In a move that caught many by surprise, Level 3 Communications today announced that it will acquire WilTel Communications Group from Leucadia National for 115 million shares of Level 3 common stock and $370 million cash, or about $380.5 million. The acquisition combines two major U.S. backbone network providers and will include WilTel’s master services agreement with SBC Communications and its Vyvx video service business but not its outstanding debt or mortgage obligations.

The acquisition will bring 50 new markets and include 3000 new route miles of fiber optic network for Level 3, according to Kevin O’Hara, president and COO of Level 3. Both companies currently operate Internet Protocol backbone networks and serve primarily as wholesale operators, although Wiltel launched an enterprise services division earlier this year, following the negotiation of a new deal with SBC, which has been WilTel’s largest source of revenue.

Convincing the investors

By bringing new scale to Level 3’s network, the company will exhibit the growth needed to meet its biggest challenge – convincing investors it can pay or refinance almost $6 billion in debt by mid-2008, admitted Level 3 CEO James Crowe.

While Level 3 is given credit for operating a superior network in an efficient fashion, “the question for many is whether we can generate sufficient growth to finance or pay off our debt by mid 2008,” he said in a conference call with analysts. “In a nutshell, this transaction reduces the contribution of cash flow needed to break even from new growth areas.”

“It’s all about scale and companies that ride the scale curves at the lowest incremental costs,” Crowe said. “You can see what our current margins are and what our current incremental margins are. We think we lead the industry so scale benefits us more than the rest of the industry. That’s what makes us a logical consolidator.”

According to Level 3, the WilTel acquisition will generate $125 million to $150 million in new profits beginning in 2007, and about 40% of that in 2006, once the cost of integration is factored in. That takes into account the fact that SBC’s revenue essentially disappears after 2007.

The master agreement

Following the SBC-AT&T merger announcement, WilTel and SBC negotiated a new master services agreement, under which SBC has committed to purchase a minimum of $675 million in WilTel voice and data services, at current price levels, between now and 2009. According to Level 3, $290 million of that will have been spent by the end of 2005, before the merger takes place.

“It’s smart that they are discounting SBC, because they could pull the plug very quickly,” said Brian Washburn, analyst with Current Analysis. “Level 3 certainly makes the numbers sound good. Whether they can deliver on the numbers I have no idea. What it does accomplish is that they’ve got a message out there on how to turn the business around and make the business work. It’s great for them to have this kind of long-term integration plan. In a worst case scenario, they buy a lot of time and buy a lot of investor confidence that they have a strategy and a growth business that can serve nearly $6 billion in debt.”

Washburn admits some skepticism, however, as to whether Level 3 can generate the $125 million to $150 million in profit on what will basically be $600 million in revenue by 2008, when the SBC business goes away.

“That’s a 20% to 25% margin, and in a wholesale business, that’s extraordinary,” he said. That’s particularly true in the U.S., where the wholesale transport business remains highly competitive and price sensitive.

A big part of the increased profit will depend on the efficiency of the integration process, something at which Level 3 executives say they excel. The two networks will undergo route-by-route analysis, O’Hara said, to determine where they overlap and which of the two overlapping facilities will be decommissioned.

“We will roll all traffic onto retained routes, and then harvest and re-use equipment where necessary,” he said. “We will operate a single optimized network carrying all lit services and some physical routes to support existing dark fiber customers of WilTel’s.”

Level 3 expects to reduce operating expenses by 40%, and to save significantly by cutting off-net expenses for both companies by moving WilTel’s traffic onto Level 3’s metro networks, and moving Level 3 traffic onto WilTel routes where possible, said Sunit Patel, CFO.

An endorsement from SBC?

The announcement of the Level 3 acquisition of WilTel apparently has SBC’s endorsement.

“We have had a long and mutually beneficial relationship with WilTel Communications and Leucadia National Corporation and their management teams,” said James S. Kahan, senior executive vice president of corporate development for SBC, in a prepared statement. “We are supportive of the transaction with Level 3 and look forward to working with the Level 3 team as we have on numerous occasions in the past.”

Under the terms of the deal, Leucadia retains the right to receive a $236 million termination payment from SBC as well as WilTel’s $358 million credit facility, its headquarters building and its $60 million mortage.

Level 3 does get the Vyvx subsidiary, which provides live and non-live broadcast video distribution for the media and entertainment industry, with nearly 250,000 fiber and satellite video feeds, and more than 5 million ads and promotional media content around the world each year. Vyvx had $120 million in revenue in 2004 and $59 million in revenue for the first six months of 2005.

“We recognize the importance of Vyvx's customers and are committed to ensuring they receive the highest quality service without disruption,” said O'Hara. “We believe that Vyvx's expertise in transporting video combined with its strong brand and customer relationships may create some additional opportunities for Level 3 as the video transport market evolves.”