1 perspective on the carrier market: is there light at the end of the tunnel? sureel choksi level 3...

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Perspective on the Carrier Market:Is there light at the end of the tunnel?

Sureel ChoksiLevel 3 Communications

sureel.choksi@level3.com

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Life a Year Ago

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Summary of the Past Year

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Only a portion of the market caps of all of these companies are known from 11/00 (Level3, Global Crossing, ITC Deltacom, MFN, and Neon). Their average loss from 11/5/00 to 5/10/01 was 70%. The other companies market cap of 11/5/00 was calculated based on this average loss.

Market Value of Emerging Carriers

NEONNETWORK PLUS

ITC DELTACOM FLAG

XO 360NETWORKS

MFNGENUITY

GLOBAL CROSSING

WILLIAMSCOMMS

TIMEWARNER

KPNQWEST

BROADWING

LEVEL3

COLTTELECOM

11/5/00 5/10/01 9/28/01 10/5/01 10/17/01

$168B

$56B

$13B $11B $14B

0

50

100

150

200

Bill

ions

ofdo

llars

ITC DELTACOM NEONNETWORKFLAG TELECOM

MFNXO

WILLIAMS

TIMEWARNER TLC

LEVEL3 COMMS

COLTTELECOMGLOBAL

CROSSING

GENUITYINC A

BROADWING

KPNQWESTNV

10/17/01

$14B

0

5

10

15

Bill

ions

ofdo

llars

1-year decline from $168B to $14B

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Wall Street’s Perspective

“It’s the end of the world as we know it”

- REM

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Reality

“Rumors of our demise are greatly

exaggerated”

- Mark Twain

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Today’s Agenda

What went wrong in the communications services industry?

Current state of the carrier market

Wall Street perspective

What should carriers do in this environment?

Where does Level 3 fit into all of this?

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What Went Wrong?

The 1996 Telecom Act opened the market for competition

Investment thesis: Demand for bandwidth is unlimited Incumbents were viewed as slow-moving Improvements in optics and IP fundamentally changed

economics of communications Assets are worth at least 2-3x cost for facilities-based

carriers

Capital markets for capital intensive communications industry were free flowing Over $150 billion in capital raised by emerging

communications providers in 1999 and 2000

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Early Signs of Trouble

Capital availability was virtually unlimited

Several “me too” business plans

Sum of companies’ projections were 2x market size

Dot-com fever spread to communications industry

Liberal interpretations of the term “fully funded”

Financial engineering by certain companies

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Evidence of the “Me Too” Phenomenon

Europe as an example(1): 29 long haul networks constructed or partially

constructed in Europe 21 consist of swapped fiber and/or limited reach 8 are conduit-based networks Approximately 40% are financially distressed

today At least 8 are in the process of shutting down or

exiting Consolidation activity is limited to date

(1) Source: Level 3 Analysis

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Catalysts to the Decline

A “perfect storm” of: The dot-com growth followed by implosion Slowing economy Bandwidth supply / demand imbalance Shutdown of the capital markets to newer carriers Reduced revenue projections exposed significant

funding gaps for certain companies

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What Happened to Bandwidth Demand?

First, the bad news: Demand was “exaggerated” by emerging

carriers and dot-coms Companies were purchasing bandwidth well in

advance in anticipation of exponential growth that did not materialize

Economic downturn has reduced short-term demand

As a result, there is generally a supply / demand imbalance

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What Happened to Bandwidth Demand?

Now, the good news: End user demand for bandwidth continues to

grow at a rapid rate Even the most bearish industry assessments

of unit growth are 60-100% per year The industry is under-investing in capacity Supply / demand imbalance is temporary

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Affected Sectors

• Emerging fiber backbone carriers

• CLECs / DLECs / BLECs

• ISPs

• Colocation / Hosting

• LD carriers, wireless companies, RBOCs and PTTs are in a separate category

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Chapter 11

Over 50 emerging carriers have filed Chapter 11 in the past 12 months(1), including:

360 Networks Exodus Iaxis Viatel Winstar PSINet

Most companies facing liquidation rather than a reorganization

Teligent Covad Rhythms Northpoint ICG

(1) Source: JP Morgan Securities

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Current Wall Street Perspectives

Shaken investor confidence as a result of unexpected bankruptcies and liquidations Too much competition and too much leverage Market is unable to differentiate between winners and losers Timing of economic recovery is uncertain

The result….

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The Dichotomy of Market Views

The market is struggling to value emerging carriers

Banks, bondholders and equity investors have widely diverging views

Level 3 capital structure:

($ in millions) Book Market Implied Value Value Firm Value

Senior Secured Bank Debt 1,125$ 788$ 788$ High Yield and Other Debt 3,710$ 1,591$ 2,716$ Subordinated Debt 1,365$ 369$ 5,204$

Total Debt 6,200$ 2,747$

Common Stock 1,724$ 7,924$

10x difference!

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What are Carriers Doing in This Difficult Environment?

Scaled back business plans Back to basics

Focusing on sales to customers that can pay their bills Differentiate through operational capabilities, not

pricing Reducing expenses to weather the storm

SG&A Capital Expenditures

Selling non-core assets Restructuring the balance sheet Consolidation?

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Capital Spending Projections

A recent Bernstein Research report provided capital spending projections.

Carrier Capital Spending

0

20

40

60

80

100

120

1999 2000 2001E 2002E

ILECs / LECs New Long Distance Backbones CLECs ISPs / Hosting

40% Total Growth

16% Growth

-14% Growth

-16% Growth

121% Growth

-45% Growth

-29% Growth

33%

-38%

-60%

-27% Total Growth

-22% Total Growth

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What Role will Consolidation Play?

“Elimination” will outpace consolidation

Most distressed companies will be forced to liquidate at 5 to 20 cents on the dollar

Acquisitions will be focused on acquiring valuable customer relationships, as opposed to network assets

Major industry consolidation would require restructurings High yield 101% change of control provisions would have to

be waived

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There is Good News…

There will be fewer competitors

Those that survive will prosper

The economy will improve

The supply demand imbalance is temporary

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What Factors Will Determine Who Survives and Prospers?

Realism

Liquidity

Ability to restructure balance sheet to create value

Ability to generate cash flow (versus revenue growth)

Focus on areas of competitive advantage

Operational capability

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Why Level 3 is Well Positioned

See previous slide!