FORM 10-Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE
ACT OF 1934
For the Quarterly Period Ended September 30, 2002
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period__________to__________
Commission file number 0-15658
LEVEL 3 COMMUNICATIONS, INC.
(Exact name of registrant as specified in its charter)
Delaware 47-0210602
(State of Incorporation) (I.R.S. Employer
Identification No.)
1025 Eldorado Blvd., Broomfield, CO 80021
(Address of principal executive offices) (Zip Code)
(720) 888-1000
(Registrant's telephone number,
including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports(s)), and (2) has been subject to
such filing requirements for the past 90 days. Yes X No
The number of shares outstanding of each class of the issuer's common
stock, as of November 6, 2002:
Common Stock 422,689,028 shares
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Page
Part I - Financial Information
------------------------------
Item 1. Unaudited Financial Statements:
Consolidated Condensed Statements of Operations 2
Consolidated Condensed Balance Sheets 3
Consolidated Statements of Cash Flows 5
Consolidated Statement of Changes in Stockholders' Deficit 7
Consolidated Statements of Comprehensive Loss 8
Notes to Consolidated Condensed Financial Statements 9
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 38
Part II - Other Information
---------------------------
Item 4. Submission of Matters to a Vote of Security Holders 50
Item 6. Exhibits and Reports on Form 8-K 50
Signatures 51
Certifications 52
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Condensed Statements of Operations
(unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
-----------------------------------------------------
(dollars in millions, except per share data) 2002 2001 2002 2001
Revenue......................................................... $ 1,067 $ 372 $2,203 $1,207
Costs and Expenses:
Cost of revenue.............................................. 759 146 1,389 620
Depreciation and amortization................................ 201 306 601 864
Selling, general and administrative.......................... 233 316 726 993
Restructuring and impairment charges......................... 3 -- 50 111
----- ----- ----- -----
Total Costs and Expenses........................................ 1,196 768 2,766 2,588
----- ----- ----- -----
Loss from Operations............................................ (129) (396) (563) (1,381)
Other Income (Expense):
Interest income.............................................. 8 34 23 142
Interest expense, net........................................ (154) (183) (414) (495)
Other, net................................................... (29) 38 79 3
----- ----- ----- -----
Total Other Expense............................................. (175) (111) (312) (350)
----- ----- ----- -----
Loss from Continuing Operations Before Income Taxes............. (304) (507) (875) (1,731)
Income Tax Benefit.............................................. -- -- 119 --
----- ----- ----- -----
Net Loss from Continuing Operations............................. (304) (507) (756) (1,731)
Loss from Discontinued Operations, net.......................... -- (24) -- (66)
Extraordinary Gain on Debt Extinguishments, net................. 5 94 211 94
----- ----- ----- -----
Net Loss ....................................................... $ (299) $ (437) $ (545) $ (1,703)
====== ====== ====== ======
Earnings (Loss) Per Share of Level 3 Common Stock
(Basic and Diluted):
Continuing operations...................................... $ (0.74) $(1.35) $ (1.89) $ (4.67)
Discontinued operations, net............................... -- (0.07) -- (0.18)
Extraordinary gain on debt extinguishments, net............ 0.01 0.25 0.53 0.25
----- ----- ----- -----
Net loss................................................... $ (0.73) $(1.17) $ (1.36) $ (4.60)
====== ====== ====== ======
See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Condensed Balance Sheets
(unaudited)
September 30, December 31,
(dollars in millions, except per share data) 2002 2001
Assets
Current Assets:
Cash and cash equivalents........................................................ $ 963 $1,297
Marketable securities............................................................ -- 206
Restricted securities............................................................ 541 155
Accounts receivable, less allowances of $37 and $46, respectively................ 443 239
Current assets of discontinued Asian operations.................................. -- 74
Other. 121 63
----- -----
Total Current Assets................................................................ 2,068 2,034
Property, Plant and Equipment, net.................................................. 6,360 6,890
Goodwill and Intangibles, net....................................................... 375 28
Other Assets, net................................................................... 291 364
----- -----
$9,094 $9,316
====== ======
See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Condensed Balance Sheets
(unaudited)
September 30, December 31,
(dollars in millions, except per share data) 2002 2001
Liabilities and Stockholders' Deficit
Current Liabilities:
Accounts payable............................................................... $ 560 $ 714
Current portion of long-term debt.............................................. 12 7
Accrued payroll and employee benefits.......................................... 173 162
Accrued interest............................................................... 74 86
Deferred revenue............................................................... 158 124
Current liabilities of discontinued Asian operations........................... -- 74
Other. 234 225
------ ------
Total Current Liabilities......................................................... 1,211 1,392
Long-Term Debt, less current portion.............................................. 6,385 6,209
Deferred Revenue.................................................................. 1,291 1,335
Accrued Reclamation Costs......................................................... 92 92
Other Liabilities................................................................. 369 353
Commitments and Contingencies
Stockholders' Deficit:
Preferred stock, $.01 par value, authorized 10,000,000 shares: no
shares outstanding........................................................... -- --
Common stock:
Common stock, $.01 par value, authorized 1,500,000,000 shares:
416,869,716 outstanding in 2002 and 384,703,922
outstanding in 2001........................................................ 4 4
Class R, $.01 par value, authorized 8,500,000 shares: no
shares outstanding......................................................... -- --
Additional paid-in capital..................................................... 5,939 5,602
Accumulated other comprehensive loss........................................... (125) (144)
Accumulated deficit............................................................ (6,072) (5,527)
------ ------
Total Stockholders' Deficit....................................................... (254) (65)
----- -----
$9,094 $9,316
====== ======
See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(unaudited)
Nine Months Ended
September 30,
(dollars in millions) 2002 2001
Cash Flows from Operating Activities:
Net Loss.................................................................................. $ (545) $ (1,703)
Loss from discontinued operations......................................................... -- 66
Extraordinary gain on debt extinguishment, net............................................ (211) (94)
----- -----
Loss from continuing operations........................................................... (756) (1,731)
Adjustments to reconcile net loss from continuing operations to
net cash (used in) provided by operating activities:
Equity earnings........................................................................ (10) (7)
Depreciation and amortization.......................................................... 601 864
Induced conversion expense on convertible debt......................................... 20 --
Dark fiber and submarine cable non-cash cost of revenue................................ 3 152
Loss on impairments.................................................................... 46 61
Writedown of investments............................................................... -- 37
Gain on sale of assets................................................................. (100) (12)
Non-cash compensation expense attributable to stock awards............................. 154 239
Deferred revenue....................................................................... 26 576
Accrued interest on marketable securities.............................................. 4 22
Deposits............................................................................... -- 60
Federal income tax refunds............................................................. -- 72
Interest expense on discount notes..................................................... 82 88
Accrued interest on long-term debt..................................................... (10) (28)
Changes in working capital items, net of amounts acquired:
Receivables......................................................................... 107 207
Other assets........................................................................ (45) 9
Payables............................................................................ (475) (475)
Other liabilities................................................................... (59) 63
Other.................................................................................. (30) 34
----- -----
Net Cash (Used in) Provided by Operating Activities.......................................... (442) 231
Cash Flows from Investing Activities:
Proceeds from sales and maturities of marketable securities............................... 200 2,770
Purchases of marketable securities........................................................ -- (1,112)
(Increase) decrease in restricted cash and securities, net................................ (387) 76
Capital expenditures...................................................................... (173) (2,225)
Release of capital accruals............................................................... 164 --
Purchases of assets held-for-sale......................................................... -- (97)
Investments, net.......................................................................... (16) --
McLeod business acquisition............................................................... (51) --
CorpSoft acquisition, net of transaction costs and cash acquired of $34................... (93) --
Software Spectrum acquisition, net of transaction costs and cash acquired of $40.......... (94) --
Proceeds from sale of Commonwealth Telephone shares....................................... 166 --
Proceeds from sale of property, plant and equipment, and other assets..................... 45 47
----- -----
Net Cash Used in Investing Activities........................................................ $ (239) $ (541)
(continued)
See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(unaudited)
(continued)
Nine Months Ended
September 30,
-------------------------
(dollars in millions) 2002 2001
Cash Flows from Financing Activities:
Long-term debt borrowings, net of issuance costs.......................................... $ 490 $ 761
Purchases of and payments on long-term debt, including current portion.................... (98) (116)
Stock options exercised................................................................... -- 2
------ ------
Net Cash Provided by Financing Activities.................................................... 392 647
Net Cash Used in Discontinued Operations..................................................... (48) (127)
Effect of Exchange Rates on Cash and Cash Equivalents........................................ 3 (25)
------ ------
Net Change in Cash and Cash Equivalents...................................................... (334) 185
Cash and Cash Equivalents at Beginning of Period............................................. 1,297 1,255
------ ------
Cash and Cash Equivalents at End of Period................................................... $ 963 $1,440
====== ======
Supplemental Disclosure of Cash Flow Information:
Income tax refunds received............................................................. $ 119 $ 72
Interest paid........................................................................... 325 175
Noncash Investing and Financing Activities:
Common stock issued in exchange for long term debt........................................ $ 161 $ 61
Long term debt principal retired by issuing common stock.................................. 299 169
See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Statement of Changes in Stockholders' Deficit
For the nine months ended September 30, 2002
(unaudited)
Accumulated
Additional Other
Common Paid-in Comprehensive Accumulated
(dollars in millions) Stock Capital Loss Deficit
Total
Balances at December 31, 2001........... $ 4 $ 5,602 $ (144) $ (5,527) $ (65)
Common Stock:
Issued to extinguish long-term -- 161 -- -- 161
debt..............................
Stock plan and warrant grants........ -- 176 -- -- 176
Net Loss................................ -- -- -- (545) (545)
Other Comprehensive Income.............. -- -- 19 -- 19
----- ----- ----- ----- -----
Balances at September 30, 2002.......... $ 4 $ 5,939 $ (125) $ (6,072) $ (254)
======= ======= ======= ======== =======
See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Statements of Comprehensive Loss
(unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------------------------------------------
(dollars in millions) 2002 2001 2002 2001
Net Loss...................................................... $ (299) $ (437) $ (545) $(1,703)
Other Comprehensive Income (Loss) Before Tax:
Foreign currency translation gains (losses)................ (24) 28 6 (22)
Unrealized holding losses arising during
period................................................... -- 3 1 1
Reclassification adjustment for (gains) losses
included in net loss..................................... 16 3 12 (14)
----- ----- ----- -----
Other Comprehensive Income (Loss) Before Tax.................. (8) 34 19 (35)
Income Tax Benefit Related to Items of Other
Comprehensive Income (Loss)................................ -- -- -- --
Other Comprehensive Income (Loss) Net of Taxes................ (8) 34 19 (35)
----- ----- ----- -----
Comprehensive Loss............................................ $ (307) $ (403) $ (526) $ (1,738)
======= ======= ======= =======
See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Notes to Consolidated Condensed Financial Statements
1. Summary of Significant Accounting Policies
The consolidated condensed financial statements include the accounts of Level 3
Communications, Inc. and subsidiaries (the "Company" or "Level 3") in which it
has control, which are engaged in enterprises primarily related to
communications, information services, and coal mining. Fifty-percent-owned
mining joint ventures are consolidated on a pro rata basis. Investments in other
companies in which the Company exercises significant influence over operating
and financial policies or has significant equity ownership are accounted for by
the equity method. All significant intercompany accounts and transactions have
been eliminated.
The consolidated condensed balance sheet of Level 3 Communications, Inc. and
subsidiaries at December 31, 2001 has been condensed from the Company's audited
balance sheet as of that date. All other financial statements contained herein
are unaudited and, in the opinion of management, contain all adjustments
(consisting only of normal recurring accruals) necessary for a fair presentation
of financial position, results of operations and cash flows for the periods
presented. The Company's accounting policies and certain other disclosures are
set forth in the notes to the consolidated financial statements contained in the
Company's Annual Report on Form 10-K as amended, for the year ended December 31,
2001. These financial statements should be read in conjunction with the
Company's audited consolidated financial statements and notes thereto. The
preparation of the consolidated condensed financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amount of assets and
liabilities, disclosure of contingent assets and liabilities and the reported
amount of revenue and expenses during the reported period. Actual results could
differ from these estimates.
The results of operations for the three and nine months ended September 30, 2002
are not necessarily indicative of the results expected for the full year.
The Company's communications business provides a broad range of integrated
communications services primarily in the United States and Europe as a
facilities-based provider (that is, a provider that owns or leases a substantial
portion of the property, plant and equipment necessary to provide its services.)
The Company has created, through a combination of construction, purchase and
leasing of facilities and other assets, an advanced international, end-to-end,
facilities-based communications network. The Company has built and continues to
upgrade the network based on optical and Internet Protocol technologies in order
to leverage the efficiencies of these technologies to provide lower cost
communications services.
Revenue for communications services, including private line, wavelengths,
colocation, Internet access, managed modem, voice and dark fiber revenue from
contracts entered into after June 30, 1999, is recognized monthly as the
services are provided. Reciprocal compensation revenue is recognized only when
an interconnection agreement is in place with another carrier, and the relevant
regulatory authorities have approved the terms of the agreement. Revenue
attributable to leases of dark fiber pursuant to indefeasible rights-of-use
agreements ("IRUs") that qualify for sales-type lease accounting, and were
entered into prior to June 30, 1999, are recognized at the time of delivery and
acceptance of the fiber by the customer.
It is the Company's policy to recognize termination revenue when certain
conditions have been met. These conditions include: 1) the customer has accepted
all or partial delivery of the asset or service; 2) Level 3 has received
consideration for the asset or service provided; and 3) Level 3 is not legally
obligated to provide additional product or services to the customer or their
successor. Termination revenue is typically recognized in situations where a
customer and Level 3 mutually agree to terminate all or a portion of the service
provided, or the customer and/or its assets fail to emerge from bankruptcy, thus
Level 3 is not obligated to provide additional service to the customer or its
successor. If the conditions described
above are met, the Company will recognize termination revenue equal to the fair
value of consideration received, less any amounts previously recognized.
Termination revenue is reported in the same manner as the original product or
service provided.
Level 3 entered into joint build arrangements during the construction of its
North American and European networks in which it was the sponsoring partner.
These arrangements are generally characterized as fixed fee or cost sharing
arrangements. For fixed-fee joint build arrangements in which Level 3 is the
sponsor, the Company assumes the cost risk of completing the work for a fixed
price agreed upon at the inception of the arrangement between the parties. Level
3 recognizes revenue equal to the value of the contract when construction is
complete and payment is received from the joint build partner. For cost sharing
arrangements each of the joint build parties shares the cost risk of completing
the work. These contracts typically include provisions in which the sponsoring
partner receives a management fee for construction services provided. Level 3
recognizes this management fee as revenue in the period when the contract is
completed and payment is received from the joint build partner.
For the nine months ended September 30, 2002, Level 3 did not recognize revenue
attributable to non-monetary exchange transactions entered into in 2002 whereby
it sold IRUs, other capacity, or other services to a company from which Level 3
received communications assets or services. During the three and nine months
ended September 30, 2002, $1 million and $5 million, respectively, of amortized
revenue was recognized related to contracts performed in 2001.
In August 2002, the staff of the Securities and Exchange Commission ("SEC")
indicated that the SEC had concluded that all non-monetary exchange transactions
for telecommunications capacity should be accounted for as an exchange of assets
irrespective of whether transaction involved the lease of assets. The conclusion
was based on the SEC staff's view that the right to use an asset (that is, a
lease), is in fact an asset and not a service contract, irrespective of whether
such asset is recognized on the balance sheet. This conclusion requires that
non-monetary exchange transactions for telecommunications capacity involving the
exchange of one or more operating leases be recognized based on the carrying
value of the assets exchanged, rather than at fair value, resulting in no
recognition of revenue for the transactions. Prior to the SEC's communication on
this issue, Level 3's accounting for these transactions, which resulted in Level
3 recognizing revenue, had been consistent with industry guidance for these
types of transactions provided by its current independent accountants (KPMG) and
its prior independent accountants (Arthur Andersen). In addition, the revenue
recognition approach for these transactions that the Company followed was an
acceptable practice in not only the communications industry but other industries
as well. The SEC has indicated that it expects affected companies to
retroactively apply this guidance to historical non-monetary exchange capacity
transactions that occurred in prior years and, if appropriate, restate their
financial statements.
Level 3 was a party to three transactions that involved the use of operating
leases for capacity. The revenue recognized in 2001 from these transactions was
$21 million and $2 million has been recognized in the first six months of 2002
from these transactions.
Taking into account the SEC's guidance, Level 3 does not believe that it is
appropriate to restate its previously issued financial statements for this issue
involving non-monetary transactions, as the amount of revenue recognized was not
significant to the reported revenue of the Company and Level 3 has previously
disclosed the nature and amount of these transactions in its previous filings
with the SEC and in a press release issued on February 13, 2002. However, Level
3 ceased recognizing revenue from the three transactions involving operating
leases, estimated to be approximately $1 million per quarter, in the third
quarter of 2002.
The Company is obligated under dark fiber IRUs and other capacity agreements to
maintain its network in efficient working order and in accordance with industry
standards. Customers are obligated for the term of the agreement to pay for
their allocable share of the costs for operating and maintaining the network.
The Company recognizes this revenue monthly as services are provided.
Cost of revenue for the communications business includes leased capacity,
right-of-way costs, access charges and other third party circuit costs directly
attributable to the network, as well as costs of assets sold pursuant to
sales-type leases. The cost of revenue associated with sales-type leases of dark
fiber agreements entered into prior to June 30, 1999, was determined based on an
allocation of the total estimated costs of the network to the dark fiber
provided to the customers. The allocation takes into account the service
capacity of the specific dark fiber provided to customers relative to the total
expected capacity of the network. Changes to total estimated costs and network
capacity are included prospectively in the allocation in the period in which
they become known. Cost of revenue associated with the sale of transoceanic
capacity that previously met the accounting requirements as sales-type leases,
were also determined based on taking into account service capacity and costs
incurred by Level 3 and its contractors to construct such assets.
Accounting practice and guidance with respect to the treatment of submarine dark
fiber sales and terrestrial IRU agreements continue to evolve. Any changes in
the accounting treatment could affect the way the Company accounts for revenue
and expenses associated with these transactions in the future.
The Company's information services business is comprised of two operating units:
(i)Structure, a provider of computer outsourcing and systems integration
services, and Software Spectrum, Inc. ("Software Spectrum"), a distributor,
marketer and reseller of business software. (i)Structure provides outsourcing
services, typically through contracts ranging from 3-5 years, to firms that
desire to focus their resources on their core businesses. Under these contracts,
(i)Structure recognizes revenue in the month the service is provided.
Additionally, (i)Structure provides systems integration services that help
customers define, develop and implement cost-effective information systems.
Revenue from the existing contracts is generally recognized on a straight-line
basis and in the month the service is provided. Cost of revenue includes costs
of consultants' salaries and other direct costs for (i)Structure's businesses.
Software Spectrum, which includes the operations of CorpSoft, Inc. ("CorpSoft"),
is a reseller of business software. Accounting literature provides guidance to
enable companies to determine whether revenues from the reselling of goods and
services should be recorded on a "gross" or "net" basis. The Company believes
that the facts and circumstances, particularly those involving pricing and
credit risk indicate that the majority of Software Spectrum's sales should be
recorded on a "gross" basis. The latitude and ability of Software Spectrum to
establish the selling price to the customer is a clear indication of "gross"
revenue reporting. The assumption of credit risk is another important factor in
determining "gross" versus "net" reporting. Software Spectrum has the
responsibility to pay suppliers for all products ordered, regardless of when, or
if, it collects from its customers. Software Spectrum is also solely responsible
for determining the creditworthiness of its customers.
Software Spectrum recognizes revenue from software sales at the time of product
shipment, or in accordance with terms of licensing contracts, when the price to
the customer is fixed, and collectibility is reasonably assured. Revenue from
maintenance contracts is recognized when invoiced, the license period has
commenced, when the price to the customer is fixed, and collectibility is
reasonably assured, as Software Spectrum has no material costs or future
obligations associated with future performance under these maintenance
contracts. Consulting service revenue is recognized on a time and materials
basis or percentage of completion basis. Advance billings are recorded as
deferred revenue until services are provided. Cost of revenues includes direct
costs of the licensing activity, costs to purchase and distribute software and
direct costs to provide consulting services. The costs directly attributable to
advance billings are deferred and included in Other Current Assets on the
Consolidated Condensed Balance Sheet. Rebate income received from software
publishers is recognized in the period in which the rebate is earned and
reflected as a reduction of cost of revenue.
In June 2001, the FASB issued SFAS No. 141, "Business Combinations" ("SFAS No.
141"). SFAS No. 141 requires all business combinations initiated after June 30,
2001, to be accounted for using the purchase method of accounting. Prior to the
issuance of SFAS No. 141, companies accounted for
mergers and acquisitions using one of two methods; pooling of interests or the
purchase accounting method. Level 3 has accounted for acquisitions using the
purchase method and the adoption of SFAS No. 141 has not had a material effect
on the Company's results of operations or financial position.
In June 2001, the FASB also issued SFAS No. 142, "Goodwill and Other Intangible
Assets" ("SFAS No. 142"). SFAS No. 142 is effective for fiscal years beginning
January 1, 2002. SFAS No. 142 requires companies to segregate identifiable
intangible assets acquired in a business combination from goodwill. The
remaining goodwill is no longer subject to amortization over its estimated
useful life. However, the carrying amount of the goodwill must be assessed at
least annually for impairment using a fair value based test. Goodwill
attributable to equity method investments is no longer amortized but is still
subject to impairment analysis using existing guidance for equity method
investments. For the goodwill and intangible assets in place as of December 31,
2001, the adoption of SFAS No. 142 did not have a material impact on the
Company's results of operations or its financial position. The Company believes
the impact of SFAS No. 142 will not have a material effect on accounting for
future acquisitions. (See Notes 2 and 8)
In June 2001, the FASB also approved SFAS No. 143, "Accounting for Asset
Retirement Obligations" ("SFAS No. 143"). SFAS No. 143 establishes accounting
standards for recognition and measurement of a liability for an asset retirement
obligation and the associated asset retirement cost. The fair value of a
liability for an asset retirement obligation is to be recognized in the period
in which it is incurred if a reasonable estimate of fair value can be made. The
associated retirement costs are capitalized and included as part of the carrying
value of the long-lived asset and amortized over the useful life of the asset.
SFAS No. 143 will be effective for the Company beginning on January 1, 2003. The
Company expects that its coal mining business will be affected by this standard
and is currently evaluating the potential effect of SFAS No. 143 on its future
results of operations and financial position.
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No.
4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections"
("SFAS No. 145"). SFAS No. 145 is effective for fiscal years beginning and
certain transactions entered into after May 15, 2002. SFAS No. 145 requires
gains and losses from the extinguishment of debt be classified as extraordinary
items only if they meet the criteria in APB Opinion No. 30. Previously, SFAS No.
4 generally required all gains and losses from debt extinguished prior to
maturity to be classified as an extraordinary item in the statement of
operations. APB Opinion No. 30 requires that to qualify as an extraordinary
item, the underlying event or transaction should possess a high degree of
abnormality and be of a type clearly unrelated to, or only incidentally related
to, the ordinary activities of the Company, and would not reasonably be expected
to recur in the foreseeable future. Any gain or loss on extinguishment of debt
classified as an extraordinary item in prior periods presented that does not
meet the criteria in APB Opinion No. 30 shall be reclassified. The Company
believes that due to the recurring nature of its debt repurchases and exchanges,
the adoption of SFAS No. 145 in 2003 will result in the reclassification of the
related extraordinary gains and losses in the statement of operations to other
non-operating income.
SFAS No. 145 also addresses other issues including amending certain provisions
of SFAS No. 13, "Accounting for Leases" ("SFAS No. 13"). SFAS No. 145 requires
that capital leases that are modified so that the resulting lease agreement is
classified as an operating lease be accounted for under sales-leaseback
provisions. This amendment and the other issues addressed in SFAS No. 145 are
not expected to have a material effect on the financial position or results of
operations of the Company.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities", ("SFAS No. 146"). SFAS No. 146 addresses
financial accounting and reporting for costs associated with exit or disposal
activities (excluding an entity newly acquired in a business combination), often
referred to as "restructuring costs", and nullifies prior accounting guidance
with respect to such costs. This Statement will spread out the reporting of
expenses related to restructurings initiated after 2002, because commitment to a
plan to exit an activity or dispose of long-lived assets will no longer be
enough to record a liability for the anticipated costs. Under previous guidance,
a liability for an exit cost was recognized at the date of an entity's
commitment to an exit plan. Instead, exit and disposal costs will be recorded
when they are incurred and can be measured at fair value, and related
liabilities will be
subsequently adjusted for changes in estimated cash flows. The provisions of
SFAS No. 146 shall be effective for exit or disposal activities initiated after
December 31, 2002, with no retroactive restatement allowed. Early application is
permitted. Level 3's management continues to review portions of its
communications business and other businesses to determine how those businesses
will assist with the Company's focus on delivery of communications and
information services and reaching free cash flow breakeven. If the Company
elects to exit these businesses, the costs required to exit or dispose of these
businesses will not be recorded until they are actually incurred. Level 3 is
unable to determine at this time whether these costs will be incurred or whether
they will be material to its results of operations or financial position.
In September 2002, the Emerging Issues Task Force "EITF" addressed the
accounting for convertible debt for equity exchanges in Issue 02-15: Determining
Whether Certain Conversions of Convertible Debt to Equity Securities Are within
the Scope of FASB Statement No. 84. The EITF concluded in EITF 02-15 that these
types of transactions should be accounted for as induced conversions in
accordance with FASB No. 84, "Induced Conversions of Convertible Debt" ("SFAS
No. 84"). SFAS No. 84 requires a non-cash charge to earnings for the implied
value of an inducement to convert from convertible debt to common equity
securities of the issuer. The accounting is to be applied prospectively for
those convertible debt for equity exchanges completed after September 11, 2002,
the date of the EITF's consensus. The Company applied the provisions of SFAS No.
84 to all convertible debt for equity exchange transactions completed during the
third quarter.
Deferred income taxes are provided for the temporary differences between the
financial reporting and tax basis of the Company's assets and liabilities using
enacted tax rates in effect for the year in which the differences are expected
to reverse. Net operating losses not utilized can be carried forward for 20
years to offset future taxable income. A valuation allowance has been recorded
against deferred tax assets, as the Company is unable to conclude under relevant
accounting standards that it is more likely than not that deferred tax assets
will be realizable. Federal legislation enacted in 2002 permitted the Company to
apply unutilized net operating losses against 1996 taxable income. As a result,
the Company recognized an income tax benefit and received a refund of $119
million in the first quarter of 2002.
In 2001, the Company agreed to sell its Asian telecommunications business to
Reach Ltd ("Reach"). Therefore, the assets, liabilities, results of operations
and cash flows for this business have been classified as discontinued operations
in the consolidated condensed financial statements (See Note 3).
Where appropriate, items within the consolidated condensed financial statements
have been reclassified from the previous periods to conform to current period
presentation.
2. Acquisitions
On January 24, 2002, Level 3 completed the acquisition of the wholesale dial-up
access business of McLeodUSA Incorporated for approximately $51 million in cash
consideration and the assumption of certain operating liabilities related to
that business. The acquisition includes customer contracts, approximately 350
POPs (Points of Presence) and related facilities across the U.S., equipment,
underlying circuits and certain employees. The acquisition enables Level 3 to
provide managed modem services in all 50 states with a coverage area that
includes approximately 80 percent of the United States population, up from 37
states, and approximately 57 percent of the United States population. The
preliminary allocation of the purchase price resulted in the cash consideration
plus assumed liabilities exceeding the fair value of the identifiable tangible
and intangible assets acquired by approximately $34 million, which is recorded
as goodwill. In accordance with SFAS No. 142, the goodwill will be assessed
annually for impairment and will not be amortized. The results of operations
attributable to the McLeod assets and liabilities are included in the condensed
statement of operations from the date of acquisition.
On March 13, 2002, the Company acquired privately held CorpSoft, Inc., a major
distributor, marketer and reseller of business software. Level 3 agreed to pay
approximately $89 million in cash and retire approximately $37 million in debt
to acquire CorpSoft. The transaction is valued at approximately $94 million,
adjusted for CorpSoft's $34 million cash position on the acquisition date. The
$128 million cash purchase price, including transaction costs, exceeded the fair
value of the net tangible and intangible assets by approximately $130 million
based on an independent formal valuation of the value of the assets and
liabilities acquired.
On June 18, 2002, the Company completed the acquisition of Software Spectrum,
Inc., a global provider, marketer and reseller of business software. Software
Spectrum shareholders received $37 in cash from Level 3 for each share of
Software Spectrum common stock. The total cash consideration, including
outstanding options and expected transaction costs, was approximately $136
million. The transaction is valued at approximately $96 million, adjusted for
Software Spectrum's $40 million cash position on the acquisition date. The $136
million purchase price, including transaction costs, exceeded the fair value of
the net tangible and intangible assets by approximately $75 million based on an
independent formal valuation of the value of the assets and liabilities
acquired.
The results of CorpSoft and Software Spectrum's operations are included in the
condensed statement of operations from the dates of acquisition. On a pro-forma
basis, CorpSoft and Software Spectrum would have had combined annual revenues of
approximately $2.4 billion for the most recent fiscal year. Level 3 expects
these acquisitions will enable its information services business to leverage
CorpSoft and Software Spectrum's customer base, worldwide presence and
relationships to expand its portfolio of services. The Company believes that
communications price performance will improve more rapidly than computing and
data storage price performance. As a result, companies will, over time seek to
gain information technology operating efficiency by acquiring software
functionality and data storage capability as commercial services purchased and
then delivered over broadband networks such as the Level 3 network. In addition,
Level 3 expects to utilize its network infrastructure to facilitate the
deployment of software to CorpSoft and Software Spectrum's customers.
The following is pro-forma financial information of the Company assuming the
acquisitions of McLeod, CorpSoft and Software Spectrum had occurred at the
beginning of each period presented:
Pro-Forma
---------------------------------------------------------
Nine Months Ended Year Ended
(dollars in millions, except per share data) September 30, September 30, December 31,
2002 2001 2001
Revenue ................................................... $2,826 $2,909 $4,015
Loss from Continuing Operations............................ (762) (1,795) (5,579)
Net Loss................................................... (551) (1,812) (5,109)
Net Loss per Share......................................... (1.38) (4.89) (13.67)
The following are the assets and liabilities acquired in the McLeod, CorpSoft
and Software Spectrum transactions as of their respective acquisition dates:
Software
(dollars in millions) McLeod CorpSoft Spectrum
Assets:
Cash and cash equivalents................................................. $ -- $ 34 $ 40
Accounts receivable....................................................... -- 151 130
Other current assets...................................................... -- 18 3
Property, plant and equipment, net........................................ 19 6 13
Identifiable intangibles.................................................. 49 26 49
Goodwill.................................................................. 34 130 75
Other assets.............................................................. -- 6 1
--- --- ---
Total Assets................................................................. 102 371 311
Liabilities:
Accounts payable.......................................................... -- 182 138
Accrued payroll........................................................... -- 19 19
Other current liabilities................................................. 43 6 18
Current portion of long-term debt......................................... 8 19 --
Other liabilities......................................................... -- 17 --
--- --- ---
Total Liabilities............................................................ 51 243 175
--- --- ---
Purchase Price............................................................... $ 51 $ 128 $ 136
===== ===== =====
3. Discontinued Asian Operations
In December 2001, Level 3 announced that it had agreed to sell its Asian
telecommunications business to Reach Ltd. for no cash consideration. The
agreement covered subsidiaries that included the Asian network operations,
assets, liabilities and future financial obligations. This included Level 3's
share of the Northern Asian cable system, capacity on the Japan-US cable system,
capital and operational expenses related to these two systems, gateways in Hong
Kong and Tokyo, and existing customers on Level 3's Asian network.
The transaction closed on January 18, 2002. As of December 31, 2001, the net
carrying value of Level 3's Asian assets was approximately $465 million. In
accordance with SFAS No. 144, in the fourth quarter of 2001, Level 3 recorded an
impairment loss on these assets held for sale within discontinued operations,
equal to the difference between the carrying value of the assets and their fair
value. Based upon the terms of the agreement, the Company also accrued
approximately $51 million in certain capital obligations it retained for the two
submarine systems to be sold to Reach, and estimated transaction costs. As of
September 30, 2002, approximately $3 million of the total accrual had not yet
been paid.
The 2002 operating results through the transaction date were not significant.
The following is the summarized results of operations for the three and nine
months ended September 30, 2001 for the discontinued Asian operations:
Three Months Ended Nine Months Ended
(dollars in millions) September 30, 2001 September 30, 2001
Revenue............................................................ $ 3 $ 6
Costs and Expenses:
Cost of revenue................................................. (4) (9)
Depreciation and amortization................................... (8) (18)
Selling, general and administrative............................. (15) (45)
--- ---
Total costs and expenses...................................... (27) (72)
--- ---
Loss from Discontinued Operations.................................. $ (24) $ (66)
===== =====
SFAS No. 144 requires that long-lived assets that have met relevant criteria
should be classified as "held for sale" and shall be identified separately in
the asset and liability sections of the balance sheet. The assets and
liabilities of the Asian operations met these criteria as of December 31, 2001
and are classified as current due to their sale to Reach in January of 2002.
The following is summarized financial information for the discontinued Asian
operations as of December 31, 2001 (dollars in millions):
Financial Position
Current Assets:
Cash and cash equivalents................................................$ 34
Restricted securities.................................................... 17
Receivables.............................................................. 21
Other.................................................................... 2
----
Total Current Assets........................................................$ 74
====
Current Liabilities:
Accounts payable and accrued liabilities.................................$ 58
Current portion of long-term debt........................................ 8
Deferred revenue......................................................... 6
Other.................................................................... 2
----
Total Current Liabilities..................................................$ 74
=====
Net Assets ................................................................$ --
=====
4. Restructuring and Impairment Charges
In 2001, the Company announced that due to the duration and severity of the
slowdown in the economy and the telecommunications industry, it would be
necessary to reduce operating expenses as well as reduce and reprioritize
capital expenditures in an effort to be in a position to benefit when the
economy recovers. As a result of these actions, the Company reduced its global
work force, primarily in the communications business in the United States and
Europe by approximately 2,700 employees. Restructuring charges of approximately
$10 million, $40 million and $58 million were recorded in the first, second and
fourth quarters of 2001, respectively, of which $66 million related to staff
reduction and related costs and $42 million to real estate lease termination
costs. In total, the Company has paid $66 million in severance and related
fringe benefit costs and $17 million in lease termination costs as of September
30,
2002 for these actions. The Company was able to record benefits of $2 million
and $6 million for the three and nine month periods ending September 30, 2002,
respectively, due to the successful termination of European leases for less than
had originally been estimated and included it in Restructuring and Impairment
Charges in the consolidated condensed statement of operations. Lease termination
obligations of $19 million are expected to be substantially paid by December 31,
2002.
In the second quarter of 2002, Level 3 recorded a restructuring charge of $3
million and a non-cash impairment charge of $44 million. The $3 million
restructuring charge was attributable to the costs associated with an additional
workforce reduction of approximately 200 employees in the communications
business in North America and Europe. As of September 30, 2002, the company had
paid $3 million in costs associated with the additional workforce reduction. The
Company recorded an impairment charge of $44 million related to an operating
colocation facility near Boston, as well as excess communications inventory and
certain corporate facilities in Colorado, which are classified as held for sale
in other non-current assets. As a result of the completion of additional
colocation space in Boston by other providers, the continued overabundance of
communications equipment in the secondary markets, and the soft demand for
office space in the metropolitan Denver area, the Company believes that these
assets are obsolete and that the estimated future undiscounted cash flows
attributable to these assets will be insufficient to recover their current
carrying value. The new carrying values of these assets are based on offers
received from third parties for the real estate properties or actual sales of
similar communications assets.
In the third quarter of 2002, the Company recorded a restructuring charge of $5
million primarily for severance and employee related costs associated with the
integration of CorpSoft and Software Spectrum. Approximately 100 employees,
primarily in Boston, were affected by the workforce reduction.
Level 3 continues to conduct a comprehensive review of its communications
assets, specifically assets deployed along its intercity network and in its
gateway facilities. It is possible that additional communications equipment may
be identified as obsolete or excess and additional impairment charges recorded
to reflect the realizable value of these assets in future periods.
5. Loss Per Share
The Company had a loss from continuing operations for the three and nine months
ended September 30, 2002 and 2001, respectively. Therefore, the dilutive effect
of the approximately 158 million and 17 million shares at September 30, 2002 and
2001, respectively, attributable to the three series of convertible subordinated
notes and the approximately 56 million and 41 million stock-based awards and
warrants outstanding at September 30, 2002 and 2001, respectively, have not been
included in the computation of diluted loss per share because their inclusion
would have been anti-dilutive to the computation.
The following details the earnings (loss) per share calculations for the Level 3
common stock:
Three Months Ended Nine Months Ended
September 30, September 30,
-----------------------------------------------------
(dollars in millions, except per share data) 2002 2001 2002 2001
Net Loss from Continuing Operations............................. $ (304) $ (507) $ (756) $(1,731)
Discontinued Operations, net.................................... -- (24) -- (66)
Extraordinary Gain on Debt Extinguishments, net................. 5 94 211 94
------ ------ ------ ------
Net Loss........................................................ $ (299) $ (437) $ (545) $(1,703)
====== ====== ======= ======
Total Number of Weighted Average Shares Outstanding
used to Compute Basic and Dilutive Earnings Per
Share (in thousands) ......................................... 410,898 375,638 400,371 370,582
Earnings (Loss) Per Share of Level 3 Common Stock
(Basic and Diluted):
Continuing operations...................................... $ (0.74) $ (1.35) $ (1.89) $ (4.67)
Discontinued operations, net............................... -- (0.07) -- (0.18)
Extraordinary gain on debt extinguishments, net............ 0.01 0.25 0.53 0.25
------ ------ ------ ------
Net loss................................................... $ (0.73) $ (1.17) $ (1.36) $ (4.60)
====== ====== ====== ======
6. Receivables
Receivables at September 30, 2002 and December 31, 2001 were as follows:
Information
(dollars in millions) Communications Services Coal Other Total
September 30, 2002
Accounts Receivable - Trade:
Services................... $ 89 $ 356 $ 11 $ 2 $ 458
Upfront Dark Fiber......... -- -- -- -- --
Joint Build Costs............. 11 -- -- -- 11
Other Receivables............. 11 -- -- -- 11
Allowance for Doubtful
Accounts................... (30) (7) -- -- (37)
----- ----- ----- ----- -----
$ 81 $ 349 $ 11 $ 2 $ 443
===== ===== ===== ===== =====
December 31, 2001
Accounts Receivable - Trade:
Services................... $ 171 $ 21 $ 11 $ 1 $ 204
Upfront Dark Fiber......... 23 -- -- -- 23
Joint Build Costs............. 33 -- -- -- 33
Other Receivables............. 25 -- -- -- 25
Allowance for Doubtful
Accounts................... (43) (3) -- -- (46)
----- ----- ----- ----- -----
$ 209 $ 18 $ 11 $ 1 $ 239
===== ===== ===== ===== =====
Joint build receivables primarily relate to costs incurred by the Company for
construction of network assets in which Level 3 is partnering with other
companies. Generally, under these types of agreements, the sponsoring partner
will incur 100% of the construction costs and bill the other party as certain
construction milestones are accomplished.
Other receivables primarily include non-service related receivables including
European VAT (Value Added Taxes), sales tax refunds, equipment sales and other
miscellaneous items.
7. Property, Plant and Equipment, net
The Company has substantially completed the construction of its communications
network. Costs associated directly with the uncompleted network, including
employee related costs, have been capitalized, and interest expense incurred
during construction was capitalized based on the weighted average accumulated
construction expenditures and the interest rates related to borrowings
associated with the construction (Note 10). The Company generally capitalizes
operating expenses associated with network construction, provisioning of
services and software development. Capitalized operating expenses associated
with employees working on capital projects were approximately $12 million and
$53 million for the three and nine months ended September 30, 2002. Intercity
segments, gateway facilities, local networks and operating equipment that have
been placed in service are being depreciated over their estimated useful lives,
primarily ranging from 3-25 years.
The Company continues to develop business support systems required for its
business plan. The external direct costs of software, materials and services,
payroll and payroll related expenses for employees directly associated with the
project, and interest costs incurred when developing the business support
systems are capitalized. Upon completion of a project, the total cost of the
business support system is amortized over a useful life of three years.
In 2001, the Company recorded a charge on the statement of operations for
impairment of certain assets. The impairments primarily relate to colocation
assets ($1.6 billion), conduits in North America and European intercity and
metropolitan networks ($1.2 billion), and certain transoceanic assets ($320
million). For those assets that are determined to be impaired, the fair value of
the asset becomes the new basis or "cost" of the asset and the accumulated
depreciation that had previously been recorded, is eliminated in accordance with
SFAS No. 144.
During 2002, Level 3 was able to finalize negotiations and claims on several of
its large multi-year network construction projects. As a result, the Company was
able to release approximately $50 million and $164 million of capital accruals
for the three and nine months ended September 30, 2002 that had previously been
reported as property, plant and equipment. In the ordinary course of business,
as construction projects come to a close, the Company reviews the final amounts
due and settles any outstanding amounts related to these contracts which can
result in changes to estimated costs of the construction projects.
Capitalized business support systems and network construction costs that have
not been placed in service have been classified as construction-in-progress
within Property, Plant & Equipment below.
Accumulated Book
(dollars in millions) Cost Depreciation Value
September 30, 2002
Land and Mineral Properties...................................... $ 193 $ (15) $ 178
Facility and Leasehold Improvements
Communications................................................ 1,377 (105) 1,272
Information Services.......................................... 27 (5) 22
Coal Mining................................................... 65 (63) 2
CPTC.......................................................... 92 (16) 76
Network Infrastructure........................................... 4,149 (345) 3,804
Operating Equipment
Communications................................................ 1,382 (593) 789
Information Services.......................................... 80 (50) 30
Coal Mining................................................... 81 (72) 9
CPTC.......................................................... 18 (12) 6
Network Construction Equipment................................... 50 (17) 33
Furniture, Fixtures and Office Equipment......................... 181 (129) 52
Construction-in-Progress......................................... 87 -- 87
------ ------ ------
$7,782 $ (1,422) $6,360
====== ====== ======
December 31, 2001
Land and Mineral Properties...................................... $ 203 $ (16) $ 187
Facility and Leasehold Improvements
Communications................................................ 1,423 (22) 1,401
Information Services.......................................... 26 (5) 21
Coal Mining................................................... 65 (62) 3
CPTC.......................................................... 92 (14) 78
Network Infrastructure........................................... 4,111 (107) 4,004
Operating Equipment
Communications................................................ 1,159 (390) 769
Information Services.......................................... 69 (41) 28
Coal Mining................................................... 82 (72) 10
CPTC.......................................................... 18 (11) 7
Network Construction Equipment................................... 67 (17) 50
Furniture, Fixtures and Office Equipment......................... 173 (81) 92
Construction-in-Progress......................................... 240 -- 240
------ ------ ------
$7,728 $ (838) $6,890
====== ====== ======
Depreciation expense was $195 million and $585 million for the three and nine
months ended September 30, 2002, respectively. Depreciation expense was $298 and
$823 for the three and nine months ended September 30, 2001, respectively.
8. Goodwill and Intangibles, Net
As of September 30, 2002, $70 million, $155 million and $122 million of goodwill
and intangibles, net of amortization, are attributable to the McLeod, CorpSoft
and Software Spectrum acquisitions, respectively.
Level 3 completed the acquisition of McLeod's wholesale dial-up business on
January 24, 2002. The Company has attributed approximately $49 million of the
purchase price to customer contracts with an amortization period equal to the
term of the primary contract or approximately 30 months. The purchase price in
excess of the fair value allocated to identifiable tangible and intangible
assets resulted in goodwill of $34 million that will be assessed at least
annually for impairment in accordance with SFAS No. 142.
The acquisition of CorpSoft was completed on March 13, 2002. The $128 million
cash purchase price, including transaction costs, exceeded the fair value of the
net assets by approximately $130 million based on a third party formal valuation
of the assets and liabilities acquired. The Company has attributed approximately
$26 million of the purchase price to a customer relationship intangible asset
with an amortization period equal to ten years. The $130 million residual amount
of goodwill will be assessed at least annually for impairment in accordance with
SFAS No. 142.
On June 18, 2002, the Company completed the acquisition of Software Spectrum,
Inc. The $136 million purchase price, including transaction costs, exceeded the
fair value of the net assets by approximately $75 million based on a third party
formal valuation of the assets and liabilities acquired. The Company has
attributed approximately $49 million of the purchase price to a customer
relationship intangible asset with an amortization period equal to ten years.
The $75 million residual amount of goodwill will be assessed at least annually
for impairment in accordance with SFAS No. 142.
Intangible asset amortization expense was $6 million and $16 million for the
three and nine months ended September 30, 2002, respectively. Goodwill and
intangible asset amortization expense, excluding amortization expense
attributable to equity method investees, was $8 million and $41 million for the
three and nine months ended September 30, 2001, respectively. The Company
amortized $17 million of goodwill attributable to the 1998 acquisition of XCOM
Technologies, Inc. for the nine months ended September 30, 2001. Goodwill
attributable to this investment has not been amortized in 2002 as a result of
the adoption of SFAS No. 142.
The following is pro-forma financial information of the Company assuming that
SFAS No. 142 had been in effect in 2001:
Adjusted
Goodwill Net
(dollars in millions) As Reported Amortization Income
Three Months Ended September 30, 2001
Net Loss Before Extraordinary Items........................ $ (531) $ 6 $ (525)
Net Loss................................................... (437) 6 (431)
Per Share:
Net Loss Before Extraordinary Items..................... (1.42) (1.40)
Net Loss................................................ (1.17) (1.15)
Nine Months Ended September 30, 2001
Net Loss Before Extraordinary Items........................ $ (1,797) $ 35 $ (1,762)
Net Loss................................................... (1,703) 35 (1,668)
Per Share:
Net Loss Before Extraordinary Items..................... (4.85) (4.76)
Net Loss................................................ (4.60) (4.50)
The amortization expense related to intangible assets currently recorded on the
Company's books for each of the five succeeding years is estimated to be the
following for the years ended December 31: 2002 - $23 million; 2003 - $27
million; 2004 - $19 million; 2005 - $8 million and 2006 - $8 million.
9. Other Assets, Net
At September 30, 2002 and December 31, 2001 other assets consisted of the
following:
September 30, December 31,
(dollars in millions) 2002 2001
Investments .................................................................... $ 88 $127
Debt Issuance Costs, net........................................................ 103 113
Prepaid Network Assets.......................................................... 13 16
CPTC Deferred Development and Financing Costs................................... 19 20
Assets Held for Sale............................................................ 49 62
Employee and Officer Notes Receivable........................................... 5 10
Other........................................................................... 14 11
---- ----
$291 $359
==== ====
The Company holds significant equity positions in two publicly traded companies:
RCN Corporation ("RCN") and Commonwealth Telephone Enterprises, Inc.
("Commonwealth Telephone"). RCN is a facilities-based provider of bundled local
and long distance phone, cable television and Internet services to residential
markets primarily on the East and West coasts as well as Chicago. Commonwealth
Telephone holds Commonwealth Telephone Company, an incumbent local exchange
carrier operating in various rural Pennsylvania markets, and CTSI, Inc. a
competitive local exchange carrier.
On February 22, 2002, Level 3 Holdings, Inc., a wholly owned subsidiary of the
Company, agreed to acquire from Mr. David C. McCourt, a director of the Company,
his 10% interest in Level 3 Telecom Holdings, Inc., the Company's subsidiary
that indirectly holds the Company's ownership interests in RCN Corporation and
Commonwealth Telephone Enterprises, Inc. The total cash consideration paid to
Mr. McCourt in this transaction was $15 million.
On September 30, 2002, Level 3 owned approximately 24% and 25% of the
outstanding shares of RCN and Commonwealth Telephone, respectively, and accounts
for each entity using the equity method. The market value of the Company's
investment in RCN and Commonwealth Telephone was $14 million and $200 million,
respectively, on September 30, 2002.
During 2000, Level 3's proportionate share of RCN's losses exceeded the
remaining carrying value of Level 3's investment in RCN. Level 3 does not have
additional financial commitments to RCN; therefore it recognized equity losses
only to the extent of its investment in RCN. If RCN becomes profitable, Level 3
will not record its equity in RCN's profits until unrecorded equity in losses
has been offset. The Company's investment in RCN, including goodwill, was zero
at September 30, 2002 and December 31, 2001. The Company did not recognize
approximately $41 million and $357 million of suspended equity losses
attributable to RCN for the three and nine months ended September 30, 2002,
respectively, bringing the total amount of suspended equity losses to
approximately $628 million at September 30, 2002.
The Company recognizes gains from the sale, issuance and repurchase of stock by
its equity method investees in its statements of operations. The Company did not
recognize any gains for the nine months ended September 30, 2002 or 2001 and
does not expect to recognize future gains on RCN stock activity until the
suspended equity losses are recognized by the Company.
The following is summarized financial information of RCN for the three and nine
months ended September 30, 2002 and 2001, and as of September 30, 2002 and
December 31, 2001 (dollars in millions).
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------------------------------------------------
2002 2001 2002 2001
Operations:
RCN Corporation:
Revenue .................................. $ 114 $ 104 $ 340 $ 296
Net loss available to common shareholders. (169) (112) (1,412) (1,046)
Level 3's Share:
Net loss.................................. $ -- $ -- $ -- $ --
Goodwill amortization..................... -- -- -- --
---- ---- ---- ----
$ -- $ -- $ -- $ --
==== ==== ==== ====
September 30, December 31,
2002 2001
Financial Position:
Current Assets.................................................................. $ 471 $ 956
Other Assets . 1,607 2,647
----- -----
Total assets................................................................. 2,078 3,603
Current Liabilities............................................................. 302 358
Other Liabilities............................................................... 1,710 1,884
Minority Interest............................................................... 1 51
Preferred Stock................................................................. 2,263 2,142
----- -----
Total liabilities and preferred stock........................................ 4,276 4,435
----- -----
Common shareholders' deficit............................................... $(2,198) $ (832)
======= =======
On April 2, 2002, Eldorado Equity Holdings, Inc., an indirect, wholly owned
subsidiary of Level 3 Communications, Inc., completed the sale of 4,898,000
shares of common stock of Commonwealth Telephone in an underwritten public
offering. The 4,898,000 shares represent approximately 46 percent of Level 3's
economic ownership of Commonwealth Telephone. Eldorado Equity Holdings received
net proceeds of approximately $166 million and recognized a gain on the sale of
approximately $102 million in the second quarter of this year and is included in
Other, net on the consolidated condensed statement of operations. As a result of
the transaction, the Company owns approximately 25% of the total Commonwealth
Telephone shares outstanding as of September 30, 2002.
The Company's investment in Commonwealth Telephone, including goodwill, was $82
million and $121 million at September 30, 2002 and December 31, 2001,
respectively.
The Company previously made investments in certain public and private companies
in connection with those entities agreeing to purchase various services from the
Company. The Company recorded a charge of $37 million during the first six
months of 2001, for an other-than temporary decline in the value of such
investments, which is included in Other, net on the consolidated condensed
statements of operations due to the decline in market value and business
opportunities of the investments. Future appreciation will be recognized only
upon sale or other disposition of these securities. The carrying amount of the
investments was zero at September 30, 2002 and December 31, 2001. The Company
provided services to entities participating in this program of $1 million and $2
million for the three and nine months ended September 30, 2002, respectively.
The Company provided services valued at approximately $3 million and $11 million
related to this program for the three and nine months ended September 30, 2001,
respectively. As of September 30, 2002, the Company had deferred revenue
obligations of $4 million with respect to these transactions.
Assets held for sale includes certain corporate facilities that management of
the Company has elected to dispose of as soon as practicable. Also included in
assets held for sale are certain telecommunications equipment identified as
excess and which management expects to sell due to the Company's decision in
June 2001 to reprioritize its capital expenditures. The Company recorded an
additional impairment charge of $13 million in the second quarter of 2002 to
reflect the current market value of these assets.
Loans outstanding from certain employees and officers of the Company totaled $5
million at September 30, 2002. The loans are generally secured by Level 3 common
stock or other personal assets of the borrower and bear interest at the prime
rate on December 31, 2001, or 4.75%.
10. Long-Term Debt
At September 30, 2002 and December 31, 2001, long-term debt was as follows:
September 30, December 31,
(dollars in millions) 2002 2001
Senior Secured Credit Facility:
Term Loan Facility
Tranche A (5.04% due 2007)................................................. $ 450 $ 450
Tranche B (6.04% due 2008)................................................. 275 275
Tranche C (6.32% due 2008)................................................. 400 400
Senior Notes (9.125% due 2008).................................................. 1,388 1,430
Senior Notes (11% due 2008)..................................................... 433 442
Senior Discount Notes (10.5% due 2008).......................................... 629 583
Senior Euro Notes (10.75% due 2008)............................................. 314 307
Senior Discount Notes (12.875% due 2010)........................................ 368 386
Senior Euro Notes (11.25% due 2010)............................................. 102 93
Senior Notes (11.25% due 2010).................................................. 124 129
Convertible Subordinated Notes (6.0% due 2009).................................. 413 612
Convertible Subordinated Notes (6.0% due 2010).................................. 671 728
Junior Convertible Subordinated Notes (9% due 2012) ............................ 500 --
Commercial Mortgages:
GMAC (4.22% due 2003)...................................................... 120 120
iStar (8.5% due 2002-2004)................................................. 59 112
CPTC Long-term Debt (with recourse only to CPTC):
(7.63% due 2004-2028)........................................................ 140 140
Software Spectrum Debt.......................................................... 7 --
Other........................................................................... 4 9
----- -----
6,397 6,216
Less current portion......................................................... (12) (7)
----- -----
$6,385 $6,209
====== ======
In July 2001, Level 3 announced that it had amended its Senior Secured Credit
Facility to permit the Company to acquire certain of its outstanding
indebtedness in exchange for shares of common stock. Various issuances of Level
3's outstanding senior notes, senior discount notes and convertible subordinated
notes have traded at discounts to their respective face or accreted amounts.
In August 2002, the SEC notified certain public companies and accounting firms
that it was reviewing the accounting treatment for certain transactions
involving the conversion of convertible debt pursuant to inducements made to
prompt conversion of the debt to equity securities of the issuer. The SEC
acknowledged that there was diversity in accounting practice and asked the
Emerging Issues Task Force of the Financial Accounting Standards Board to
address the issue as part of its September 2002 agenda.
In September 2002, the EITF issued 02-15, "Determining Whether Certain
Conversions of Convertible Debt to Equity Securities Are within the Scope of
FASB Statement No. 84"). The EITF concluded that these types of transactions
should be accounted for as induced conversions in accordance with SFAS No. 84.
SFAS No. 84 requires a non-cash charge to earnings for the implied value of an
inducement to convert from convertible debt to common equity securities of the
issuer. In addition, under SFAS No. 84, an extraordinary gain or loss, as
applicable, is not recorded upon the conversion of convertible debt. The
accounting is to be applied prospectively for those convertible debt for equity
exchanges completed after September 11, 2002, the date of the EITF's consensus.
The Company applied the provisions of SFAS No. 84 to all convertible debt for
equity exchange transactions completed during the third quarter of 2002.
In the third quarter of 2002, the Company purchased $50 million aggregate
principal amount of its 6% Convertible Subordinated Notes due 2009 and $13
million aggregate principal amount of its 6% Convertible Subordinated Notes due
2010. The Company issued approximately five million shares of its common stock
with a market value of approximately $25 million. The value of securities
issuable pursuant to original conversion privileges was approximately $5
million. Therefore, pursuant to the provisions of SFAS No. 84, a debt conversion
expense of $20 million was recorded and is included in Other income (expense) in
the consolidated condensed statement of operations.
The Company purchased $12 million aggregate principal amount of its 9.125%
Senior Notes during the third quarter of 2002. The Company issued approximately
one million shares of its common stock worth approximately $7 million in
exchange for these senior notes. The transaction was accounted for as an
extinguishment of debt, in accordance with APB No. 26, "Early Extinguishment of
Debt". The net gain on the early extinguishment of the debt, including
transaction costs and unamortized debt issuance costs, was $5 million and was
recorded as an extraordinary item in the consolidated condensed statement of
operations.
For the nine months ended September 30, 2002, the Company purchased $186 million
aggregate principal amount of its 6% Convertible Subordinated Notes due 2009 and
$48 million aggregate principal amount of its 6% Convertible Subordinated Notes
due 2010. The Company issued approximately 16 million shares of its common stock
worth approximately $77 million in exchange for the convertible debt.
Transactions completed prior to July 1, 2002 were accounted for as
extinguishments of debt, in accordance with APB No. 26 and an extraordinary net
gain of approximately $114 million was recorded.
In the second quarter of 2002, the Company purchased $75 million face value ($53
million carrying value) of its 12.875% Senior Discount Notes due 2010. The
Company issued approximately five million shares of its common stock worth
approximately $19 million in exchange for the discount notes. The net gain on
the early extinguishment of the debt, including transaction costs and
unamortized debt issuance costs, was $33 million and was recorded as an
extraordinary item in the consolidated condensed statement of operations.
In February 2002, the Company's first-tier, wholly owned subsidiary, Level 3
Finance, LLC purchased $89 million principal amount of Company debt for cash of
$31 million. The net gain on the extinguishments of the debt, including
transaction costs, realized foreign currency gains and unamortized debt issuance
costs, was approximately $59 million and was recorded as an extraordinary item
in the consolidated condensed statement of operations.
The following information summarizes the cash repurchases of long-term debt:
Principal Amount
at Maturity Actual Weighted
Repurchased Average Purchase
($ millions) Price/$1,000
Senior Notes (9.125%)...................................................... $ 30 $ 381
Senior Notes (11%)......................................................... 8 423
Senior Euro Notes (10.75%)................................................. 23 422
Senior Euro Notes (11.25%)................................................. 1 405
Senior Notes (11.25%)...................................................... 5 415
Convertible Subordinated Notes (due 2010).................................. 8 184
Convertible Subordinated Notes (due 2009).................................. 14 195
----
$ 89
====
Assumes 1EURO = .87 USD
Level 3 will continue to evaluate these transactions in the future. The amounts
involved in any such transactions, individually or in the aggregate, may be
material.
Senior Secured Credit Facility
In September 1999, Level 3 and certain Level 3 subsidiaries entered into a
$1.375 billion secured credit facility ("Senior Secured Credit Facility"), which
was amended in March 2001 to increase the borrowing capacity by $400 million, to
$1.775 billion.
In August 2002, Level 3 and the Lenders amended the terms of the Senior Secured
Credit Facility. Modifications to the Credit Facility, per the terms of the
amendment, include, but are not limited to, the following:
o Increased flexibility for the Company to pursue acquisitions for cash
consideration;
o Removal of two revenue-based financial covenants;
o Modification of an Adjusted EBITDA-based covenant in accordance with
the Company's current business plan;
o Reduction of the $650 million undrawn revolving credit facility by
$500 million to $150 million, with restrictions on availability;
o Maintenance of minimum cash balance, generally equal to $525 million,
of which $400 million is pledged to the banks; and
o Increase of 0.5% per year to the cost of borrowing
The remaining financial covenants contained in the credit agreement will now be
calculated on a consolidated basis, but those calculations will exclude the
Company's toll road operations. Certain modifications were also made to the
Total Leverage Ratio covenant (which is defined in the agreement as the ratio of
Total Debt to Adjusted EBITDA) in accordance with the Company's current business
plan. In addition, this covenant will now be tested on a trailing twelve-month
basis beginning on June 30, 2004, with a maximum allowable level of 11.5x,
versus the original maximum allowable level of 6.0x beginning on December 31,
2004. Certain other covenants have also been modified.
The Company is required to maintain a minimum cash balance, generally equal to
$525 million. No default under the Senior Secured Credit Facility shall be
deemed to have occurred with respect to the minimum cash balance test if, within
a six month period following the date on which the cash balance falls below $525
million, the Company again attains a cash balance greater than or equal to $525
million.
Additionally, the Company is required to pledge to the lenders under the Senior
Secured Credit Facility $400 million of the minimum cash balance. The Company
shall be deemed to be in default under the Senior Secured Credit Facility if the
cash balance of the restricted subsidiaries falls below $450 million.
Due to the reduced borrowing capacity of the revolving credit facility, existing
debt issuance costs were written off in proportion to the decrease in the
borrowing capacity. Approximately $6 million of the total $7 million of
unamortized existing debt issuance costs, related to the revolving credit
facility, were included in interest expense during the third quarter 2002. In
addition, approximately $5 million of direct costs and bank fees incurred to
amend the Credit Facility were included in interest expense during the third
quarter 2002. Approximately $7 million of costs incurred to amend the Credit
Facility were capitalized and will be amortized over the life of the Credit
Facility.
The Senior Secured Credit Facility, as amended, is comprised of a senior secured
revolving credit facility in the amount of $150 million and a three-tranche
senior secured term loan facility aggregating $1.125 billion. The secured term
loan facility consisted of a $450 million tranche A, a $275 million tranche B
and a $400 million tranche C term loan facility, all of which have been fully
drawn and are outstanding as of December 31, 2001 and September 30, 2002. In the
amendment, the Company agreed to reduce the amount of the undrawn senior secured
revolving credit facility portion from $650 million to $150 million. Of the $150
million, $50 million is available immediately for letters of credit and the
remaining $100 million becomes available after August 30, 2003 provided that the
Company has satisfied an incurrence test that is related to a pro forma fixed
charge coverage ratio. As of September 30, 2002, the Company had approximately
$8 million in letters of credit outstanding under this agreement.
The Senior Secured Credit Facility, as amended, has customary covenants, or
requirements, that the Company and certain of its subsidiaries must meet to
remain in compliance with the contract. If the Company does not remain in
compliance with the covenants, it could be in default under the terms of the
Senior Secured Credit Facility. In this event, the lenders could take actions to
require repayment.
As of September 30, 2002, Level 3 had not borrowed any funds under the $150
million revolving credit facility. The availability of funds and any requirement
to repay previously borrowed funds is contingent upon the continued compliance
with the relevant debt covenants. The Company believes, based upon management's
review of the amended covenants and other provisions of the Senior Secured
Credit Facility, that it is in full compliance with all the terms of the Senior
Secured Credit Facility as of September 30, 2002.
A full copy of the Senior Secured Credit Facility was filed by the Company with
the Securities and Exchange Commission on a Current Report on Form 8-K dated
August 26, 2002.
Junior Convertible Subordinated Notes
On July 8, 2002, the Company sold $500 million aggregate principal amount of 9%
Junior Convertible Subordinated Notes due 2012 to entities controlled by three
institutions: Longleaf Partners Funds, Berkshire Hathaway, Inc., and Legg Mason,
Inc. Level 3 intends to use the net proceeds of approximately $488 million,
after transactions costs of $12 million, for general corporate purposes,
including potential acquisitions relating to industry consolidation
opportunities, capital expenditures and working capital. The notes, which mature
in 10 years, pay 9% cash interest annually, payable quarterly beginning October
15, 2002. The notes are convertible, at the option of the holders, into Level 3
common stock at any time at a conversion price of $3.41, subject to certain
adjustments, which could result in the issuance of approximately 147 million
common shares. The notes are convertible at the Company's option into
convertible preferred stock under certain conditions and circumstances. The
convertible notes rank junior to substantially all of the Level 3
Communications, Inc.'s outstanding indebtedness.
iStar Commercial Mortgage due 2004
In March 2002, 85 Tenth Avenue, LLC (a wholly owned subsidiary of the Company)
amended its $113 million floating-rate loan, originally provided by Lehman
Brothers Holdings, Inc. (the "Lehman Mortgage") that provided secured,
non-recourse debt to finance the purchase and renovations of the New York
Gateway facility. The amendment resulted in iStar DB Seller, LLC ("iStar")
becoming the sole lender for the property. Previously, iStar, along with other
third parties, owned notes of the 85 Tenth Avenue Trust, purchased from Lehman
Brothers Holdings, Inc. Using funds previously reserved for additional
renovations at the New York Gateway facility, along with funds advanced from
iStar, 85 Tenth Avenue, LLC repaid the other third party holders of the notes of
85 Tenth Avenue Trust and reduced the principal outstanding under the amended
loan agreement to $60 million. Additionally, the amendment negotiated with iStar
(the "iStar Mortgage") extended the initial term of the loan to March 1, 2004,
with two optional one-year extensions. There is no prepayment penalty under the
revised agreement. Interest varies monthly with the 30 day LIBOR for U.S. Dollar
Deposits, plus 650 basis points. The amendment provides a LIBOR floor of 2.00%
at all times. This interest, together with principal payments based on a 20-year
amortization period, are due monthly during the initial term of the loan.
85 Tenth Avenue, LLC is a single purpose entity organized solely to own, hold,
sell, lease, transfer, exchange, operate and manage the New York Gateway
facility. Under the terms of the original loan agreement, 85 Tenth Avenue, LLC
was not to engage in any business other than the ownership management,
maintenance and operation of the New York Gateway facility. Under the terms of
the original loan agreement, the Company was required to build out the entire
building for colocation space by March 1, 2002. The Company has elected not to
complete the build-out of the New York Gateway facility due to the excess
capacity in the local market. The amendment reduced the scope of originally
contemplated build-out and requires the Company to obtain a permanent
certificate of occupancy by December 31, 2002. Under certain conditions, this
date can be extended by iStar to September 30, 2003.
Approximately $6 million of debt issuance costs related to this loan agreement
were capitalized and are being amortized as interest expense over the term of
the iStar Mortgage.
Software Spectrum
Certain foreign subsidiaries of the information services business have factoring
arrangements with a local financial institution. These agreements allow Software
Spectrum to sell up to EURO17.5 million of certain accounts receivable from
customers, with recourse to the Company, to the local financial institution. In
addition, certain foreign affiliates have overdraft facility arrangements with
local institutions. At September 30, 2002, borrowings related to these
agreements were approximately $7 million.
The debt instruments above contain certain covenants with which the Company
believes it is in full compliance as of September 30, 2002.
The Company capitalized $1 million and $58 million of interest expense and
amortized debt issuance costs related to network construction and business
systems development projects for the three and nine months ended September 30,
2001, respectively. No interest expense or amortized debt issuance costs were
capitalized for the nine months ended September 30, 2002.
11. Stock-Based Awards
The Company adopted the recognition provisions of SFAS No. 123, "Accounting for
Stock Based Compensation" ("SFAS No. 123") in 1998. Under SFAS No. 123, the fair
value of an option (as computed in accordance with accepted option valuation
models) on the date of grant is amortized over the vesting periods of the
options in accordance with FASB Interpretation No. 28 "Accounting For Stock
Appreciation Rights and Other Variable Stock Option or Award Plans" ("FIN 28").
Although the recognition of the value of the instruments results in compensation
or professional expenses in an entity's financial statements,
the expense differs from other compensation and professional expenses in that
these charges may not be settled in cash, but rather, are generally settled
through issuance of common stock.
The adoption of SFAS No. 123 has resulted in material non-cash charges to
operations since its adoption in 1998, and will continue to do so. The amount of
the non-cash charges will be dependent upon a number of factors, including the
number of grants and the fair value of each grant estimated at the time of its
award. The Company recognized a total of $154 million and $239 million of
non-cash expense for the nine months ended September 30, 2002 and 2001,
respectively. Included in discontinued operations for the nine months ended
September 30, 2001 is $5 million of non-cash compensation expense. In addition,
the Company capitalized $6 million and $13 million of non-cash compensation for
those employees directly involved in the construction of the network or
development of the business support systems for the nine months ended September
30, 2002 and 2001, respectively.
The following table summarizes non-cash compensation expense and capitalized
non-cash compensation for the three and nine months ended September 30, 2002 and
2001.
Three Months Ended Nine Months Ended
September 30, September 30,
------------- -------------
(dollars in millions) 2002 2001 2002 2001
---- ---- ---- ----
NQSO................................. $ -- $ 2 $ -- $ 7
Warrants............................. 4 2 9 8
OSO.................................. 22 59 101 178
C-OSO................................ 10 16 34 43
Restricted Stock..................... -- -- 1 2
Shareworks Match Plan................ 2 3 9 8
Shareworks Grant Plan................ 1 2 6 6
----- ----- ----- -----
39 84 160 252
Capitalized Noncash Compensation..... (2) (4) (6) (13)
----- ----- ----- -----
37 80 154 239
Discontinued Asian Operations........ -- 2 -- 5
----- ----- ----- -----
$ 37 $ 82 $ 154 $ 244
===== ===== ===== =====
The Level 3 1995 Stock Plan ("the Stock Plan") reserved 70 million shares for
issuance upon the exercise of stock-based awards. On July 24, 2002, the
Company's stockholders approved an amendment to the Company's 1995 Stock Plan
increasing the number of shares of common stock reserved for issuance under the
Stock Plan by 50 million shares. The total number of shares now available under
the Stock Plan is approximately 100 million.
The Stock Plan limits the maximum number of awards that can be granted to one
participant to 10 million, provides for the acceleration of vesting in the event
of a change in control, allows for the grant of stock-based awards to directors
of Level 3, and other persons providing services to Level 3; and allows for the
grant of nonqualified stock options with an exercise price less than the fair
market value of Level 3 common stock.
Non-Qualified Stock Options and Warrants
In June, 2002, the Company issued two million warrants to a contractor as
payment for consulting services. The warrants allow the contractor to purchase
common stock at $4.25 per share. Warrants to purchase 640,000 shares of common
stock were vested immediately upon grant with the remaining 1,360,000 vesting
equally over eight months. The warrants expire in February 2010. Pursuant to the
relevant accounting guidance, the fair value of these warrants is determined on
their respective vesting dates. The fair value of the unvested portion of these
warrants is determined on the interim financial reporting date. At September 30,
2002, the fair value of these warrants was approximately $7 million and was
calculated using the Black-Scholes valuation model with a risk free interest
rate of 4.88% and a term
of approximately eight years. The Company used an expected volatility rate of
86%. The Company did not grant any NQSOs during the nine months ended September
30, 2002. As of September 30, 2002, the Company had not reflected $3 million of
unamortized expense in its financial statements for NQSOs and warrants
previously granted.
Outperform Stock Option Plan
In 1998, the Company adopted an outperform stock option ("OSO") program that was
designed so that the Company's stockholders would receive a market return on
their investment before OSO holders receive any return on their options. The
Company believes that the OSO program aligns directly management's and
stockholders' interests by basing stock option value on the Company's ability to
outperform the market in general, as measured by the Standard & Poor's ("S&P")
500 Index. Participants in the OSO program do not realize any value from awards
unless the Company's common stock price outperforms the S&P 500 Index during the
life of the grant. When the stock price gain is greater than the corresponding
gain on the S&P 500 Index (or less than the corresponding loss on the S&P
Index), the value received for awards under the OSO plan is based on a formula
involving a multiplier related to the level by which the Company's common stock
outperforms the S&P 500 Index. To the extent that Level 3's common stock
outperforms the S&P 500 Index, the value of OSOs to a holder may exceed the
value of nonqualified stock options.
o In August 2002, the Company modified the Outperform Stock Option Plan
to target that no more than 25% of Level 3's outperformance was
delivered to employee-owners, and that the exercise of past and future
OSO grants does not exceed shares reserved for issuance under the 1995
Stock Plan. The following modifications, affecting August 19, 2002 and
later grants, were made to the Plan: OSO targets will be defined in
terms of number of OSOs rather than a target theoretical dollar value.
o The success multiplier was reduced from eight to four.
o Awards will continue to vest over 2 years and have a 4-year life.
However, 50% of the award will vest at the end of the first year after
grant, with the remaining 50% vesting over the second year (12.5% per
quarter).
o A 2-year exercise moratorium was enacted for Senior Vice Presidents
and the senior executive team on quarterly OSO grants above a given
threshold.
The mechanics for determining the value of an individual OSO is described below:
The initial strike price, as determined on the OSO grant date, is adjusted over
time (the "Adjusted Strike Price"), until the exercise date. The adjustment is
an amount equal to the percentage appreciation or depreciation in the value of
the S&P 500 Index from the date of grant to the date of exercise. The value of
the OSO increases for increasing levels of outperformance. OSOs granted prior to
August 19, 2002 have a multiplier range from zero to eight depending upon the
performance of Level 3 common stock relative to the S&P 500 Index as shown in
the following table. OSOs granted August 19, 2002 and later have a multiplier
range from zero to four depending upon the performance of Level 3 common stock
relative to the S&P 500 Index as shown in the following table.
If Level 3 Stock Outperforms
the Then the Pre-multiplier Gain Is
S&P 500 Index by: Multiplied by a Success Multiplier of:
----------------- --------------------------------------
Pre August 19, 2002 Grants August 19, 2002 and Later Grants
-------------------------- --------------------------------
0% or Less 0.00 0.00
More than 0% but Outperformance percentage Outperformance percentage
Less than 11% multiplied by 8/11 multiplied by 4/11
11% or More 8.00 4.00
The Pre-multiplier gain is the Level 3 common stock price minus the Adjusted Strike Price on the date of exercise
OSO awards are made quarterly to eligible participants on the date of the grant.
Awards granted prior to August 19, 2002 vest in equal quarterly installments
over two years and have a four-year life. Awards granted prior to March 2001
typically have a two-year moratorium on exercise from the date of grant. As a
result, once a participant is 100% vested in the grant, the two-year moratorium
expires. Therefore, most awards granted prior to March 2001 have an exercise
window of two years. Level 3 granted 2.1 million OSOs to employees in December
2000 that vest 25% after six months with the remaining 75% vesting after 18
months. These OSOs and all additional OSOs granted March 1, 2001 and later are
exercisable immediately upon vesting and have a four-year life. One half of OSOs
granted on and after August 19, 2002 vest at the end of the first year after
grant, with the remaining 50% vesting over the second year (12.5% per quarter).
The fair value under SFAS No. 123 for the approximately five million OSOs
awarded to participants during the nine months ended September 30, 2002 was
approximately $31 million. As of September 30, 2002, the Company had not
reflected $33 million of unamortized compensation expense in its financial
statements for OSOs granted previously.
In July 2000, the Company adopted a convertible outperform stock option
("C-OSO") program, as an extension of the existing OSO plan. The program is a
component of the Company's ongoing employee retention efforts and offers similar
features to those of an OSO, but provides an employee with the greater of the
value of a single share of the Company's common stock at exercise, or the
calculated OSO value of a single OSO at the time of exercise.
C-OSO awards were made to eligible employees employed on the date of the grant.
The awards were made in September 2000, December 2000, and September 2001. The
awards granted in 2000 vest over three years as follows: 1/6 of each grant at
the end of the first year, a further 2/6 at the end of the second year and the
remaining 3/6 in the third year. The September 2001 awards vest in equal
quarterly installments over three years. Each award is immediately exercisable
upon vesting. Awards expire four years from the date of the grant.
As of September 30, 2002, the Company had not reflected $26 million of
unamortized compensation expense in its financial statements for C-OSOs awarded
in 2000 and 2001.
Shareworks and Restricted Stock
For the three and nine months ended September 30, 2002, Level 3 recognized $3
million and $14 million, respectively, of noncash compensation expense
attributable to its Shareworks programs. As of September 30, 2002, the Company
had not reflected unamortized compensation expense of $16 million for Shareworks
and restricted stock granted in prior years in its financial statements.
12. Industry and Segment Data
SFAS No. 131 "Disclosures about Segments of an Enterprise and Related
Information" defines operating segments as components of an enterprise for which
separate financial information is available and which is evaluated regularly by
the Company's chief operating decision maker, or decision making group, in
deciding how to allocate resources and assess performance. Operating segments
are managed separately and represent strategic business units that offer
different products and serve different markets. The Company's reportable
segments include: communications; information services (including Software
Spectrum); and coal mining. Other primarily includes California Private
Transportation Company, L.P. ("CPTC"), equity investments, and other corporate
assets and overhead not attributable to a specific segment.
EBITDA, as defined by the Company, consists of earnings (loss) before interest,
income taxes, depreciation, amortization, non-cash operating expenses (including
stock-based compensation and impairments) and other non-operating income or
expense. The Company excludes non-cash
compensation due to its adoption of the expense recognition provisions of SFAS
No. 123. EBITDA is commonly used in the communications industry to analyze
companies on the basis of operating performance. EBITDA is not intended to
represent cash flow for the periods presented and is not recognized under
Generally Accepted Accounting Principles ("GAAP").
In 2002, Level 3 was able to finalize negotiations and claims on several of its
large multi-year network construction projects. As a result, the Company was
able to release approximately $50 million and $164 million of capital accruals
for the three and nine months ended September 30, 2002 previously reported as
property, plant and equipment. In the ordinary course of business, as
construction projects come to a close, the Company reviews the final amounts due
and settle any outstanding amounts related to these contracts which can result
in adjustments to the estimated costs of the construction projects.
The information presented in the tables following includes information for the
three and nine months ended September 30, 2002 and 2001 for all income statement
and cash flow information presented, and as of September 30, 2002 and December
31, 2001 for all balance sheet information presented. Revenue and the related
expenses are attributed to countries based on where services are provided.
Industry and geographic segment financial information follows. Certain prior
year information has been reclassified to conform to the 2002 presentation.
Information Coal
(dollars in millions) Communications Services Mining Other Total
Three Months Ended September 30, 2002
Revenue:
North America................. $ 251 $ 546 $ 22 $ 7 $ 826
Europe........................ 23 193 -- -- 216
Asia.......................... -- 25 -- -- 25
------- ------- ------- ------- -------
$ 274 $ 764 $ 22 $ 7 $ 1,067
======= ======= ======= ======= =======
Cost of Revenue:
North America................. $ 39 $ 500 $ 14 $ -- $ 553
Europe........................ 3 180 -- -- 183
Asia.......................... -- 23 -- -- 23
------- ------- ------- ------- -------
$ 42 $ 703 $ 14 $ -- $ 759
======= ======= ======= ======= =======
EBITDA:
North America................. $ 79 $ 10 $ 6 $ 5 $ 100
Europe........................ 5 4 -- -- 9
Asia.......................... -- -- -- -- --
------- ------- ------- ------- -------
$ 84 $ 14 $ 6 $ 5 $ 109
======= ======= ======= ======= =======
Gross Capital Expenditures:
North America................. $ 25 $ 4 $ -- $ 1 $ 30
Europe........................ 1 -- -- -- 1
Asia.......................... -- -- -- -- --
------- ------- ------- ------- -------
$ 26 $ 4 $ -- $ 1 $ 31
======= ======= ======= ======= =======
Depreciation and Amortization:
North America................. $ 183 $ 9 $ -- $ 1 $ 193
Europe........................ 8 -- -- -- 8
Asia.......................... -- -- -- -- --
------- ------- ------- ------- -------
$ 191 $ 9 $ -- $ 1 $ 201
======= ======= ======= ======= =======
Information Coal
(dollars in millions) Communications Services Mining Other Total
-------------- -------- ------ ----- -----
Nine Months Ended September 30, 2002
Revenue:
North America................. $ 751 $ 904 $ 62 $ 22 $ 1,739
Europe........................ 77 348 -- -- 425
Asia.......................... -- 39 -- -- 39
------- ------- ------- ------- -------
$ 828 $ 1,291 $ 62 $ 22 $ 2,203
======= ======= ======= ======= =======
Cost of Revenue:
North America................. $ 155 $ 821 $ 42 $ -- $ 1,018
Europe........................ 15 321 -- -- 336
Asia.......................... -- 35 -- -- 35
------- ------- ------- ------- -------
$ 170 $ 1,177 $ 42 $ -- $ 1,389
======= ====== ======= ======= =======
EBITDA:
North America................. $ 121 $ 31 $ 15 $ 7 $ 174
Europe....................... 55 6 -- -- 61
Asia.......................... -- 1 -- -- 1
------- ------- ------- ------- -------
$ 176 $ 38 $ 15 $ 7 $ 236
======= ======= ======= ======= =======
Gross Capital Expenditures:
North America................. $ 136 $ 13 $ 1 $ 2 $ 152
Europe........................ 21 -- -- -- 21
Asia.......................... -- -- -- -- --
------- ------- ------- ------- -------
$ 157 $ 13 $ 1 $ 2 $ 173
======= ======= ======= ======= =======
Depreciation and Amortization:
North America................. $ 515 $ 18 $ 2 $ 3 $ 538
Europe....................... 63 -- -- -- 63
Asia.......................... -- -- -- -- --
------- ------- ------- ------- -------
$ 578 $ 18 $ 2 $ 3 $ 601
======= ======= ======= ======= =======
Three Months Ended September 30, 2001
Revenue:
North America................. $ 278 $ 27 $ 20 $ 6 $ 331
Europe........................ 38 3 -- -- 41
------- ------- ------- ------- -------
$ 316 $ 30 $ 20 $ 6 $ 372
======= ======= ======= ======= =======
Cost of Revenue:
North America................. $ 95 $ 20 $ 14 $ -- $ 129
Europe........................ 16 1 -- -- 17
------- ------- ------- ------- -------
$ 111 $ 21 $ 14 $ -- $ 146
======= ======= ======= ======= =======
EBITDA:
North America................. $ (6) $ 3 $ 5 $ (2) $ --
Europe........................ (11) 1 -- -- (10)
------- ------- ------- ------- -------
$ (17) $ 4 $ 5 $ (2) $ (10)
======= ======= ======= ======= =======
Capital Expenditures:
North America................. $ 283 $ 3 $ 1 $ 1 $ 288
Europe........................ 77 -- -- -- 77
------- ------- ------- ------- -------
$ 360 $ 3 $ 1 $ 1 $ 365
======= ======= ======= ======= =======
Depreciation and Amortization:
North America................. $ 251 $ 3 $ -- $ 1 $ 255
Europe........................ 51 -- -- -- 51
------- ------- ------- ------- -------
$ 302 $ 3 $ -- $ 1 $ 306
======== ======= ======= ======= =======
Information Coal
(dollars in millions) Communications Services Mining Other Total
Nine Months Ended September 30, 2001
Revenue:
North America................. $ 911 $ 84 $ 66 $ 18 $ 1,079
Europe........................ 118 10 -- -- 128
------- ------- ------- ------- -------
$ 1,029 $ 94 $ 66 $ 18 $ 1,207
======= ======= ======= ======= =======
Cost of Revenue:
North America................. $ 440 $ 66 $ 45 $ -- $ 551
Europe........................ 65 4 -- -- 69
------- ------- ------- ------- -------
$ 505 $ 70 $ 45 $ -- $ 620
======= ======= ======= ======= =======
EBITDA:
North America................. $ (183) $ 7 $ 17 $ 2 $ (157)
Europe........................ (62) 2 -- -- (60)
------- ------- ------- ------- -------
$ (245) $ 9 $ 17 $ 2 $ (217)
======= ======= ======= ======= =======
Capital Expenditures:
North America................. $ 1,983 $ 13 $ 4 $ 1 $ 2,001
Europe........................ 224 -- -- -- 224
------- ------- ------- ------- -------
$ 2,207 $ 13 $ 4 $ 1 $ 2,225
======= ======= ======= ======= =======
Depreciation and Amortization:
North America................. $ 689 $ 9 $ 2 $ 4 $ 704
Europe........................ 159 1 -- -- 160
------- ------- ------- ------- -------
$ 848 $ 10 $ 2 $ 4 $ 864
======= ======= ======= ======= =======
Identifiable Assets
September 30, 2002
North America................. $ 5,779 $ 595 $ 321 $ 1,377 $ 8,072
Europe........................ 843 135 -- 27 1,005
Asia.......................... -- 17 -- -- 17
------- ------- ------- ------- -------
$ 6,622 $ 747 $ 321 $ 1,404 $ 9,094
======= ======= ======= ======= =======
December 31, 2001
North America................. $ 6,256 $ 74 $ 303 $ 1,566 $ 8,199
Europe........................ 1,001 5 -- 37 1,043
Discontinued Asian
Operations.................. 74 -- -- -- 74
------- ------- ------- ------- -------
$ 7,331 $ 79 $ 303 $ 1,603 $ 9,316
======= ======= ======= ======= =======
Long-Lived Assets (excluding Goodwill)
September 30, 2002
North America................. $ 5,633 $ 137 $ 14 $ 187 $ 5,971
Europe........................ 781 5 -- -- 786
Asia.......................... -- -- -- -- --
------- ------- ------- ------- -------
$ 6,414 $ 142 $ 14 $ 187 $ 6,757
======= ======= ======= ======= =======
December 31, 2001
North America................. $ 6,038 $ 50 $ 16 $ 228 $ 6,332
Europe........................ 919 1 -- -- 920
------- ------- ------- ------- -------
$ 6,957 $ 51 $ 16 $ 228 $ 7,252
======= ======= ======= ======= =======
Goodwill
September 30, 2002
North America................. $ 64 $ 205 $ -- $ -- $ 269
Europe........................ -- -- -- -- --
------- ------- ------- ------- -------
$ 64 $ 205 $ -- $ -- $ 269
======= ======= ======= ======= =======
December 31, 2001
North America................. $ 30 $ -- $ -- $ -- $ 30
Europe........................ -- -- -- -- --
------- ------- ------- ------- -------
$ 30 $ -- $ -- $ -- $ 30
======= ======= ======= ======= =======
Product information for the Company's communications segment follows:
Reciprocal Upfront
(dollars in millions) Services Compensation Dark Fiber Total
-------- ------------ ---------- -----
Communications Revenue
- ---------------------------------------------
Three Months Ended September 30, 2002
North America............................ $ 223 $ 28 $ -- $ 251
Europe................................... 23 -- -- 23
------- ------- ------- -------
$ 246 $ 28 $ -- $ 274
======= ======= ======= =======
Nine Months Ended September 30, 2002
North America............................ $ 659 $ 92 $ -- $ 751
Europe................................... 77 -- -- 77
------- ------- ------- -------
$ 736 $ 92 $ -- $ 828
======= ======= ======= =======
Three Months Ended September 30, 2001
North America............................ $ 192 $ 26 $ 60 $ 278
Europe................................... 38 -- -- 38
------- ------- ------- -------
$ 230 $ 26 $ 60 $ 316
======= ======= ======= =======
Nine Months Ended September 30, 2001
North America............................ $ 532 $ 103 $ 276 $ 911
Europe................................... 118 -- -- 118
------- ------- ------- -------
$ 650 $ 103 $ 276 $ 1,029
======= ======= ======= =======
The majority of North American revenue consists of services and products
delivered within the United States. The majority of European revenue consists of
services and products delivered within the United Kingdom. Transoceanic revenue
is allocated equally between North America and Europe as it represents services
provided between these two regions.
Product information for the Company's information services segment follows:
Three Months Ended Nine Months Ended
September 30, September 30,
-----------------------------------------------------------------------
(dollars in millions) 2002 2001 2002 2001
Services
(i)Structure:
Outsourcing.......................... $ 19 $ 22 $ 60 $ 64
Systems Integration.................. 3 8 14 30
Software Spectrum.................... 19 -- 26 --
----- ----- ----- -----
41 30 100 94
Software Sales
Software Spectrum......................... 723 -- 1,191 --
----- ----- ----- -----
$ 764 $ 30 $1,291 $ 94
===== ===== ===== =====
The following information provides a reconciliation of EBITDA to loss from
continuing operations for the three and nine months ended September 30, 2002 and
2001:
Three Months Ended Nine Months Ended
September 30, September 30,
-----------------------------------------------------------------------
(dollars in millions) 2002 2001 2002 2001
EBITDA....................................... $ 109 $ (10) $ 236 $ (217)
Depreciation and Amortization Expense........ (201) (306) (601) (864)
Non-Cash Impairment Expense.................. -- -- (44) (61)
Non-Cash Compensation Expense................ (37) (80) (154) (239)
------ ------ ------ ------
Loss from Operations...................... (129) (396) (563) (1,381)
Other Expense................................ (175) (111) (312) (350)
Income Tax Benefit........................... -- -- 119 --
------ ------ ------ ------
Loss from Continuing Operations.............. $ (304) $ (507) $ (756) $(1,731)
====== ====== ====== ======
13. Related Party Transactions
Peter Kiewit Sons', Inc. ("Kiewit") acted as the general contractor on several
significant projects for the Company in 2002 and 2001. These projects include
the North American intercity network, local loops and gateway sites, and the
Company's corporate headquarters in Colorado. Kiewit provided approximately $9
million and $662 million of construction services related to these projects in
the first nine months of 2002 and 2001, respectively.
Level 3 also receives certain mine management services from Kiewit. The expense
for these services was $2 million and $5 million for the three and nine months
ended September 30, 2002, respectively, and is recorded in selling, general and
administrative expenses. The expense for these services was $1 million and $4
million for the three and nine months ended September 30, 2001, respectively.
14. Other Matters
On August 27, 2002, the Securities and Exchange Commission (the Commission)
adopted the first rules required by the Sarbanes-Oxley Act. The Commission also
finalized proposed rules to accelerate the filing of annual and quarterly
reports and the reporting of certain trades by insiders. The finalized rules
will have the following effect on the Company:
o The principal executive and financial officer must certify the
Company's annual and quarterly reports.
o Beginning with the December 31, 2003 annual report, the Company must
file its quarterly (10-Q) and annual (10-K) reports on a phased-in
accelerated schedule. Once the phase-in is complete, the annual report
will be due 60 days after year-end; quarterly reports will be due 35
days after quarter end.
o Insider transaction activity of both open market and to-the-company
securities trades must be reported more quickly. Effective August 29,
2002, executives, directors and other insiders must report sales and
purchases of company securities within two days.
On July 24, 2002, the Company's stockholders approved an amendment to the
Company's 1995 Stock Plan increasing the number of shares of common stock
reserved for issuance under the Stock Plan by 50 million shares. The total
number of shares now available under the Stock Plan is approximately 100
million.
On April 23, 2002, the Company announced that it had reached a non-binding
letter of intent to sell its 65% interest in CPTC. If this transaction is
consummated, Level 3 expects to receive approximately $45
million in cash proceeds upon the close of the transaction and the Company's
consolidated long-term debt would decrease by approximately $140 million. A sale
is subject to execution of definitive documentation and approval by appropriate
legislative and regulatory authorities. There can be no assurance that the
Company will complete the sale of its interest in CPTC.
In the third quarter of 2002, the Company entered into a sale/leaseback
transaction whereby it received approximately $34 million in proceeds from the
sale of a communications facility in Europe. The gain from the sale of the
property of approximately $19 million was deferred and will be amortized to
Other Income over the 15 year term of the lease.
In May 2001, a subsidiary of the Company was named as a defendant in Bauer, et.
al. v. Level 3 Communications, LLC, et al., a purported multi-state class
action, filed in the U.S. District Court for the Southern District of Illinois
and in July 2001, the Company was named as a defendant in Koyle, et. al. v.
Level 3 Communications, Inc., et. al., a purported multi-state class action
filed in the U.S. District Court for the District of Idaho. Both of these
actions involve the Company's right to install its fiber optic cable network in
easements and right-of-ways crossing the plaintiffs' land. In general, the
Company obtained the rights to construct its network from railroads, utilities,
and others, and is installing its network along the rights-of-way so granted.
Plaintiffs in the purported class actions assert that they are the owners of
lands over which the Company's fiber optic cable network passes, and that the
railroads, utilities, and others who granted the Company the right to construct
and maintain its network did not have the legal ability to do so. The action
purports to be on behalf of a class of owners of land in multiple states over
which the Company's network passes or will pass. The complaint seeks damages on
theories of trespass, unjust enrichment and slander of title and property, as
well as punitive damages. The Company has also received, and may in the future
receive, claims and demands related to rights-of-way issues similar to the
issues in these cases that may be based on similar or different legal theories.
Although it is too early for the Company to reach a conclusion as to the
ultimate outcome of these actions, management believes that the Company has
substantial defenses to the claims asserted in all of these actions (and any
similar claims which may be named in the future), and intends to defend them
vigorously. During the third quarter of 2002, the Company made a $21 million
payment in full settlement of an outstanding litigation matter that did not
relate to the Company's core businesses. The settlement was within the reserve
that had been established for this issue.
The Company and its subsidiaries are parties to certain other legal proceedings.
Management believes that any resulting liabilities for these legal proceedings,
beyond amounts reserved, will not materially affect the Company's financial
condition, future results of operations, or future cash flows.
On March 9, 2002, legislation was enacted that enabled the Company to carry its
taxable net operating losses back five years. As a result, on March 15, 2002,
the Company received a Federal income tax refund of approximately $119 million
after filing its 2001 Federal income tax return and carrying back the net
operating loss for 2001 to 1996. This benefit is reflected in the consolidated
condensed statement of operations.
It is customary in Level 3's industries to use various financial instruments in
the normal course of business. These instruments include items such as letters
of credit. Letters of credit are conditional commitments issued on behalf of
Level 3 in accordance with specified terms and conditions. As of September 30,
2002, Level 3 had outstanding letters of credit of approximately $44 million.
Management's Discussion and Analysis of Financial
Condition and Results of Operations
The following discussion should be read in conjunction with the Company's
consolidated condensed financial statements (including the notes thereto),
included elsewhere herein.
This document contains forward-looking statements and information that are based
on the beliefs of management as well as assumptions made by and information
currently available to the Company. When used in this document, the words
"anticipate", "believe", "plans", "estimate" and "expect" and similar
expressions, as they relate to the Company or its management, are intended to
identify forward-looking statements. Such statements reflect the current views
of the Company with respect to future events and are subject to certain risks,
uncertainties and assumptions. Should one or more of these risks or
uncertainties materialize, or should underlying assumptions prove incorrect,
actual results may vary materially from those described in this document. For a
more detailed description of these risks and factors, please see the Company's
additional filings with the Securities and Exchange Commission.
Results of Operations 2002 vs. 2001
The operating results of the Company's Asian operations are included in
discontinued operations for all periods presented due to their sale to Reach
Ltd. in January 2002. Certain prior year amounts have been reclassified to
conform to current year presentation.
Revenue for the periods ended September 30, is summarized as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------------- ---------------------------
(dollars in millions) 2002 2001 2002 2001
Communications...................... $274 $316 $ 828 $1,029
Information Services................ 764 30 1,291 94
Coal Mining......................... 22 20 62 66
Other .............................. 7 6 22 18
------ ------ ------ ------
$1,067 $372 $ 2,203 $1,207
====== ====== ====== ======
Communications revenue of $274 million for the three months ended September 30,
2002 was comprised of $246 million of services revenue which includes private
line, wavelengths, colocation, Internet access, managed modem, voice and
amortized dark fiber revenue, and $28 million attributable to reciprocal
compensation. Communications revenue for the same period in 2001 was comprised
of $230 million of services revenue, $60 million of non-recurring revenue from
dark fiber contracts entered into before June 30, 1999 for which sales-type
lease accounting was applied, and $26 million of reciprocal compensation. For
the nine months ended September 30, 2002, communications revenue was comprised
of $736 million of services revenue, and $92 million of reciprocal compensation.
Communication revenue for the same nine-month period in 2001 was comprised of
$650 million of services revenue, $276 million of non-recurring dark fiber
revenue and $103 million of reciprocal compensation revenue. The increase in
services revenue from 2001 was primarily due to growth from existing customers
and new customer contracts, and increases in termination revenue. Due to the
turmoil in the telecommunications industry, the Company experienced a
significant increase in the number of customers disconnecting or terminating
service and believed that as much as 25% of its recurring revenue base as of
December 31, 2001 consisted of financially weaker, or "at-risk" customers. As of
September 30, 2002, the Company believes that the credit quality of its customer
base has improved to and stabilized at a level where recurring revenue from
at-risk customers now comprises less than 15% of total recurring revenue. For
some of these at-risk customers, Level 3 is able to negotiate and collect
termination penalties. Level 3 recognized $16 million and $75 million of
services revenue in the three and nine months ended September 30, 2002,
respectively, for early termination of services. For the first nine months of
2002, Level 3 recorded in
services, $11 million of revenue for construction management services provided
to other communications companies. Level 3 recognized $11 million of one-time
revenue in the third quarter of 2002 of which $10 million was attributable to a
settlement with XO Communications, and $11 million of one-time revenue in the
third quarter of 2001 attributable to the sale of transoceanic capacity. The
decrease in dark fiber revenue reflects the completion of the intercity network
in 2001. Dark fiber revenue under sales-type lease accounting is expected to be
insignificant in 2002 as the last remaining segments sold prior to June 30, 1999
were delivered to and accepted by customers in the fourth quarter of 2001. The
decrease in reciprocal compensation revenue for the nine months ending September
30, 2002 is attributable to the Company receiving regulatory approval from
several states regarding its agreements with SBC Communications Inc. and
BellSouth during the first half of 2001. These agreements established a rate
structure for transmission and switching services provided by one carrier to
complete or carry traffic originating on another carrier's network. It is the
Company's policy not to recognize revenue from these agreements until the
relevant regulatory authorities approve the agreements. Certain interconnection
agreements with carriers are scheduled to expire in the second half of 2002 and
in 2003. To the extent that the Company is unable to sign new interconnection
agreements or signs new agreements containing lower rates reciprocal
compensation revenue may decline significantly over time. The Company does
expect to recognize one-time reciprocal compensation revenue in the fourth
quarter due to a settlement with a major carrier
Level 3 was a party to seven non-monetary exchange transactions in 2001 whereby
it sold indefeasible rights of use or IRUs, other capacity, or other services to
a company from which Level 3 received communications assets or services in a
contemporaneous transaction. In total these exchanges accounted for $24 million
or less than 2% of total communications revenue ($2 million of additional
revenue was recognized within the loss from discontinued operations as the
transaction was completed by the Company's discontinued Asian operations) in
2001 and in each case, provided network capacity or redundancy on unprotected
transmission routes that Level 3's engineers determined was required. The fair
value of these non-monetary transactions was determined using similar
transactions for which cash consideration was received. Level 3 recognized no
revenue from non-monetary exchange transactions prior to 2001. The Cash Revenue
from these exchanges was $81 million which was 4% of total Cash Revenue of
$2.097 billion reported in 2001. No Cash Revenue was reported for these
transactions in 2002.
Level 3 recognized $1 million of revenue in the third quarter of 2002 and $5
million of revenue in the nine months ended September 30, 2002 relative to the
performance of services in 2002 pursuant to the above-described seven
non-monetary exchange transactions completed in 2001. No additional non-monetary
exchange transactions were executed in 2002.
In August 2002, the staff of the Securities and Exchange Commission indicated
that the SEC had concluded that all non-monetary exchange transactions for
telecommunications capacity should be accounted for as an exchange of assets
irrespective of whether the transaction involved the lease of assets. The
conclusion was based on the SEC staff's view that the right to use an asset
(that is, a lease), is in fact an asset and not a service contract, irrespective
of whether such asset is recognized on the balance sheet. This conclusion would
require that non-monetary exchange transactions for telecommunications capacity
involving the exchange of one or more operating leases be recognized based on
the carrying value of the assets exchanged, rather than at fair value, resulting
in no recognition of revenue for the transactions. Prior to the SEC's
communication on this issue, Level 3's accounting for these transactions, which
resulted in Level 3 recognizing revenue, had been consistent with industry
guidance for these types of transactions provided by its current independent
accountants (KPMG) and its prior independent accountants (Arthur Andersen). In
addition, the revenue recognition approach for these transactions that the
Company followed was an acceptable practice in not only the communications
industry but other industries as well. The SEC has indicated that it expects
affected companies to retroactively apply this guidance to historical
non-monetary exchange capacity transactions that occurred in prior years and, if
appropriate, restate their financial statements.
Of the seven non-monetary transactions described above, three of the
transactions involved the use of operating leases for capacity. The revenue
recognized in 2001 from these transactions was $21 million and $2 million has
been recognized in the first six months of 2002 from these transactions. The
Cash Revenue from these transactions was $62 million, or 3% of total Cash
Revenue of $2.097 billion reported in 2001. No Cash Revenue was reported for
these transactions in 2002.
Taking into account the SEC's guidance, Level 3 does not believe that it is
appropriate to restate its previously issued financial statements for this issue
involving non-monetary transactions, as the amount of revenue recognized was not
significant to the reported revenue of the Company and Level 3 has previously
disclosed the nature and amount of these transactions in its previous periodic
filings with the SEC and in a press release issued on February 13, 2002.
However, Level 3 has ceased recognizing revenue from the three transactions
involving operating leases, estimated to be approximately $1 million per
quarter, as of June 30, 2002.
The accounting guidance for non-monetary exchange transactions continues to be
subject to review and modification. The Company continues to follow these
developments. While the Company is not aware of any specific information related
to this issue, the Company believes there is some risk that regulators or
accounting standards setting bodies, such as the SEC or Financial Accounting
Standards Board, may, at a later date, interpret accounting guidance in a way
that concludes that one or more of the remaining four non-monetary exchange
transactions completed by Level 3 do not qualify for revenue recognition. In any
event, the Company does not believe that any accounting change related to
non-monetary exchange transactions would have a material impact on Level 3's
historical financial statements.
Information services revenue, which is comprised of the businesses of
(i)Structure, and Software Spectrum (including CorpSoft), increased from $30
million and $94 million in the three and nine months ended September 30, 2001,
respectively, to $764 million and $1,291 million for the same periods in 2002.
This increase is primarily attributable to the inclusion of $742 million of
revenue in the third quarter and $1,117 million of revenue in the nine months
ended September 30, 2002 reflecting activity subsequent to the acquisitions of
CorpSoft and Software Spectrum, which occurred late in the first and second
quarter of this year, respectively. Software sales were higher than expected as
a result of upgrade promotions that Microsoft offered its customers during the
third quarter. The software reseller industry is highly seasonal, with revenues
and profits typically being higher in the second and fourth quarters of the
Company's fiscal year. However, due to Microsoft's special promotions that
accelerated sales into the third quarter that likely would have occurred during
the fourth quarter, the Company does not expect to see the pronounced effects of
the usual seasonality during the fourth quarter. (i)Structure's revenues
declined in both periods primarily as a result of lower systems integration
revenue. The Company expects revenues attributable to the systems integration
business to continue to be below last year's levels as certain existing
contracts expire and (i)Structure continues to focus on its outsourcing
business.
The communications business generated Cash Revenue of $275 million and $925
million during the three and nine months ended September 30, 2002. The Company
defines Cash Revenue as communications revenue plus changes in cash deferred
revenue during the respective period. Communications Cash Revenue reflects
upfront cash or other communications assets received for dark fiber and other
capacity sales that are recognized over the term of the contract under GAAP, but
it is not intended to represent revenues or cash flows as defined by GAAP.
Communications Cash Revenue was $386 million and $1,682 million for the three
and nine months ended September 30, 2001, respectively. This decrease in Cash
Revenue is a result of the substantial completion of the intercity network in
2001. Dark fiber revenue for the three and nine months ended September 30, 2002
was less than the respective periods ended September 30, 2001 as the last
remaining segments were delivered to and accepted by customers in the fourth
quarter of 2001. In addition, the Company continues to experience a significant
decline in dark fiber and capacity indefeasible rights of use or IRU sales,
particularly during the second and third quarters of 2002.
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------------------------------------
(dollars in millions) 2002 2001 2002 2001
Communications Revenue............................................ $ 274 $ 316 $ 828 $1,029
Increase (Decrease) in Communications Deferred Revenue............ (12) 76 8 611
Decrease (Increase) in Deferred Revenue not Collected............. 13 (6) 89 42
----- ----- ----- -----
Communications Cash Revenue $ 275 $ 386 $ 925 $1,682
===== ===== ===== =====
Coal mining revenue was $22 million and $62 million for the three and nine
months ended September 30, 2002 compared to $20 million and $66 million for the
same periods in 2001. The increase in third quarter revenue is attributable to
higher spot market coal sales. The decline in the nine-month amounts is a result
of scheduled reductions in contracted tonnage for a number of customers in 2002.
Other revenue for the 2002 periods was comparable to 2001 and is primarily
attributable to California Private Transportation Company, L.P, the
owner-operator of the SR91 tollroad in southern California.
Cost of Revenue for the third quarter 2002 for the communications business was
$42 million, representing a 62% decrease over the third quarter of 2001 cost of
revenue of $111 million. For the nine months ended September 30, 2002, the cost
of revenue attributable to the communications business was $170 million, a 66%
decline from the same period in 2001. These decreases are a result of the lack
of costs in 2002 associated with pre-June 30, 1999 dark fiber sales and the
migration of customer traffic from a leased network to the Company's own
operational network. In the third quarter of 2002, the Company was able to reach
a settlement agreement with a telecommunications provider which resulted in the
reversal of $4 million of costs recorded in prior periods. Overall, the cost of
revenue for the communications business, as a percentage of communications
revenue, decreased significantly from 35% and 49% during the three and nine
months ended September 30, 2001, respectively, to 15% and 21% during the same
periods of 2002. The Company expects communications cost of revenue, as a
percentage of communications revenue, to remain at approximately 20% for the
remainder of the year. The cost of revenue for the information services
businesses, as a percentage of its revenue, was 92% for the third quarter of
2002 up from 70% in the same period in 2001. For the nine months ended September
30, 2002 and 2001, these were 91% and 74%, respectively. The margins of the
information services' existing businesses were more than offset by the lower
margins of Software Spectrum, which are typical of the software reseller
industry. The cost of revenue for the coal mining business, as a percentage of
revenue, was 64% and 70% for the third quarter of 2002 and 2001, respectively
and 68% for the nine month periods ended September 30, 2002 and 2001. The lower
cost of revenue percentages during the third quarter of 2002 result from the
release of $4 million in certain royalty accruals for which the matter was
favorably resolved, partially offset by the increase in lower margin spot coal
sales.
Depreciation and Amortization expenses for the quarter were $201 million, a 34%
decrease from the depreciation and amortization expenses of $306 million
recorded in the third quarter of 2001. Depreciation for the nine months ended
September 30, 2002 declined $263 million, or 30%, from depreciation of $864
million for the nine months ended September 30, 2001. This decrease is primarily
attributable to the reduced basis of the Company's communications assets
resulting from the $3.2 billion impairment charge recorded in the fourth quarter
of 2001 and a $35 million charge recorded in the second quarter of 2001 for the
writedown of certain corporate facilities. The Company also amortized $17
million of goodwill attributable to the 1998 acquisition of XCOM Technologies,
Inc. for the nine months ended September 30, 2001. Goodwill attributable to this
investment has not been amortized in 2002 as a result of the adoption of SFAS
No. 142. In addition, certain assets with two and three-year depreciable lives
became fully depreciated in late 2001 and 2002. Partially offsetting these
declines was $13 million of amortization expense attributable to the intangible
assets acquired in the McLeod, CorpSoft and Software Spectrum transactions
completed in 2002.
Selling, General and Administrative expenses, excluding non-cash compensation,
were $196 million in the three months ended September 30, 2002, a 17% decrease
over the third quarter of 2001. This decrease reflects the Company's efforts to
reduce and tightly control operating expenses. The Company has reduced its
global communications workforce by approximately 2,700 employees since the
beginning of 2001. Reductions in employee related costs, including compensation,
facilities costs, recruiting and training, as well as lower professional and
travel expenses contributed to the decline in selling, general and
administrative costs. The Company was also able to settle certain legal matters
for amounts less than previously recorded and release accruals for which the
original purpose no longer exists. These items resulted in a decrease in
operating expenses of $8 million in the third quarter of 2002. These reductions
were partially offset by $39 million of selling, general and administrative
expenses attributable to Software Spectrum. Included in operating expenses for
the three months ended September 30, 2002 and 2001, were $37 million and $80
million, respectively, of non-cash compensation expenses recognized under SFAS
No. 123 related to grants of stock options, warrants and other stock-based
compensation programs. The decline in non-cash compensation is a result of
decreased headcount and a decline in the value of equity based compensation
awards distributed to employee-owners.
For the nine months ended September 30, 2002 and 2001, selling, general and
administrative expenses were $572 million and $754 million, respectively. These
figures exclude $154 million and $239 million of non-cash compensation. The
factors described above are also the primary reasons for the decline in selling,
general and administrative expenses and non-cash compensation between the
periods in 2002 and 2001. In addition, the Company also released $4 million of
professional fee accruals in the second quarter due to the favorable resolution
of certain matters for which they were originally recorded.
Restructuring and Impairment Charges of $3 million were recorded in the third
quarter of 2002. In 2002, the Company recorded a restructuring charge of $5
million primarily for the costs associated with the termination of approximately
100 CorpSoft employees due to its integration with Software Spectrum. This
charge was partially offset by a $2 million reversal of lease termination
accruals attributable to communications facilities the Company has elected to
continue utilizing. In the second quarter of 2002, the Company recorded a
restructuring charge of $3 million for the costs associated with the termination
of approximately 200 communications employees in North America and Europe. In
the first half of 2001, the Company recorded charges of $50 million for global
work force reductions of approximately 1,700 employees, primarily in the
communications business. The restructuring charge in 2001 was comprised of $45
million for staff reduction costs and $5 million for real estate lease
termination costs.
The Company also recorded impairment charges of $44 million and $61 million
during the second quarter of 2002 and 2001, respectively. In 2002, the Company
decreased the carrying value of certain colocation assets, excess communications
equipment and corporate facilities by approximately $44 million due to the
continued deterioration of the value of these assets. In 2001, the Company
announced that it was reducing and reprioritizing capital expenditures. The
capital reprioritization resulted in certain communications assets being
identified as excess, obsolete or impaired. As a result, the Company recorded a
non-cash impairment charge of $61 million in June 2001, representing the excess
of the carrying value over the fair value of these assets.
EBITDA, as defined by the Company, consists of earnings (losses) before
interest, income taxes, depreciation, amortization, non-cash operating expenses
(including stock-based compensation and impairments) and other non-operating
income or expenses. The Company excludes non-cash compensation due to its
adoption of the expense recognition provisions of SFAS No. 123. EBITDA improved
to earnings of $109 million and $236 million for the three and nine months
ending September 30, 2002 from losses of $10 million and $217 million for the
same periods in 2001. Restructuring charges of $3 million and $6 million for the
three and nine months ended September 30, 2002 and $50 million for the nine
months ended September 30, 2001, respectively, are included in EBITDA. This
improvement was predominantly due to the higher margins earned by the
communications business, reductions in selling, general and administrative
expenses and the results of Software Spectrum.
Adjusted EBITDA, as defined by the Company, is EBITDA as defined above plus the
change in cash deferred revenue and excluding the non-cash cost of goods sold
associated with certain capacity sales and dark fiber contracts. For the three
and nine months ended September 30, 2002, Adjusted EBITDA was $110 million and
$336 million, respectively compared to $81 million and $588 million for the same
periods in 2001. The increase in the three months amounts is primarily
attributable to the significant improvement in communications and information
services operating earnings which were partially offset by lower IRU sales. The
decrease for the nine-month period can be attributed to the decline in Cash
Communications Revenue, partially offset by reduced operating expenses and
earnings attributable to Software Spectrum.
Three Months Ended Nine Months Ended
June 30, June 30,
--------------------------------------------------
(dollars in millions) 2002 2001 2002 2001
- --------------------- ---- ---- ---- ----
EBITDA............................................................ $ 109 $ (10) $ 236 $ (217)
Increase (Decrease) in Communications Deferred Revenue........... (12) 76 8 611
Decrease (Increase) in Deferred Revenue not Collected............. 13 (6) 89 42
Non-cash Cost of Goods Sold....................................... -- 21 3 152
---- ---- ---- ----
Adjusted EBITDA $ 110 $ 81 $ 336 $ 588
===== ===== ===== =====
EBITDA and Adjusted EBITDA are not intended to represent operating cash flow or
profitability for the periods indicated and are not defined under GAAP. See
Consolidated Condensed Statement of Cash Flows.
Interest Income was $8 million for the third quarter of 2002 compared to $34
million in the same period in 2001 and $23 million for the nine months ended
September 30, 2002 versus $142 million for the same nine month period in 2001.
The decrease is primarily attributable to the decline in the average cash and
marketable security portfolio balance and a reduction in the weighted average
interest rate earned on the portfolio. The Company expects interest income to
continue to be below 2001 levels due to utilization of funds to pay operating
and interest expenses, and fund capital expenditures, as well as lower market
interest rates. Interest income in the third quarter of 2002 did increase from
second quarter levels as a result of the proceeds received from the $500 million
offering of 9% Junior Convertible Subordinated Notes in July 2002. Pending
utilization of the cash and cash equivalents, the Company invests the funds
primarily in government and government agency securities and money market funds.
The investment strategy generally provides lower yields on the funds than on
alternative investments, but reduces the risk to principal in the short term
prior to using the funds in implementing the Company's business plan.
Interest Expense, net decreased from the corresponding period in 2001 by $29
million to $154 million during the third quarter of 2002 and by $81 million to
$414 million in the first nine months of 2002. Interest expense declined as a
result of the debt repurchased during the second half of 2001 and the first nine
months of 2002, and lower interest rates on the Senior Secured Credit Facility
and commercial mortgages during the nine months ended September 30, 2002. The
declines were partially offset by the interest attributable to the additional
borrowings under the Senior Secured Credit Facility in the first quarter of
2001, the Junior Convertible Subordinated Notes in the third quarter of 2002,
and a decline in the amount of capitalized interest. The Company substantially
completed the construction of its network in 2001, therefore reducing the amount
of interest capitalization. Capitalized interest was $1 million and $58 million
for the three and nine months ended September 30, 2001, respectively, and zero
in the first nine months of 2002. Excluding fluctuations in interest rates and
debt outstanding, interest expense is expected to increase as a result of the 50
basis point rate increase on borrowings under the amended Senior Secured Credit
Facility.
Other, net decreased to a loss of $29 million in the third quarter of 2002 from
a $38 million gain in the third quarter of 2001. In 2002, the loss is primarily
comprised of $20 million of induced conversion expenses resulting from the
Company's repurchase of convertible debt securities and realized losses of
$16 million resulting from the sale foreign denominated currency. In 2001 Other,
net is primarily comprised of the $27 million of income recognized when Level 3
settled and was released from an obligation to provide services to an investee.
For the nine months ended September 30, 2002 and 2001, Other income was $79
million and $3 million, respectively. In addition to the items above, the
Company realized a $102 million gain on the sale of the Commonwealth Telephone
shares in 2002. In 2001, the Company recorded an other-than-temporary decline in
the value of certain investments of $37 million. Other, net in all periods also
includes equity earnings attributable to Commonwealth Telephone, which did not
change significantly. Commonwealth's results of operations improved for the
three and nine months ended September 30, 2002 versus the same periods in 2001.
However, Level 3's proportionate share of those earnings decreased as a result
of its sale of the Commonwealth Telephone shares in April 2002.
Income Tax Benefit for the nine months ended September 30, 2002 was $119 million
compared to zero for the same period in 2001. Federal legislation enacted in the
first quarter of 2002 enabled the Company to carryback its 2001 Federal income
tax net operating losses to 1996. In accordance with SFAS No. 109 "Accounting
for Income Taxes", the Company recorded the benefit in the period in which the
legislation was enacted. The Company does not expect to recognize additional
benefits in 2002, as it is unable to conclude that it is more likely than not
that the tax benefits attributable to the net operating losses will be
realizable. The income tax benefit was zero in 2001 as a result of the Company
exhausting the taxable income in the carryback period (as previously defined) in
2000.
Extraordinary Gain on Debt Extinguishment for the three and nine months ended
September 30, 2002 was $5 million and $211 million, respectively. During the
third quarter, Level 3 purchased approximately $12 million face value of its
debt by issuing approximately one million shares of its common stock, valued at
approximately $7 million. These exchanges resulted in a gain of approximately $5
million after transaction and unamortized debt issuance costs. In the first half
of 2002, a wholly owned subsidiary of the Company, Level 3 Finance, LLC.,
purchased $89 million of debt for cash consideration of $31 million. In
addition, Level 3 issued approximately 17 million shares, valued at $71 million
to repurchase $245 million face amount ($223 million carrying amount) of the
Company's debt. These transactions, together with those in the third quarter,
resulted in extraordinary gains of approximately $211 million for the nine
months ended September 30, 2002.
In August 2002, the SEC notified certain public companies and accounting firms
that it was reviewing the accounting treatment for certain transactions
involving the conversion of convertible debt pursuant to inducements made to
prompt conversion of the debt to equity securities of the issuer. The SEC
acknowledged that there was diversity in accounting practice and asked the
Emerging Issues Task Force of the Financial Accounting Standards Board to
address the issue as part of its September 2002 agenda.
In September 2002, the EITF issued 02-15 which addressed the accounting for
convertible debt for equity exchanges. The EITF concluded that these types of
transactions should be accounted for as induced conversions in accordance with
SFAS No. 84. SFAS No. 84 requires a non-cash charge to earnings for the implied
value of an inducement to convert from convertible debt to common equity
securities of the issuer. In addition, under SFAS No. 84, an extraordinary gain
or loss, as applicable, is not recorded upon the conversion of convertible debt.
The accounting is to be applied prospectively for those convertible debt for
equity exchanges completed after September 11, 2002, the date of the EITF's
consensus. The Company has applied the provisions of SFAS No. 84 to all
convertible debt for equity exchange transactions completed during the third
quarter. During the quarter, Level 3 purchased $50 million aggregate principal
amount of its 6% Convertible Subordinated Notes due 2009 and $13 million
aggregate principal amount of its 6% Convertible Subordinated Notes due 2010.
The Company issued approximately 5 million shares of its common stock worth
approximately $25 million. The value of securities issuable pursuant to original
conversion privileges was approximately $5 million. As a result, the Company
recorded induced conversion expenses of $20 million during the quarter and
included it in Other, net on the Consolidated Condensed Statement of Operations.
The extraordinary gain on debt extinguishments was $94 million for the three and
nine months ended September 30, 2001, respectively. The Company purchased $169
million of its convertible subordinated
notes during the three-month period ending September 30, 2001. The Company
issued approximately 14 million shares of its common stock worth approximately
$61 million in exchange for the debt. The net gain on the extinguishment of the
debt, including transaction costs and unamortized debt issuance costs, was $103
million. Offsetting this gain were $9 million of prepayment expenses CPTC
incurred to refinance its development and construction debt.
Financial Condition--September 30, 2002
The Company's working capital increased from $642 million at December 31, 2001
to $857 million at September 30, 2002 due primarily to the funds received from
the sale of the Junior Convertible Notes in the third quarter. These proceeds
were partially offset by the use of available funds for operating expenses and
interest payments, and the net liabilities assumed in the acquisitions of
CorpSoft, Software Spectrum and McLeod's wholesale dial-up access business.
Cash provided by operations decreased from a source of $231 million in the first
nine months of 2001 to a use of $443 million in the same period of 2002. Changes
in components of working capital, primarily deferred revenue, were responsible
for the fluctuation in cash provided by operations. In addition, the Company
made a $21 million payment in full settlement of an outstanding litigation
matter that did not relate to the Company's core businesses.
Investing activities primarily include the acquisitions of CorpSoft for $94
million, net of cash received, Software Spectrum for $93 million, net of cash
received, the purchase of McLeod's wholesale dial-up business for approximately
$51 million and capital expenditures of $173 million before the release of
capital accruals. In 2002, Level 3 was able to finalize negotiations and claims
on several of its large multi-year network construction projects. As a result,
the Company was able to release approximately $164 million of capital accruals
previously reported as property, plant and equipment. The Company continues to
resolve outstanding claims for other network construction projects. If these
claims are settled favorably, additional capital expenditure accruals could be
released in the future. In the ordinary course of business, as construction
projects come to a close, the Company reviews the final amounts due and settles
any outstanding amounts related to these contracts. In the context of the
multi-billion cost incurred in constructing the Level 3 network, the
construction cost accruals are normal and not significant to the financial
statements. The Company received $200 million of proceeds from the sale of
marketable securities, $166 million from the sale of Commonwealth Telephone
shares and $45 million from the sale of property, plant and equipment and other
assets. In the third quarter, the Company entered into a sale/leaseback
transaction whereby it received approximately $34 million in proceeds from the
sale of a communications facility in Europe. The Company was also required to
pledge $400 million as restricted cash to the lenders of the Senior Secured
Credit Facility in the third quarter as part of amending the credit facility.
Financing activities in 2002 consisted primarily of the repurchase of the
Company's long-term debt for $31 million by Level 3 Finance, LLC, a reduction in
the iStar mortgage of $52 million and the payment of $12 million of capitalized
leases. Level 3 received $488 million of net proceeds from the issuance of the
Junior Convertible Subordinated Notes in the third quarter of 2002 and the
foreign subsidiaries of Software Spectrum borrowed $2 million during the first
nine months of 2002.
Liquidity and Capital Resources
The Company provides a broad range of integrated communications services as a
facilities-based provider (that is, a provider that owns or leases a substantial
portion of the property, plant and equipment necessary to provide its services.)
The Company has created, through a combination of construction, purchase and, to
a lesser extent, leasing of facilities and other assets, an advanced,
international, end-to-end, facilities-based communications network. The Company
has designed its network based on optical and Internet Protocol technologies in
order to leverage the efficiencies of these technologies to provide lower cost
communications services.
The further development of the communications business will continue to require
significant expenditures. These expenditures may result in negative operating
cash flow and net operating losses for the Company for the foreseeable future.
The Company's expenditures are now primarily attributable to operating expenses,
working capital requirements and interest payments. The Company's capital
expenditures declined by approximately $2.2 billion for the nine months of 2002
versus the same period in 2001 and are expected to remain significantly below
2001 levels due to the completion of initial construction related to the North
American and European networks in 2001. The majority of the Company's ongoing
capital expenditures are expected to be success-based, or tied to incremental
revenue. The Company estimates that its capital expenditures will total
approximately $218 million in 2002, excluding the release of $164 million of
accruals through September 30, 2002.
Level 3 has approximately $960 million of cash and marketable securities on hand
at September 30, 2002, excluding $400 million of cash that was pledged to the
banks participating in the Company's amended Senior Secured Credit Facility.
This cash is reflected on the balance sheet as Restricted Cash. Based on
information available at this time, management of the Company believes that the
Company's current liquidity and anticipated future cash flows from operations
will be sufficient to fund its business plan through free cash flow breakeven,
and at least through the next twelve months. In addition, the Company has
undrawn commitments of approximately $150 million under its amended Senior
Secured Credit Facility. There are certain restrictions on the availability of
the undrawn amounts.
The Company currently estimates that its operations will reach free cash flow
breakeven without a requirement for additional financing. The timing of free
cash flow breakeven will be a function of revenue and Cash Revenue growth as
well as the Company's management of network, selling, general and
administrative, and capital expenditures. The Company's successful debt and
equity offerings have given the Company the ability to implement the business
plan. However, if additional investment opportunities should present themselves,
the Company may be required to secure additional financing in the future. In
order to pursue these possible opportunities and provide additional flexibility
to fund its business plan, in January 2001 the Company filed a "universal" shelf
registration statement for an additional $3 billion of common stock, preferred
stock, debt securities, warrants, stock purchase agreements and depository
shares. The Company sold $500 million of 9% Junior Convertible Subordinated
Notes due in July 2012 under this shelf registration statement. The remaining
availability under this registration statement and under a previously existing
registration statement would allow Level 3 to offer an aggregate of up to $2.7
billion of additional securities to fund its business plan.
In addition to raising capital through the debt and equity markets, the Company
may sell or dispose of existing businesses or investments to fund portions of
the business plan. On April 2, 2002, the Company completed the sale of
approximately 4.9 million shares of Commonwealth Telephone for approximately
$166 million. Level 3 has indicated that it may sell an additional 4.9 million
shares in the future. The Company also announced that it had reached a
non-binding letter of intent to sell its interest in CPTC, for potential
proceeds of $45 million. In addition, the Company has announced that it will
seek to sell or sublease excess real estate and may enter into sales/leaseback
transactions for required communications facilities.
The Company may not be successful in producing sufficient cash flow, raising
sufficient debt or equity capital on terms that it will consider acceptable, or
selling or leasing fiber optic capacity or access to its conduits. In addition,
proceeds from dispositions of the Company's assets may not reflect the assets'
intrinsic values. Further, expenses may exceed the Company's estimates and the
financing needed may be higher than estimated. Failure to generate sufficient
funds may require the Company to delay or abandon some of its future expansion
or expenditures, which could have a material adverse effect on the
implementation of the business plan.
In connection with the implementation of the Company's business plan, management
continues to review the existing businesses to determine how those businesses
will assist with the Company's focus on delivery of communications and
information services and reaching free cash flow breakeven. To the
extent that certain businesses are not considered to be compatible with the
delivery of communication and information services or with obtaining cash flow
objectives, the Company may exit those businesses. It is possible that the
decision to exit these businesses could result in the Company not recovering its
investment in the businesses, and in those cases, a significant charge to
earnings could result. For example, the Company sold its Asian operations to
Reach Ltd. and incurred a loss of $516 million.
In July 2001, Level 3 announced that it had amended its Senior Secured Credit
Facility to permit the Company to acquire certain of its outstanding
indebtedness in exchange for shares of common stock. During the first nine
months of 2002 and during 2001, various issuances of Level 3's outstanding
senior notes, senior discount notes and convertible subordinated notes traded at
discounts to their respective face or accreted amounts. Through September 30,
2002, the Company had exchanged, in private transactions, approximately $493
million (carrying value) of its debt for shares of its common stock valued at
approximately $175 million.
In October 2001, the Company completed through its first tier, wholly owned
subsidiary, Level 3 Finance, LLC, a "Modified Dutch Auction" tender offer for a
portion of the Company's senior notes and convertible subordinate notes. Level 3
Finance repurchased debt with a face value of approximately $1.7 billion, plus
accrued interest, if applicable, for a total cash purchase price of
approximately $731 million. Level 3 retired an additional $89 million face
amount of debt securities using approximately $31 million of cash during the
second quarter of 2002.
Level 3 is aware that the various issuances of its outstanding senior notes,
senior discount notes and convertible subordinated notes continue to trade at
discounts to their respective face or accreted amounts. In order to continue to
reduce future cash interest payments, as well as future amounts due at maturity,
Level 3 or its affiliates may, from time to time, purchase these outstanding
debt securities for cash or exchange shares of Level 3 common stock for these
outstanding debt securities pursuant to the exemption provided by Section
3(a)(9) of the Securities Act of 1933, as amended, in open market or privately
negotiated transactions. Level 3 will evaluate any such transactions in light of
then existing market conditions. The amounts involved in any such transactions,
individually or in the aggregate, may be material.
The Company has a $1.275 billion Senior Secured Credit Facility. As of September
30, 2002, $1.125 billion of the $1.275 billion Senior Secured Credit Facility
was drawn. The balance represents the approximately $150 million revolving
credit facility, which contains certain limitations on availability.
In August 2002, Level 3 amended the terms of the Senior Secured Credit Facility.
Modifications to the Credit Facility, per the terms of the amendment, include,
but are not limited to, the following:
o Increased flexibility for the Company to pursue acquisitions for cash
consideration;
o Removal of two revenue-based financial covenants;
o Modification of an Adjusted EBITDA-based covenant in accordance with
the Company's current business plan;
o Reduction of the $650 million undrawn revolving credit facility by
$500 million to $150 million, with restrictions on availability;
o Maintenance of minimum cash balance, generally equal to $525 million,
of which $400 million is pledged to the banks; and
o Increase of 0.5% per year to the cost of borrowing
The remaining financial covenants contained in the credit agreement will now be
calculated on a consolidated basis, but those calculations will exclude the
Company's toll road operations. Certain modifications were also made to the
Total Leverage Ratio covenant (which is defined in the agreement as the ratio of
Total Debt to Adjusted EBITDA) in accordance with the Company's current business
plan. In addition, this covenant will now be tested on a trailing twelve-month
basis beginning on June 30, 2004, with a maximum allowable level of 11.5x,
versus the original maximum allowable level of 6.0x beginning on December 31,
2004. Certain other covenants have also been modified.
The Company is required to maintain a minimum cash balance, generally equal to
$525 million. No default under the Senior Secured Credit Facility shall be
deemed to have occurred with respect to the minimum cash balance test if, within
a six month period following the date on which the cash balance falls below $525
million, the Company again attains a cash balance greater than or equal to $525
million. Additionally, the Company is required to pledge to the lenders under
the Senior Secured Credit Facility $400 million of the minimum cash balance. The
Company shall be deemed to be in default under the Senior Secured Credit
Facility if the cash balance of the restricted subsidiaries falls below $450
million.
The Senior Secured Credit Facility, as amended, has customary covenants, or
requirements, that the Company and certain of its subsidiaries must meet to
remain in compliance with the contract. If the Company does not remain in
compliance with the covenants, it could be in default under the terms of the
Senior Secured Credit Facility. In this event, the lenders could take actions to
require repayment.
In the amendment, the Company agreed to reduce the amount of the undrawn senior
secured revolving credit facility portion from $650 million to $150 million. Of
the $150 million, $50 million is available immediately for letters of credit and
the remaining $100 million becomes available after August 30, 2003 provided that
the Company has satisfied an incurrence test that is related to a pro forma
fixed charge coverage ratio. As of September 30, 2002, the Company had
approximately $8 million in letters of credit outstanding under this agreement.
As of September 30, 2002, Level 3 had not borrowed any funds under the $150
million revolving credit facility. The availability of funds and any requirement
to repay previously borrowed funds is contingent upon the continued compliance
with the relevant debt covenants. The Company believes, based upon management's
review of the amended covenants and other provisions of the Senior Secured
Credit Facility, that it is in full compliance with all the terms of the Senior
Secured Credit Facility as of September 30, 2002 and will be for at least the
next twelve months.
Current economic conditions of the telecommunications and information services
industry, combined with Level 3's financial position and significant liquidity,
have created potential opportunities for Level 3 to acquire companies or
portions of companies at attractive prices. Level 3 continues to evaluate these
opportunities and could make additional acquisitions in 2002.
Market Risk
Level 3 is subject to market risks arising from changes in interest rates,
equity prices and foreign exchange rates. As of September 30, 2002, the Company
had borrowed $1.125 billion under the Senior Secured Credit Facility and $180
million under the commercial mortgages. Amounts drawn on the debt instruments
bear interest at the alternate base rate or LIBOR rate plus applicable margins.
As the alternate base rate and LIBOR rate fluctuate, so too will the interest
expense on amounts borrowed under the credit facility and mortgages. The
weighted average interest rate based on outstanding amounts under these variable
rate instruments of $1.3 billion at September 30, 2002, was approximately 5.7%.
A hypothetical increase in the variable portion of the weighted average rate by
1% (i.e. a weighted average rate of 6.7%) would increase annual interest expense
of the Company by approximately $13 million. At September 30, 2002, the Company
had $5.09 billion of fixed rate debt bearing a weighted average interest rate of
9.2%. A decline in interest rates in the future will not benefit the Company due
to the terms and conditions of the loan agreements that require the Company to
repurchase the debt at specified premiums. The Company has been able to reduce
its exposure to interest rate risk by acquiring certain outstanding indebtedness
in exchange for shares of common stock and cash. The Company continues to
evaluate other alternatives to limit interest rate risk.
Level 3 continues to hold positions in certain publicly traded entities,
primarily Commonwealth Telephone and RCN. The Company accounts for these two
investments using the equity method. On April 2, 2002, the Company sold
approximately 46% of its holdings in Commonwealth Telephone for approximately
$166
million. The market value of RCN and Commonwealth Telephone was approximately
$214 million at September 30, 2002, which is significantly higher than their
carrying value of $82 million. Level 3 has also stated that it may dispose of
all or part of the remaining investments in the next 12-18 months. The value
received for the remaining investments would be affected by the market value of
the underlying stock at the time of any such transaction. A 20% decrease in the
price of Commonwealth Telephone and RCN stock would result in approximately a
$43 million decrease in fair value of these investments. The Company does not
currently utilize financial instruments to minimize its exposure to price
fluctuations in equity securities.
The Company's business plan includes developing and operating a
telecommunications network in Europe. As of September 30, 2002, the Company had
invested significant amounts of capital in that region and will continue to
expand its presence in Europe in 2002. The Company issued EURO800 million
(EURO425 million outstanding at September 30, 2002) in Senior Euro Notes in
February 2000 as an economic hedge against its net investment in its European
subsidiaries. Due to the historically low exchange rates involving the U.S.
Dollar and the Euro, during the fourth quarter of 2000, Level 3 elected to set
aside the remaining Euros received from the debt offerings. During the third
quarter of 2001, Level 3 elected to start funding its current European investing
and operating activities with the Euros that had previously been set aside. As
of September 30, 2002, the Company held only enough Euro denominated cash and
cash equivalents to fund its immediate working capital obligations. Other than
the issuance of the Euro denominated debt and the holding of the Euros, the
Company has not made significant use of financial instruments to minimize its
exposure to foreign currency fluctuations. Foreign exchange rate fluctuations in
2002 did not have a material effect on Level 3's results of operations. The
Company continues to analyze risk management strategies to reduce foreign
currency exchange risk.
The change in interest rates and equity security prices is based on hypothetical
movements and are not necessarily indicative of the actual results that may
occur. Future earnings and losses will be affected by actual fluctuations in
interest rates, equity prices and foreign currency rates.
Item 4. Controls and Procedures
(a) Disclosure controls and procedures. The Company's Chief Executive
Officer and Chief Financial Officer have evaluated the effectiveness of the
Company's disclosure controls and procedures within the 90 days prior to the
date of filing of this Quarterly Report on Form 10-Q. Based upon such review,
the Chief Executive Officer and Chief Financial Officer have concluded that the
Company has in place appropriate controls and procedures designed to ensure that
information required to be disclosed by the Company in the reports it files or
submits under the Securities Exchange Act of 1934, as amended, and the rules
thereunder, is recorded, processed, summarized and reported within the time
periods specified in the Commission's rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed by an issuer in reports it
files or submits under the Securities Exchange Act is accumulated and
communicated to the Company's management, including its principal executive
officer and principal financial officer, as appropriate to allow timely
decisions regarding required disclosure.
(b) Internal controls. Since the date of the evaluation described above,
there have not been any significant changes in our internal controls or in other
factors that could significantly affect those controls.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
PART II - OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders
At the annual meeting of stockholders held on July 24, 2002 the following
matters were submitted to a vote:
1. Election of four Class II Directors to the Board of Directors of Level 3
for a three-year term until the 2005 Annual Meeting of Stockholders:
In Favor Withheld
Mogens C. Bay 345,692,188 8,418,724
Richard R. Jaros 344,828,789 9,282,123
Robert E. Julian 346,784,765 7,326,147
David C. McCourt 340,010,051 14,100,861
2. Proposal to adopt an amendment to Level 3's Stock Plan to increase the
number of shares of common stock, par value $.01 per share of Level 3,
reserved for issuance under the Stock Plan by 50,000,000 shares of Level 3
Common Stock:
Affirmative votes: 198,970,010
Negative votes: 38,128,524
Abstain: 2,621,955
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits filed as part of this report are listed below.
99.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.
99.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.
(b) On July 9, 2002, the Company filed a Current Report on Form 8-K disclosing
the sale of $500 million of its 9% Junior Convertible Subordinated Notes to
certain institutional investors.
On August 14, 2002, the Company filed a Current Report on Form 8-K related
to the modification of its long-term incentive program.
On August 26, 2002, the Company filed a Current Report on Form 8-K
disclosing that it had amended its Senior Secured Credit Facility.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
LEVEL 3 COMMUNICATIONS, INC.
Dated: November 14, 2002 \s\ Eric J. Mortensen
Eric J. Mortensen
Vice President, Controller
and Principal Accounting Officer
CERTIFICATIONS*
I, James Q. Crowe, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Level 3 Communications,
Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 14, 2002
/s/ James Q. Crowe
James Q. Crowe
Chief Executive Officer
* Provide a separate certification for each principal executive officer and
principal financial officer of the registrant. See Rules 13a-14 and 15d-14. The
required certification must be in the exact form set forth above.
CERTIFICATIONS*
I, Sureel A. Choksi, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Level 3 Communications,
Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures
based on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 14, 2002
/s/ Sureel A. Choksi
Sureel A. Choksi
Group Vice President and Chief Financial Officer
* Provide a separate certification for each principal executive officer and
principal financial officer of the registrant. See Rules 13a-14 and 15d-14. The
required certification must be in the exact form set forth above.