Level 3 Communications (LVLT, Financial) is a technology company that belongs to the industry of diversified communications.
The company owns and leases PPE required to provide integrated communication services. It has an extensive fiber optic network around the globe. Level 3 primarily provides IP and data services including Internet services, VPN and CDN, or media delivery services. It’s also involved in the provision of fiber and transport services including wavelength, private line, dark fiber and related services.
Level 3 generates most of its revenue from IP and data services and transport and fiber, which combined to bring in $5.92 billion in revenue during the year ended 2015, translating into around 28% year-over-year revenue growth. The company serves 500 markets across 60 countries. Level 3 was founded in 1884 and is based in Broomfield, Colorado.
Level 3's stock hasn’t been performing well recently as it lost around 15% of its value during the last month or so. Thanks to the revenue miss in the recent quarter, there seem to be no signs of reversal as of yet. Let’s look at some key thesis points and the valuation of the company to see if it falls under the value investing category.
The positives
The company is focused on corporate customers; 72% of the company’s revenue came from corporate customers during the second quarter, and 96% of the customer base of the company is made up of corporate customers. Due to the need for high bandwidth, cloud computing and private cloud services for enterprises, Level 3 will benefit from providing the needed infrastructure services to corporate customers going forward.
The company generates more than 30% of revenue from transport and fiber. As Internet delivery of video content is becoming the standard of video distribution, Level 3 will benefit from monetizing the use of its fiber optical network by content providers. Note that the company holds more than 33,000 route miles of undersea fiber optic cables around the world, and it also has purchased capacity from other undersea cable providers in Australia, Asia and Africa.
Content delivery network is another positive for the company. The company has a global communication network. Content delivery across the globe is a major problem for providers trying to compete on the content streaming side. Level 3’s global reach can be beneficial for players trying to compete on content internationally. Global presence is one of the key selling points for Level 3’s CDN services.
Regarding the industry, it’s set to witness double-digit growth in coming years. Cisco forecasts that IP traffic will grow 300% during the next five years. Moreover, the CDN market is expected to grow at 26% during 2015-2020, notes marketsandmarkets.
The problem
Despite a positive industry outlook, current quarter top-line was not impressive. Revenue had been stagnant for the second quarter as core network service revenue grew by 0.7% during the quarter. What’s more alarming is that the revenue was affected due to higher disconnects at the lower end of the company's enterprise customer base, according to the earnings report. This is indicative that management strategy in retaining and acquiring new corporate clients is not up to the mark; industry outlook and global position of Level 3 points to the contrary.
Although the industry outlook is positive and Level 3 is positioned well to benefit from IP growth, bandwidth growth and CDN growth, investors should look out for Level 3’s revenue growth in coming quarters as it will be indicative of management’s efficacy in landing new customers and retaining old ones.
Valuation
Assumptions include FCF growth of 5% during 2016-2020 and no growth in perpetuity. Note that these are cautious assumptions as earnings are expected to grow at 10% for the next five years, and double-digit industry growth is in the cards.
However, as the company posted stagnant revenue growth during the second quarter, FCF is assumed to be lower than the expected growth. The cost of equity is increased each year to reflect higher retained earnings and dilution in share count. CAPM is used to calculate the required rate of return. NASDAQ return is used as a proxy for market return.
Focus Equity Estimates
FCF-based valuation reveals that the stock has an upside of around 7% under cautious assumptions. Based on price-earnings (P/E), the stock seems to be on the expensive side. It’s trading at a forward 2017 P/E of 29 while earnings are only expected to grow at 10%. Further, the discounted EPS-based valuation indicates that the stock is priced for perfection.
Focus Equity Estimates
Final thoughts
Despite its strong position and positive industry prospects, the company showcased stagnant revenue growth in the first half of the year. Moreover, the current earnings call mentioned loss of corporate clients. The company failed to meet earnings estimates during the past four quarters. And there have been downward revisions in earnings' estimates from analysts. Unless the company rediscovers revenue growth in coming quarters, the stock is a hold.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
