The following is from Fitch Ratings on August 28:
Fitch Ratings has upgraded the Issuer Default Rating (IDR) assigned to Level 3 Communications (LVLT) and its wholly owned subsidiary level 3 Financing (Level 3 Financing) to 'BB-' from 'B+'. In addition, Fitch has upgraded specific issue ratings assigned to LVLT and affirmed issue ratings assigned to Level 3 Financing as outlined at the end of this release. LVLT had approximately $11 billion of consolidated debt outstanding on June 30.
The rating action recognizes LVLT's strengthening financial and operating profile as the company completes the integration of tw telecom (TWTC). The capture of further operating synergies, coupled with operating leverage inherent within its business model and anticipated changes in the company's revenue mix (i.e. the shift to higher-margin enterprise revenues) will fuel expected gross margin and EBITDA margin expansion during the ratings horizon.
LVLT's credit profile continues to improve in line with Fitch's expectations as the company capitalizes on its on-going revenue mix transformation, growing high-margin core network services revenues, and the cost and revenue benefits associated with the TWTC acquisition. Fitch anticipates LVLT's credit profile will continue to strengthen over the ratings horizon as the company benefits from anticipated EBITDA growth, strong free cash flow (FCF) generation and modest debt reduction.
KEY RATING DRIVERS
Leverage on Target: LVLT remains committed to deleveraging to the low end of its target of between 3x to 5x net leverage. The enhanced scale and ability to generate meaningful FCF resulting from TWTC reinforces Fitch's expectation for further strengthening of LVLT's credit profile. Fitch foresees LVLT leverage will approach 4.2x by the end of 2015 and under 4x by year-end 2016 as the company clearly is operating within its 3x to 5x net leverage target.
TWTC Acquisition Supports Strategy: The TWTC acquisition is in line with LVLT's strategy to shift its revenue and customer focus to become a predominately enterprise-focused entity. TWTC's strong metropolitan network supports LVLT's overall strategy.
Synergies Fuel Margin Expansion: The integration of TWTC is LVLT's highest priority as an organization and the key integration and synergy assumptions the company disclosed when the transaction was announced remain unchanged. Since the transaction closed, Level 3 has achieved approximately $115 million of annualized run rate EBITDA synergies through the end of the second quarter 2015 (2Q15). LVLT indicates it remains on track to achieve 70 percent or $140 million of its annualized run-rate synergy target by the end of 1Q16.
FCF Enhances Credit Profile: LVLT is poised to generate sustainable levels of FCF (defined as cash flow from operations less capital expenditures and dividends). Fitch believes the company's ability to grow high-margin core network services (CNS) revenues coupled with the strong operating leverage inherent in its operating profile position the company to generate consistent levels of FCF. Fitch anticipates LVLT FCF generation will exceed 10 percent of consolidated revenues by year-end 2016 on a pro forma basis.
Revenue Mix Transformation Proceeding: LVLT's operating strategies are aimed at shifting its revenue and customer focus to become a predominantly enterprise-focused entity. LVLT's network capabilities, in particular its strong metropolitan network, along with a broad product and service portfolio emphasizing IP-based infrastructure and managed services provide the company with a solid base to grow its enterprise segment revenues.
Strong Operating Leverage: The products and services LVLT sells combined with its strategy to sell services 'on net' enable the company to generate significant operating leverage. At scale, the services sold within this business segment generate 60 percent incremental EBITDA margins. From Fitch's perspective, the company must be successful in growing the CNS revenue base to improve its credit profile and generate FCF.
Overall, Fitch's ratings incorporate LVLT's improving competitive position while acknowledging its smaller market share and lack of scale relative to larger and better capitalized market participants. The ratings for LVLT reflect the company's strong metropolitan network facilities position relative to alternative carriers, as well as the diversity of its customer base and service offering, and a relatively stable pricing environment for a significant portion of its service portfolio.
Outside of material change to its financial strategy, ratings concerns center on event-driven merger and acquisition activity and the resultant increase in integration risks, and the sensitivity of the company's operating profile to the effects of a weaker economic outlook or a more competitive operating and pricing environment. Fitch expects that M&A activity will remain a key component of LVLT's overall growth strategy. M&A is expected to focus on building incremental network and product capabilities and building scale in Europe and Latin America.
LVLT's enterprise segment continues to drive overall revenue growth within CNS. Fitch believes that revenue growth prospects within CNS stand to benefit from the transition among enterprise customers from legacy time division multiplexing (TDM) communications infrastructure to Ethernet or IP VPN infrastructure based in Internet protocol. In addition LVLT is positioned to benefit from favorable secular trends including explosive bandwidth demand growth (video), the growth in number of devices connected to the Internet, and the increasing globalization of enterprises. Revenues generated from enterprise customers accounted for approximately 71 percent of CNS revenues during the quarter ended June 30. From a regional perspective, North America CNS revenue represented 80 percent of total CNS revenue during 2Q15, up from approximately 77 percent during the same period last year.
The key integration and synergy assumptions LVLT disclosed when the TWTC transaction was announced remain unchanged. Through the 2Q the company achieved $40 million of expected capital expenditure synergies and realized $115 million of annualized run-rate operating synergies. The operating cost synergies consist of $25 million on network access cost synergies and $90 million of operating expense synergies. Going forward the focus will be on achieving incremental network access cost synergies, as the company has achieved its $90 million of annualized run-rate operating expense synergies. From a timing perspective, LVLT expects to capture 70 percent of the run- rate operating cost synergies, or $140 million of its total synergy target by the end of 2Q16.
Leverage and Financial Policy
The focus of LVLT's capital structure strategy is to strengthen the company's overall credit profile and efficiently manage its maturity profile. LVLT remains committed to deleveraging to the low end of its target of between 3x and 5x on a net debt basis. The pace of further deleveraging will largely depend on the company's ability to capture anticipated cost synergies and capitalize on incremental EBITDA growth stemming from the positive operating momentum within LVLT's CNS segment.
Total debt outstanding as of June 30, was approximately $11 billion, reflecting a modest 2.9 percent decline relative to the $11.4 billion of debt outstanding as of Dec. 31, 2014. LVLT's outstanding debt materially increased during 2014 to facilitate the tw telecom acquisition. LVLT's leverage as of the LTM period ended June 30, was 4.84x, marking an improvement from 5.98x, 5.17x, and 5.85x as of year-end 2014, 2013, 2012, respectively. Pro forma leverage, considering the tw telecom acquisition as of the same LTM was 4.6x (4.3x excluding transaction and integration costs) and is expected to decrease to 4.2x by year-end 2015 and dip below 4x by year-end 2016.
Fitch's key assumptions within our rating case include:
--LVLT continues to be successful in achieving anticipated cost synergies related to its acquisition of tw telecom. Specifically, to realize 70 percent of the $200 million run-rate annualized cost synergies within 18 months of the close of the TWTC acquisition.
--CNS revenue growth ranging between 2 percent and 3 percent during 2015 (relative to 2014 pro forma CNS revenues) driven by continued strong growth within the company's North American Enterprise segment.
--LVLT's network access margin (gross margin) ranging between 65 percent and 66 percent during 2015 and growing to over 67 percent by year-end 2017.
--Capital expenditures will approximate 15 percent of consolidated revenues.
--FCF generation ranging between $600 million and $650 million during 2015, exceeding 10 percent and 12 percent during years ended 2016 and 2017, respectively.
--Debt levels are expected to remain relatively consistent and Fitch anticipates that LVLT will repay the floating-rate notes due 2018 ($300 million outstanding June 30,) with available cash on hand.
What Could Lead to a Positive Rating Action:
Positive rating action would likely coincide with the expectation that Level 3 will maintain leverage at 3.5x or lower while consistently generating positive FCF with FCF/adjusted debt of 8 percent or greater. Additionally the company will need to demonstrate positive operating momentum characterized by consistent core network services revenue growth, gross margin expansion, no material delays in achieving anticipated cost synergies, and lack of a material erosion of revenue churn.
What Could Lead to a Negative Rating Action:
Negative rating actions are more likely to coincide with a perceived weakening of LVLT's operating profile, as signaled by deteriorating margins and revenue erosion brought on by difficult economic conditions or competitive pressure. Additionally, negative rating actions could result from discretionary management decisions including, but not limited to, execution of merger and acquisition activity that increases leverage beyond 5x in the absence of a credible deleveraging plan.
LVLT reported $364 million of FCF generation during the LTM ended June 30. Based on public guidance, the company expects to generate FCF of $600 million to $650 million during 2015, which is in line with Fitch's expectations. Looking forward, FCF generation should accelerate as integration costs diminish and cost synergies materialize. Fitch anticipates LVLT FCF generation will exceed 10 percent of consolidated revenues by year-end 2016 on a pro forma basis. In addition to LVLT's positive operating momentum driving EBITDA growth, additional factors such as interest expense savings derived from capital market activities completed during 2014 and 1H15 and on-going operating cost optimization efforts position the company to grow FCF during the ratings horizon.
Fitch believes that LVLT's liquidity position is adequate given the rating and that overall financial flexibility is enhanced with positive FCF generation. The company's liquidity position was primarily supported by cash carried on its balance sheet, which as of June 30, totaled approximately $469 million (net of the $80 million of cash held in Venezuelan bolivares by its Venezuelan subsidiary which Fitch views as restricted) and expected FCF generation. Importantly, there are no restrictions on the company's ability to repatriate foreign cash (other than the conversion and repatriation restrictions existing in Venezuela and Argentina) to fund domestic operations including debt service. The company does not maintain a revolver, which limits its financial flexibility in Fitch's opinion.
LVLT's maturity profile is manageable within the context of FCF generation expectations and access to capital markets. The company does not have material scheduled maturities during the remainder of 2015, and the next scheduled maturity is not until 2018 when approximately $300 million of debt is scheduled to mature.
FULL LIST OF RATING ACTIONS
Fitch upgrades the following with a Stable Outlook:
--IDR to 'BB-' from 'B+';
--Senior unsecured notes to 'B+/RR5' from 'B/RR5'.
Level 3 Financing, Inc.:
--IDR to 'BB-' from 'B+';
Fitch affirms the following ratings with a Stable Outlook:
Level 3 Financing, Inc.:
--Senior secured term loan at 'BB+/RR1';
--Senior unsecured notes at 'BB/RR2'.
The Rating Outlook has been revised to Stable from Positive.
Additional information is available on fitchratings.com
Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)
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