DBRS Confirms Level 3 Communications/Financing at B/B (low)/CC

DBRS has today confirmed the ratings of Level 3 Communications Inc. at B (low) and CC and the ratings of Level 3 Financing Inc. (collectively, Level 3 or the Company) at B and B (low). The trend is Stable.

The ratings confirmation is based on two factors. Firstly, the Company has achieved additional scale as a result of a number of acquisitions that it has completed over the past couple of years. The acquisitions have served to: (a) expand the Company’s presence further in metropolitan area markets which align well with its significant long haul network and capabilities; and (b) expand its focus to enterprise customers. As a result, this has boosted the Company’s EBITDA (roughly $825 million expected for 2007) and should further strengthen its EBITDA margins once integration efforts are complete and traffic is shifted to Level 3’s network. However, while this expansion remains strategic for Level 3, DBRS notes that these acquisitions position the Company into areas that are more competitive with incumbent telcos and service aggregators. Additionally, these acquisitions have nearly tripled Level 3’s revenue mix to voice services (now roughly one-third of its core communications revenue) which is a services that continues to be commoditized.

Secondly, DBRS continues to expect Level 3 to be in a position to generate positive free cash flow – albeit now more likely in 2009 versus the previous expectation of 2008. This is because the Company recently revised its guidance for 2007 and 2008.

Despite these two underlying factors that support a Stable trend, DBRS continues to acknowledge that Level 3 will continue to face challenges in the near- to medium-term. These continue to include integration risks, as DBRS reiterated in its previous report dated October 31, 2006. DBRS notes that the challenges surrounding executing its integration plans have caused the Company to revise its EBITDA guidance for 2007 and 2008 as the Company is expected to continue to experience longer provisioning cycles as key functions of acquired companies were eliminated before they were successfully integrated. While the Company believes that demand for its services is strong, it has pulled back its sales efforts until orders can be executed within a reasonable timeframe. This is expected to continue into the first half of 2008 with the Company expecting stronger results in the second half of 2008 as these issues are corrected and as additional acquisition synergies are achieved. Should this not be the case in terms of rectifying its provisioning times or if demand is weaker than anticipated, this could lead to pressure on the Company’s ratings.

Finally, DBRS notes that while Level 3 maintains a relatively smooth maturity schedule with only modest amounts of debt due to the end of 2008, the Company’s continued cash burn in 2008 and its reduced liquidity profile (cash balance at $700 million versus $900 million at December 31, 2006 – pro forma for its Broadwing and CDN acquisitions that closed in January 2007) could restrict its financial flexibility until it can ultimately generate positive free cash flow in 2009. While DBRS believes that reaching free cash flow positive in 2009 appears achievable, a significant portion of its capex is success-based which is required before the corresponding revenue can be realized. Should the Company’s liquidity become pressured significantly before 2009, this could also pressure its ratings.

While DBRS believe that the challenges that Level 3 faces over the next year appear to be manageable, should any of these persist or become protracted, DBRS expects that this could impact Level 3’s current ratings.

Note:
All figures are in U.S. dollars unless otherwise noted.