The downgrade was based on Standard & Poor's assessment that Level 3 will not be able to generate substantial cash flows to materially reduce its leverage due to poor fundamentals of the data transport industry, says analyst Michael Tsao. The industry is expected to remain weak for many years due to excess capacity, slow demand for long-haul data services, and potentially increased competition from service providers that may emerge from bankruptcy. Given Level 3's substantial leverage, weak interest coverage, and limited liquidity, the company is not well positioned to deal with such weak industry fundamentals.
The rating was originally placed on CreditWatch with negative implications in January 2002 due to concerns that Level 3 would violate its minimum telecom revenue bank covenant. The company has been able to meet this covenant through additional revenues gained from two software companies that were acquired in the first half of 2002.
Based in part on the company's guidance of $400 million in consolidated adjusted EBITDA for 2002, debt to EBITDA leverage is projected to be about 16 times (x) at year-end 2002, with EBITDA interest coverage of less than 0.8x for the year. Liquidity of about $1.5 billion in cash and $650 million in availability under a revolving bank facility on July 31, 2002, provides only a limited safety margin after adjusting for future capital expenditures, working capital requirements, and more than $500 million in annual interest expense. With Level 3 now positioning itself as an industry consolidator, additional acquisitions have the potential to further strain liquidity.
Level 3 is a provider of long-haul data transport services. It has a 16,000 route-mile fiber network spanning the U.S. Commensurate with the downturn in the telecommunications sector, the company has taken active measures to stabilize its operations. These measures include focusing on financially solid customers, reducing overhead, cutting capital expenditures, and selling assets.
In addition, the company has sought ways to reduce its leverage and improve liquidity. In October 2001, $1.7 billion in senior and convertible subordinated notes were repurchased for about $731 million. In July 2002, $500 million in junior convertible subordinated notes were raised from a group of well-known investors. Although these steps are in the right direction, Standard & Poor's remains concerned that they are not sufficient to eliminate the possibility of a distressed debt exchange or bankruptcy filing.
Outlook: Level 3 operates in an industry that is likely to experience long-term capacity oversupply and weak demand. The potential for execution risks has also increased due to interest in making acquisitions. Given these factors, Standard & Poor's does not believe the company will have the ability in the foreseeable future to generate material free cash flow relative to its $6.4 billion in total debt. From Standard & Poor's RatingsDirect