Level 3 Elopes with Broadwing

The smart deal gives Level 3 the means to transport data traffic, upping its appeal—and cost—as a potential acquisition for Google

by Steve Rosenbush

There's been intense speculation that Internet giant Google could be interested in acquiring the struggling telecom company Level 3 (LVLT). It began months ago when Google (GOOG) participated in a bid to provide free Internet service in the city of San Francisco via wireless technology. The thinking was that Google, with Level 3's nationwide fiber-optic network, could provide wireless Net service throughout the country.

Then on Oct. 10, Google agreed to acquire YouTube, setting off another round of speculation that Level 3's network would be perfect for zipping all of YouTube's videos around the country (see BusinessWeek.com, 10/10/06, "YouTube's New Deep Pockets").

Now it's Level 3's turn to make a big acquisition. On Oct. 17, the company announced plans to buy telecom provider Broadwing (BWNG) for $1.4 billion. The deal gives Level 3 local telecom operations and technology for efficiently transporting data traffic around the Internet. It improves Level 3's balance sheet, although it also makes it a more expensive acquisition candidate.

BANDWIDTH DEMAND

Level 3 sells telecom services to a number of big Internet companies, including Yahoo! (YHOO), Microsoft (MSFT), AOL (TWX), and YouTube. The telecom company also sold Google about $300 million worth of fiber-optic capacity about one year ago, says analyst Donna Jaegers of researcher Janco Partners. The Net companies use Level 3 telecom services to connect their servers to the telecom and cable companies that sell Internet access directly to consumers. Level 3 also provides services to corporations and telecom companies.

With its deal for YouTube, Google is placing a huge bet on the growth of Internet video. The company told analysts and investors at the time of the acquisition that it hopes to be able to put more advertising on video clips on the Net. If it realizes its high hopes for video, Google might conceivably generate enough traffic to justify owning its own telecom network. Google also could use that network to offer free high-speed Internet access across the U.S., supporting the service with additional advertising.

Level 3 Chairman and CEO Jim Crowe declined to comment on rumors suggesting that Google could acquire Level 3. However, he said in an interview on Tuesday that he believes online video will spur rising demand for Internet bandwidth. "We think entertainment and video are moving to the Internet, and that will be a huge driver of demand for bandwidth," Crowe said.

HEAVY DEBT

While an acquisition looks unlikely, at least in the near future, Google and Level 3 may forge closer commercial ties during the coming years. If anything, the Level 3–Broadwing deal may decrease the odds of a buyout by Google, Jaegers said. "The Level 3–Broadwing deal is complex and requires a lot of integration. Companies rarely do such deals if they believe they are going to be bought out," she said.

Level 3 will reduce its debt level by acquiring Broadwing, a step that could make it more attractive to an acquirer. Its debt level will fall from 9.7 times earnings before interest, taxes, depreciation, and amortization (EBITDA) to about 7.7 times EBITDA. But that reduction still could be high enough to discourage a buyer.

Level 3 is expensive, with a market cap of $7 billion and $6.5 billion worth of debt. That means Level 3 would cost $13.5 billion, before an acquirer paid a premium. "Google would have to take all that debt, and it would end up acquiring much more capacity than it needs," Jaeger said.

MORE TRAFFIC

In all probability, Level 3 will remain independent for the present. The Broadwing deal, at least, makes that easier. In addition to improving the balance sheet, Level 3 is acquiring Broadwing's cash flow, which will be useful as the company's debt matures. It is due to pay off $140 million in 2008, $360 million in 2009, and the remainder of its debt between 2010 and 2013.

There are no covenants on the debt. The increased cash flow and cleaner balance sheet mean that it probably can replace its long-term debt, which carries interest rates as high as 12%. Thanks to a cleaner balance sheet, it could probably raise cheaper debt in the 9% range. "We expect that this could open up substantial refinancing opportunities for Level 3 going forward, helping to reduce interest costs and improve free cash flow in the out-years," says analyst Jonathan Schildkraut of Jefferies & Co.

The Broadwing deal will put more traffic from big corporate customers on the combined Level 3 network. That could improve operating profit margins from about 50% to the 60% to 65% range.

The Broadwing deal makes a lot of sense for Level 3. The company, which rode the highs and lows of the telecom bubble and bust, has come a long way (see BusinessWeek.com, 9/5/03, "Level 3's Crowe: 'Moving to Offense'"). But one thing it probably won't do is turn an investor's dream of a Google buyout into reality.

Rosenbush is a senior writer for BusinessWeek.com in New York.