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 June 30, 1998
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.)
3555 Farnam Street, Omaha, Nebraska 68131
(Address of principal executive offices) (Zip Code)
(402)-536-3677
(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 August 10, 1998:
Common Stock 306,479,016 shares
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Part I - Financial Information
Item 1. Financial Statements:
Consolidated Condensed Statements of Operations
Consolidated Condensed Balance Sheets
Consolidated Condensed Statements of Cash Flows
Consolidated Statement of Changes in Stockholders' Equity
Notes to Consolidated Condensed Financial Statements
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations
Part II - Other Information
Item 2. Changes in Securities
Item 6. Exhibits and Reports on Form 8-K
Signatures
Index to Exhibits
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Condensed Statements of Operations
(unaudited)
Three Months Ended Six Months Ended
June 30, June 30,
(dollars in millions, except share data) 1998 1997 1998 1997
Revenue $ 103 $ 81 $ 190 $ 161
Costs and Expenses:
Operating expenses 49 41 91 80
Depreciation and amortization 7 5 13 10
General and administrative expenses 55 19 103 35
Write-off of in process research
& development 115 - 115 -
----- ----- ----- ------
Total costs and expenses 226 65 322 125
Earnings (Loss) from Operations (123) 16 (132) 36
Other Income (Expense):
Interest income 45 8 71 15
Interest expense, net (36) (4) (40) (7)
Other, net, principally equity losses of
unconsolidated entities (4) (3) (26) (6)
------ ----- ----- -----
Total other income 5 1 5 2
------ ----- ----- -----
Earnings (Loss) Before Income Taxes and
Discontinued Operations (118) 17 (127) 38
Income Tax (Provision) Benefit 2 (5) 5 (10)
------ ----- ----- -----
Earnings (Loss) from
Continuing Operations (116) 12 (122) 28
Discontinued Operations:
Gain on split-off of
construction operations - - 608 -
Gain on disposition of energy business,
net of income tax expense of $174 - - 324 -
Energy, net of income tax expense of
$5 and $7 - 9 - 13
Construction, net of income tax
expense of $23 and $33 - 35 - 50
----- ----- ----- -----
Earnings from discontinued operations - 44 932 63
----- ----- ----- -----
Net Earnings (Loss) $(116) $ 56 $ 810 $ 91
===== ===== ====== ======
Earnings (Loss) Per Share:
Continuing Operations:
Basic $ (.39) $ .06 $ (.41) $ 0.12
====== ===== ====== ======
Diluted $ (.39) $ .06 $ (.41) $ 0.12
====== ===== ====== ======
Discontinued Operations:
Basic $ - $ .03 $ 3.14 $ 0.05
====== ===== ====== ======
Diluted $ - $ .03 $ 3.14 $ 0.05
====== ===== ====== ======
Net Earnings (Loss):
Basic $ (.39) $ .09 $ 2.73 $ 0.17
====== ===== ====== ======
Diluted $ (.39) $ .09 $ 2.73 $ 0.17
====== ===== ====== ======
Net Earnings (Loss), excluding gain on
split-off of construction operations:
Basic $ (.39) $ .09 $ .68 $ 0.17
====== ===== ====== ======
Diluted $ (.39) $ .09 $ .68 $ 0.17
====== ===== ====== ======
See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Condensed Balance Sheets
June 30, December 27,
1998 1997
(dollars in millions, except share data) (unaudited)
Assets
Current Assets
Cash and cash equivalents $ 801 $ 87
Marketable securities 2,959 678
Restricted securities 25 22
Accounts receivable 61 42
Investment in discontinued operations - energy - 643
Other 28 22
------- -------
Total Current Assets 3,874 1,494
Property, Plant and Equipment, less
accumulated depreciation and amortization
of $224 and $228 349 184
Investments 341 383
Investment in Discontinued Operations - Construction - 652
Other Assets 155 66
------- -------
$ 4,719 $ 2,779
======= =======
See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Condensed Balance Sheets
June 30, December 27,
1998 1997
(dollars in millions, except share data) (unaudited)
Liabilities and Stockholders' Equity
Current Liabilities:
Accounts payable $ 52 $ 31
Current portion of long-term debt 5 3
Accrued reclamation and other mining costs 13 19
Accrued interest 35 2
Deferred income taxes 14 15
Income taxes payable 34 -
Other 22 19
------ -------
Total Current Liabilities 175 89
Long-Term Debt, less current portion 2,137 137
Deferred Income Taxes 65 83
Accrued Reclamation Costs 101 100
Other Liabilities 140 140
Stockholders' Equity:
Preferred stock, no par value, authorized
10,000,000 shares; no shares outstanding
in 1998 and 1997 - -
Common Stock, $.01 par value in 1998:
Common Stock (Class D in 1997),
authorized 500,000,000 shares;
306,252,930 shares outstanding in 1998 and
271,034,280 outstanding in 1997 3 8
Class B, no shares outstanding in 1997 -
Class C, 10,132,343 outstanding in 1997 1
Additional paid-in capital 691 427
Accumulated other comprehensive income (loss) 8 (5)
Retained earnings 1,399 1,799
------- -------
Total Stockholders' Equity 2,101 2,230
------- -------
$ 4,719 $ 2,779
======= =======
See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Condensed Statements of Cash Flows
(unaudited)
Six Months Ended
June 30,
(dollars in millions) 1998 1997
Cash flows from continuing operations:
Net cash provided by (used in) continuing operations $ (158) $ 107
Cash flows from investing activities:
Proceeds from sales and maturities of
marketable securities 2,484 99
Purchases of marketable securities (4,713) (102)
Investments (22) (23)
Proceeds from sale of property, plant and
equipment and other investments 26 -
Capital expenditures (144) (12)
Other - 1
-------- -----
Net cash used in investing activities (2,369) (37)
Cash flows from financing activities:
Payments on long-term debt including current portion (5) (2)
Issuance of long-term debt 1,937 16
Issuances of common stock 21 5
Proceeds from exercise of stock options 7 -
Dividends paid - (12)
Exchange of Class C Stock for Common Stock, net 122 72
------- ------
Net cash provided by financing activities 2,082 79
Cash flows from discontinued operations:
Proceeds from sale of energy operations 1,159 -
Investments in discontinued energy operations - (17)
-------- ------
Net cash provided by (used in) discontinued operations 1,159 (17)
Cash and cash equivalents of C-TEC at the beginning of 1997 - (76)
------- -----
Net change in cash and cash equivalents 714 56
Cash and cash equivalents at beginning of year 87 147
------- -----
Cash and cash equivalents at end of period $ 801 $ 203
======= =====
The activities of the Construction & Mining Group have been removed from the
Consolidated Condensed Statements of Cash Flows.
See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Statement of Changes in Stockholders' Equity
For the six months ended June 30, 1998
(unaudited)
Class Common Other
B&C Stock Additional Accumulated
Common (Class D Paid-in Comprehensive Retained
(dollars in Stock in 1997) Capital Income (Loss) Earnings Total
millions)
Balance at
December 28, 1997 $ 1 $ 8 $ 427 $ (5) $ 1,799 $ 2,230
Common Stock:
Issuance of Common
Stock - 1 173 - - 174
Stock options exercised - 1 7 - (1) 7
Designation of par
value to $.01 - (8) 8 - - -
Stock dividend 1 (1) - - -
Stock option grants - - 11 - - 11
Income tax benefit from
exercise of options - - 11 - - 11
Issuance of Class
R Stock - - 92 - (92) -
Forced conversion of
Class R Stock to
Common Stock 72 - (72) -
Class C Stock:
Repurchases - - (25) - - (25)
Conversion of debentures - - 10 - - 10
Net Earnings - - - - 810 810
Other Comprehensive
Loss - - - (2) - (2)
Split-off of
the Construction
& Mining Group (1) - (94) 15 (1,045) (1,125)
----- ----- ----- ----- ------- ------
Balance at
June 30, 1998 $ - $ 3 $ 691 $ 8 $ 1,399 $ 2,101
===== ===== ===== ===== ======= =======
See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Notes to Consolidated Condensed Financial Statements
1. Basis of Presentation
The consolidated condensed balance sheet of Level 3 Communications, Inc. and
subsidiaries ("Level 3" or the "Company"), at December 27, 1997 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 27, 1997.
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.
In 1997, the Company agreed to sell its energy assets to CalEnergy Company,
Inc. ("CalEnergy") and to separate the construction operations ("Construction
& Mining Group") from the Company. On January 2, 1998, the Company completed
the sale of its energy assets to CalEnergy. On March 31, 1998, the
Company completed the split-off of the Construction & Mining Group to
stockholders that held Class C Stock. Therefore, the assets and liabilities
and results of operations of both businesses have been classified as
discontinued operations on the consolidated condensed balance sheet, statements
of operations and cash flows for all periods presented.
The Company is currently developing advanced business support systems. 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 the project, the total cost of the
business support systems will be amortized over its useful life.
The Company is currently constructing its communications network.
Costs associated with the uncompleted network and interest expense incurred
during construction are capitalized. As segments of the network become
operational, the assets will be depreciated over their useful lives.
The capitalized business support systems and network construction costs
incurred to date have been classified as assets under construction within
Property, Plant & Equipment in the accompanying consolidated balance sheet.
The results of operations for the three and six months ended June 30, 1998,
are not necessarily indicative of the results to be expected for the full
year.
On May 1, 1998, the Company's Board of Directors changed Level 3's fiscal year
end from the last Saturday in December to a calendar year end. The
additional five days in the 1998 fiscal year will be reflected in the
Company's Form 10-K for the period ended December 31, 1998.
Where appropriate, items within the consolidated condensed financial statements
have been reclassified from the previous periods to conform to current
period presentation.
2. Reorganization - Discontinued Construction Operations
On March 31, 1998, a separation of the Company's Construction & Mining Group
and Diversified Group was completed through the split-off of the
Construction and Mining Group (the "Split-off").
The Company recognized a gain of $608 million equal to the difference between
the carrying value of the Construction & Mining Group and its fair value in
accordance with the Financial Accounting Standards Board Emerging Issues
Tax Force Issue 96-4. No taxes were provided on this gain due to the tax-free
nature of the Split-off. The Company then reflected the fair value of the
Construction & Mining Group as a distribution to the Class C stockholders.
In connection with the Split-off, Level 3 and the Construction & Mining Group
entered into various agreements including a Separation Agreement, a Tax
Sharing Agreement and an amended Mine Management Agreement.
The Separation Agreement, as amended, provides for the allocation of certain
risks and responsibilities between Level 3 and the Construction & Mining
Group and for cross-indemnifications that are intended to allocate financial
responsibility to the Construction & Mining Group for liabilities arising
out of the construction business and to allocate to Level 3 financial
responsibility for liabilities arising out of the non-construction
businesses. The Separation Agreement also allocates certain corporate-level
risk exposures not readily allocable to either the construction businesses
or the non-construction businesses.
Under the Tax Sharing Agreement, with respect to periods, or portions thereof,
ending on or before the Split-off, Level 3 and the Construction & Mining
Group generally will be responsible for paying the taxes relating to such
returns, including any subsequent adjustments resulting from the
redetermination of such tax liabilities by the applicable taxing
authorities, that are allocable to the non-construction businesses and
construction businesses, respectively. The Tax Sharing Agreement also
provides that Level 3 and the Construction & Mining Group will indemnify
the other from certain taxes and expenses that would be assessed if the
Split-off were determined to be taxable, but solely to the extent that such
determination arose out of the breach by Level 3 or the Construction &
Mining Group, respectively, of certain representations made to the Internal
Revenue Service in connection with the private letter ruling issued
with respect to the Split-off. If the Split-off were determined to be
taxable for any other reason, those taxes would be allocated equally to
Level 3 and the Construction & Mining Group. Finally, under certain
circumstances, Level 3 would make certain liquidated damage payments
to the Construction & Mining Group if the Split-off was determined to
be taxable, in order to indirectly compensate Class C stockholders for
taxes assessed upon them in that event.
In connection with the Split-off, the Mine Management Agreement, pursuant
to which the Construction & Mining Group provides mine management and
related services to Level 3's coal mining operations, was amended to
provide the Construction & Mining Group with a right of offer in the
event that Level 3 were to determine to sell any or all of its coal
mining properties. Under the right of offer, Level 3 would be required
to offer to sell those properties to the Construction & Mining Group.
If the Construction & Mining Group were to decline to purchase the
properties at that price, Level 3 would be free to sell them to a third
party for an amount greater than or equal to that price. If Level 3 were
to sell the properties to a third party, thus terminating the Mine
Management Agreement, it would be required to pay the Construction &
Mining Group an amount equal to the discounted present value of the
Mine Management Agreement, determined, if necessary, by an appraisal process.
Following the Split-off, the Company's Common Stock began trading on
The Nasdaq National Market on April 1, 1998, under the symbol "LVLT".
In connection with the Split-off, the construction business was
renamed "Peter Kiewit Sons', Inc." and the Class D Stock became
the common stock of Level 3 Communications, Inc. ("Common Stock").
Accordingly, the separate financial statements of Peter Kiewit
Sons', Inc. should be obtained to review the financial position
of the Construction & Mining Group as of March 31, 1998 and
December 27, 1997 and the results of operations for the three months
ended March 31, 1998 and the three and six months ended June 30, 1997.
The Company's certificate of incorporation gave stockholders the right to
exchange their Class C Stock for Class D Stock under a set conversion
formula. That right was eliminated as a result of the Split-off. To
replace that conversion right, Class C stockholders received 6.5 million
shares of a new Class R Convertible Stock ("Class R Stock") in January
1998, which was convertible into Level 3 Common Stock in accordance
with terms ratified by stockholders in December 1997. The Company
reflected in the equity accounts the exchange of the conversion right
and issuance of the Class R Stock at its fair value of $92
million at the date of the Split-off.
On May 1, 1998, the Board of Directors of Level 3 Communications, Inc.
determined to force conversion of all shares of the Company's Class R
Stock into common stock of the Company, effective May 15, 1998.
The Class R Stock was converted into Level 3 Common Stock in accordance
with the formula set forth in the Certificate of Incorporation of the
Company. The formula provides for a conversion ratio equal to $25,
divided by the average of the midpoints between the high and low sales
prices for Level 3 Common Stock on each of the fifteen trading days
during the period beginning April 9 and ending April 30. The average
for that period was $32.14, adjusted for the dividend issued August 10, 1998.
Accordingly, each holder of Class R Stock received .7778 of a share of
Level 3 Common Stock for each share of Class R Stock held. In total 6.5
million shares of Class R Stock were converted into 5.1 million shares
of Common Stock. The value of the Class R Stock at the time of the forced
conversion was $25 times the 6.5 million shares outstanding, or $164 million.
The Company recognized the additional $72 million of value upon conversion
of the Class R Stock to Common Stock. As a result of the forced conversion,
certain adjustments were made to the cost sharing and risk allocation
provisions of the Separation Agreement and Tax Sharing Agreement between
the Company and Peter Kiewit Sons', Inc. which reduced the costs and risks
allocated to the Company.
The Company has embarked on a plan to become a facilities-based provider
(that is, a provider that owns or leases a substantial portion of the
plant, property and equipment necessary to provide its services) of a
broad range of integrated communications services. To reach this goal, the
Company plans to expand substantially the business of its PKS Information
Services, Inc. subsidiary and to create, through a combination of
construction, purchase and leasing of facilities and other assets, an
international, end-to-end, facilities-based communications network
(the "Business Plan"). The Company is designing the network based on Internet
Protocol ("IP") technology in order to leverage the efficiencies of this
technology to provide lower cost communications services.
3. Discontinued Energy Operations
On January 2, 1998, the Company completed the sale of its energy assets to
CalEnergy. Level 3 recognized an after-tax gain on the disposition of
$324 million and the after-tax proceeds of approximately
$967 million from the transaction will be used to fund in part the
Business Plan. Results of operations for the period through
January 2, 1998, were not considered significant and the gain on disposition
was calculated using the carrying amount of the energy assets as of
December 27, 1997.
4. Earnings Per Share
Basic earnings per share have been computed using the weighted average number
of shares during each period. Diluted earnings per share have been computed
by including stock options considered to be dilutive common stock
equivalents.
The Company had a loss from continuing operations for the periods ended
June 30, 1998, therefore, no potential common shares related to Company
stock options have been included in the computation of the diluted
earnings per share because the resulting computation would be anti-dilutive.
For the periods ending June 30, 1997, potentially dilutive stock options
are calculated in accordance with the treasury stock method which assumes
that proceeds from exercise of all options are used to repurchase common
stock at the average market value. The number of shares remaining after
the proceeds are exhausted represent the potentially dilutive effect of
the options.
The following details the earnings per share calculations for Level 3
Common Stock:
Three Months Six Months
Ended June 30, Ended June 30,
1998 1997 1998 1997
Earnings (loss) from continuing
operations (in millions): $ (116) $ 12 $ (122) $ 28
Earnings from discontinued operations - 9 932 13
------ ----- ------ -----
Net earnings (loss) $ (116) $ 21 $ 810 $ 41
====== ===== ====== =====
Total number of weighted average shares
outstanding used to compute basic
earnings per share (in thousands) 301,786 245,123 296,986 244,765
Additional dilutive stock options - 540 - 540
------- ------- ------- -------
Total number of shares used to
compute dilutive earnings per share 301,786 245,663 296,986 245,305
======= ======= ======= =======
Continuing operations:
Basic earnings (loss) per share $ (.39) $ .06 $ (.41) $ 0.12
====== ======= ======= =======
Diluted earnings (loss) per share $ (.39) $ .06 $ (.41) $ 0.12
====== ======= ======= =======
Discontinued operations:
Basic earnings per share $ - $ .03 $ 3.14 $ 0.05
====== ======= ======= =======
Diluted earnings per share $ - $ .03 $ 3.14 $ 0.05
====== ======= ======= =======
Net earnings (loss):
Basic earnings (loss) per share $ (.39) $ .09 $ 2.73 $ 0.17
====== ======= ======= ========
Diluted earnings (loss) per share $ (.39) $ .09 $ 2.73 $ 0.17
====== ======= ======= ========
Net earnings (loss) excluding gain on
split-off of construction operations:
Basic earnings (loss) per share $ (.39) $ .09 $ .68 $ 0.17
====== ======= ======= ========
Diluted earnings (loss) per share $ (.39) $ .09 $ .68 $ 0.17
====== ======= ======= ========
The Company has 19,718,014 options outstanding that were not included in the
computation of diluted earnings per share because to do so would have been
anti-dilutive for the three and six month periods ended June 30, 1998.
Effective August 10, 1998, and December 26, 1997, the Company issued
dividends of one share and four shares of Level 3 Common Stock (previously
Class D Stock) for each share of Level 3 Common Stock outstanding. All
share information and per share data have been restated to reflect these
dividends.
5. Acquisitions
On April 23, 1998, the Company acquired XCOM Techologies, Inc. ("XCOM"), a
privately held company that has developed technology which the Company
believes will provide certain key components necessary for the Company to
develop an interface between its IP-based network and the public
switched telephone network. The Company issued approximately 5.3
million restricted shares of Level 3 Common Stock and 0.8 million options
and warrants to purchase Level 3 Common Stock in exchange for all the
stock, options and warrants of XCOM.
The Company accounted for this transaction, valued at $154 million, as a
purchase. Of the total purchase price, $115 million was attributable
to in-process research and development, and was taken as a nondeductible
charge to earnings in the second quarter of 1998. The purchase price
exceeded the fair value of the net assets acquired by $30 million
which was recognized as goodwill.
XCOM's 1997 and 1998 operating results prior to the acquisition were not
significant relative to the Company's results.
6. Investments
In September 1997, C-TEC Corporation ("C-TEC") announced that its Board of
Directors had approved the planned restructuring of C-TEC into three
publicly traded companies effective September 30, 1997. Under the terms
of the restructuring C-TEC stockholders received stock in the following
companies:
Commonwealth Telephone Enterprises, Inc., containing the local telephone
group and related engineering business;
Cable Michigan, Inc. containing the cable television operation; and
RCN Corporation, Inc. which consists of RCN Telecom Services; C-TEC, existing
cable systems in the Boston-Washington D.C. corridor; and the investment
in Megacable S.A. de C.V., a cable operator in Mexico. RCN Telecom
Services is a provider of packaged local and long distance telephone, video and
internet access services provided over fiber optic networks to residential
customers.
As a result of the restructuring, Level 3 owns less than 50% of each of the
outstanding shares and voting rights of each entity, and therefore accounts
for each entity using the equity method.
On June 4, 1998, Cable Michigan announced that its Board of Directors had
reached a definitive agreement to sell the company to Avalon Cable for
$40.50 per share in a cash-for-stock transaction, subject to certain
possible closing adjustments. The transaction, which is subject to
stockholder and regulatory approval, is expected to close in the fourth
quarter of 1998. Level 3 expects to recognize a pre-tax gain of
approximately $90 million upon consummation of the transaction.
The following is summarized financial information of the three entities
created as a result of the C-TEC restructuring for the three and six
months ended June 30, 1998 and 1997, and as of June 30, 1998 and
December 31, 1997 (in millions):
Three Months Six Months
Ended June 30, Ended June 30,
Operations: 1998 1997 1998 1997
Commonwealth Telephone Enterprises:
Revenue $ 56 $ 49 $ 109 $ 95
Net income available to common stockholders 5 6 9 12
Level 3's share:
Net income 2 3 4 6
Goodwill amortization - - (1) (1)
---- ---- ---- ----
Equity in net income $ 2 $ 3 $ 3 $ 5
===== ===== ==== ====
Cable Michigan:
Revenue $ 22 $ 20 $ 43 $ 40
Net loss available to common stockholders (5) (1) (6) (3)
Level 3's share:
Net Loss (2) (1) (3) (2)
Goodwill amortization (1) (2) (2) (2)
----- ----- ---- ----
Equity in net loss $ (3) $ (3) $ (5) $ (4)
===== ===== ==== ====
RCN Corporation:
Revenue $ 50 $ 31 $ 90 $ 61
Net loss available to common stockholders (49) (9) (117) (20)
Level 3's share:
Net loss (22) (5) (53) (10)
Goodwill amortization - - - -
----- ---- ---- ----
Equity in net loss $ (22) $ (5) $(53) $(10)
===== ==== ==== ====
Commonwealth
Telephone Cable RCN
Enterprises Michigan Corporation
Financial Position: 1998 1997 1998 1997 1998 1997
Current assets $ 71 $ 71 $ 16 $ 23 $ 1,226 $ 703
Other assets 331 303 115 120 627 448
---- ---- ----- ---- ------- -----
Total assets 402 374 131 143 1,853 1,151
Current liabilities 78 76 21 16 148 70
Other liabilities 277 260 156 166 1,228 708
Minority interest - - 14 15 36 16
---- ---- ----- ---- ------ -----
Total liabilities 355 336 191 197 1,412 794
---- ---- ----- ---- ------ ----
Net assets (liabilities) $ 47 $ 38 $ (60) $(54) $ 441 $ 357
===== ===== ===== ==== ====== =====
Level 3's share:
Equity in net
assets (liabilities) $ 23 $ 18 $ (29) $(26) $ 182 $ 173
Goodwill 56 57 70 72 - 41
----- ----- ----- ---- ----- ----
$ 79 $ 75 $ 41 $ 46 $ 182 $ 214
===== ===== ===== ==== ===== =====
The Company recognizes gains from the sale, issuance and repurchase of stock
by its subsidiaries and equity method investees once any unamortized
goodwill associated with the investment has been reduced to zero.
During 1998, RCN issued stock in a public offering and for certain
acquisitions. The increase in the Company's proportionate share of RCN's
net assets as a result of these transactions eliminated the unamortized
goodwill attributable to the Company's investment in RCN and resulted in a
pre-tax gain of $21 million to the Company in the second quarter of 1998.
On June 30, 1998, Level 3 owned 48%, 48% and 41% of the outstanding shares
of Commonwealth Telephone, Cable Michigan and RCN, respectively. The
market value of the Company's investment in the three entities on June 30,
1998, was $234 million, $130 million and $516 million, respectively.
7. Long Term Debt
On April 28, 1998, the Company received $1.94 billion of proceeds from an
offering of $2 billion aggregate principal amount 9.125% Senior Notes Due
2008 (the "Senior Notes"). The Senior Notes are senior, unsecured
obligations of the Company, ranking pari passu with all existing and future
senior unsecured indebtedness of the Company. The Senior Notes contain
certain covenants, which among others, limit consolidated debt, dividend
payments, and transactions with affiliates. The Company is using the net
proceeds of the Senior Notes in connection with the implementation of its
Business Plan to increase substantially its information services business
and to expand the range of services it offers by building an advanced
international, facilities-based communications network based on IP
technology. Debt issuance costs of $65 million have been capitalized
and will be amortized over the term of the notes. The Company
capitalized $1 million of interest expense and amortized debt
issuance costs related to network construction and systems development
projects in the second quarter of 1998.
8. Level 3 Stock Plan
Subsequent to the Split-off, the Company adopted the recognition provisions
of Statement of Financial Accounting Standards ("SFAS") No. 123,
"Accounting for Stock Based Compensation" ("SFAS No. 123") when it adopted
an outperform stock option program ("OSO"). 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
period of the option. The recognition provisions of SFAS No. 123 are
applied prospectively upon adoption. As a result, they are applied to
all stock awards granted in the year of adoption and are not applied to
awards granted in previous years unless those awards are modified or
settled in cash after adoption of the recognition provisions.
The OSO program was designed by the Company so that its stockholders 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 options unless the Level 3
Common Stock price outperforms the S&P 500 Index. When the stock
price gain is greater than the corresponding gain on the S&P 500 Index,
the value received for options under the OSO plan is based on
a formula involving a multiplier related to the level by which
the Level 3 Common Stock outperforms the S&P 500 Index. To the extent
that the Level 3 Common Stock outperforms the S&P 500, the value of
OSOs to an option holder may exceed the value of non-qualified stock options.
The Company believes that the fair value method of accounting more
appropriately reflects the substance of the transaction between an entity
that issues stock options, or other stock-based instruments, and its
employees and consultants; that is, an entity has granted something of
value to an employee and consultants (the stock option or other instrument)
generally in return for their continued employment and services. The
Company believes that the value of the instrument granted to employees and
consultants should be recognized in financial statements because
nonrecognition implies that either the instruments have no value or that
they are free to employees and consultants, neither of which is an accurate
reflection of the substance of the transaction. 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 will not be settled in cash, but rather, generally, through
issuance of common stock.
The Company believes that the adoption of SFAS No. 123 will result in material
non-cash charges to operations in 1998 and thereafter. The amount of the
non-cash charge will be dependent upon a number of factors, including the
number of options granted and the fair value of each option estimated at the
time of its grant. The expense recognized for options granted to
employees and consultants for services performed for the three and six
months ended June 30, 1998, was $9 million and $11 million, respectively.
On a pro forma basis, adopting SFAS No. 123 would not have had a material
effect on the results of operations for the three and six month periods in
1997.
9. Comprehensive Income
In the first quarter of 1998, the Company adopted SFAS No. 130,
"Reporting Comprehensive Income." The standard requires the display and
reporting of comprehensive income which includes all changes in
stockholders' equity with the exception of additional investments by
stockholders or distributions to stockholders. Comprehensive
income for the Company includes net earnings (loss), unrealized gains
(losses) on securities and foreign currency translation adjustments,
which are charged or credited to the cumulative translation account
within stockholders' equity.
Comprehensive income (loss) for the three and six months ended June 30,
1998 and 1997 was as follows (in millions):
Three Months Six Months
Ended June 30, Ended June 30,
1998 1997 1998 1997
Net earnings (loss) $ (116) $ 56 $ 810 $ 91
Other comprehensive income before tax:
Foreign currency translation adjustments, - (3) 1 (1)
Unrealized holding gains (losses)
arising during period (5) (4) 3 (21)
Reclassification adjustment for
(gains) losses included in net earnings (3) - (8) -
----- ----- ----- -----
Other comprehensive (loss), before tax (8) (7) (4) (22)
Income tax benefit related to items of
other comprehensive income 3 1 2 7
----- ----- ----- -----
Other comprehensive (loss) net of taxes (5) (6) (2) (15)
----- ----- ----- -----
Comprehensive income (loss) $(121) $ 50 $ 808 $ 76
===== ===== ===== =====
10. New Accounting Pronouncements
In 1997, the Financial Accounting Standards Board issued SFAS No. 131,
"Disclosures about Segments of an Enterprise and Related Information",
("SFAS No. 131") which changes the way public companies report information
about segments. SFAS No.131, which is based on the management approach to
segment reporting includes requirements to report selected segment
information quarterly, and entity wide disclosures about products and
services, major customers, and geographic data. This statement is effective
for financial statements for periods beginning after December 15, 1997.
The Company will reflect the adoption of SFAS No. 131 in its
December 31, 1998 financial statements.
On March 4, 1998, the Accounting Standards Executive Committee (AcSEC) issued
Statement of Position 98-1, "Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use", ("SOP 98-1").
The effective date of this pronouncement is for fiscal years beginning
after December 15, 1998, however, earlier application is encouraged and
the Company is accounting for this cost in accordance with SOP 98-1 in 1998.
On April 3, 1998, the AcSEC issued Statement of Position 98-5,
"Reporting on the Costs of Start-Up Activities" ("SOP 98-5"), which provides
guidance on the financial reporting of start-up and organization costs. It
requires costs of start-up activities and organization costs to be expensed
as incurred. SOP 98-5 is effective for financial statements for fiscal
years beginning after December 15, 1998. The Company is required to
reflect the initial application of SOP 98-5 as the cumulative effect of a
change in accounting principle, as described in Accounting Principles
Board Opinion No. 20, Accounting Changes. As a result of the cumulative
effect of a change in accounting treatment, the Company expects to record
a charge to earnings in the first quarter of 1999 for any unamortized
start-up or organization costs as of the beginning of 1999.
On June 15, 1998, the FASB issued Statement of Financial Accounting Standards
No. 133, "Accounting for Derivative Instruments and Hedging Activities"
(SFAS No. 133). SFAS No. 133 is effective for fiscal years beginning
after June 15, 1999 (January 1, 2000 for the Company). SFAS No. 133 requires
that all derivative instruments be recorded on the balance sheet at the
fair value. Changes in the fair value of derivatives are recorded each
period in current earnings or other comprehensive income, depending on
whether a derivative is designated as part of a hedge transaction and,
if it is, the type of hedge transaction. The Company does not currently
utilize derivative instruments, therefore the adoption of SFAS No. 133 is
not expected to have a significant effect on the Company's results of
operations or its financial position.
11. Business Development
On March 23, 1998, the Company and Frontier Communications International,
Inc. ("Frontier") entered into an agreement ("Frontier Agreement") enabling
the Company to lease approximately 8,300 miles of OC-12 network capacity on
Frontier's new 13,000 mile SONET fiber optic, IP-capable network currently
under construction for a period of up to five years. The leased network
will initially connect 15 of the larger cities across the United States.
While requiring an aggregate minimum payment of $165 million over its
five-year term, the Frontier Agreement does not impose monthly minimum
consumption requirements on the Company, allowing the Company to order,
alter or terminate circuits as it deems appropriate. The Company expects
to recognize these costs as the leased network is utilized, beginning
in the third quarter of 1998.
On April 2, 1998, the Company announced it had reached a definitive agreement
with Union Pacific Railroad Company ("Union Pacific") granting the Company
rights-of-way along Union Pacific's rail routes for construction of the
Company's North American intercity network. The Company expects that the
Union Pacific agreement will satisfy substantially all of its anticipated
right-of-way requirements west of the Mississippi River and approximately
50% of the right-of-way requirements for its North American intercity
network. The agreement provides for initial fixed payments of up to
$8 million to Union Pacific upon execution of the agreement and
throughout the construction period, recurring payments in the form of
cash, communications capacity, and other communications services based
on the number of conduits that are operational and certain construction
obligations of the Company to provide fiber or conduit connections for
Union Pacific at the Company's incremental cost of construction.
On June 23, 1998, the Company signed a master easement agreement with
Burlington Northern and Sante Fe Railway Company ("BNSF"). The agreement
grants Level 3 right-of-way access to BNSF rail routes in as many as 28
states, over which to build its network. Under the easement agreement,
Level 3 will make annual payments to BNSF and provide communications
capacity to BNSF for its internal requirements. The amount of the
annual payments is dependent upon the number of conduits installed,
the number of conduits with fiber, and the number of miles of conduit
installed along BNSF's route.
On June 18, 1998, Level 3 selected Peter Kiewit Sons', Inc. ("Kiewit") to
build its 15,000 mile intercity communications network. The overall cost
of the project is estimated at $2 billion. Construction of the
network has begun in the third quarter of 1998 and is expected to
be completed by 2001. The contract provides that Kiewit be reimbursed
for its costs relating to all direct and indirect project level costs. In
addition, Kiewit will have the opportunity to earn an award fee that will
be based on cost and speed of construction, quality, safety and program
management. The award fee will be determined by Level 3's assessment of
Kiewit's performance in each of these areas.
12. Other Matters
Prior to the Split-off, as of January 1 of each year, holders of Class C
Stock had the right to convert Class C Stock into Class D Stock, subject
to certain conditions. In January 1998, holders of Class C Stock converted
2.3 million shares, with a redemption value of $122 million, in to 21 million
shares of Level 3 Common Stock (formerly Class D Stock).
The Company is involved in various lawsuits, claims and regulatory
proceedings incidental to its business. Management believes that any
resulting liability for legal proceedings beyond that provided should not
materially affect the Company's financial position, future results of
operations or future cash flows.
13. Subsequent Events
On July 20, 1998, Level 3 entered into a network construction cost-sharing
agreement with INTERNEXT, LLC, a subsidiary of NEXTLINK Communications,
Inc. valued at $700 million. The agreement calls for INTERNEXT to acquire
the right to use 24 fibers and certain associated facilities installed
along the entire route of Level 3's 15,000 mile intercity fiber optic
network in the United States. INTERNEXT will pay Level 3 as segments of
the intercity network are completed which will offset the capital
expenditures made by the Company for the network.
The network as provided to INTERNEXT will not include the necessary
electronics that allow the fiber to carry communications transmissions.
INTERNEXT will be restricted from selling or leasing fiber to unaffiliated
companies for the next four years. Also, under the terms of the agreement,
INTERNEXT has the right to an additional conduit for its exclusive use
and to share costs and capacity in certain future fiber cable
installations in Level 3 conduits.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
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",
"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.
Recent Developments
Split-off
In October 1996, the Board of Directors of the Company (the "Board") directed
management of the Company to pursue a listing of the Company's Class D
Diversified Group Convertible Exchangeable Common Stock, par value $.0625
per share (the "Class D Stock"), as a way to address certain issues
created by the Company's then two-class capital stock structure and
the need to attract and retain the best management for the Company's
businesses. During the course of its examination of the consequences of
a listing of the Class D Stock, management concluded that a listing of the
Class D Stock would not adequately address these issues, and instead
began to study a separation of the construction operations ("Construction
Group") from the other businesses of the Company (the "Diversified Group"),
thereby forming two independent companies. At the regular meeting of the
Board on July 23, 1997, management submitted to the Board for
consideration a proposal for separation of the Construction Group
and the Diversified Group through a split-off of the Construction
Group (the "Split-off"). At a special meeting on August 14, 1997, the
Board approved the Split-off.
The separation of the Construction Group and the Diversified Group was
contingent upon a number of conditions, including the favorable
ratification by a majority of the holders of both the Company's Class C
Construction & Mining Group Restricted Redeemable Convertible Exchangeable
Common Stock, par value $.0625 per share (the "Class C Stock"), and the
Class D Stock, and the receipt by Company of an Internal Revenue Service
ruling or other assurance acceptable to the Board that the separation would
be tax-free to U.S. stockholders. On December 8, 1997, the holders of
Class C Stock and Class D Stock approved the Split-off and on March 5,
1998, the Company received a favorable private letter ruling from
the Internal Revenue Service. The Split-off occurred on March 31,
1998. In connection with the Split-off, (i) the Company exchanged each
outstanding share of Class C Stock for one share of Common Stock of
PKS Holdings, Inc. ("New PKS"), the company formed to hold the Construction
Group, to which eight-tenths of a share of the Company's Class R
Convertible Common Stock, par value $.01 per share (the "Class R Stock"),
was attached, (ii) New PKS was renamed "Peter Kiewit Sons', Inc.," (iii) the
Company was renamed "Level 3 Communications, Inc." and (iv) Class D Stock
was designated as common stock, par value $.01 per share ("Common Stock").
As a result of the Split-off, the Company no longer owns any interest in
New PKS or the Construction Group. Accordingly, the separate financial
statements and management's discussion and analysis of financial condition
and results of operations of Peter Kiewit Sons', Inc. should be obtained
to review the financial position of the Construction Group as of March 31,
1998 and December 27, 1997, and the results of operations for the three
months ended March 31, 1998 and the three and six months ended June 30, 1997.
On March 31, 1998, as a result of the Split-off, the Company recognized,
within discontinued operations, a gain of $608 million equal to the
difference between the carrying value of the Construction Group and its
fair value in accordance with Financial Accounting Standards Board Emerging
Issues Task Force Issue 96-4. No taxes were provided on this gain due to
the tax-free nature of the Split-off. Also on March 31, 1998, the Company
reflected the fair value of the Construction Group as a distribution to the
Class C stockholders.
Listing of Common Stock
Effective April 1, 1998, the Company's Common Stock began trading on The Nasdaq
National Market under the symbol "LVLT."
Conversion of Class R Stock
On May 1, 1998, the Board of the Company determined to force conversion of all
shares of the Company's Class R Stock into Common Stock of the Company,
effective May 15, 1998. The Class R Stock was converted into the Company's
Common Stock in accordance with the formula set forth in the Company's
Certificate of Incorporation. The formula provides for a conversion ratio
equal to $25, divided by the average of the midpoints between the high and
low sales prices for the Company's Common Stock on each of the fifteen
trading days during the period beginning April 9 and ending April 30, 1998.
That average for that period was $32.14, adjusted for the dividend issued
August 10, 1998. Accordingly, each holder of Class R Stock received .7778
of a share of Common Stock for each share of Class R Stock held. In total,
the 6.5 million shares of Class R Stock were converted into 5.1 million
shares of Common Stock on May 15, 1998. As a result of the forced
conversion, certain adjustments were made to the cost sharing and risk
allocation provisions of the Separation Agreement and Tax Sharing Agreement
between the Company and Peter Kiewit Sons', Inc. which reduced the costs
and risks allocated to the Company.
Conversion of Class C Stock in January 1998
Prior to the Split-off, as of January 1 of each year, holders of Class C Stock
had the right to convert Class C Stock into Class D Stock, subject to
certain conditions. In January 1998, holders of Class C Stock
converted 2.3 million shares, with a redemption value of $122
million, into 21 million shares of Level 3 Common Stock (formerly Class D
Stock).
CalEnergy Transaction
In January 1998, the Company and CalEnergy Company, Inc. ("CalEnergy") closed
the sale of the Company's energy assets to CalEnergy (the "CalEnergy
Transaction"). The Company received proceeds of approximately $1.16
billion and recognized an after-tax gain of $324 million in the first
quarter of 1998. The after-tax proceeds from this transaction of
approximately $967 million will be used to fund in part the Company's
planned expansion of its information services business and the development
of an advanced international, facilities-based communications network
based on Internet Protocol ("IP") technology ("Business Plan").
Stock Options
Subsequent to the Split-off, the Company adopted the recognition provisions of
Statement of Financial Accounting Standards No. 123, "Accounting for
Stock Based Compensation" ("SFAS No. 123") when it adopted an outperform
stock option program ("OSO"). 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 period of the option.
The recognition provisions of SFAS No. 123 are applied prospectively
upon adoption. As a result, they are applied to all stock awards granted in
the year of adoption and are not applied to awards granted in previous years
unless those awards are modified or settled in cash after adoption of the
recognition provisions. The OSO program was designed by the Company so
that its stockholders 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 options unless the Level 3 Common Stock price outperforms the
S&P 500 Index. When the stock price gain is greater than the
corresponding gain on the S&P 500 Index, the value received for options under
the OSO plan is based on a formula involving a multiplier related to the
level by which the Level 3 Common Stock outperforms the S&P 500 Index.
To the extent that the Level 3 Common Stock outperforms the S&P 500, the
value of OSOs to an option holder may exceed the value of non-qualified
stock options.
The Company believes that the fair value method of accounting more
appropriately reflects the substance of the transaction between an entity
that issues stock options, or other stock-based instruments, and its
employees and consultants; that is, an entity has granted something
of value to an employee and consultants (the stock option or other
instrument) generally in return for their continued employment and
services. The Company believes that the value of the instrument
granted to employees and consultants should be recognized in financial
statements because nonrecognition implies that either the instruments
have no value or that they are free to employees and consultants, neither
of which is an accurate reflection of the substance of the transaction.
Although the recognition of the value of the instruments results in
compensation and professional expenses in an entity's financial statements,
the expense differs from other compensation and professional expenses in
that these charges will not be settled in cash, but rather, generally,
through issuance of common stock.
The Company believes that the adoption of SFAS No. 123 will result in material
non-cash charges to operations in 1998 and thereafter. The amount of the
non-cash charge will be dependent upon a number of factors, including
the number of options granted and the fair value of each option estimated at
the time of its grant. The expense recognized for options granted to
employees and consultants for services performed for the three and six months
ended June 30, 1998, was $9 million and $11 million, respectively.
Frontier Agreement
On March 23, 1998, the Company and Frontier Communications International, Inc.
("Frontier") entered into an agreement ("Frontier Agreement") enabling the
Company to lease approximately 8,300 miles of OC-12 network capacity on
Frontier's new 13,000 mile SONET fiber optic, IP-capable network currently
under construction for a period of up to five years. The leased network will
initially connect 15 of the larger cities across the United States. While
requiring an aggregate minimum payment of $165 million over its five-year
term, the Frontier Agreement does not impose monthly minimum consumption
requirements on the Company, allowing the Company to order, alter or
terminate circuits as it deems appropriate. The Company expects to
recognize these costs as the leased network is utilized beginning
in the third quarter of 1998.
Union Pacific Rights-of-Way
On April 2, 1998, the Company announced it had reached a definitive agreement
with Union Pacific Railroad Company (the "Union Pacific Agreement")
granting the Company the use of approximately 7,800 miles of rights-of-way
along Union Pacific's rail routes for construction of the Company's North
American intercity network. The Company expects that the Union Pacific
Agreement will satisfy substantially all of its anticipated right-of-way
requirements west of the Mississippi River and approximately 50% of the
right-of-way requirements for its North American intercity network.
The agreement provides for initial fixed payments of up to $8 million to
Union Pacific upon execution of the agreement and throughout the
construction period, recurring payments in the form of cash, communications
capacity, and other communications services based on the number of
conduits that are operational and certain construction obligations of the
Company to provide fiber or conduit connections for Union Pacific at the
Company's incremental cost of construction.
XCOM Technologies, Inc. Acquisition
On April 23, 1998, the Company acquired XCOM Technologies, Inc. ("XCOM"), a
privately held company that has developed technology which the Company
believes will provide certain key components necessary for the Company to
develop an interface between its IP-based network and the public
switched telephone network. The Company issued approximately 5.3
million shares of Level 3 Common Stock and 0.8 million options and
warrants to purchase Level 3 Common Stock in exchange for all the
stock, options and warrants of XCOM.
The Company accounted for this transaction, valued at $154 million, as a
purchase. Of the total purchase price, $115 million was attributable to
in-process research and development, and was taken as a nondeductible
charge to earnings in the second quarter. The purchase price exceeded the
fair value of the net assets acquired by $30 million which was recognized
as goodwill.
Senior Notes
On April 28, 1998, the Company received $1.94 billion of proceeds from an
offering of $2 billion aggregate principal amount 9.125% Senior Notes Due
2008 (the "Senior Notes"). The Senior Notes are senior, unsecured
obligations of the Company, ranking pari passu with all existing and future
senior unsecured indebtedness of the Company. The Senior Notes contain
certain covenants, which among others, limit consolidated debt, dividend
payments and transactions with affiliates. The Company is using the net
proceeds of the Senior Notes in connection with the implementation of its
Business Plan.
Burlington Northern Sante Fe Rights-of-Way
On June 23, 1998, the Company signed a master easement agreement with
Burlington Northern and Sante Fe Railroad Company ("BNSF"). The agreement
grants Level 3 right-of-way access to BNSF rail routes in as many as 28
states over which to build its network. Under the easement agreement,
Level 3 will make annual payments to BNSF and provide communications
capacity to BNSF for its internal requirements. The amount of the annual
payments is dependent upon the number of conduits installed, the number
of conduits with fiber, and the number of miles of conduit installed along
BNSF's route.
Network Construction Contract
On June 18, 1998, Level 3 selected Peter Kiewit Sons', Inc. ("Kiewit") to
build its 15,000 mile intercity communications network. The overall
cost of the project is estimated at $2 billion. Construction of the
network has begun in the third quarter of 1998 and is expected to be
completed by 2001. The contract provides that Kiewit be reimbursed for
its costs relating to all direct and indirect project level costs. In
addition, Kiewit will have the opportunity to earn an award fee that will
be based on cost and speed of construction, quality, safety and program
management. The award fee will be determined by Level 3's assessment of
Kiewit's performance in each of these areas.
NEXTLINK Agreement
On July 20, 1998, Level 3 entered into a network construction cost-sharing
agreement with INTERNEXT, LLC, a subsidiary of NEXTLINK Communications,
Inc. valued at $700 million. The agreement calls for INTERNEXT to acquire
the right to use 24 fibers and certain associated facilities installed along
the entire route of Level 3's 15,000 mile intercity fiber optic network
in the United States. INTERNEXT will pay Level 3 as segments of the
intercity network are completed which will offset the capital expenditures
made by the Company for the network.
The network as provided to INTERNEXT will not include the necessary
electronics that allow the fiber to carry communications transmissions.
INTERNEXT will be restricted from selling or leasing fiber to unaffiliated
companies for the next four years. Also, under the terms of the agreement,
INTERNEXT has the right to an additional conduit for its exclusive use and
to share costs and capacity in certain future fiber cable installations
in Level 3 conduits.
Results of Operations
In late 1997, the Company announced a plan to increase substantially its
information services business and to expand the range of services it
offers by building an advanced, international, facilities-based
communications network based on IP technology. Since the Business Plan
represents a significant expansion of the Company's communications and
information services business, the Company does not believe that the
Company's financial condition and results of operations for prior periods
will serve as a meaningful indication of the Company's future financial
condition or results of operations. The Company expects to incur
substantial net operating losses for the foreseeable future, and there
can be no assurance that the Company will be able to achieve or sustain
operating profitability in the future.
Revenue for the quarters ended June 30, is summarized as follows (in millions):
1998 1997
Communications and Information Services $ 36 $ 24
Coal Mining 62 54
Other 5 3
----- -----
$ 103 $ 81
===== =====
Communications and Information Services revenue consists of computer
outsourcing revenue of $16 million, systems integration revenue of $14
million and $6 million of communications revenue from XCOM, subsequent
to its acquisition on April 23, 1998. XCOM's revenue is derived primarily
from reciprocal compensation fees paid by a regional telephone company.
The comparable amounts in 1997 for computer outsourcing and systems
integration were $13 million and $11 million, respectively. Computer
outsourcing revenues increased due to the addition of several new customers
throughout 1997. The increase in systems integration revenue was
primarily attributable to $2 million of revenue from DataBase
Technologies, a firm acquired by the Company on April 8, 1998.
Revenue from communications services is expected to increase in the
third and fourth quarters as the Company begins to recognize revenue from
its IP related services.
Coal mining revenue increased $8 million in the second quarter of 1998
compared to the same period in 1997. Additional alternate source coal
sales to Commonwealth Edision was partially offset by the
expiration of other long term contracts at the end of 1997
and lower priced contracts with new customers in 1998.
Operating Expenses increased 20% in 1998 to $49 million. Overall, margin,
as a percentage of revenue, was consistent with that of 1997 for the
communications and information services businesses. The early
termination of a large contract in March of this year for the
systems integration business, resulted in lower staff utilization and a
decrease in margins. Margins for the computer outsourcing business improved
as it had incurred significant migration costs in the second quarter of
1997 for new customers. Migration costs are expensed as incurred and were
lower in the second quarter of 1998. Margins on coal sales increased
2% in the second quarter of 1998. An increase in sales of the higher
margin alternate source coal was partially offset by lower margins on
coal sold by the Company's mines. If current market conditions continue,
the Company will experience a significant decline in coal revenue and
earnings over the next several years as delivery requirements under
long-term contracts decline as these long-term contracts begin to expire.
Depreciation Expense increased $2 million in 1998 to $7 million. Depreciation
on equipment for computer outsourcing contracts and depreciation and
amortization of assets acquired in the XCOM acquisition are primarily
responsible for the increase. Additional depreciation is expected beginning
in the third quarter of 1998 when the Company commences operations on a
portion of its IP network.
General and Administrative Expenses increased significantly in 1998 to $55
million from $19 million in 1997 primarily due to the cost of activities
associated with preparing for the expected launch of the IP related
services in the third quarter of 1998. The Company incurred incremental
compensation and travel costs for the substantial number of new employees
that have been hired to begin implementation of the Business Plan,
legal costs associated with obtaining licenses, agreements and technical
facilities and other development costs associated with the Company's
plans to begin offering services in 15 U.S. cities in the fall of 1998.
In addition to the costs to expand the communications and information
services businesses, the Company recorded $9 million of noncash
compensation and professional service expenses in the second quarter of
1998 for expenses recognized under FAS No. 123. General and administrative
costs are expected to increase significantly in future periods as the
Company implements the Business Plan.
Write-off of In Process Research and Development was $115 million in 1998.
The in process research and development costs were the portion of the
purchase price allocated to the telephone network-to-IP network bridge
technology acquired by the Company in the XCOM transaction and were estimated
through formal valuation, at $115 million. In accordance with generally
accepted accounting principles, the $115 million was taken as a
nondeductible charge against earnings in the second quarter of 1998.
EBITDA which consists of earnings (losses) before interest, income taxes,
depreciation, amortization, noncash stock-based compensation and other
non-operating income or expenses was $8 million in 1998 and $21 million in
1997. The primary reason for the decrease between periods is the significant
increase in general and administrative expenses, described above, incurred
in connection with the implementation of the Company's Business Plan.
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. See Consolidated Condensed Statements
of Cash Flows.
Interest Income increased significantly in 1998 to $45 million from $8
million in 1997 as the Company's average cash, cash equivalents and
marketable securities balance approximated $3.2 billion in the
second quarter of 1998. The Company's average cash, cash equivalents
and marketable securities balance approximated $625 million in 1997.
Pending utilization of the cash equivalents and marketable
securities in implementing the Business Plan, the Company
intends to invest the funds primarily in government and governmental
agency securities. This investment strategy will provide for less yield on
the funds, but is expected to reduce the risk to principal prior to using
the funds in implementing the Business Plan.
Interest Expense increased significantly in 1998 to $36 million from $4
million in 1997. Interest expense increased substantially due to the
completion of the offering of $2 billion aggregate principal amount of
9.125% Senior Notes Due 2008 issued on April 28, 1998. The amortization
of $65 million of debt issuance costs associated with the Senior Notes
also increased interest expense in the second quarter. The Company
capitalized $1 million of interest expense on network construction and systems
development projects.
Other Expense, net increased slightly in 1998 to $4 million. The decline is
due to the losses incurred by the Company's equity method investees,
primarily RCN Corporation, Inc. ("RCN"). RCN is a full service
provider of local, long distance internet and cable television
services to primarily residential users in the densely populated areas of
the Northeast United States. RCN is incurring significant costs in
developing its business plan including the acquisitions of several internet
service providers. The Company recorded $22 million of equity losses
attributable to RCN in the second quarter of 1998. Partially offsetting these
losses was the gain on RCN's stock activity. In 1998, RCN issued stock
through a public offering and for certain acquisitions. These issuances
resulted in a decrease in the Company's ownership percentage but
an increase in the Company's proportionate share of RCN's equity.
The Company first applied this increase against the goodwill,
previously established for RCN, and then recognized a pre-tax gain of $21
million in the second quarter of 1998. Also included in Other Expense are
equity earnings in Commonwealth Telephone Enterprises, Inc., a
Pennsylvania public utility providing telephone service,
equity in losses of Cable Michigan, Inc., a cable television operator
in the State of Michigan, of marketable securities, investments and
other assets each not individually significant to the Company's results of
operations.
Income Tax Benefit differs from the statutory rate in 1998 primarily due to
the $115 million nondeductible write-off of the research and development
costs acquired in the XCOM acquisition. The income tax provision in 1997
is slightly below the statutory rate due primarily to depletion allowances,
tax exempt interest income and other individually insignificant deductions
for tax purposes in excess of that recognized for financial reporting
purposes.
Six Months 1998 vs. Six Months 1997
Revenue for the six months ended June 30, is summarized as follows
(in millions):
1998 1997
Communications and Information Services $ 65 $ 40
Coal Mining 115 115
Other 10 6
----- -----
$ 190 $ 161
===== =====
Revenue increased 18% to $190 million in 1998 for the six months ended June
30, 1998 compared to the same period in 1997. Systems integration revenue
increased 88% to $29 million in 1998. The Company's systems integration
business was still in its early states of development in 1997 and the
increase in revenue reflects the strong demand for system integration
services. Revenue for the computer outsourcing business increased 21% to
$30 million in 1998. The increase is attributable to the addition of
several new customers in 1997 and early 1998. The remaining $6 million
communications revenue is attributable to XCOM acquired on April 23, 1998.
Mining revenue in 1998 was consistent with that of 1997. Increases in
alternate source coal sales were offset by a decrease in coal sold from
the Company's mines. Coal sold from the Company's mines declined due to
the expiration of a long-term contract in 1997.
Operating Expenses increased 14% to $91 million in 1998. Margin, as a percent
of revenue, decreased 10% for the systems integration business as the
early termination of a large contract resulted in a lower utilization rate
of operating personnel. Gross margins for the computer outsourcing business
increased 9% during the first six months of 1998. Migration costs
incurred in 1997 to implement new outsourcing contracts were lower in 1998.
Margins for the mining business were consistent with the same period in
1997. In 1998 an increase in higher margin alternate source coal sales
were partially offset by the reduced margins on coal sold from the
Company's mines. In 1997, margins were positively effected by the buyout
of a spot coal contract. Under the buyout, the customer was able to cancel
its contract commitments by making a payment equal to 60% of the price
of the coal. These proceeds, with no corresponding costs, resulted in the
higher margin for the period.
Depreciation Expense increased $3 million during the first six months of 1998.
Depreciation on the computer equipment purchased for general and
administrative personnel and computer outsourcing businesses and the
depreciation and amortization of equipment and goodwill acquired in the XCOM
acquisition, were primarily responsible for the increase in depreciation
expense.
General and Administrative Expenses increased significantly in 1998 due to the
expansion of the communications & information services. The hiring of
several hundred employees to implement the IP business led to increases
in compensation, relocation and travel expenses. In addition to regular
compensation, the Company recognized $11 million of noncash expense for stock
options and warrants granted in the first half of 1998. The Company also
incurred approximately $8 million of professional service fees associated
with the initial development of a substantial, scalable business support
infrastructure, specifically designed to enable the Company to offer services
efficiently to its targeted customers. In addition, the Company also
incurred legal costs associated with obtaining licenses, agreements and
technical facilities and other development costs associated with the new
Business Plan.
Write-off of In Process Research and Development was $115 million in 1998.
The in process research and development costs were the portion of the
purchase price allocated to the telephone network-to-IP network bridge
technology acquired by the Company in the XCOM transaction and were
estimated through formal valuation, at $115 million. In accordance with
generally accepted accounting principles, the $115 million was taken as
a nondeductible charge against earnings in the second quarter of 1998.
EBITDA declined to $7 million in 1998 from $46 million in 1997. The increase
in operating costs and general and administrative expenses associated
with the expanding communications and information services businesses was
primarily responsible for the decline.
Interest Income increased to $71 million in 1998 from $15 million in 1997. The
$1.16 billion proceeds from the sale of the energy assets on January 2, and
the $1.94 billion proceeds from the debt offering on April 28, were primarily
responsible for the average cash, cash equivalents and marketable securities
balance increasing from $630 million to $2.6 billion for the six months
ending June 30, 1997 and 1998, respectively. The increase in the average
balance was directly responsible for the increase in interest income.
Interest Expense increased to $40 million in 1998. The increase in interest
expense is directly attributable to the interest on the Senior Notes and
the amortization of the deferred debt issuance costs. The interest
expense for 1997 is primarily attributable to the debt on the California toll
road which is nonrecourse to the Company.
Other Expense, net increased substantially in 1998 to $26 million from $6
million in 1997 due primarily to increased losses recognized by the
Company's equity method investee, RCN. The Company's share of
these losses approximated $53 million in 1998. RCN recognized a
charge to earnings of approximately $52 million (Company's share $24
million) with respect to certain costs of the acquisitions associated with
in process research and development activities. Partially offsetting these
losses was the gain on RCN's stock activity of $21 million. Also included
in Other Expense are equity earnings in Commonwealth Telephone Enterprises,
Inc., equity in losses of Cable Michigan, Inc., of marketable securities,
investments and other assets each not individually significant to the
Company's results of operations.
Income Tax (Provision) Benefit differs from the expected statutory rate of
35% primarily due to the nondeductible write-off of the in process research
and development costs allocated in the XCOM transaction. The effective
rate in 1997 is lower than the expected rate due to depletion allowances and
tax exempt interest income.
Discontinued Operations includes the one-time gain of $608 million recognized
upon the distribution of the Construction Group to former Class C
stockholder on March 31, 1998. Also included in discontinued operations
is the gain, net of tax, of $324 million from the Company's sale of its energy
assets to CalEnergy on January 2, 1998.
Financial Condition-June 30, 1998
The Company's working capital increased substantially during 1998 due primarily
to the sale of the Company's energy assets to CalEnergy for $1.16 billion on
January 2, 1998, and the $2 billion issuance of Senior Notes on April 28,
1998. The Company's working capital increased $2.3 billion to $3.7 billion
on June 30, 1998. The Company's operations used $158 million of cash
during the first half of 1998, primarily for the payment of income
taxes and the costs in implementing the Business Plan, partially offset
by funds provided by coal mining operations.
Investing activities include the purchase of $4,713 million of marketable
securities, the sales and maturities of marketable securities of $2,484
million, $144 million of capital expenditures, primarily for the expanding
IP and information services business and $22 million of investments,
principally $18 million for information services businesses. The Company
also realized $26 million of proceeds from the sale of property, plant and
equipment and other assets.
Financing sources in 1998 consisted primarily of the net proceeds of $1.94
billion from the sale of Senior Notes in April, the conversion of 2.3
million shares of Class C Stock, with a redemption value of $122
million, into 21 million shares of Level 3 Common Stock (formerly
Class D Stock) in January, proceeds from the sale of Level 3 Common
Stock of $21 million and the exercise of the Company's stock options for
$7 million. The Company reflected in the equity accounts the $164 million
fair value of the issuance and forced conversion of the Class R Stock
during the first half of 1998.
Liquidity and Capital Resources
Since late 1997, the Company has substantially increased the emphasis it
places on and the resources devoted to its communications and information
services business. The Company has commenced the implementation of a plan
to become a facilities-based provider (that is, a provider that owns or leases
a substantial portion of the plant, property and equipment necessary to
provide its services) of a broad range of integrated communications
services. To reach this goal, the Company plans to expand substantially
the business of its subsidiary, PKS Information Services, Inc., and to create,
through a combination of construction, purchase and leasing of facilities
and other assets, an international, end-to-end, facilities-based
communications network. The Company is designing its network based on IP
technology in order to leverage the efficiencies of this technology to
provide lower cost communications services.
The development of the Business Plan will require significant capital
expenditures, a substantial portion of which will be incurred before
any significant related revenues from the Business Plan are expected to
be realized. These expenditures, together with the associated early
operating expenses, will result in substantial negative operating cash
flow and substantial net operating losses for the Company for the
foreseeable future. Although the Company believes that its cost estimates
and build-out schedule are reasonable, there can be no assurance that the
actual costs or the timing of the expenditures will not deviate from
current estimates. The Company estimates that its capital expenditures in
connection with the Business Plan will be in excess of $500 million in
1998 and will approximate $2 billion in 1999. The Company's
current liquidity in addition to the net proceeds from the Senior Note
and the cost sharing agreement with NEXTLINK, should be sufficient to
fund the currently committed portions of the Business Plan.
The Company currently estimates that the implementation of the Business Plan,
as currently contemplated, will require between $8 and $10 billion over the
next 10 years. The Company's ability to implement the Business Plan and
meet its projected growth is dependent upon its ability to secure
substantial additional financing in the future. The Company expects to meet
its additional capital needs with the proceeds from sales or issuance of
equity securities, credit facilities and other borrowings, or additional
debt securities. The Senior Notes were issued under an indenture which
permits the Company and its subsidiaries to incur substantial amounts
of debt. In addition, the Company may sell or dispose of existing
businesses or investments to fund portions of the Business Plan. The Company
may, sell or lease capacity, its conduits or access to its conduits.
There can be no assurance that the Company will 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, or that proceeds of dispositions of
the Company's assets will reflect the assets' intrinsic value. Further,
there can be no assurance that expenses will not exceed the Company's
estimates or that the financing needed will not likewise 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.
There can be no assurance that the Company will be able to obtain such
financing if and when it is needed or that, if available, such financing
will be on terms acceptable to the Company. If the Company is unable to
obtain additional financing when needed, it may be required to scale back
significantly its Business Plan and, depending upon cash flow from its
existing businesses, reduce the scope of its plans and operations.
In connection with implementing the Business Plan, management will continue
reviewing the existing businesses of the Company to determine how those
businesses will complement the Company's focus on communications and
information services. If it is decided that an existing business is not
compatible with the communications and information services business and
if a suitable buyer can be found, the Company may dispose of that business.
New Accounting Pronouncement
In 1997, the Financial Accounting Standards Board issued SFAS No. 131,
"Disclosures about Segments of an Enterprise and Related Information",
("SFAS No. 131") which changes the way public companies report
information about segments. SFAS No.131, which is based on the management
approach to segment reporting includes requirements to report selected
segment information quarterly, and entity wide disclosures about products
and services, major customers, and geographic data. This statement is
effective for financial statements for periods beginning
after December 15, 1997. The Company will reflect the adoption of SFAS No.
131 in its December 31, 1998 financial statements.
On March 4, 1998, the Accounting Standards Executive Committee (AcSEC) issued
Statement of Position 98-1, "Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use", ("SOP 98-1"). The effective
date of this pronouncement is for fiscal years beginning after December 15,
1998, however, earlier application is encouraged and the Company is accounting
for this cost in accordance with SOP 98-1 in 1998.
On April 3, 1998, the AcSEC issued Statement of Position 98-5,
"Reporting on the Costs of Start-Up Activities", ("SOP 98-5"), which
provides guidance on the financial reporting of start-up and organization
costs. It requires costs of start-up activities and organization costs to
be expensed as incurred.
SOP 98-5 is effective for financial statements for fiscal years beginning
after December 15, 1998. The Company is required to reflect the initial
application of SOP 98-5 as the cumulative effect of a change in accounting
principle, as described in Accounting Principles Board Opinion No. 20,
Accounting Changes. As a result of the cumulative effect of a change in
accounting treatment, the Company expects to record a charge to earnings
in the first quarter of 1999 for any unamortized start-up or organization
costs as of the beginning of 1999.
On June 15, 1998, the FASB issued Statement of Financial Accounting Standards
No. 133, "Accounting for Derivative Instruments and Hedging Activities"
("SFAS No. 133"). SFAS No. 133 is effective for fiscal years beginning
after June 15, 1999 (January 1, 2000 for the Company). SFAS No. 133 requires
that all derivative instruments be recorded on the balance sheet at the
fair value. Changes in the fair value of derivatives are recorded each
period in current earnings or other comprehensive income, depending on
whether a derivative is designated as part of a hedge transaction and,
if it is, the type of hedge transaction. The Company does not
currently utilize derivative instruments, therefore the adoption of
SFAS No. 133 is not expected to have a significant effect on the Company's
results of operations or its financial position.
The Company has conducted a review of its computer systems to identify those
systems that could be affected by the "Year 2000" computer issue, and has
developed and is implementing a plan to resolve the issue. The Year 2000
issue results from computer programs written with date fields of two digits,
rather than four digits, thus resulting in the inability of the computer
programs to distinguish between the year 1900 and 2000.
The Company expects that its Year 2000 compliance project will be completed
before the Year 2000 date change. During the execution of this project, the
Company has and will continue to incur internal staff costs as well as
consulting and other expenses. These costs will be expensed, as incurred,
in compliance with generally accepted accounting principles. The expenses
associated with this project, as well as the related potential effect on the
Company's earnings is not expected to have a material effect on its future
operating results or financial condition. There can be no assurance,
however, that the Year 2000 problem will not adversely affect the Company
and its business.
The Company has reviewed the guidance issued by the Securities and Exchange
Commission Staff on August 4, 1998 with respect to Year 2000, and has begun the
process of addressing the additional information requested by such guidance.
The Company will include the information so requested in its filing on Form
10-Q for the quarter ended September 30, 1998.
PART II - OTHER INFORMATION
Item 2. Changes in Securities
Pursuant to an agreement dated March 2, 1998, the Company sold 200,000 shares
of Common Stock, par value $.01 per share to Gleacher NatWest Inc., in
connection with financial advisory services to be provided to the Company
at an aggregate purchase price of $4,000,000. The sale to Gleacher NatWest
Inc. was made pursuant to the exemption from registration contained in
Section 4(2) under the Securities Act of 1933, as amended.
Pursuant to an agreement on April 23, 1998, the Company issued 5,255,534 to
the holders of the capital stock of XCOM Technologies, Inc. in connection
with its acquisition by the Company. The issuance of stock to the holders
of XCOM Technologies, Inc. capital stock was made pursuant to the exemption
from registration contained in Section 4(2) under the Securities Act of
1933, as amended.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits filed as part of this report are listed below.
Exhibit
Number
27 Financial Data Schedule.
(b) The Company filed a Form 8-K on April 16, 1998, and a Form 8-K/A on April
30, 1998, providing general information concerning the Company and its
Business Plan not otherwise called for by Form 8-K.
The Company also filed a Form 8-K on June 9, 1998, reporting that on May 29,
1998, the Board of Directors had adopted a Stockholders Rights Plan in
which preferred stock purchase rights have been distributed as a dividend.
SIGNATURES
Pursuant to the requirements of the Securities and 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: August 14, 1998 \s\ Eric J. Mortensen
Eric J. Mortensen
Controller and
Principal Accounting Officer
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
INDEX TO EXHIBITS
Exhibit
No.
27 Financial Data Schedule.