Trouble Ahead For Level 3

Level 3 has some tricky financial water to tread in the
coming months, but a recent asset sell off and continued analyst confidence
could be enough to stave off potential disaster.

Goldman, Sachs & Co. issued a warning Monday to its clientele that four of
the carrier’s top 10 customers are unlikely to keep up with contractual
obligations as executives from those companies worry about their own
financial troubles.

One of those companies that stand out is Enron , which
analysts figure owes Level 3 around $7 million in the fourth quarter of
2001. Enron, a Texas-based energy company that recently filed for
bankruptcy protection, got walloped in the press for it’s shady accounting
sleight-of-hand and Congress is mulling whether to bring executives in for
hearings.

Another of its key customers is McLeodUSA, Inc. , once a
rising star in the competitive local exchange carrier (CLEC) industry with
more than 20 states in its coverage area and a massive fiber and wireless
network buildup, is also in financial straits.

The “super-CLEC” (a moniker for a regional telephone company with national
aspirations) recently threatened bankruptcy to bondholders clear its
substantial debt.

On Dec. 7, McLeod was forced to sell its wholesales dial up access assets
to Level 3 to help pay off its debts. The $55 million move was bad news
for the independent phone company, a sign it is ramping back operations to
its core analog telephone services; McLeod’s fiber and wireless expansion
are essentially dead in the water.

The acquisition is a mixed blessing for Level 3. While the wholesale
business will bring in recurring revenues for the carrier, the company is
now spreading its operations from just providing the fiber to providing
services for the people who need Internet access — markedly different
operational mindsets are needed to make both successful.

Enron and McLeod only make up a portion of Level 3’s business, but is part
of a growing number of companies that are showing signs going away and
leaving Level 3 to find their own financial solution.

Already, 40 percent of Level 3 revenues are tied into these failing
companies, which include Enron, McLeod and SurfEU, a leading European
Internet access unit. Last quarter, Level 3 was forced to write off $80
million in accounts receivable (almost one-quarter of its expected 2001
communications revenues), and analysts expect that loss to grow in the
fourth quarter.

Goldman Sachs remains confident Level 3 can maintain its fourth quarter
numbers, but is worried that continued write offs could hurt the company in
2002 despite a $650 million credit cushion and contracts with “blue chip”
clients.

“The implication is that while we believe Level 3 has the cash to make it
to break-even (for Q4 2001), the size of its funding cushion is highly
dependent on the health of its customer base, creating yet more uncertainty
and possibly negative news flow,” its report to credits notes. “It will be
a great challenge to grow its blue chip customer base faster than the rate
of erosion of its ‘troubled’ customer base in a depressed demand environment.”

Level 3 has taken steps to ensure its business remains viable into the New
Year with deals that will reduce its worldwide clout in the short term but
hopefully keep it afloat in the long run.

A Nov. 27 deal with ISP mega-giant AOL Time Warner ties
the two companies closer, with added broadband pipe for AOL customers and
leased collocation space in several cities throughout Europe for AOL’s
continued European expansion.

The carrier’s decision to sell some of its assets to a rival means the end
of Level 3’s presence in the ever-growing Asian market but will shore up
its bottom line for 2002. The short-term loss (a $500 million write off in
the fourth quarter) will save the company $300 million in future funding
requirements and the expenses needed to keep operations going in the Far
East market.

Level 3 officials were unavailable for comment at press time.

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