DBRS Assigns B (low) Issuer Rating to Level 3 Financing & Recovery Ratings to Level 3 Financing, Level 3 Communications

DBRS has today assigned an Issuer Rating of B (low) to Level 3 Financing Inc., a wholly-owned finance subsidiary of Level 3 Communications Inc. Additionally, DBRS has assigned recovery and instrument ratings to both Level 3 Financing and Level 3’s specific debt instruments. The changes in the instrument ratings result from the application of DBRS’s new Leveraged Finance rating methodology (see press release dated June 9, 2008). All trends have been changed to Positive from Stable.

The Positive trend reflects DBRS’s expectation that further realization of the Company’s integration efforts – following a number of acquisitions over the past couple of years – and the expectation of positive free cash flow should lead to a stronger credit profile for Level 3 over the next 12 to 18 months. Specifically, this expectation is based on more predictable gross margins of 57% currently and potentially improving toward 60%, improved EBITDA margins of 21.6% currently heading toward the mid-20% range over time and, after many years of free cash flow deficits, the generation of free cash flow.

The Company’s Issuer Rating of B (low), which is consistent with DBRS’s previous view of the Company’s implied Issuer Rating, is based on three factors. Firstly, the Company has achieved additional scale as a result of its acquisitions. This has served to: (a) expand the Company’s presence further in metropolitan area markets which align well with its significant long haul network and capabilities; (b) expand its focus to enterprise customers; and (c) diversify its revenue base across product line as well as geography with its enhanced European presence. As a result, the Company’s EBITDA has grown significantly (over $1 billion expected for 2008) and should further strengthen as it unlocks its operational leverage.

Secondly, DBRS continues to expect that Level 3 is well-positioned to generate positive free cash flow for the first time on an annual basis in 2009. Thirdly, this free cash flow along with the Company’s current liquidity of $666 million at June 30, 2008, should more than cover its 2009 maturities and better position the Company to handle its steady amount of debt that matures over the 2009 to 2014 timeframe.

Despite these factors, DBRS continues to acknowledge that Level 3 will continue to face challenges over the medium term. These continue to include: (a) further integration risks, although the Company appears to be well on its way to rectifying previously stated integration issues in conjunction with good progress on its plan to complete the consolidation of its operating and billings systems (Project Unity); (b) a highly competitive operating environment as its acquisitions have positioned the Company into areas that are more competitive with incumbent telcos and service aggregators; and (c) a sizable revenue mix of voice services (roughly one-third of its core communications revenue). DBRS notes that of its voice services, the wholesale portion is managed for its incremental gross margin contribution (30%) despite this service largely being commoditized. The other portion is local and enterprise voice service which is sold along with other enterprise services that collectively contribute strong incremental gross margins of 80%.

DBRS has simulated a default scenario for Level 3 in order to analyze potential recovery for various debt classes in the event of default. DBRS has stressed Level 3 under such a scenario whereby, under certain assumptions, it could potentially default on its debt obligations over the 2009 to 2011 timeframe. This default scenario results in a decline in EBITDA to a point that is 42% lower at the end of 2011 than the EBITDA for the twelve months period ending June 30, 2008. Additionally, the implied EBITDA multiple has been discounted by over 2.0 times to 5.0 times for the base case. The resulting valuation assumes a total enterprise value of $3.4 billion under the base case, which is nearly 50% below the current implied enterprise value of $6.7 billion.

At a distressed valuation level, DBRS believes the Senior Secured Credit Facility (guaranteed by most of the operating subsidiaries and secured by the assets of most of the domestic operating subsidiaries) has outstanding prospects for full recovery of 100%. As such, DBRS has assigned this debt a recovery rating of RR1 and an instrument rating of BB (low), three notches above Level 3 Financing’s B (low) Issuer Rating. DBRS notes that even in the worst case valuation scenario where the enterprise value plummets by 54% versus the current enterprise value, the senior secured lenders should experience full recovery.

Level 3 Financing’s Senior Unsecured Notes have a meaningful recovery after the secured creditors have been paid. As such, the recovery rating on these unsecured notes is RR3 and assumes a Good recovery that ranges between 50% to 70%. As such, this debt is rated B or one notch above Level 3 Financing’s B (low) Issuer Rating.

Level 3’s Senior Unsecured Notes and Convertible Senior Notes have been assigned a recovery rating of RR6 given their Poor recovery prospects of 0%. This debt is rated CCC, two notches below Level 3 Financing’s B (low) Issuer Rating. DBRS notes that this debt is inherently superior relative to Level 3’s Subordinated Notes. Level 3’s Subordinated Notes have been assigned a recovery rating of RR6 given their Poor recovery prospects of 0%. This debt is also rated CCC, two notches below Level 3 Financing’s B (low) Issuer Rating.

DBRS believes that Level 3 has the ability to improve its B (low) Issuer Rating given improvements in both its business and financial risk profile with gross debt-to-EBITDA possibly improving to below 5.5 times in 2009 from 7.27 times currently. However, should any of its current operational issues persist or become protracted or demand not materialize as expected, this could lead to a removal of its Positive trend and/or possibly even pressure its current ratings.

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