecom and retail industries seldom produced the expected cost savings and improved profits. TimeWarner-aol, Alcatel-Lucent are two recent examples of consolidations that didn’t work out.

We’ve observed that acquisition of this scale rarely go smoothly and realize the promised benefits. The consolidation of operations support and network management systems is one huge obstacle. Another is to merge two different corporate cultures. Level 3 will face key decisions regarding its personnel when its workforce is joined with GC’s. Layoffs are inevitable.

This merger of two long haul, fiber based network operators, leaves the new Level 3 without a wireless broadband strategy. If the mobile enterprise that analysts are talking so much about is a reality, then the combined company must offer mobile broadband access to participate in the growth of mobile devices, mobile apps and mobile computing.

For sure, this deal will spark new interest in other fiber based carriers that sell wholesale bandwidth to telecom carriers/ ISPs and also offer hosting, IP VPN and other business class services to enterprise customers. Examples of such facility based carriers include Cogent Communications, Savvis, and XO Holdings.

Bottom line, this merger is an important test for the fiber facilities based telecom industry, which has been plagued for years by overcapacity and weak pricing. It remains to be seen if that condition will persist. It will also be interesting to see if the new entity can succesfully compete with the large (tier one) global network operators previously mentioned.

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