Thursday, October 23, 2008

Stresswatch - 23rd October

If you're in the market for disappointment and bafflement, there's no shortage today. Xerox seems to have disappointed with its Q4 guidance, and makes reference to further weakness in EuropeSony has cut its full-year earnings outlook by 38% from what it expected only back in July (okay, a lot of this has to do with the yen, but what really matters here is the consumer). Continued dire predictions about the Great Hedge Fund shakeout, if correct, will no doubt fuel more distressed sales of assets - yesterday I saw some quotes on senior secured debt from the European telecom/cable space which seemed ridiculously out of line with how some of the companies are performing, suggesting that some paper is getting dumped under duress. 

So now to the chart above, grabbed just a few minutes ago from Bloomberg. This is our beloved Level(3) on the wrong side of $1, which stock market historians will tell you is not a place you want to be. Level(3) reported Q3 results today which seemed to be marginally ahead of expectations, but the stock has been torched, presumably due to the outlook statements. I quote: 

"The Wholesale Markets Group has seen a lengthening of sales cycles. However, the company has seen increased sales interest as certain large customers express heightened interest in purchasing more cost effective local and regional transport services, particularly local and regional connectivity to and between mobile switching centers, enterprise buildings and other traffic aggregation points.

-- The Business Markets Group has also experienced a general lengthening of sales cycles across several segments. The company has reviewed its exposure to distressed financial services institutions and the company has not experienced any material negative effects from customers in this market segment.

-- The Content Markets Group has experienced a decrease in sales to certain media and entertainment companies who may be dependent on external financing sources. At the same time, the company has seen increased sales activity among larger media, entertainment and sports enterprises who seek to make more content available online.

-- To date, the European Markets Group has not seen the effect of the macroeconomic environment on sales activity."

I'm intrigued as to what these statements actually mean. The wholesale group statement about large customers bulking up on "more cost effective" transport could be read two ways: these customers are moving business to Level(3) and away from other providers, or these customers are opportunistically hammering Level(3) on price in a period of vulnerability. The remarks about financial services institutions and the European economy (KPN made the same statement yesterday) may be true, but then again I would naturally expect a lag here, as the real fun and games has taken place in Q4. As for the content distribution comment, my reading is that the contraction seen among "certain media and entertainment companies who may be dependent on external financing sources" points to some strain and cash-hoarding among the Video 2.0 start-up brigade, and I would assume that the growth among traditional media companies is supported by aggressive pricing.

Whatever the underlying dynamics, this company has unique assets and great people, and is under no imminent threat of default, despite the fact that the share price today seems to imply near term bankruptcy. Level(3)'s next debt maturities are $305m in September 2009, but the company has $587m in cash and equivalents, is free cash flow neutral in the past two quarters and expects to be positive in 2009, so the real test comes in March 2010, i.e., 16 months from now. Level(3)'s 11.5% bonds maturing March currently trade at 57 (!), so I have to assume that those who have taken a bath on the equity will be backing up the truck on the bonds in anticipation of a trade sale (at the current share price the company has a market cap of only $1.3bn) or eventual bankruptcy. This is the distressed waiting game, and it must be distinctly uncomfortable for those trying to focus on actually running the company.

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