Level 3's high risk manuever

That's what analysts are trying to determine following the network operator's recent acquisitions of two major software distributors within just two months.

Level 3 provides a range of services, from maintaining the dial-up modem banks that America Online customers use to connect to the Internet, to serving up bandwidth to corporations and other network operators over its fiber-optic network.

Led by maverick telecommunications veteran Jim Crowe, who made a fortune building and selling other networks, Level 3 was at the vanguard of a new wave of network operators that could undercut entrenched competitors by using new low-cost, Internet-based technologies. The company spent billions of dollars on a 20,000-mile network through much of North America and parts of Europe, reaping the benefits of runaway investment in fiber optics during a late 1990s telecom boom.

But with the dot-com collapse, and a glut of network capacity, Level 3 is now looking for greener pastures. Recently, Velocita, a potential Level 3 competitor, became the latest in a string of telecom casualties when it filed for Chapter 11 bankruptcy protection.

Level 3's new strategy is to combine its sprawling network with two powerhouses of software distribution. It can then in theory offer big companies delivery of commercial software packages, asset management and software licensing, all in a digital format.

In March, Level 3 completed the purchase of Norwood, Mass.-based CorpSoft, more widely known as Corporate Software, for $89 million in cash plus the assumption of $31 million in debt. It then snagged Dallas-based software distributor Software Spectrum last month for $122 million in cash.

The two moves essentially transform Level 3 into a software company--at least in terms of revenue.

Analysts estimate that the acquisitions of CorpSoft and Software Spectrum--the No. 2 and No. 3 software distributors on the market--will contribute 70 percent of Level 3's revenue by the fourth quarter of this year, according to a recent Credit Lyonnais Securities report. At the close of the Software Spectrum acquisition, non-telecom employees will outnumber telecom employees at Level 3. Software Spectrum shareholders will vote on the Level 3 deal June 18.

"Perfuming the pig"
This has been a trend-in-waiting for some time, said Level 3 executives. The new strategy "creates a whole new animal that's pretty unique in the industry," said Howard Diamond, chief executive of CorpSoft, now a subsidiary of Level 3.

But many analysts and market watchers see the strategy as simply a thinly disguised survival plan. "There's absolutely no business synergies today (in Level 3's software distribution plan). That's perfuming the pig," said Jon Oltsik, analyst with Hype-Free Consulting and a former executive with a start-up network operator.

Oltsik and other analysts said Level 3 acquired the two companies in order to meet revenue requirements mandated by creditors, not to build some software distribution empire. CorpSoft and Software Spectrum reported sales margins of 1.6 percent and 2.2 percent, respectively, for 2001, and were relative bargains due to their low valuation.

CorpSoft's Diamond said Level 3, his parent company, has clear intentions: To stay in business. "There's no pretense. Level 3 had some issues in terms of a revenue covenant."

According to Level 3's quarterly filing with the Securities and Exchange Commission, CorpSoft had $1.1 billion in revenue for 2001. Software Spectrum had $1.2 billion in 2001 sales.

Put the two companies with Level 3, which had $1.5 billion in sales in 2001, and the company is likely to keep creditors at bay for a while, said analysts. Without the acquisitions, however, Level 3 would have to face its creditors.

Level 3 is burdened by $6 billion in long-term debt, according to company financial statements. The company must have $2.3 billion in sales by the fourth quarter of this year in order to stave off creditors who have tied its credit line to revenue growth, according to the company's annual report to shareholders.

According to Adam Quinton, an analyst at Merrill Lynch, Level 3 has escaped any immediate debt worries, but the reprieve may not last long--especially if revenue falls.

"Following the announced Software Spectrum acquisition, we expect the company will not risk breaching financial covenants until mid-2004," Quinton said in a research note earlier this month. "Should revenue deteriorate from current levels, the company stated that it could seek to refinance debt maturing in 2005."

Between 2005 and 2010, Level 3 will need to refinance or repay the $6 billion in debt, said Quinton.

Further revenue covenants kick in by the fourth quarter of 2003 and 2004, Level 3's annual report said. For example, by the end of 2004, Level 3 has to collect $4.75 billion in sales to remain in compliance with the terms of its loans--a potentially tall order in a telecom climate that shows few signs of growth. If Level 3 falls short of these goals, its creditors could request payment of the loans, forcing the company to sell assets or otherwise restructure in order to pay off its creditors.

Vic Grover, an analyst at Kaufman Brothers, recently updated his estimates for Level 3 based on the Software Spectrum acquisition. Grover is projecting revenue of $2.82 billion in 2002, $4 billion in 2003 and $4.5 billion in 2004.

"The customers of Level 3 should take this as conscious measures by Level 3 to bolster its financial strength while influencing the demand for its low-cost broadband network," said John Gonsalves, a vice president with technology consultants Adventis. "All this came for an approximately $200 million outflow for a more than $2 billion revenue stream."

What's the plan?
Although Level 3's recent acquisitions bought it some time, analysts are questioning the strategy beyond fending off creditors.

Some financial experts, even those relatively positive about Level 3's moves, are perplexed by the company's plan. A Merrill Lynch report, for example, questioned the "commercial logic" of the acquisitions, noting that the Software Spectrum deal added a significant low-margin business to Level 3's balance sheet.

There is also no guarantee that the software distribution business CorpSoft and Software Spectrum are in will remain stable. One just has to look at the telecom industry to realize how quickly a market can turn sour. But Level 3 remains optimistic.

"Improvements in communications technology will continue to drive down the price of moving information and allow businesses to buy software functionality and data storage as a commercial service accessed remotely over broadband networks," Crowe said in a statement at the time of the Software Spectrum acquisition.

Level 3 already boasts a subsidiary that provides information technology (IT) outsourcing services to corporations, called (i)Structure.

The company may be clinging to a pie-in-the-sky hope that an industry, already proven to be a niche at best, morphs in a manner it seems ill-prepared to do, according to some analysts.

"We heard all of this speculation in droves five years ago and it didn't pan out," said Hype-Free's Oltsik.

Others note that telecom companies seem ill-equipped to handle new opportunities such as delivering software over networks, even if Level 3 is part of what was once a "new breed" of network operators. As such, Level 3's strategy is less a hopeful sign for a moribund industry bent on melding telecom with software and more a statement of the tenuous times in the market.

If nothing else, Level 3 gains a large customer base through the acquisitions, and goes straight to the head of the class in software distribution. The company becomes one of the largest license managers and software resellers in the world, according to company executives. CorpSoft says it serves more than 5,000 clients in 128 countries. Software Spectrum says it serves half of the Global 1000 companies.

The bad news is that heavyweights like Dell Computer and IBM are Level 3's new competitors. A Dell representative declined to comment on the competitive environment, but said, "We're focused on our own customers." An IBM representative couldn't immediately be reached for comment.

And Level 3 management doesn't have history on its side. "The fact is, telecom companies haven't done anything (successfully) but deliver telecom services," said Kneko Burney, director of business infrastructure and services at market researcher In-Stat/MDR.