Converging with Level 3

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After a series of mergers Level 3 is bringing together services for traditional media giants such as broadcasters and IP-based services for rapidly expanding internet-based companies. Capacity is expanding as demand booms and it is looking for further acquisitions. Interviews with Kevin O'Hara and Brady Rafuse of Level 3

O'Hara: We're interested in acquisitions in the US and Europe. We're very cautious. We have a significant plateful of work to integrate the companies that we have acquired. ... When you do five deals in a couple of quarters, people notice. It's not just people who are interested in selling their business to Level 3 but people who are looking for a liquidity event for their company

Rafuse:We've been trained to think that entertainment should come in 30 or 60 minute blocks. ... Now people are saying two minutes is pretty good. Content used to go to the TV set but now it's going to your PC and increasingly your mobile. It's every piece of content to all three of those screens

Level 3 has survived, which is something you can't say about a lot of companies in this business. And it's changed.

There are two outstanding characteristics, says chief operating officer Kevin O'Hara: "Better operating performance that anybody we compete with — that's operating performance being measured in terms of margin. For instance, gross margin and ebitda margin are better than anybody we compete with."

There were questions about the company a few years ago. It had a lot of debt, but he uses the charming phrase "growing into the balance sheet" to explain what's happened. What, precisely, does that mean? "We had to generate enough cash from operations to cover the full debt burden. I think those questions are largely behind us as a result of both improvements in the core business, organic growth, as well as a whole series of acquisitions."

Level 3 has been "pretty opportunistic" in dealing with the balance sheet "as the capital markets allowed", he says. "As a result we're sitting here with a pretty favourable position. The bond market has rallied strongly around the remaining bonds we have outstanding."

And the company "has shown strong organic growth", he notes, "and we have acquired five companies in the last 10 months".

Has there been a strategy behind those acquisitions? They fall into two categories, says O'Hara: "Backbone acquisitions, which are really about consolidation and reaping the benefits of putting two really similar businesses together and having an improved financial profile as a result of the synergies."

This means it's possible to put the traffic of the acquired company onto the Level 3, eliminating much of the duplication in network costs. "While they tend not to be growth stories, they tend to be very position from a cashflow standpoint."

The first of these was Wiltel Communications, "a company very similar to us in the US, where we were able to put Wiltel and Level 3 together". The revenue from such a deal "takes a step function", but you don't see growth incremental growth from it, he admits. However, "you see great incremental cashflow from it" by combining the two businesses, he notes.

Video distribution network

The Wiltel deal, which also brought Vyvx, a company that specialises in video distribution, was valued at around $720 million and was completed in December 2005. Since then Level 3 has bought four metropolitan operators.

More recently, in late October and after the date of this interview, it announced a deal to buy another competitor, Broadwing, for $740 million plus shares. That deal will not be closed until early in 2007.

O'Hara explains the purchase of the metropolitan networks. "Historically Level 3 has constructed a fair amount of local fibre along with its intercity fibre. That's true in Europe and to a greater degree in the US. The last four deals were all about acquiring local facilities."

Level 3 has had gross margins in the 70-75% range. "We've been able to report those margins because we had superior facilities. We had products and services to a targeted set of customers. The combination really allowed for our great financial performance."

The acquisition has allowed Level 3 to extend that footprint, he says. The acquisitions "are all about growth". There are some synergies as well, he notes, but the prime motivator is growth into new markets.

"We now have 110 markets with fibre." The company has 5,300 buildings served with its fibre, "a great footprint to continue to grow".

Let's go back for the moment to Wiltel. Did that acquisition give Level 3 extra network, or did it close down Wiltel's infrastructure and move all traffic over? "Both," says O'Hara. "There were some unique routes. There were some incremental markets but there weren't a lot."

Level 3 has been decommissioning duplicated routes since the deal. "We'll decommission more of those routes into the future."

And Wiltel had "an awful lot of business from SBC", which merged with the old AT&T to create the new AT&T a year ago. The old AT&T was a direct competitor of Wiltel. "Roughly $1 billion of the $1.6 billion revenue was attributable to SBC, which will all go to AT&T."

That loss of business "was all factored into the deal", says O'Hara, but Level 3 is not able to decommission some routes until the traffic has moved over to AT&T. "It doesn't make sense to roll the traffic to the Level 3 route and then decommission it. In some cases we're waiting for the traffic to stabilise."

But that's revenue that the combined company, Level 3 with the old Wiltel, will lose to the other combined company, SBC with AT&T. "We've told the investment community to value that as an annuity. We paid for a gross margin commitment. We're going to meet that gross margin commitment — SBC will. Assume it's going to zero over time. It shouldn't surprise anybody."

Rationalisation has been different when it comes to staff of the two companies. It's been said in the market that Wiltel salaries were lower than Level 3 salaries, so that has affected the way Level 3 has determined redundancies. Is that true?

"It depends," says O'Hara. A long pause: "We said at the time of the acquisition that we thought Wiltel had some very strong capabilities. They had some strengths in areas that Level 3 historically did not. Two very specific areas are the video broadcasting and distribution business that came with Vyvx, where Level 3 had no capabilities. And they had very strong voice capabilities, mainly because of what they had stood up for SBC." Level 3 "was not a particularly strong player" in traditional voice services, he adds.

Staff reductions

The challenge was to put together "a company that had the best of both organisations", he says. "That's what we said. That's what we meant."

Of the reduction in staff — a mixture of redundancies and natural attrition — since the deal, "roughly 50% came from Level 3 people and 50% from legacy Wiltel". Cost "was a factor but it was much more about the right set of skills, the right capabilities — more so than absolute cost".

Back to the metro networks that Level 3 has acquired. They're exclusively in the US, says O'Hara. "There were four companies, and the combined consideration for those four was just under $2 billion. Without exception, they were very healthy ebitda margins, generating cash and without exception reporting strong organic growth."

Those acquisitions were for growth, of companies with solid financial performance. "We could take further advantage of their assets."

Level 3 "is careful about what we purchase", he adds. The company prefers "not to have to fix something" — though clearly Wiltel, as it was losing the SBC revenue, would have needed fixing if Level 3 hadn't bought it. "At the right price it may be worth it. The worst of all worlds is somebody that is broken that wants a high price."

There are "some companies out there that have some pretty hefty valuations" and clearly he doesn't feel that they would be worth it.

Some years ago Level 3 moved heavily into Europe, though later partially withdrew. Is the company looking to build up again outside the US?

"I'll give you my two favourite statistics about London," says O'Hara. "Five years ago we had approximately 1,800 employees and $20 million of revenue, and we were not generating cash. This year we have 285 employees. We're going to do close to $180 million revenue and we're generating cash. I don't think we've pulled back. I think we started to treat it as a proper business."

Those numbers apply to all of Level 3's European activities, he explains. "We don't break it out by country. It's become a very solid business for us. We got focussed."

The person in charge of this transformation in Europe is Brady Rafuse, president and CEO of its European operations.

He's now been rewarded by being put in charge of Level 3's activities in the content markets — covering media companies, TV broadcasters and movie makers — in addition to his European task. A former BT executive, who later worked for its ill-fated Concert joint venture with AT&T, Rafuse is now in charge of Level 3's Vyvx business and its IP and collocation product lines globally.

European expansion plans

Level 3 has committed itself to expanding in Europe "to nine new markets", says O'Hara. "We are extending our traditional two rings up through the Nordic region —Oslo, Copenhagen. We are extending further east." Leased facilities to places such as Warsaw and Prague will be replaced with Level 3's own kit. "We have also approved the funding for a southern ring and what we refer to as an Alpine ring for central Europe."

That's not new construction. "We're not digging up the streets. We're getting third party dark fibre and putting our own transmission kit on it, our own routing kit, and growing our product set and the number of markets we can serve end-to-end."

There is a lot of fibre in places such as Paris, Brussels and Frankfurt, says O'Hara, but that doesn't apply everywhere. "If you want to go to Prague, Warsaw, Vienna, Milan, it gets quite a bit tighter." There's not as much capacity available in those cities.

Rafuse adds that Spain is also short of fibre. "Spain's really tight." There are a few providers "but they are all in the same trench".

That doesn't meet Level 3's design criteria, adds Rafuse. "We need to be diverse. We'll get there. We'll work it out."

Is Level 3 looking for other acquisitions? This interview was just before Level 3's announcement in late October of its plan to buy Broadwing, an exclusively US-based operator, so clearly that was already being planned.

"We're interested in acquisitions in the US and Europe," says O'Hara. "We're very cautious. We have a significant plateful of work to integrate the companies that we have acquired. We are very conscious about meeting our integration objectives, our financial objectives. I think the right opportunity in North America or Europe would still be interesting."

Level 3 "is not interested in going beyond those two markets" at the moment, because it wants "to leverage the investments that we've already put in the ground". It has an operating infrastructure and teams in place, "we have a network that we can integrate on top of".

There are opportunities around, companies that are being offered. "When you do five deals in a couple of quarters, people notice," says O'Hara. "It's not just people who are interested in selling their business to Level 3 but people who are looking for a liquidity event for their company."

There's been "a tremendous amount" of that sort of activity in the US, though Europe "is still a year or two years behind the States in terms of investors looking for a liquidity event", he says.

That implies that, in 2007 or 2008, Level 3 might well be interested in acquisitions in Europe.

"The fact of the matter is that there are a lot of companies that are not in the hands of strategic investors, through either a bankruptcy process or a distress sale. There are "non-natural holders" that have "ended up with a lot of assets", he says. "They are looking for the right time to get out."

There "have been a lot of calls to a lot of different companies, not just Level 3", says O'Hara. "But Europe is lagging a little bit. Lagging is the wrong word: trailing."

Why the different timing? "The boom in Europe lagged by a year or two. The correction lagged by a year or two. I think the ultimate shake-out is lagging by a year or two."

Part of the reason is that "there is more financial sponsorship in Europe for a number of the companies than there was in the States", he adds.

In the US "a number of investors, for whatever reason, decided that they'd had enough", he says. "In Europe some of them haven't reached that same conclusion yet. Maybe they won't. Certainly in the States it was pretty obvious that a number of investors were going to look for an exit strategy."

What sort of companies does he expect to come onto the market in Europe? "Europe isn't a market. You've got the pan-European business and you've got a number of countries with specific businesses and a number of local businesses."

Five or six years ago a number of incumbents had ambitions to be dominant international communications companies. "They've all pulled back and they've instead typically done a good job in their home country and their aspirations outside of their home country have waned a bit. That creates some opportunity."

There are a number of local fibre providers, and pan-European providers. "It's not obvious that over the long run there is a way for all those companies to make money," he says. "There will be opportunities in Europe. And Europe you need to look at more locally."

Rafuse offers a local perspective, though with his new media responsibilities he is increasingly based in the US.

The US metro acquisitions are individually different but they have much in common. In Europe similar operations vary widely, he reports: many of them are associated with local utility companies and are often part-owned by the city authorities. "It's just not homogenous."

Some cities have a single carrier, but others might have a number of operators — though sometimes they share ducts.

Never buy what you wouldn't build

One rule that Level 3 applies, he says, is: "Never buy anything that you wouldn't build." The business must be right. "We don't tend to be opportunistic" and buy something "that would be handy". It has to be a company "that our business strategy supports", he says.

"Would we build it? If we would, is this an acquisition that would help us achieve our goals quicker?"

We turn to Level 3's new enthusiasm for the content market. O'Hara explains the background. "Wiltel had an interesting subsidiary, Vyvx, which was very strong in fibre-based broadcast signal origination and transmission." It wasn't broadcasting, but was carrying the feeds for sports, news and other services.

"It also had an ad distribution business," says O'Hara. "The relationships it had with traditional media companies and traditional advertising companies, and the technical capabilities it had were very good."

Level 3 has not previously been in those markets, "but it has a very strong set of IP products" and "an interesting set of relationships with emerging companies".

Following the takeover of Wiltel, Rafuse has been given the task of developing Level 3's strategy for this market, says O'Hara, "to bring together both the traditional media and the emerging media companies, and the capabilities of both Level 3 and Vyvx".

The company believes that "video over the network is going to become much bigger than it is today", says O'Hara. "The Web 2.0 services you're seeing rolled out are going to continue to grow at exponential rates. We're figuring out how we can make the most of our capabilities and what else we should do in order to attack that segment we've give to Brady to sort through."

As a result of the move Rafuse, a Londoner, is now regularly commuting across the Atlantic. He's handed over direct responsibility to a new managing director for Europe, Craig Butrym, a former Genuity executive who came into the group through Level 3's acquisition of Genuity in 2003: it's long been one of the most acquisitive companies in the industry.

"He does that and I spend two or three weeks in the States every month," says Rafuse. "I'm very well known on flight BA219." That goes to Denver, Level 3's headquarters, but he's spending an increasing amount of time in California, talking to technology companies, and on the East Coast, where the broadcasters are, and in Hollywood.

"It's a very exciting, interesting business. We're drawing a line from broadcasting the SuperBowl in HD through to kids falling off skateboards."

Wiltel was in charge of the SuperBowl feed "for the last 17 years", says O'Hara. "Showing the kids falling off skateboards on YouTube: that's what Level 3 was doing."

Services for YouTube

YouTube is one of Level 3's big customers, says Rafuse. "It took us five years in Europe to grow our IP business to 100 gigs. We think we're the biggest, but say we're only the fifth biggest. That was five years: YouTube grew that in six months. YouTube is one of the biggest."

Other Level 3 customers include Yahoo!, Google, Microsoft, PhotoBucket and Flickr. There are application hosters such as Windows Live. "I had an operating system update the other day which was 128 megabits," says Rafuse. "Two years ago I'd have been disappointed if it had arrived in a box and been 128 megabits."

He continues the list of customers: Second Life, World of Warcraft. "There's a lot of really interesting opportunity for us there and we look at the customers on one axis, the traditional media customers, the big search guys, Web 2.0, if that isn't a bit passé. It's a business that is generating an incredible amounts of traffic and our raison d'être is always to bring scale to — for want of a better term — existing problems."

And it's exciting. No longer are people talking of "cutting a lot more people", he says. "You drive from San Francisco to San Jose now and it's like it used to be. People say it was the bubble, but if you drive down that road it doesn't feel like a bubble, because Yahoo!'s still here, and Google's still here and eBay's still here and Amazon's still here."

And behind that are new companies such as YouTube and FaceBook, as well as MySpace, bought by News Corporation in 2005. "Everybody says about MySpace, what an incredible purchase. Why would you spend that money? They made more money from making Google the preferred search engine in MySpace than it cost them to buy it," he says.

"Whether these numbers make sense, I don't know. What I do know is that communities are important, and you're not seeing the hub-and-spoke communications of the past."

More than half of content viewed by young people on the internet now "is produced by someone that they know", says Rafuse. "That's really different. When we went to FaceBook it was very clear what they said. It was very clear they had a community that was incredibly valuable."

Vyvx was "by far the strongest company" in its section of the market, says O'Hara. "But Vyvx and the traditional carriers weren't really looking at the MySpaces and the YouTubes. That was a different set of companies — the IP-centric carriers."

But run the maths, he adds. "Unless you own your facilities you're not going to be able to meet the needs of those companies over time. From a Level 3 perspective it's going to be hard to think on a continuum which are the traditional media companies and which are the emerging media. As best we can tell, you don't have anyone looking holistically at the media space — and we thought we were the logical company. Because of what Vyvx had and our IP expertise."

If many of the traditional telecoms operators are missing the opportunity, what about the traditional broadcasters? Are they spotting the way the market is changing and are they starting to move into these new areas?

"They do," says O'Hara. "In America the broadcasters still show the shows on particular day and at a particular time. Most of the stations carrying those signals are affiliates of those main broadcasters." That's the way the US television industry works. "The affiliates make their revenue through advertising, but the affiliates don't own the content."

Bypass the business model

But increasingly people want to watch at any time, not when the local affiliate says. The broadcasters would like to put the programmes live on a server, "but that would bypass the business model".

The industry all has to make a transition, but until that happens "increasingly broadcasters are putting their content on the server the next day". And that means viewers can miss programmes, knowing they'll be able to catch up with them later online.

"We're starting to see that transition occur. We're at the very, very early stage of that."

That all has implications for the bandwidth. A standard definition TV show requires "roughly 450 times the bandwidth of a web page", says O'Hara. "If you want to watch it in high-def that's roughly 2,700 times the bandwidth. There is no carrier in the world that has the kind of capacity available for network-based video distribution."

Look at the economics of the network providers. "We think we have the most cost-effective network and the lowest incremental cost. If anybody is going to do that cost-effectively we think we have a better chance," says O'Hara.

Rafuse's challenge, he notes, is to talk to the content owners, broadcast companies and media companies to find ways that "Level 3 can play a role in their supply chain".

Some content will be distributed to strategic locations around the market. "If you are going to see a high frequency of hits", then that content will be "pushed to the edge" of the network. There will be regional distribution points for material that will be in moderate demand. "There is some stuff you're going to get only occasional hits on and that you'll keep in a more centralised way. So you're really going to see pressure on all elements of the network — the last mile, the regional and the core."

Data centre expansion

But this material is all going to be on huge servers that are themselves distributed widely. Internet companies "are talking of data centres that are literally millions of square feet", says O'Hara. "The amount of bandwidth that you need to connect those up is massive." Clearly companies such as Google, Microsoft and Yahoo! are talking to Level 3 and its competitors to ensure that networks are in the right place and have the right capacity for these data centre plans.

A report in the New York Times in June 2006 suggested that Google has 450,000 servers in at least 25 locations across the world. Its capex for the first quarter of this year was $345 million — which one observer has suggested could buy it at least 100,000 more servers. One of Google's biggest projects is in a place called The Dalles in Oregon — where there is cheap hydroelectric power to feed servers on a 12-hectare site.

Microsoft is reported to have 200,000 servers worldwide, said the New York Times, and is expected to have 800,000 by 2011. "We're talking about huge numbers," says O'Hara. "And this would be no value if it is not connected with huge amounts of bandwidth."

It's happening in the US and across the world. "How do you physically move information?" says O'Hara.

As a result Level 3 is spending hundreds of millions on boosting its network capacity. It's no longer digging up roads, but it's lighting dark fibres and, when necessary, pulling new fibres through existing ducts.

To improve capacity it's introducing photonic switching, using kit from Infinera, and is increasingly adopting ethernet standards. "We pay a fraction of the cost charged by the big router guys," says O'Hara.

The nature of content is different from what was expected, says Rafuse. People thought the industry would be about TV shows and movies, but now personal content — YouTube and so on — is taking over. People are exchanging video clips and sending links to YouTube — which is getting over 100 million hits a day for links of an average duration of about two and a half minutes.

"We've been trained to think that entertainment should come in 30 or 60 minute blocks. Now people are saying two minutes is pretty good." It's changing the whole nature of distribution of entertainment.

TV, PC and mobile screens

"And it used to go to the TV set but now it's going to your PC and increasingly your mobile," adds Rafuse. "It's every piece of content to all three of those screens. That might be direct, which is why we have the relationship with NBC or Fox or whoever it happens to be. Or it might go through an aggregator, such as YouTube or iTunes."

There are many different relationships. "I'd like to say there's a very clear value chain but it's not like that."

Level 3 "didn't have the relationships that Vyvx has", he says. "Vyvx has incredible relationships." With the broadcasters and the big sports organisations, he means. "Those relationships match ours with the big search guys, the Web 2.0 guys. It's a compelling proposition."

Are there similar trends in the rest of the world? "Personal opinion, here," says Rafuse. "I think Mark Thompson is a genius." He's been the director-general of the BBC, the biggest broadcaster in the UK, since 2004, but previously headed the successful independent operation Channel 4. "He's one of the most enlightened broadcasters in the world."

The BBC has a very different model to what applies in the US, "but I think Mark Thompson has a very clear vision of how being a broadcaster in the 21st century is very different. He gets a lot of this stuff."

O'Hara adds: "In many ways the BBC is ahead of the States, the broadcasters there."

What is Level 3's view of those telcos that want to expand to become media companies, to compete with cable TV services and provide video on demand, rather than just making their network available to other companies offering video.

"In the US Verizon and AT&T are the 800-pound gorillas," he says. "The cable TV operators are typically much stronger than those in the rest of the world. They got ahead of the telephone companies in broadband, and then started to put voice over the top. As a result the consumer marketplace is a pitched battle." The telcos had little alternative, he says.

"For the consumer, two companies are now competing for services. It's better than where we were." Time will tell who wins.

Telephone companies have typically been very vertically integrated, he adds. "We have said from the beginning of Level 3 that the world is moving this quickly on so many different planes, vertical integration tends to fall apart. We still believe that."

The business model is horizontal, he says, and that's how it will continue — even though the telcos are trying to rebuild a vertical model.

Rafuse is clearly dubious personally about integrated packages: he recently moved house in the UK and turned down an offer of six months free cable "because I didn't want the guys to dig up my drive", he says. He kept his high-definition Sky satellite service. "Someone could come free with television services and I'd struggle to think that I'd pull Sky HD out of my house. I'm happy with what I've got."

And he has "four or five voice clients on my PC — the integrated package isn't something I'm interested in". That doesn't make him a typical consumer.

"You're increasingly marketing to a market of one in this world. For Verizon or BT maybe an IPTV offer is a great idea but they're not going to sell it to me." GTB