FORM 10-Q/A
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, 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 November 1, 1998:
Common Stock 307,122,673 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 4. Submission of Matters to a Vote of Security Holders
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 Nine Months Ended
September 30, September 30,
(dollars in millions, except share data) 1998 1997 1998 1997
Revenue $ 106 $ 81 $ 296 $ 242
Costs and Expenses:
Operating expenses 47 37 138 117
Depreciation and amortization 15 5 31 15
General and administrative expenses 96 26 199 61
Write-off of in process
research & development - - 30 -
------ ----- ----- ------
Total costs and expenses 158 68 398 193
------ ----- ----- ------
Earnings (Loss) from Operations (52) 13 (102) 49
Other Income (Expense):
Interest income 53 8 124 23
Interest expense, net (46) (3) (86) (10)
Other, net, principally equity losses of
unconsolidated entities (27) (10) (53) (11)
------ ----- ----- ------
Total other income (expense) (20) (5) (15) 2
------ ----- ----- ------
Earnings (Loss) Before Income Taxes and
Discontinued Operations (72) 8 (117) 51
Income Tax (Provision) Benefit 23 (2) 28 (17)
------ ----- ----- ------
Earnings (Loss) from Continuing
Operations (49) 6 (89) 34
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 benefit of
$26 and $19 - (50) - (37)
Construction, net of income tax
expense of $21 and $56 - 34 - 84
------ ----- ----- ------
Earnings (loss) from discontinued
operations - (16) 932 47
------ ----- ----- ------
Net Earnings (Loss) $ (49) $ (10) $ 843 $ 81
====== ===== ===== ======
Earnings (Loss) Per Share:
Continuing Operations:
Basic $ (.16) $ .03 $(.30) $ .14
====== ===== ===== ======
Diluted $ (.16) $ .03 $(.30) $ .14
====== ===== ===== ======
Discontinued Operations, excluding
construction operations:
Basic $ - $(.21) $3.11 $ (.15)
====== ===== ===== ======
Diluted $ - $(.21) $3.11 $ (.15)
====== ===== ===== ======
Net Earnings(Loss), excluding
construction operations:
Basic $ (.16) $(.18) $2.81 $ (.01)
====== ===== ===== ======
Diluted $ (.16) $(.18) $2.81 $ (.01)
====== ===== ===== ======
Net Earnings (Loss), excluding gain on
split-off of construction operations:
Basic $ (.16) $(.18) $ .78 $ (.01)
====== ===== ===== ======
Diluted $ (.16) $(.18) $ .78 $ (.01)
====== ===== ===== ======
See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Condensed Balance Sheets
(Unaudited)
September 30, December 27,
(dollars in millions, except share data) 1998 1997
Assets
Current Assets
Cash and cash equivalents $ 653 $ 87
Marketable securities 2,980 678
Restricted securities 24 22
Accounts receivable 59 42
Investment in discontinued operations - energy - 643
Other 56 22
------- -------
Total Current Assets 3,772 1,494
Property, Plant and Equipment, less
accumulated depreciation and amortization
of $232 and $228 594 184
Investments 313 383
Investment in Discontinued Operations - Construction - 652
Other Assets 259 66
------- -------
$ 4,938 $ 2,779
======= =======
See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Condensed Balance Sheets
(Unaudited)
September 30, December 27,
(dollars in millions, except share data) 1998 1997
Liabilities and Stockholders' Equity
Current Liabilities:
Accounts payable $ 126 $ 31
Current portion of long-term debt 6 3
Accrued reclamation and other mining costs 16 19
Accrued interest 80 2
Deferred income taxes 6 15
Income taxes payable 6 -
Other 37 19
------- -------
Total Current Liabilities 277 89
Long-Term Debt, less current portion 2,140 137
Deferred Income Taxes 92 83
Accrued Reclamation Costs 96 100
Other Liabilities 157 140
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 and
$.0625 par value in 1997:
Common Stock(Class D in 1997), authorized
500,000,000 shares;307,187,326 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 736 427
Accumulated other comprehensive income (loss) 5 (5)
Retained earnings 1,432 1,799
------- -------
Total Stockholders' Equity 2,176 2,230
------- -------
$ 4,938 $ 2,779
======= =======
See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Condensed Statements of Cash Flows
(unaudited)
Nine Months Ended
September 30,
(dollars in millions) 1998 1997
Cash flows from continuing operations:
Net cash (used in) provided by continuing operations $ (16) $ 167
Cash flows from investing activities:
Proceeds from sales and maturities of
marketable securities 2,882 160
Purchases of marketable securities (5,132) (168)
Change in restricted securities - 4
Acquisitions and investments (24) (32)
Proceeds from sale of property, plant and equipment
and other investments 26 1
Capital expenditures (409) (20)
------- ------
Net cash used in investing activities (2,657) (55)
Cash flows from financing activities:
Payments on long-term debt including current portion (7) (2)
Issuance of long-term debt, net 1,937 17
Issuances of common stock 21 49
Proceeds from exercise of stock options 7 -
Dividends paid - (12)
Exchange of Class B&C Stock for Common Stock, net 122 72
------- ------
Net cash provided by financing activities 2,080 124
Cash flows from discontinued operations:
Proceeds from sale of energy operations 1,159 -
Investments in discontinued energy operations - (34)
------- ------
Net cash provided by (used in) discontinued
operations 1,159 (34)
Cash and cash equivalents of C-TEC at the
beginning of 1997 - (76)
------- ------
Net change in cash and cash equivalents 566 126
Cash and cash equivalents at beginning of year 87 147
------- ------
Cash and cash equivalents at end of period $ 653 $ 273
======= ======
Non-Cash investing activities:
Issuance of stock for acquisitions:
XCOM Technologies, Inc. $ 154 $ -
GeoNet Communications, Inc. 19 -
Other 10 -
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 nine months ended September 30, 1998
(unaudited)
Class Common Other
B&C Stock Additional Accumulated
Common (Class D Paid-in Comprehensive Retained
(dollars in millions) Stock in 1997) Capital Income (Loss) Earnings Total
Balance at
December 28, 1997 $ 1 $ 8 $ 427 $ (5) $ 1,799 $ 2,230
Common Stock:
Issuance of Common
Stock - 1 203 - - 204
Stock options exercised - 1 7 - (1) 7
Designation of par
value to $.01 - (8) 8 - - -
Stock dividend - 1 (1) - - -
Stock option grants - - 25 - - 25
Income tax benefit from
exercise of options - - 12 - - 12
Class R Stock:
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 - - - - 843 843
Other Comprehensive Loss - - - (5) - (5)
Split-off of the
Construction & Mining
Group (1) - (94) 15 (1,045) (1,125)
---- ---- ----- ---- ------- -------
Balance at
September 30, 1998 $ - $ 3 $ 736 $ 5 $ 1,432 $ 2,176
===== ==== ====== ===== ======= =======
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 and statement of operations for all periods presented. Only the
results of operations of the energy business have been reflected as
discontinued on the statement of cash flows.
The Company is currently constructing its communications network. Costs
associated directly 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 Company is currently developing 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 capitalized business support systems and network construction costs
incurred to date, $364 million, have been classified as assets under
construction within Property, Plant & Equipment in the accompanying
consolidated condensed balance sheet.
The results of operations for the three and nine months ended September 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 December 27, 1997
and the results of operations for the three and nine months ended September 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
provided 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
stock 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 are being 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 potentially dilutive common
shares.
The Company had a loss from continuing operations for the three and nine month
periods ended September 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 September 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 (loss) per share calculations for Level 3
Common Stock:
Three Months Ended Nine Months Ended
September 30, September 30,
1998 1997 1998 1997
Earnings (loss) from continuing
operations (in millions) $ (49) $ 6 $ (89) $ 34
Earnings (loss) from discontinued
operations, excluding construction
operations - (50) 932 (37)
------ ------ ------ ------
Net earnings (loss) $ (49) $ (44) $ 843 $ (3)
====== ====== ====== ======
Total number of weighted average
shares outstanding used to compute
basic earnings per share
(in thousands) 306,515 245,854 300,151 245,130
Additional dilutive stock options - 540 - 540
------- ------- ------- -------
Total number of shares used to
compute dilutive earnings per share 306,515 246,394 300,151 245,670
======= ======= ======= =======
Continuing operations:
Basic earnings (loss) per share $ (.16) $ .03 $ (.30) $ .14
======= ======= ======= =======
Diluted earnings (loss) per share $ (.16) $ .03 $ (.30) $ .14
======= ======= ======= =======
Discontinued operations, excluding
construction operations:
Basic earnings (loss) per share $ - $ (.21) $ 3.11 $ (.15)
======= ====== ======= =======
Diluted earnings (loss) per share $ - $ (.21) $ 3.11 $ (.15)
======= ====== ======= =======
Net earnings (loss), excluding
construction operations:
Basic earnings (loss) per share $ (.16) $ (.18) $ 2.81 $ (.01)
======= ====== ======= =======
Diluted earnings (loss) per share $ (.16) $ (.18) $ 2.81 $ (.01)
======= ====== ======= =======
Net earnings (loss) excluding gain
on split-off of construction
operations:
Basic earnings (loss) per share $ (.16) $ (.18) $ .78 $ (.01)
======= ====== ======= =======
Diluted earnings (loss) per share $ (.16) $ (.18) $ .78 $ (.01)
======= ====== ======= =======
The Company had 19,690,144 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 nine month periods ended September 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 stock
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 0.7 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, $30 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 $115 million which was
recognized as goodwill and is being amortized over five years.
XCOM's in-process research and development value is comprised primarily of
one project to develop an interface between an IP-based network and the
existing public switched telecommunications network. Remaining development
efforts for the project include various phases of design, development and
testing. The anticipated completion date for the project in progress is
expected to be over the next 15 months, at which time the Company expects
to begin generating the full economic benefits from the technology. Funding for
this project is expected to be obtained from internally generated sources.
The value of the in-process research and development represents the estimated
fair value based on risk-adjusted cash flows related to the incomplete project.
At the date of acquisition, the development of this project had not yet reached
technological feasibility and the research and development ("R&D") in progress
had no alternative future uses. Accordingly, these costs were expensed as of
the acquisition date.
The Company used independent third-party appraisers to assess and allocate
the value of the in-process research and development. The value assigned
to the asset was determined, using the income approach, by identifying
significant research projects for which technological feasibility had not been
established.
The nature of the efforts to develop the acquired in-process technology into
commercially viable products and services principally relate to the completion
of all planning, designing, prototyping, high-volume verification, and testing
activities that are necessary to establish that the proposed technologies meet
their design specifications including functional, technical, and economic
performance requirements.
The value assigned to purchased in-process technology was determined by
estimating the contribution of the purchased in-process technology to developing
a commercially viable product, estimating the resulting net cash flows from the
expected product sales over a 15 year period, and discounting the net cash flows
to their present value using a risk-adjusted discount rate of 30%, and adjusting
it for the estimated stage of completion.
The Company believes that the foregoing assumptions used in the forecasts were
reasonable at the time of the acquisition. No assurance can be given, however,
that the underlying assumptions used to estimate expected project sales,
development costs or profitability, or the events associated with such projects,
will transpire as estimated. For these reasons, actual results may vary from
the projected results.
Management expects to continue their support of this effort and believes the
Company has a reasonable chance of successfully completing the R&D project.
However, there is risk associated with the completion of the project and there
is no assurance that it will meet with either technological or commercial
success. If the XCOM project is not successful, the Company would not realize
its investment in XCOM and would be required to modify its business plan to
utilize alternative technologies which may increase the cost of its network.
The Company believes that its resulting charge for acquired research and
development conforms to the Securities and Exchange Commission's ("SEC")
expressed guidelines and methodologies. However, no assurances can be given
that the SEC will not require additional adjustments.
On September 30, 1998, Level 3 acquired GeoNet Communications, Inc. ("GeoNet"),
a regional Internet service provider located in Northern California. The
Company issued approximately 0.6 million shares and options in exchange for
GeoNet's capital stock, which based on Level 3's closing price on September
30, valued the transaction at approximately $19 million. Goodwill of $20
million was recognized from this transaction and will be amortized over
five years.
XCOM's and GeoNet's 1997 and 1998 operating results prior to the acquisitions
were not significant relative to the Company's results.
For the Company's acquisitions the excess purchase price over the fair market
value of the underlying assets was allocated to goodwill, other intangible
assets and property based upon preliminary estimates of fair value. The
Company does not believe that the final purchase price allocation will vary
significantly from the preliminary purchase price allocation.
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. Level 3 received approximately
$129 million when the transaction closed on November 6, 1998 and expects to
recognize a pre-tax gain of approximately $90 million in the fourth quarter.
On September 25, 1998, Commonwealth Telephone Enterprises, Inc. ("CTCO")
announced that it was commencing a rights offering of 3.7 million shares of
its common stock. Under the terms of the offering, each stockholder
received one right for every five shares of CTCO Common Stock or CTCO Class B
Common Stock held. The rights enabled the holder to purchase CTCO Common Stock
at a subscription price of $21.25 per share. Each right also carried the
right to oversubscribe at the subscription price for the offered shares not
purchased pursuant to the initial exercise of rights.
Level 3, which owned approximately 48% of CTCO prior to the rights offering,
exercised its 1.8 million rights it received with respect to the shares it
held. Messrs. Walter Scott, Jr., James Q. Crowe and David C. McCourt,
members of the Board of Directors of both Level 3 and CTCO, agreed to
oversubscribe for all the other shares offered for sale in the rights
offering. The commitments of Messrs. Scott, Crowe, McCourt and other
stockholders, resulted in Level 3 maintaining its 48% ownership interest in
CTCO after the rights offering.
The following is summarized financial information of the three entities created
as a result of the C-TEC restructuring for the three and nine months ended
September 30, 1998 and 1997, and as of September 30, 1998 and December 31,
1997 (in millions):
Three Months Ended Nine Months Ended
September 30, September 30,
Operations: 1998 1997 1998 1997
Commonwealth Telephone Enterprises:
Revenue $ 58 $ 50 $ 167 $ 145
Net income available to common
stockholders 3 6 12 18
Level 3's share:
Net income 2 3 6 9
Goodwill amortization - - (1) (1)
------ ------ ----- -----
Equity in net income $ 2 $ 3 $ 5 $ 8
====== ====== ===== =====
Cable Michigan:
Revenue $ 23 $ 21 $ 66 $ 61
Net loss available to common
stockholders (3) - (9) (3)
Level 3's share:
Net (loss) income (1) - (4) (2)
Goodwill amortization (1) - (3) (2)
------ ------ ----- -----
Equity in net loss $ (2) $ - $ (7) $ (4)
====== ====== ===== =====
RCN Corporation:
Revenue $ 58 $ 31 $ 148 $ 92
Net loss available to common
stockholders (53) (15) (170) (35)
Level 3's share:
Net loss (22) (7) (75) (17)
Goodwill amortization - - - -
------ ------ ----- -----
Equity in net loss $ (22) $ (7) $ (75) $ (17)
====== ====== ===== =====
Commonwealth
Telephone Cable RCN
Enterprises Michigan Corporation
Financial Position: 1998 1997 1998 1997 1998 1997
Current assets $ 70 $ 71 $ 16 $ 23 $1,185 $ 703
Other assets 339 303 112 120 705 448
----- ----- ----- ----- ------ ------
Total assets 409 374 128 143 1,890 1,151
Current liabilities 71 76 22 16 178 70
Other liabilities 287 260 154 166 1,251 708
Minority interest - - 14 15 59 16
----- ----- ----- ----- ------ ------
Total liabilities 358 336 190 197 1,488 794
----- ----- ----- ----- ------ ------
Net assets
(liabilities) $ 51 $ 38 $ (62) $ (54) $ 402 $ 357
===== ===== ===== ===== ====== ======
Level 3's share:
Equity in net assets
(liabilities) $ 25 $ 18 $ (30) $ (26) $ 164 $ 173
Goodwill 55 57 69 72 - 41
----- ----- ----- ----- ----- -----
$ 80 $ 75 $ 39 $ 46 $ 164 $ 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 pre-tax gains of $4 million
and $25 million to the Company for the three months and nine months ended
September 30, 1998, respectively.
On September 30, 1998, Level 3 owned approximately 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 September 30, 1998, was $216 million, $116 million and $346
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 $5 million of
interest expense and amortized debt issuance costs related to network
construction and systems development projects in the third quarter of 1998
and $6 million for the nine months ended September 30, 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, the recognition provisions 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 nine months ended
September 30, 1998, was $12 million and $23 million, respectively. In
addition to the expense recognized, the Company capitalized $2 million of
non-cash compensation for employees directly involved in the construction
of the IP network and the development of the business support systems. 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 nine 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 nine months ended September 30,
1998 and 1997 was as follows (in millions):
Three Months Ended Nine Months Ended
September 30, September 30,
1998 1997 1998 1997
Net earnings (loss) $ (49) $ (10) $ 843 $ 81
Other comprehensive income (loss)
before tax:
Foreign currency translation
adjustments, - (1) 1 (2)
Unrealized holding gains (losses)
arising during period (4) 14 (1) (7)
Reclassification adjustment for
(gains) losses included in net
earnings - - (8) -
------ ------ ------ ----
Other comprehensive income (loss),
before tax (4) 13 (8) (9)
Income tax benefit (provision)
related to items of other
comprehensive income (loss) 1 (5) 3 2
------ ------ ------ ----
Other comprehensive income (loss)
net of taxes (3) 8 (5) (7)
------ ------ ------ ----
Comprehensive income (loss) $ (52) $ (2) $ 838 $ 74
====== ====== ====== ====
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
these costs 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 Developments
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
recognized costs in the third quarter of 1998 as portions of the network
became operational.
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
began in the third quarter of 1998 and is expected to be completed during the
first quarter of 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.
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 reduce the overall cost of the network to
the Company.
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.
On August 3, 1998, Level 3 and a group of 32 other global telecommunications
companies entered into an agreement to construct an undersea cable system
connecting Japan and the United States by mid-year 2000. The parties to
this agreement are investing in excess of $1 billion to build the network, of
which Level 3 is expected to contribute approximately $130 million. In
addition, each party will have joint responsibility for network oversight,
maintenance and administration.
On October 14, Level 3 announced that it had signed an agreement with Global
Crossing Ltd. for trans-oceanic capacity on Global Crossing's fiber optic
cable network. The agreement, covering 25 years and valued at approximately
$100 million, will provide Level 3 with as-needed dedicated capacity across the
Atlantic Ocean. Level 3 will have the option of utilizing capacity on other
segments of Global Crossing's worldwide network.
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, into 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.
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. For a more detailed description of these risks and factors,
please see the Company's additional filings with the Securities and
Exchange Commission.
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 December 27, 1997, and the results of operations for the three and
nine months ended September 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.
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 provided 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.
The average for that period was $32.14, adjusted for the stock 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 are being 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, the recognition provisions 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 nine months ended
September 30, 1998, was $12 million and $23 million, respectively. In
addition to the expense recognized, the Company capitalized $2 million of
non-cash compensation costs for employees directly involved in the
construction of the IP network and the development of the business support
systems.
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
recognized costs in the third quarter of 1998 as portions of the network
became operational.
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 0.7 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, $30 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 $115 million which was recognized as
goodwill and is being amortized over five years.
XCOM's in-process research and development value is comprised primarily
of one project to develop an interface between an IP-based network and the
existing public switched telecommunications network. Remaining development
efforts for this project include various phases of design, development and
testing. The anticipated completion date for this project in progress is
expected to be over the next 15 months, at which time the Company expects to
begin generating the full economic benefit from the technology. Funding for
this project is expected to be obtained from internally generated sources.
The value of the in-process research and development represents the estimated
fair value based on risk-adjusted cash flows related to the incomplete project.
At the date of acquisition, the development of the project had not yet reached
technological feasibilty and the research and development ("R&D") in progress
had no alternative future uses. Accordingly, these costs were expensed as
of the acquisition date.
The Company used an independent third-party appraiser to assess and allocate
a value to the in-process research and development. The value assigned to the
asset was determined, using the income approach, by identifying significant
research projects for which technological feasibility had not been edstablished.
The nature of the efforts to develop the acquired in-process technology into
commercially viable products and services principally related to the completion
of all planning, designing, prototyping, high-volume verification, and testing
activities that are necessary to establish that the proposed technologies meet
their design specifications including functional, technical, and economic
performance requirements.
The value assigned to purchased in-process technology was determined by
estimating the contribution of the purchased in-process technology to developing
a commerically viable product, estimating the resulting net cash flows from the
expected product sales over a 15 year period, and discounting the net cash flows
to their present value using a risk-adjusted discount rate of 30%, and
adjusting it for the estimated stage of completion.
The Company believes that the foregoing assumptions used in the forecase were
reasonable at the time of the acquisition. No assurance can be given,
however, that the underlying assumptions used to estimate expected project
sales, development costs or profitability, or the events associated with this
project, will transpire as estimated. For these reasons, actual results may
vary from the projected results.
Management expects to continue their support of this effort and believes the
Company has a reasonable chance of successfully completing the R&D program.
However, there is risk associated with the completion of the project and there
is no assurance that it will meet with either technological or commerical
success. If the XCOM project is not successful, the Company would not realize
its investment in XCOM and would be required to modify its business plan to
utilize alternative technologies which may increase the cost of its network.
The Company believes that its resulting charge for acquired research and
development conforms to the Securities and Exchange Commission's ("SEC")
expressed guideline and methodologies. However, no assurances can be
given that the SEC will not require additional adjustments.
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
began in the third quarter of 1998 and is expected to be completed during the
first quarter of 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.
INTERNEXT 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 reduce the overall cost of the network to the
Company.
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.
GeoNet Communications, Inc. Acquisition
On September 30, 1998, Level 3 acquired GeoNet Communications, Inc. ("GeoNet"),
a regional Internet service provider located in Northern California. The
Company issued approximately 0.6 million shares and options in exchange for
GeoNet's capital stock, which based on Level 3's closing price on September
30, valued the transaction at approximately $19 million. Goodwill of $20
million was recognized from this transaction and will be amortized over
five years.
Japan-US Cable Network
On August 3, 1998, Level 3 and a group of 32 other global telecommunications
companies entered into an agreement to construct an undersea cable system
connecting Japan and the United States by mid-year 2000. The parties to
this agreement are investing in excess of $1 billion to build the network, of
which Level 3 is expected to contribute approximately $130 million. The
Company anticipates investing approximately $25 million in this project in
the fourth quarter. In addition, each party will have joint responsibility
for network oversight, maintenance and administration.
Commonwealth Telephone Enterprises, Inc.
On September 25, 1998, Commonwealth Telephone Enterprises, Inc. ("CTCO")
announced that it was commencing a rights offering of 3.7 million shares of
its common stock. Under the terms of the offering, each stockholder
received one right for every five shares of CTCO Common Stock or CTCO Class
B Common Stock held. The rights enabled the holder to purchase CTCO Common
Stock at a subscription price of $21.25 per share. Each right also carried
the right to oversubscribe at the subscription price for the offered shares
not purchased pursuant to the initial exercise of rights.
Level 3, which owned approximately 48% of CTCO prior to the rights offering,
agreed to exercise 1.8 million rights it received with respect to the
shares it held. Messrs. Walter Scott, Jr., James Q. Crowe, and David C.
McCourt, members of the Board of Directors of both Level 3 and CTCO, agreed
to oversubscribe for all the other shares offered for sale in the rights
offering. The commitments of Messrs. Scott, Crowe, McCourt and other
stockholders, resulted in Level 3 maintaining its 48% ownership interest
in CTCO after the rights offering.
Global Crossing Agreement
On October 14, Level 3 announced that it had signed an agreement with Global
Crossing Ltd. for trans-oceanic capacity on Global's fiber optic cable
network. The agreement, covering 25 years and valued at approximately $100
million, will provide Level 3 with as-needed dedicated capacity across the
Atlantic Ocean. Level 3 also will have the option of utilizing capacity on
other segments of Global Crossing's worldwide network.
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.
Third Quarter 1998 vs. Third Quarter 1997
Revenue for the quarters ended September 30, is summarized as follows
(in millions):
1998 1997
Communications and Information Services $ 37 $ 27
Coal Mining 64 50
Other 5 4
------ ------
$ 106 $ 81
====== ======
Communications and Information Services revenue consists of computer
outsourcing revenue of $15 million, systems integration revenue of $14
million and $8 million of communications revenue from XCOM, subsequent to
its acquisition in April, 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 $14 million, respectively. Computer outsourcing
revenues increased due to the addition of several new customers in late 1997
and early 1998. The acquisitions of two small firms, for a total of $15 million
in the second quarter of 1998, resulted in $3 million of additional systems
integration revenue. This increase was offset by the loss of a major contract
in early 1998 and a decline in systems reengineering revenue. Revenue from
communications services is expected to increase in the fourth quarter as
the Company recognizes additional revenue from its IP related services.
Coal mining revenue increased $14 million in the third 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 27% in 1998 to $47 million. Margin, as a
percentage of revenue, declined from 40% in 1997 to 32% in 1998 for
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 declined slightly in 1998. The start-up costs
incurred to establish a second data center in Phoenix were partially offset
by a decline in migration costs for new customers. Margins on coal sales
increased 6% in the third quarter of 1998. An increase in sales of higher
margin alternate source coal was partially offset by lower margins on coal
sold from 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 and Amortization Expense increased to $15 million in 1998 from $5
million in 1997. 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 in the fourth quarter of 1998 as the Company commences
operations on additional portions of its IP network.
General and Administrative Expenses increased significantly in 1998 to $96
million from $26 million in 1997 primarily due to the cost of activities
associated with preparing for the expected launch of the IP related services.
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 by the end of 1998. In addition to the costs to expand the
communications and information services businesses, the Company recorded
$12 million of non-cash compensation and professional service expenses in the
third quarter of 1998 for expenses recognized under SFAS No. 123. General
and administrative costs are expected to increase significantly in future
periods as the Company implements the Business Plan.
EBITDA, as defined by the Company, consists of earnings (losses) before
interest, income taxes, depreciation, amortization, non-cash stock-based
compensation and in-process research and development expenses and other
non-operating income or expenses, was $(25) million in 1998 and $18 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, however, should not be considered an
alternative to operating or net income as an indicator of the performance of
the Company's businesses, or as an alternative to cash flows from operating
activities as a measure of liquidity, in each case determined in accordance
with generally accepted accounting principles. See Consolidated Condensed
Statements of Cash Flows.
Interest Income increased significantly in 1998 to $53 million from $8 million
in 1997 as the Company's average cash, cash equivalents and marketable
securities balance approximated $3.7 billion in the third quarter of 1998.
The Company's average cash, cash equivalents and marketable securities
balance approximated $573 million in the comparable 1997 period. 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, net increased significantly in 1998 to $46 million from $3
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
debt issuance costs associated with the Senior Notes also increased
interest expense in the third quarter. The Company capitalized $5 million
of interest expense on network construction and systems development projects
in the third quarter of 1998.
Other Expense, net increased in 1998 to $27 million. The increase in Other
Expense 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 third 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. In accordance with its accounting policy,
the Company first applied this increase against the goodwill, previously
established for RCN, and then recognized pre-tax gains of $21 million and
$4 million in the second and third quarters of 1998, respectively. 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, and realized gains and losses on the sale 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
nondeductible goodwill amortization related to 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.
Discontinued Operations In 1997, the United Kingdom implemented a "Windfall
Tax" against privatized British utilities. The one-time tax was 23% of the
difference between the value at the time of privatization and the utility's
current value. The total impact of the tax to Level 3, directly through its
investment in CE Electric UK, plc., and indirectly through its 30%
ownership in CalEnergy was $63 million in the third quarter of 1997.
Nine Months 1998 vs. Nine Months 1997
Revenue for the nine months ended September 30, is summarized as follows (in
millions):
1998 1997
Communications and Information Services $ 102 $ 67
Coal Mining 178 165
Other 16 10
------ ------
$ 296 $ 242
====== ======
Revenue increased 22% to $296 million in 1998 for the nine months ended
September 30, 1998 compared to the same period in 1997. Systems
integration revenue increased 41% to $42 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. Also contributing to the growth of systems integration
revenue, was the acquisition of two small firms in the second quarter of
1998 which contributed $3 million of revenue. Revenue for the computer
outsourcing business increased 24% to $46 million in 1998. The increase is
attributable to the addition of several new customers in 1997 and early
1998. The remaining $14 million of communications revenue is primarily
attributable to XCOM which was acquired in April, 1998.
Mining revenue increased 8% in 1998 to $178 million. Increases in alternate
source coal sales were partially 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 18% to $138 million in 1998. Margin, as a
percent of revenue, decreased 18% for the systems integration business as
the early termination of a large contract resulted in a lower utilization
of operating personnel. Gross margins for the computer outsourcing business
increased 9% during the first nine months of 1998. A decrease in migration
costs incurred in 1997 to implement new outsourcing contracts was
partially offset by start up costs incurred for the second data
center in Phoenix. Margins for the mining business increased by 3% in 1998.
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 and Amortization Expense increased $16 million during the first
nine months of 1998. Depreciation on the computer equipment purchased for
general and administrative personnel, 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 and information services businesses. The
hiring of approximately 800 employees to implement the IP business led to
increases in compensation, relocation, travel and facilities expenses.
In addition to regular compensation, the Company recognized $23 million of
non-cash expense for stock options and warrants granted in the first nine
months of 1998. The Company also incurred significant 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 $30 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 $30 million. In accordance with generally
accepted accounting principles, the $30 million was taken as a
nondeductible charge against earnings in the second quarter of 1998.
EBITDA, as defined by the Company, declined to $(18) million in 1998 from $64
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 $124 million in 1998 from $23 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 $514 million to $2.9 billion for the
nine months ending September 30, 1997 and 1998, respectively. The increase
in the average balance was directly responsible for the increase in interest
income.
Interest Expense, net increased to $86 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. The Company
capitalized $6 million of interest expense on network construction and
systems development projects in 1998.
Other Expense, net increased substantially in 1998 to $53 million from $11
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 $75 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 $25 million. 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. It is the Company's policy to
first apply this increase against goodwill, previously established for RCN,
and then recognize a gain for the remaining increase in value. Also
included in Other Expense are equity earnings in Commonwealth Telephone
Enterprises, Inc., equity in losses of Cable Michigan, Inc., and realized
gains and losses on the sale 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
primarily due to the $30 million 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. In 1997, the United Kingdom
implemented a "Windfall Tax" against privatized British utilities. The
total impact of the tax to Level 3, directly through its investment in CE
Electric UK, plc., and indirectly through its 30% ownership in CalEnergy was
$63 million in 1997.
Financial Condition-September 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 $1.94 billion of proceeds from
the issuance of Senior Notes on April 28, 1998. The Company's working capital
increased $2.1 billion to $3.5 billion on September 30, 1998. The Company's
operations used $16 million of cash during the first nine months of 1998,
primarily for the payment of 1998 estimated income taxes and the costs in
implementing the Business Plan. These items were partially offset by funds
provided by coal mining operations, the receipt of a $45 million federal
tax refund, a $26 million payment from INTERNEXT and interest income.
The initial interest payment on the Senior Notes, $92 million, was made on
November 2, 1998.
Investing activities include the purchase of $5,132 million of marketable
securities, the sales and maturities of marketable securities of $2,882
million, $409 million of capital expenditures, primarily for the expanding
IP and information services business and $24 million of investments,
principally $15 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. In 1998, Level
3 issued $183 million of stock for the acquisition of several IP businesses
and reflected in the equity accounts the $164 million fair value of the issuance
and forced conversion of the Class R Stock during the first nine months 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., ("PKSIS") 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 construction 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 approximate $700 million in 1998 and exceed $2 billion in
1999. The Company's current liquidity in addition to the net proceeds from
the Senior Notes, the cost sharing agreement with INTERNEXT and the
realization of the value of certain non-core assets, 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.
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. Level 3 received
approximately $129 million when the transaction closed on November 6, 1998
and expects to recognize a pre-tax gain of approximately $90 million in
the fourth quarter.
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
these costs 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.
Year 2000
The Company is in the process of conducting a review of its computer systems,
including the computer systems used in the Company's computer outsourcing
business, to identify systems that could be affected by the "Year 2000"
computer issue. Based upon this review, the Company will develop and
implement a plan to resolve any related issues. 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 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, are not expected to have a material effect on its future
operating results or financial condition. The source of funds for Year
2000 compliance costs will be cash on hand, and are expected to represent
an immaterial amount of the Company's overall information systems budget.
There can be no assurance, however, that the Year 2000 problem will not
have a material adverse effect on the Company's business,
financial condition, competitive position and results of operations.
The Company anticipates that its plan to resolve related Year 2000 issues will
be a multiphase plan that would include (1) assessment of the potential
Year 2000 issues, (2) a detailed action plan based upon the results of its
assessment of the potential issues, (3) remediation of systems and products
that are identified in the assessment and the detailed plan as requiring
correction or elimination, (4) testing of the results of the remediation
efforts to assess Year 2000 readiness and (5) the implementation of the
remediated systems and products. Additional details of the Company's plan
will be outlined as they are finalized.
The Company's wholly owned subsidiary, Level 3 Communications, LLC is a new
company that is implementing new technologies to provide Internet Protocol
(IP) technology-based communications services to its customers. This
company has adopted a strategy to select technology vendors and suppliers
that provide products that are represented by such vendors and suppliers to be
Year 2000 compliant. In negotiating its vendor and supplier contracts, the
company secures Year 2000 warranties that address the Year 2000 compliance
of the applicable product(s). As part of the Company's Year 2000
compliance program, plans will be put into place to test these products to
confirm they are Year 2000 compliant.
The Company has initiated communications with its significant suppliers and
customers, including those that will provide leased communications capacity
to the Company as well as those of PKSIS' computer outsourcing
business and, in particular, vendors of that business' computer outsourcing
operating environments, to determine the extent to which the Company is
vulnerable to the failure by such parties to remediate Year 2000 compliance
issues. No assurance can be given, however, that the systems will be made
Year 2000 compliant in a timely manner or that the noncompliance of the systems
of any of these parties would not have a material adverse effect on the
Company's business, financial condition, competitive position and results
of operations.
PKS Systems Integration LLC ("PKS Systems"), a subsidiary of PKSIS,
provides a wide variety of information technology services to its customers.
In fiscal year 1997, approximately 80% of the revenue generated by PKS Systems
related to projects involving Year 2000 assessment and renovation services
performed by PKS Systems for its customers. These contracts generally require
PKS Systems to identify date affected fields in certain application software of
its customers and, in many cases, PKS Systems undertakes efforts to
remediate those date-affected fields so that Year 2000 data may be processed.
Thus, Year 2000 issues affect many of the services PKS Systems provides to its
customers. This exposes PKS Systems to potential risks that may include
problems with services provided by PKS Systems to its customers and the
potential for claims arising under PKS Systems' customer contracts.
PKS Systems attempts to contractually limit its exposure to liability for Year
2000 compliance issues. However, there can be no assurance as to the
effectiveness of these contractual limitations.
The expenses associated with this project by PKSIS, as well as the related
potential effect on the Company's earnings, are 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, and any loss incurred by any
customers of PKSIS as a result of the Year 2000 problem, will not have a
material adverse effect on the Company's financial condition and results of
operations.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
PART II - OTHER INFORMATION
Item 2. Changes in Securities
Pursuant to an agreement on July 1, 1998, the Company issued 187,706 common
shares to the holder of the capital stock of UltraLine (Bermuda) Limited in
connection with its acquisition by the Company. The value of the
transaction, based upon the trading price of the Company's stock, was
approximately $5 million. The issuance of stock to the holder of UltraLine
(Bermuda) Limited capital stock 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 September 16, 1998, the Company issued 150,609
common shares to the holders of the capital stock of mikNet Internet Based
Services GmbH in connection with its acquisition by the Company. The value
of the transaction, based upon the trading price of the Company's stock, was
approximately $5 million. The issuance of stock to the holders of mikNet
Internet Based Services GmbH capital stock was made pursuant to the
exemptions from registration contained in Regulation S and Section 4(2)
under the Securities Act of 1933, as amended.
Pursuant to an agreement on September 30, 1998, the Company issued 511,719
common shares to the holders of the capital stock of GeoNet Communications,
Inc. in connection with its acquisition by the Company. The value of the
issued shares, based upon the trading price of the Company's stock, was
approximately $16 million. The issuance of stock to the holders of GeoNet
Communications, Inc. capital stock was made pursuant to the exemptions from
registration contained in Regulation S and Section 4(2) under the Securities
Act of 1933, as amended.
Item 4. Submission of Matters to a Vote of Security Holders
At the annual meeting of stockholders held on July 14, 1998, the following
matters were submitted to a vote.
1. To reelect the three Class I Directors to the Board of Directors of Level 3
for a three-year term until the 2001 Annual Meeting of Stockholders:
In Favor Withheld
Walter Scott, Jr. 96,945,914 106,153
James Q. Crowe 96,982,345 69,722
Charles M. Harper 96,701,865 350,202
2. To adopt a program relating to the issuance of Outperform Stock Options
pursuant to the Level 3 1995 Stock Plan, amended and restated as of April 1,
1998:
Affirmative votes: 96,057,435
Negative votes: 726,338
Abstentions: 268,294
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits filed as part of this report are listed below.
Exhibit
Number
10.1 Cost Sharing and IRU Agreement between Level 3 Communications, LLC
and INTERNEXT, LLC, dated July 18, 1998
27 Financial Data Schedule.
(b) The Company filed a Form 8-K on September 1, 1998; reporting that Arthur
Andersen LLP had been engaged as its new independent accountants effective
August 26, 1998.
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: May 21, 1999 \s\ Eric J. Mortensen
-----------------------------
Eric J. Mortensen
Controller and Principal
Accounting Officer
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
INDEX TO EXHIBITS
Exhibit
No.
10.1 Cost Sharing and IRU Agreement between Level 3 Communications, LLC
and INTERNEXT, LLC, dated July 18, 1998
27 Financial Data Schedule.