FORM 10-Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 1999
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period__________to__________
Commission file number 0-15658
LEVEL 3 COMMUNICATIONS, INC.
(Exact name of registrant as specified in its charter)
Delaware 47-0210602
(State of Incorporation) (I.R.S. Employer
Identification No.)
1025 Eldorado Blvd., Broomfield, CO 80021
(Address of principal executive offices) (Zip Code)
(720) 888-1000
(Registrant's telephone number,
including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports(s)), and (2) has been subject to
such filing requirements for the past 90 days. Yes X No
The number of shares outstanding of each class of the issuer's common stock, as
of October 29, 1999:
Common Stock 341,076,021 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
Consolidated Statements of Comprehensive Income
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 1. Legal Proceedings
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) 1999 1998 1999 1998
- ------------------------------------------------------------------------------------------------
Revenue $ 134 $ 106 $ 342 $ 296
Costs and Expenses:
Cost of revenue 100 47 243 138
Depreciation and amortization 63 15 155 31
Selling, general and administrative expenses 178 96 460 199
Write-off of in-process research & development - - - 30
----- ----- ----- -----
Total costs and expenses 341 158 858 398
----- ----- ----- -----
Loss from Operations (207) (52) (516) (102)
Other Income (Expense):
Interest income 51 53 158 124
Interest expense, net (34) (46) (132) (86)
Gain on equity investee stock transactions 5 4 116 25
Other, net (35) (31) (65) (78)
----- ----- ----- -----
Total other income (expense) (13) (20) 77 (15)
----- ----- ----- -----
Loss Before Income Taxes and
Discontinued Operations (220) (72) (439) (117)
Income Tax Benefit 73 23 143 28
----- ----- ----- -----
Loss from Continuing Operations (147) (49) (296) (89)
Discontinued Operations:
Gain on split-off of Construction Group - - - 608
Gain on disposition of energy business,
net of income tax expense of $175 - - - 324
----- ----- ----- -----
Earnings from discontinued operations - - - 932
----- ----- ----- -----
Net Earnings (Loss) $(147) $ (49) $(296) $ 843
===== ===== ===== =====
Earnings (Loss) Per Share (Basic and Diluted):
Continuing operations $(.43) $(.16) $(.89) $(.30)
===== ===== ===== =====
Discontinued operations $ - $ - $ - $3.11
===== ===== ===== =====
Net earnings (loss) $(.43) $(.16) $(.89) $2.81
===== ===== ===== =====
Net earnings (loss), excluding gain on
split-off of Construction Group $(.43) $(.16) $(.89) $ .78
===== ===== ===== =====
- ------------------------------------------------------------------------------------------------
See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Condensed Balance Sheets
(unaudited)
September 30, December 31,
(dollars in millions, except share data) 1999 1998
- --------------------------------------------------------------------------------
Assets
Current Assets
Cash and cash equivalents $ 1,486 $ 842
Marketable securities 2,732 2,863
Restricted cash and securities 528 32
Accounts receivable, net 118 57
Income taxes receivable 163 54
Other 43 29
------- -------
Total Current Assets 5,070 3,877
Property, Plant and Equipment, net 3,072 1,061
Investments 363 323
Other Assets, net 330 261
-------- -------
$ 8,835 $ 5,522
======== =======
- -------------------------------------------------------------------------------
See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Condensed Balance Sheets
(unaudited)
September 30, December 31,
(dollars in millions, except share data) 1999 1998
- --------------------------------------------------------------------------------
Liabilities and Stockholders' Equity
Current Liabilities:
Accounts payable $ 653 $ 276
Current portion of long-term debt 6 5
Accrued payroll and employee benefits 62 16
Accrued interest 81 33
Deferred revenue 84 1
Other 53 39
------ -------
Total Current Liabilities 939 370
Long-Term Debt, less current portion 3,977 2,641
Deferred Income Taxes 40 86
Accrued Reclamation Costs 97 96
Other Liabilities 251 164
Commitments and Contingencies
Stockholders' Equity:
Preferred stock, $.01 par value, authorized
10,000,000 shares;
no shares outstanding in 1999 and 1998 - -
Common Stock:
Common Stock, $.01 par value, authorized
1,500,000,000 shares;
340,689,116 shares outstanding in 1999
and 307,874,706 outstanding in 1998 3 3
Class R, $.01 par value, authorized
8,500,000 shares;
no shares outstanding in 1999 and 1998 - -
Additional paid-in capital 2,435 765
Accumulated other comprehensive (loss)
income (4) 4
Retained earnings 1,097 1,393
------- ------
Total Stockholders' Equity 3,531 2,165
------- -------
$ 8,835 $ 5,522
======= =======
- --------------------------------------------------------------------------------
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) 1999 1998
- ------------------------------------------------------------------------------
Cash flows from continuing operations:
Net cash provided by continuing operations $ 408 $ 128
Cash flows from investing activities:
Proceeds from sales and maturities of
marketable securities 4,369 2,882
Purchases of marketable securities (4,254) (5,132)
Capital expenditures (2,154) (409)
Investments (3) (24)
Proceeds from sale of property, plant and
equipment and other investments 11 26
Other 1 -
------ ------
Net cash used in investing activities (2,030) (2,657)
Cash flows from financing activities:
Issuance of long-term debt, net of issuance costs 1,250 1,937
Payments on long-term debt including current portion (5) (7)
Increase in cash and restricted securities (495) -
Issuances of common stock 1,498 21
Proceeds from exercise of stock options 18 7
Exchange of Class C Stock for Common Stock, net - 122
------ ------
Net cash provided by financing activities 2,266 2,080
Cash flows from discontinued operations:
Proceeds from sale of energy operations,
net of income tax payments of $144 million - 1,015
------ ------
Net cash provided by discontinued operations - 1,015
------ ------
Net change in cash and cash equivalents 644 566
Cash and cash equivalents at beginning of year 842 87
------ ------
Cash and cash equivalents at end of period $ 1,486 $ 653
======= ======
The activities of the Construction & Mining Group have been removed from the
consolidated condensed statements of cash flows in 1998. The Construction Group
had cash flows of ($62) million for the three months ended March 31, 1998.
- --------------------------------------------------------------------------------
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, 1999
(unaudited)
Accumulated
Additional Other
Common Paid-in Comprehensive Retained
(dollars in millions) Stock Capital Income (Loss) Earnings Total
- ----------------------------------------------------------------------------------------------------------
Balance at
December 31, 1998 $ 3 $ 765 $ 4 $ 1,393 $ 2,165
Common Stock:
Issuances, net - 1,504 - - 1,504
Stock options exercised - 18 - - 18
Stock option grants - 88 - - 88
Income tax benefit from
exercise of options - 60 - - 60
Net Loss - - - (296) (296)
Other Comprehensive Loss - - (8) - (8)
------ ------- ------ ------ ------
Balance at September 30, 1999 $ 3 $ 2,435 $ (4) $ 1,097 $ 3,531
====== ======= ====== ======= =======
- -----------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Statements of Comprehensive Income (Loss)
(unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
(dollars in millions) 1999 1998 1999 1998
- -----------------------------------------------------------------------------------------------------
Net (Loss) Earnings $ (147) $ (49) $ (296) $ 843
Other Comprehensive Income (Loss) Before Tax:
Foreign currency translation adjustments 9 - 1 1
Unrealized holding loss arising during period - (4) (2) (1)
Reclassification adjustment for gains
included in net (loss) earnings - - (12) (8)
----- ----- ----- -----
Other Comprehensive Income (Loss) Before Tax 9 (4) (13) (8)
Income Tax (Expense) Benefit Related to Items of
Other Comprehensive Income (Loss) (3) 1 5 3
----- ----- ----- -----
Other Comprehensive Income (Loss) Net of Taxes 6 (3) (8) (5)
----- ----- ----- -----
Comprehensive (Loss) Income $ (141) $ (52) $(304) $ 838
====== ===== ===== =====
- ------------------------------------------------------------------------------------------------------
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 31, 1998 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, for the year ended December 31, 1998. These financial statements
should be read in conjunction with the Company's audited consolidated financial
statements and notes thereto. The preparation of the consolidated condensed
financial statements in conformity with generally accepted accounting principles
requires management to make estimates and assumptions that affect the reported
amount of assets and liabilities, disclosure of contingent assets and
liabilities and the reported amount of revenue and expenses during the reported
period. Actual results could differ from these estimates.
The 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 property, plant
and equipment necessary to provide its services) of a broad range of integrated
communications services in the United States, Europe and Asia. To reach this
goal, the Company is expanding substantially the business of its PKS Information
Services, Inc. subsidiary and creating, 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 building the network based on Internet Protocol technology in order
to leverage the efficiencies of this technology to provide lower cost
communications services.
In 1997, the Company agreed to sell its energy assets to MidAmerican Energy
Holding Company, Inc. (f/k/a CalEnergy Company, Inc.) ("MidAmerican") and to
separate the construction operations ("Construction Group") from the Company. On
January 2, 1998, the Company completed the sale of its energy assets to
MidAmerican. On March 31, 1998, the Company completed the split-off of the
Construction Group to stockholders that held Class C Stock. Therefore, the
results of operations of both businesses have been classified as discontinued
operations on the consolidated condensed statements of operations for 1998.
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
four days for the period ending September 30, 1998, were not material to the
overall results of operations and cash flows.
The results of operations for the nine months ended September 30, 1999, are not
necessarily indicative of the results expected for the full year.
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
Prior to March 31, 1998, the Company had a two-class capital structure. The
Company's Class C Stock reflected the performance of the Construction Group and
the Class D Stock reflected the performance of the other businesses, including
communications, information services and coal mining. In 1997 the Board of
Directors of Level 3 approved a proposal for the separation of the Construction
Group from the other operations of the Company through a split-off of the
Construction Group (the "Split-off"). In December 1997, the Company's
stockholders approved the Split-off and in March 1998, the Company received a
ruling from the Internal Revenue Service that stated the Split-off would be
tax-free to U.S. stockholders. The Split-off was effected on March 31, 1998. As
a result of the Split-off, the Company no longer owns any interest in 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 results
of operations of the Construction Group for the three months ended March 31,
1998.
On March 31, 1998, the Company reflected the fair value of the Construction
Group as a distribution to the Class C stockholders because the distribution was
considered non-pro rata as compared to the Company's previous two-class capital
stock structure. The Company recognized a gain of $608 million within
discontinued operations, 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, "Accounting
for Reorganizations Involving a Non-Pro Rata Split-off of Certain Nonmonetary
Assets to Owners". No taxes were provided on this gain due to the tax-free
nature of the Split-off.
In connection with the Split-off, the Class D Stock became the common stock of
Level 3 Communications, Inc. ("Common Stock"), and shortly thereafter, began
trading on the Nasdaq National Market under the symbol "LVLT".
3. Discontinued Energy Operations
On January 2, 1998, the Company completed the sale of its energy assets to
MidAmerican. These assets included approximately 20.2 million shares of
MidAmerican common stock (assuming the exercise of 1 million options held by
Level 3), Level 3's 30% interest in CE Electric and Level 3's investments in
international power projects in Indonesia and the Philippines. 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 in part to fund 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 (Loss) Per Share
Basic earnings (loss) per share have been computed using the weighted average
number of shares during each period. The Company had a loss from continuing
operations for the three and nine month periods ended September 30, 1999 and
1998. Therefore, the dilutive impact of the Convertible Subordinated Notes and
the 21,534,433 options and warrants outstanding at September 30, 1999 and
19,690,144 options and warrants outstanding at September 30, 1998 have not been
included in the computation of diluted earnings (loss) per share because the
resulting computation would have been anti-dilutive.
Effective August 10, 1998, the Company issued a dividend of one share of Level 3
Common Stock for each share of Level 3 Common Stock outstanding. All share
information and per share data have been restated to reflect the stock dividend.
The following details the earnings (loss) per share calculations for Level 3
Common Stock:
Three Months Ended Nine Months Ended
September 30, September 30,
1999 1998 1999 1998
- ----------------------------------------------------------------------------------------------------------------
Loss From Continuing Operations (in millions) $ (147) $ (49) $ (296) $ (89)
Discontinued Operations:
Gain on Split-off of Construction Group - - - 608
Earnings from Discontinued Energy Operations - - - 324
-------- ------- ------- -------
Earning from Discontinued Operations - - - 932
-------- ------- ------- -------
Net Earnings (Loss) $ (147) $ (49) $ (296) $ 843
======== ======= ======= =======
Total Number of Weighted Average Shares
Outstanding Used to Compute Basic and
Diluted Earnings Per Share (in thousands) 340,298 306,515 332,039 300,151
======= ======= ======= =======
Earnings (Loss) Per Share (Basic and Diluted):
Continuing operations $ (.43) $ (.16) $ (.89) $ (.30)
======= ======= ======= =======
Discontinued operations $ - $ - $ - $ 3.11
======= ======= ======= =======
Net earnings (loss) $ (.43) $ (.16) $ (.89) $ 2.81
======= ======= ======= =======
Net earnings (loss), excluding gain on Split-off
of Construction Group $ (.43) $ (.16) $ (.89) $ .78
======= ======= ======= =======
- ----------------------------------------------------------------------------------------------------------------
5. Acquisitions
On January 5, 1999, Level 3 acquired BusinessNet Ltd. ("BusinessNet"), a leading
London-based Internet service provider in a largely stock-for-stock transaction
valued at $12 million and accounted for as a purchase. After completion of
certain adjustments, the Company agreed to issue approximately 400,000 shares of
Common Stock and paid $1 million in cash in exchange for all of the issued and
outstanding shares of BusinessNet's capital stock. Of the approximately 400,000
shares Level 3 agreed to issue in connection with the acquisition, approximately
150,000 shares of Level 3 Common Stock have been pledged to Level 3 to secure
certain indemnification obligations of the former BusinessNet stockholders. In
October 1999, Level 3 released approximately 42,000 shares pursuant to the
acquisition agreement. The pledge of the remaining shares will terminate
approximately 18 months from the acquisition date, unless otherwise extended
pursuant to the terms of the acquisition agreement. Liabilities exceeded assets
acquired, and goodwill of $16 million was recognized from the transaction which
is being amortized over five years.
On April 23, 1998, the Company acquired XCOM Technologies, Inc. ("XCOM"), a
privately held company that has developed technology which provides certain key
components necessary for the Company to develop an interface between its
Internet Protocol-based network and the existing 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, $115 million was originally allocated to
in-process research and development and was taken as a nondeductible charge to
earnings in the second quarter of 1998. The purchase price exceeded the fair
value of the net assets acquired by $30 million which was recognized as
goodwill.
In October 1998, the Securities and Exchange Commission ("SEC") issued new
guidelines for valuing acquired research and development which are applied
retroactively. The Company believes its accounting for the acquisition was made
in accordance with generally accepted accounting principles and established
appraisal practices at the time of the acquisition. However, due to the
significance of the charge relative to the total value of the acquisition, the
Company reviewed the facts with the SEC. Consequently, using the revised
guidelines and assumptions, the Company reduced the charge for in-process
research and development from $115 to $30 million, and increased the related
goodwill by $85 million. The goodwill associated with the XCOM transaction is
being amortized over a five year period. The results for the three and nine
months ended September 30, 1998 have been restated to reflect the reduced charge
for in-process research and development and increased amortization expense.
The Company believes that its resulting charge for acquired research and
development conforms to the SEC's expressed guidelines and methodologies.
However, no assurances can be given that the SEC will not require additional
adjustments.
The cumulative operating results of BusinessNet, XCOM and other 1998
acquisitions were not significant relative to the Company's 1999 and 1998
results.
For the Company's acquisitions, the excess purchase price over the fair market
value of the underlying assets was allocated to goodwill and other intangible
assets and property based upon preliminary estimates of fair value. The final
purchase price allocation for XCOM did not vary significantly from preliminary
estimates. The Company does not believe that the final purchase price allocation
will vary significantly from the preliminary estimates for the entities acquired
after September 30, 1998.
6. Property, Plant and Equipment, net
Construction in Progress
The Company is currently constructing its communications network. Costs
associated directly with the uncompleted network and interest expense incurred
during construction are capitalized based on the weighted average accumulated
construction expenditures and the interest rates related to borrowings
associated with the construction. Certain gateway facilities, local networks and
operating equipment have been placed in service during 1999. These assets are
being depreciated over their useful lives, primarily ranging from 3-25 years. As
other segments of the network are placed in service, the assets will be
depreciated over their useful lives.
The Company is currently developing business support systems required for its
Business Plan. The external direct costs of software, materials and services,
payroll and payroll related expenses for employees directly associated with the
project and interest costs incurred when developing the business support systems
are capitalized. Upon completion of the projects, the total costs of the
business support systems are amortized over their useful lives of 3 years.
For the nine months ended September 30, 1999, the Company invested $2,021
million in its communications business, including $825 million on the U.S.
intercity network, $464 million on international networks, $144 million on
transoceanic networks and $419 million on gateway facilities and local networks.
Capitalized business support systems and network construction costs that have
not been placed in service have been classified as construction-in-progress
within Property, Plant and Equipment below.
Accumulated Book
(dollars in millions) Cost Depreciation Value
- --------------------------------------------------------------------------------
September 30, 1999
Land and Mineral Properties $ 41 $ (16) $ 25
Facility and Leasehold Improvements:
Communications 162 (4) 158
Information Services 26 (3) 23
Coal Mining 73 (63) 10
CPTC 91 (8) 83
Operating Equipment:
Communications 369 (64) 305
Information Services 59 (36) 23
Coal Mining 115 (104) 11
CPTC 17 (6) 11
Network Construction Equipment 91 (7) 84
Furniture and Office Equipment 103 (33) 70
Other 126 (31) 95
Construction-in-Progress 2,174 - 2,174
------ ----- ------
$3,447 $ 375 $3,072
====== ===== ======
December 31, 1998
Land and Mineral Properties $ 37 $ (16) $ 21
Facility and Leasehold Improvements:
Communications 80 (1) 79
Information Services 24 (2) 22
Coal Mining 74 (61) 13
CPTC 91 (5) 86
Operating Equipment:
Communications 245 (18) 227
Information Services 53 (30) 23
Coal Mining 119 (104) 15
CPTC 17 (4) 13
Network Construction Equipment 46 (1) 45
Furniture and Office Equipment 67 (10) 57
Other 72 (2) 70
Construction-in-Progress 390 - 390
------- ------ ------
$ 1,315 $ (254) $1,061
====== ====== ======
- --------------------------------------------------------------------------------
7. Investments
The Company holds significant equity positions in two publicly traded companies;
RCN Corporation ("RCN") and Commonwealth Telephone Enterprises, Inc.
("Commonwealth Telephone"). RCN is a facilities-based provider of communications
services to the residential market primarily in the northeastern United States
and California. RCN provides local and long distance phone, cable television and
Internet services in several markets; including Boston, New York, Washington,
D.C., and California's San Francisco to San Diego corridor.
Commonwealth Telephone holds Commonwealth Telephone Company, an incumbent local
exchange carrier operating in various rural Pennsylvania markets, and CTSI,
Inc., a competitive local exchange carrier which commenced operations in 1997.
On September 30, 1999, Level 3 owned approximately 35% and 48% of the
outstanding shares of RCN and Commonwealth Telephone, respectively, and accounts
for each entity using the equity method. The market value of the Company's
investment in the two entities was $1,092 million and $468 million,
respectively, on September 30, 1999.
The Company recognizes gains from the sale, issuance and repurchase of stock by
its subsidiaries and equity method investees in its statement of operations.
During 1999, RCN issued stock in a public offering and for certain transactions
which diluted the Company's ownership of RCN from 41% at December 31, 1998 to
35% at September 30, 1999. The increase in the Company's proportionate share of
RCN's net assets as a result of these transactions resulted in a pre-tax gain of
$5 million and $116 million for the Company for the three and nine months ended
September 30, 1999. The Company also recognized a gain of $4 million and $25
million for the three and nine months ended September 30, 1998 related to stock
transactions of RCN.
In October 1999, RCN announced that Vulcan Ventures, Inc. had agreed to invest
$1.65 billion in RCN. This transaction, expected to close during the first
quarter of 2000, is in the form of preferred stock convertible to 26.6 million
shares of RCN common stock. The preferred shares must be converted to common
shares within a three to seven year period at $62 per share. Level 3, based on
current market conditions, expects to recognize a significant gain when Vulcan
Ventures, Inc. converts its RCN preferred stock to RCN common stock.
The following is summarized financial information of RCN and Commonwealth
Telephone for the three and nine months ended September 30, 1999 and 1998, and
as of September 30, 1999 and December 31, 1998 (in millions):
Three Months Ended Nine Months Ended
September 30, September 30,
Operations 1999 1998 1999 1998
- ---------------------------------------------------------------------------------------------------
RCN Corporation:
Revenue $ 70 $ 58 $ 204 $ 148
Net loss available to common shareholders (96) (53) (232) (170)
Level 3's share:
Net loss (37) (22) (89) (75)
Goodwill amortization - - (1) -
----- ----- ------ -----
Equity in net loss $ (37) $ (22) $ (90) $ (75)
===== ===== ====== =====
Commonwealth Telephone Enterprises:
Revenue $ 68 $ 58 $ 192 $ 167
Net income available to common shareholders 6 3 17 12
Level 3's share:
Net income 3 2 8 6
Goodwill amortization - - (1) (1)
----- ----- ------ -----
Equity in net income $ 3 $ 2 $ 7 $ 5
===== ===== ====== =====
- ---------------------------------------------------------------------------------------------------
Commonwealth
RCN Telephone
Corporation Enterprises
Financial Position 1999 1998 1999 1998
- --------------------------------------------------------------------------------
Current assets $ 1,704 $ 1,093 $ 85 $ 79
Other assets 1,150 815 403 354
------- ------- ------ -----
Total assets 2,854 1,908 488 433
Current liabilities 192 178 84 85
Other liabilities 1,766 1,282 262 223
Minority interest 129 77 - -
Preferred stock 249 - - -
------- ------- ------ -----
Total liabilities and preferred stock 2,336 1,537 346 308
------- ------- ------ -----
Common Equity $ 518 $ 371 $ 142 $ 125
======= ======= ====== =====
Level 3's share:
Equity in net assets $ 184 $ 150 $ 68 $ 60
Goodwill 26 34 54 56
------- ------- ------ -----
$ 210 $ 184 $ 122 $ 116
======= ======= ====== =====
- --------------------------------------------------------------------------------
Investments at September 30, 1999 and December 31, 1998 also include $23 million
for the Company's investment in the Pavilion Towers office buildings in Aurora,
Colorado.
8. Other Assets, net
At September 30, 1999 and December 31, 1998 other assets consisted of the
following:
(in millions) 1999 1998
- ----------------------------------------------------------------------------------------
Goodwill:
XCOM, net of accumulated amortization of $32 and $15 $ 80 $ 100
GeoNet, net of accumulated amortization of $3 and $1 18 20
BusinessNet, net of accumulated amortization of $3 and $- 13 -
Other, net of accumulated amortization of $5 and $1 15 19
Prepaid Network Assets 51 -
Deferred Debt Issuance Costs 106 67
Deferred Development and Financing Costs 15 15
Unrecovered Mine Development Costs 14 15
Leases 6 9
Timberlands 3 3
Other 9 13
------ ------
Total other assets $ 330 $ 261
====== ======
- ----------------------------------------------------------------------------------------
9. Long-Term Debt
6% Convertible Subordinated Notes
On September 14, 1999, the Company received $798 million of proceeds, after
transaction costs, from an offering of $823 million aggregate principal amount
of its 6% Convertible Subordinated Notes Due 2009 ("Subordinated Notes"). The
Subordinated Notes are unsecured and subordinated to all existing and future
senior indebtedness of the Company. Interest on the notes accrues at 6% per year
and is payable each year in cash on March 15 and September 15. The principal
amount of the notes will be due on September 15, 2009. The Subordinated Notes
may be converted into shares of common stock of the Company at any time prior to
maturity, unless the Company has caused the conversion rights to expire. The
conversion rate is 15.3401 shares per each $1,000 principal amount of
Subordinated Notes, subject to adjustment in certain circumstances. On or after
September 15, 2002, Level 3, at its option, may cause the conversion rights to
expire. Level 3 may exercise this option only if the current market price
exceeds approximately $91.27 (which represents 140% of the conversion price) for
20 trading days within any period of 30 consecutive trading days including the
last day of that period.
Debt issuance costs of $25 million were capitalized and are being amortized as
interest expense over the term of the Subordinated Notes.
Senior Secured Credit Facilities
On September 30, 1999, certain Level 3 subsidiaries entered into $1.375 billion
of secured credit facilities ("Senior Secured Credit Facilities"). The
facilities are comprised of a senior secured revolving credit facility in the
amount of $650 million and a two-tranche senior secured term loan facility
aggregating $725 million. The secured term loan facility consists of a $450
million tranche A and a $275 million tranche B term loan facilities.
On September 30, 1999, Level 3 borrowed $475 million under the secured term loan
facility. The $475 million and prepaid interest have been placed in an interest
bearing escrow account until the Company receives the remaining state regulatory
approvals necessary to close this financing. The Company expects to receive all
the necessary regulatory approvals during the fourth quarter of 1999.
The obligations under the revolving credit facility are secured by substantially
all the assets of Level 3 and, subject to certain exceptions, its wholly owned
domestic subsidiaries (other than the borrower under the term loan facilities).
Such assets will also secure a portion of the term loan facilities.
Additionally, all obligations under the term loan facilities will be secured by
the equipment that is purchased with the proceeds of the term loan facilities.
Amounts drawn under the secured credit facility will bear interest, at the
option of the Company, at the alternate base rate or reserve-adjusted LIBOR plus
applicable margins. The applicable margins for the revolving credit facility and
tranche A term loan facility range from 50 to 175 basis points over the
alternate base rate and from 150 to 275 basis points over LIBOR and are fixed
for the tranche B term loan facility at 2.5% over the alternate base rate and
3.5% over LIBOR. Interest and commitment fees on the revolving credit facility
and the term loan facilities are payable quarterly with specific rates
determined by actual borrowings under each facility.
The revolving credit facility provides for automatic and permanent quarterly
reductions of the amount available for borrowing under that facility, commencing
at $17.25 million on March 31, 2004, and increasing to approximately $61 million
per quarter. The tranche A term loan facility amortizes in consecutive quarterly
payments beginning on March 31, 2004, commencing at $9 million per quarter and
increasing to $58.5 million per quarter. The revolving credit facility and
tranche A term loan facility mature on September 30, 2007. The tranche B term
loan facility amortizes with substantially all of the scheduled payments due in
equal amounts from March 31, 2007 to January 15, 2008.
The Senior Secured Credit Facilities contain certain covenants, which among
other things, limit additional indebtedness, dividend payments, certain
investments and transactions with affiliates. Level 3 and the borrowers must
also comply with specific financial and operational tests and maintain certain
financial ratios.
Debt Issuance costs of $23 million were capitalized and will be amortized as
interest expense over the terms of Senior Secured Credit Facilities.
Level 3 currently intends to use the proceeds from the Senior Secured Credit
Facilities and Subordinated Notes for working capital, capital expenditures and
other general corporate purposes in connection with the implementation of its
business plan, including the acquisition of telecommunications assets.
9.125% Senior Notes
On April 28, 1998, the Company received $1.94 billion of net proceeds from an
offering of $2 billion aggregate principal amount 9.125% Senior Notes Due 2008
("Senior Notes"). Interest on the notes accrues at 9.125% per year and is
payable on May 1 and November 1 each year in cash.
Debt issuance costs of $65 million were capitalized and are being amortized as
interest expense over the term of the Senior Notes.
10.5% Senior Discount Notes
On December 2, 1998, the Company sold $834 million aggregate principal amount at
maturity of 10.5% Senior Discount Notes Due 2008 ("Senior Discount Notes"). The
sales proceeds of $500 million, excluding debt issuance costs, were recorded as
long term debt. Interest on Senior Discount Notes accretes at a rate of 10.5%
per annum, compounded semiannually, to an aggregate principal amount of $834
million by December 1, 2003. Cash interest will not accrue on the Senior
Discount Notes prior to December 1, 2003; however, the Company may elect to
commence the accrual of cash interest on all outstanding Senior Discount Notes
on or after December 1, 2001. Accrued interest expense for the nine months ended
September 30, 1999 on the Senior Discount Notes of $40 million was added to
long-term debt.
Debt issuance costs of $14 million have been capitalized and are being amortized
as interest expense over the term of the Senior Discount Notes.
The Company capitalized $35 and $65 million of interest expense and amortized
debt issuance costs related to network construction and business systems
development projects for the three and nine months ended September 30, 1999 and
$5 million and $6 million for the three and nine months ended September 30,
1998.
10. Employee Benefit Plans
The Company adopted the recognition provisions of SFAS No. 123, "Accounting for
Stock Based Compensation" ("SFAS No. 123") in 1998. Under SFAS No. 123, the fair
value of an option (as computed in accordance with accepted option valuation
models) on the date of grant is amortized over the vesting periods of the
options. 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. Although the recognition of the value of
the stock awards 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 1999 and thereafter. The amount of the
non-cash charges will be dependent upon a number of factors, including the
number of grants and the fair value of each grant estimated at the time of its
award.
Non-Qualified Stock Options and Warrants
The Company granted 55,100 nonqualified stock options with a fair value of $1
million ("NQSO") to employees during the nine months ended September 30, 1999.
The expense recognized for the three and nine months ended September 30, 1999
for NQSOs and warrants outstanding at September 30, 1999 in accordance with SFAS
No. 123 was $1 million and $5 million, respectively. In addition to the expense
recognized, the Company capitalized less than $1 million and $1 million of
non-cash compensation costs for the three and nine months ended September 30,
1999, respectively, related to NQSOs and warrants for employees directly
involved in the construction of the Internet Protocol network and the
development of the business support systems. As of September 30, 1999, the
Company had not recognized $7 million of compensation costs for NQSOs and
warrants granted in 1998 and 1999. The Company recognized $3 million and $9
million of expense for the three and nine months ended September 30, 1998 for
NQSOs and warrants granted during the nine months ended September 30, 1998. In
addition to the expense recognized, the Company capitalized $1 million of
non-cash compensation costs for the three and nine months ended September 30,
1998.
Outperform Stock Option Plan
In April 1998, the Company adopted an outperform stock option ("OSO") program
that was designed so that the Company's stockholders would receive a market
return on their investment before OSO holders receive any return on their
options. The Company believes that the OSO program aligns directly management's
and stockholders' interests by basing stock option value on the Company's
ability to outperform the market in general, as measured by the Standard &
Poor's ("S&P") 500 Index. Participants in the OSO program do not realize any
value from awards unless the 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 awards under the OSO plan is based on a formula
involving a multiplier related to the level by which the Common Stock
outperforms the S&P 500 Index. To the extent that the Common Stock outperforms
the S&P 500, the value of OSOs to a holder may exceed the value of non-qualified
stock options.
OSO grants are made quarterly to participants employed on the date of the grant.
Each award vests in equal quarterly installments over two years and has a
four-year life. Each award typically has a two-year moratorium on exercising
from the date of grant. As a result, once a participant is 100% vested in the
grant, the two year moratorium expires. Therefore, each grant has an exercise
window of two years.
The fair value recognized under SFAS No. 123 for the 2,309,247 OSOs granted to
employees for services performed for the nine months ended September 30, 1999
was $139 million. The Company recognized $35 million and $74 million of
compensation expense for the three and nine months ended September 30, 1999 for
OSOs granted in 1999 and 1998. In addition to the expense recognized, $2 million
and $5 million of non-cash compensation was capitalized for the three and nine
months ended September 30, 1999 for employees directly involved in the
construction of the Internet Protocol network and development of business
support systems. As of September 30, 1999, the Company had not recognized $99
million of compensation costs for OSOs granted in 1998 and 1999. The Company
recognized $9 million and $14 million of expense for the three and nine months
ended September 30, 1998 for OSOs outstanding at September 30, 1998. In addition
to the expense recognized the Company capitalized $1 million of non-cash
compensation for the three and nine months ended September 30, 1998.
Shareworks and Restricted Stock
The Company recorded $3 million and $7 million of non-cash compensation expense
for the three and nine months ended September 30, 1999 related to the Shareworks
and restricted stock programs adopted in the third quarter of 1998. As of
September 30, 1999, the Company had not recognized $9 million of compensation
costs for Shareworks and restricted stock granted in 1998 and 1999. The non-cash
compensation expense for the Shareworks and restricted stock programs was less
than $1 million for the three and nine months ended September 30, 1998.
11. Stockholders' Equity
On March 9, 1999 the Company closed the offering of 28.75 million shares of its
Common Stock through an underwritten public offering. The net proceeds from the
offering of approximately $1.5 billion after underwriting discounts and offering
expenses will be used for working capital, capital expenditures, acquisitions
and other general corporate purposes in connection with the implementation of
the Company's Business Plan.
12. Industry Data
In 1998, the Company adopted SFAS No. 131 "Disclosures about Segments of an
Enterprise and Related Information". SFAS No. 131 establishes standards for
reporting information about operating segments in annual financial statements
and requires selected information about operating segments in interim financial
reports issued to stockholders. Operating segments are components of an
enterprise for which separate financial information is available and which is
evaluated regularly by the Company's chief operating decision maker, or decision
making group, in deciding how to allocate resources and assess performance.
Operating segments are managed separately and represent strategic business units
that offer different products and serve different markets.
The Company's reportable segments include: communications and information
services (including communications, computer outsourcing and systems integration
segments), and coal mining. Other primarily includes California Private
Transportation Company L.P. ("CPTC"), a privately owned tollroad in southern
California, equity investments and other corporate assets and overhead not
attributable to a specific segment.
Industry data for the Company's discontinued construction and energy operations
are not included.
EBITDA, as defined by the Company, consists of earnings (loss) before interest,
income taxes, depreciation, amortization, non-cash operating expenses (including
stock-based compensation and in-process research and development charges) and
other non-operating income or expense. The Company excludes noncash compensation
due to its adoption of the expense recognition provisions of SFAS No. 123.
EBITDA is commonly used in the communications industry to analyze companies on
the basis of operating performance. EBITDA is not intended to represent cash
flow for the periods.
The information presented in the table below includes information for the three
and nine month periods ended September 30, 1999 and 1998 for all income
statement and cash flow information presented and as of September 30, 1999 and
December 31, 1998 for all balance sheet information presented.
Communications & Information Services
Computer Systems Coal
(dollars in millions) Communications Outsourcing Integration Mining Other Total
- ---------------------------------------------------------------------------------------------------------
1999
Three Months Ended September 30, 1999
Revenue $ 36 $ 17 $ 16 $ 60 $ 5 $ 134
EBITDA (105) 4 (4) 25 (25) (105)
Capital Expenditures 903 2 - 1 33 939
Depreciation and
Amortization 51 3 1 2 6 63
Nine Months Ended September 30, 1999
Revenue $ 69 $ 51 $ 48 $ 158 $ 16 $ 342
EBITDA (272) 11 (7) 64 (71) (275)
Capital Expenditures 2,021 7 1 1 124 2,154
Depreciation and
Amortization 111 7 4 4 29 155
1998
Three Months Ended September 30, 1998
Revenue $ 8 $ 16 $ 13 $ 63 $ 6 $ 106
EBITDA (39) 3 (4) 27 (12) (25)
Capital Expenditures 243 1 - - 21 265
Depreciation and
Amortization 9 2 - 1 3 15
Nine Months Ended September 30, 1998
Revenue $ 14 $ 46 $ 42 $ 178 $ 16 $ 296
EBITDA (68) 11 (7) 73 (27) (18)
Capital Expenditures 350 10 3 1 45 409
Depreciation and
Amortization 14 6 1 4 6 31
Identifiable Assets
September 30, 1999 $ 3,119 $ 63 $ 51 $ 347 $5,255 $8,835
December 31, 1998 1,072 59 42 362 3,987 5,522
- -------------------------------------------------------------------------------------------------------------
The following information provides a reconciliation of EBITDA to loss from
continuing operations for the three and nine months ended September 30, 1999 and
1998:
Three Months Ended Nine Months Ended
September 30, September 30,
(in millions) 1999 1998 1999 1998
- -----------------------------------------------------------------------------------------------------------------
EBITDA $ (105) $ (25) $ (275) $ (18)
Depreciation and Amortization Expense (63) (15) (155) (31)
Non-Cash Compensation Expense (39) (12) (86) (23)
Write-off of In-Process Research and Development - - - (30)
------- ------ ----- ------
Loss from Operations (207) (52) (516) (102)
Other (Expense) Income (13) (20) 77 (15)
Income Tax Benefit 73 23 143 28
------- ------ ------ ------
Loss from Continuing Operations $ (147) $ (49) $ (296) $ (89)
======= ====== ====== ======
- ----------------------------------------------------------------------------------------------------------------
13. Related Party Transactions
Peter Kiewit Sons', Inc. ("Kiewit") acted as the general contractor on several
significant projects for the Company in 1999 and 1998. These projects include
the intercity network, local loops and gateway sites, the Company's new
corporate headquarters in Colorado and a new data center in Tempe, Arizona.
Kiewit provided approximately $592 million and $37 million of construction
services related to these projects in the first nine months of 1999 and 1998,
respectively.
Level 3 also receives certain mine management services from Kiewit. The expense
for these services was $9 million and $23 million for the three and nine months
ended September 30, 1999, respectively and $10 million and $27 million for the
three and nine months ended September 30, 1998, respectively, and is recorded in
selling, general and administrative expenses.
14. 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 Class
D Stock (now known as Common Stock).
In August 1999 the Company was named as a defendant in Schweizer vs. Level 3
Communications, Inc. et. al., a purported national class action, filed in the
District Court, County of Boulder, State of Colorado which involves the
Company's right to install its fiber optic cable network in easements and
right-of-ways crossing the plaintiffs' land. In general, the Company obtained
the rights to construct its network from railroads, utilities, and others, and
is installing its network along the rights-of-way so granted. Plaintiffs in the
purported class action assert that they are the owners of lands over which the
Company's fiber optic cable network passes, and that the railroads, utilities,
and others who granted the Company the right to construct and maintain its
network did not have the legal ability to do so. The action purports to be on
behalf of a national class of owners of land over which the Company's network
passes or will pass. The complaint seeks damages on theories of trespass,
unjust enrichment and slander of title and property, as well as punitive
damages. Although the Company is not aware of any additional similar claims,
the issues in the Schweizer litigation that may be based on similar or
different legal theories. Although it is too early for the Company to reach a
conclusion as to the ultimate outcome of this litigation, management
believes that the Company has substantial defenses to the claims asserted in the
Schweizer action (and any similar claims which may be named in the future), and
intends to defend them vigorously.
The Company is involved in various other 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.
Level 3 filed with the Securities and Exchange Commission a "universal" shelf
registration statement covering up to $3.5 billion of common stock, preferred
stock, debt securities and depositary shares that became effective February 17,
1999. On March 9, 1999 the Company received approximately $1.5 billion from the
sale of 28.75 million shares of Common Stock and on September 14, 1999 the
Company sold $823 million aggregate principal amount of its 6% Convertible
Subordinated Notes under the "universal" shelf registration statement.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Management's Discussion and Analysis of Financial Condition
and Results of Operations
The following discussion should be read in conjunction with the Company's
consolidated condensed financial statements (including the notes thereto),
included elsewhere herein.
This document contains forward looking statements and information that are based
on the beliefs of management as well as assumptions made by and information
currently available to the Company. When used in this document, the words
"anticipate", "believe", "estimate" and "expect" and similar expressions, as
they relate to the Company or its management, are intended to identify
forward-looking statements. Such statements reflect the current views of the
Company with respect to future events and are subject to certain risks,
uncertainties and assumptions. Should one or more of these risks or
uncertainties materialize, or should underlying assumptions prove incorrect,
actual results may vary materially from those described in this document. For a
more detailed description for these risks and factors, please see the Company's
additional filings with the Securities and Exchange Commission.
Recent Developments
BusinessNet Ltd. Acquisition
On January 5, 1999, Level 3 acquired BusinessNet Ltd., a leading London-based
Internet service provider in a largely stock-for-stock transaction valued at $12
million and accounted for as a purchase. After completion of certain
adjustments, the Company agreed to issue approximately 400,000 shares of Common
Stock and paid $1 million in cash in exchange for all of the issued and
outstanding shares of BusinessNet's capital stock. Of the approximately 400,000
shares Level 3 agreed to issue in connection with the acquisition, approximately
150,000 shares of its common stock have been pledged to Level 3 to secure
certain indemnification obligations of the former BusinessNet stockholders. In
October 1999, Level 3 released approximately 42,000 shares pursuant to the
acquisition agreement. The pledge of the remaining shares will terminate
approximately 18 months from the transaction date. Liabilities exceeded assets
acquired, and goodwill of $16 million was recognized from the transaction which
is being amortized over five years.
Common Stock Offering
On March 9, 1999 the Company closed the offering of 28.75 million shares of its
Common Stock through a public offering under the February 17, 1999 "universal"
shelf registration statement. The net proceeds from the offering of
approximately $1.5 billion, after underwriting discounts and offering expenses,
will be used for working capital, capital expenditures, acquisitions and other
general corporate purposes in connection with the implementation of the Business
Plan.
Increase in Authorized Shares Outstanding
On February 25, 1999, the Board of Directors approved an increase in the number
of authorized shares of Common Stock from 500 million to 1 billion. On April 12,
1999, the Board of Directors approved a further increase in the number of
authorized shares of Common Stock by 500 million to 1.5 billion. The Company's
stockholders approved the increase in authorized shares at its 1999 Annual
Meeting held on May 27, 1999.
Transatlantic Cable
On April 23, 1999, Level 3 announced that it had contracted with Tyco Submarine
Systems Ltd. to design and build a transatlantic terabit cable system from Long
Island, New York to North Cornwall, UK. The cable system is expected to be in
service by September 2000 and is expected to cost between $600 to $800 million.
The total cost will depend on how the cable is upgraded over time. Level 3 has
prefunded the purchase of significant amounts of undersea capacity as part of
the Business Plan, but may require additional funding depending on the cable's
ultimate structure, pre-construction sales and ownership.
European Network
Level 3 announced on April 29, 1999 that it had finalized contracts relating to
construction of Ring 1 of its European network in France, Belgium, the
Netherlands, Germany and the United Kingdom. Ring 1, which is approximately
2,000 miles, will connect Paris, Frankfurt, Amsterdam, Brussels and London. The
network is expected to be ready for service by September 2000. Ring 1 is part of
the approximately 4,750 mile intercity network that will ultimately connect a
minimum of 13 local city networks in Europe. This European network will be
linked to the Level 3 North American intercity network by the Level 3
transatlantic terabit cable system currently under development, also expected to
be ready for service by September 2000.
On July 26, 1999, the Company announced two important developments of its
European network build with agreements with Eurotunnel and Alcatel. Eurotunnel
will provide Level 3 with multiple cross-Channel cables between the United
Kingdom and continental Europe. Eurotunnel will install and supply Level 3 with
multiple cross-Channel cables between the United Kingdom and France through the
high-security service tunnel. The first of these cables will be completed by the
first quarter of 2000. Subsequent cables will be installed to upgrade and expand
the network as and when required or when new fiber technology becomes available.
Alcatel will provide Level 3 with a cross-Channel undersea cable link between
the United Kingdom and Belgium. Alcatel will design, develop, and install an
undersea cable to link the Level 3 network between the United Kingdom and
Belgium. The cable system is already under development and is expected to be
completed during the first quarter of 2000.
Colt Cost Sharing Agreement
On May 4, 1999, Level 3 and Colt Telecom Group plc ("Colt") announced an
agreement to share costs for the construction of European networks. The
agreement calls for Level 3 to share construction costs of Colt's planned 1,600
mile intercity German network linking Berlin, Cologne, Dusseldorf, Frankfurt,
Hamburg, Munich and Stuttgart. In return, Colt will share construction costs of
Ring 1 of Level 3's planned European network.
Lucent Agreement
On June 23, 1999 Level 3 announced a minimum four year, $250 million strategic
agreement with Lucent Technologies to purchase Lucent systems, including new
software switches or "softswitches." The minimum purchase commitment is subject
to certain conditions and has the potential to grow to $1 billion over five
years.
Under this non-exclusive agreement, Lucent will provide Level 3 its Lucent
Technologies Softswitch, a software switch for Internet Protocol networks that
is intended to combine the reliability and features that customers expect from
the public switched telephone network with the cost effectiveness and
flexibility of Internet Protocol technology. With the Lucent Softswitch, Level 3
expects to provide a full range of Internet Protocol-based communications
services similar in quality and ease of use to service on traditional circuit
voice networks. In addition, the companies also agreed to collaborate on future
enhancements of softswitches and gateway products to support next-generation
broadband services for business and consumers that will combine high-quality
voice and video communications with Internet-style web data services.
6% Convertible Subordinated Notes
Level 3 filed a "universal" shelf registration statement covering up to $3.5
billion of common stock, preferred stock, debt securities and depository shares
that became effective February 17, 1999. On September 14, 1999 the Company
closed the offering of $823 million aggregate principal amount of its 6%
Convertible Subordinated Notes Due 2009. The net proceeds from the offering of
approximately $798, after underwriting discounts and offering expenses, will be
used for working capital, capital expenditures, acquisitions and other general
corporate purposes in connection with the implementation of its business plan,
including the acquisition of telecommunications assets.
Senior Secured Credit Facilities
On September 30, 1999 the Company entered into $1.375 billion of senior secured
credit facilities. The facilities are comprised of a senior secured revolving
credit facility in the amount of $650 million and a two-tranche senior secured
term loan facility aggregating $725 million. At September 30, 1999 the Company
borrowed $475 million under the two-tranche secured term loan facility. These
funds and the prepaid interest are restricted until certain state regulatory
approvals are obtained.
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 Internet Protocol 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 it may not be able to achieve or sustain operating
profitability in the future.
Third Quarter 1999 vs. Third Quarter 1998
Revenue for the quarters ended September 30, is summarized as follows (in
millions):
1999 1998
Communications and Information Services $ 69 $ 37
Coal Mining 60 63
Other 5 6
----- -----
$ 134 $ 106
===== =====
Communications and information services revenue for the three months ended
September 30, 1999 increased 86% compared to the same period in 1998. New
products which the Company began offering in late 1998 and early 1999, including
private line, colocation and managed modem services, provided $36 million of
revenue for the communications segment in 1999. In 1998, communications revenue
of $8 million was directly attributable to XCOM which was acquired in April
1998. A significant portion of XCOM's revenue is attributable to reciprocal
compensation agreements with Bell Atlantic. These agreements require the company
originating a call to compensate the company terminating the call. The Federal
Communication Commission ("FCC") has been considering whether local carriers are
obligated to pay compensation to each other for the transport and termination of
calls to Internet service providers when a local call is placed from an end user
of one carrier to an Internet service provider served by the competing local
exchange carrier. Earlier this year, the FCC determined that it had no rule
addressing inter-carrier compensation for these calls. The FCC also released for
comment alternative federal rules to govern compensation for these calls in the
future. If state commissions, the FCC or the courts determine that inter-carrier
compensation does not apply, carriers, including the Company, may be unable to
recover their costs or will be compensated at a significantly lower rate and may
be required to refund amounts previously received. In May 1999 the
Massachusetts Department of Public Utilities ruled that Bell Atlantic was no
longer required to pay the established reciprocal compensation rates for certain
services. As a result Level 3 elected, effective at the beginning of the second
quarter of 1999, not to recognize this revenue source until these uncertainties
were resolved. Bell Atlantic also notified the Company that it would escrow all
amounts due the Company under the reciprocal compensation agreements until the
issue was resolved. The Company reached a tentative agreement with Bell Atlantic
in October 1999. The agreement establishes new intercarrier or reciprocal
compensation rates between the two carriers and assures that the Company will be
paid for the traffic it terminates from Bell Atlantic. As part of the agreement,
the Company and Bell Atlantic have also settled past disputes over reciprocal
compensation billing issues. The implementation of the new rate structure and
the reciprocal compensation billing settlements are contingent upon certain
conditions including approval by relevant regulatory authorities. Revenue
attributable to the Bell Atlantic settlement agreement will not be recognized
until the uncertainties related to the regulatory approvals have been resolved.
Revenue for the computer outsourcing and systems integration businesses
increased 6% and 23% to $17 million and $16 million, respectively. The growth
for the computer outsourcing business is attributable to additional services
provided to existing customers while the increase in system integration revenue
is due to application outsourcing work performed for new clients.
Coal mining revenue decreased $3 million, or 5% in the third quarter of 1999
compared to the same period in 1998. This decrease is primarily due to the
expiration of a long-term coal contract in 1998. The expiration of these
contracts are expected to result in a 10% decline in coal revenues in 1999.
Partially offsetting this decline was an increase in shipments taken by
Commonwealth Edison Company ("Commonwealth"). Commonwealth is obligated to
purchase annually, minimum amounts of coal; however, it is Commonwealth's option
as to when the coal will be purchased.
If current market conditions continue, the Company will experience a significant
decline in coal revenue and earnings beginning in 2001 as delivery requirements
under long-term contracts decline as additional long-term contracts begin to
expire.
Other revenue is primarily attributable to CPTC, a privately owned tollroad in
southern California.
Cost of Revenue increased 113% in 1999 to $100 million from $47 million in 1998.
This increase was primarily due to the continued expansion of the communications
and information services businesses. Cost of revenue for the communications
business is expected to increase substantially in the future as the Company
continues to increase the number of markets in which it offers services and the
products available in each of those markets. The cost of revenue for the
information services business was consistent with the corresponding increase in
revenue. The cost of revenue for the coal business, as a percentage of revenue,
increased approximately 2% due to the expiration of the higher margin long-term
contract in 1998.
Depreciation and Amortization expense increased to $63 million in 1999 from $15
million in 1998. The commencement of operations in 26 U.S. and 4 European
markets and the completion of the initial installation of 17 local networks in
the second half of 1998 and 1999 resulted in the higher depreciation expense in
1999. In addition, the amortization of goodwill attributable to the acquisitions
of GeoNet, BusinessNet and others contributed to the higher depreciation and
amortization expense in 1999.
Selling, General and Administrative expenses increased significantly in 1999 to
$178 million from $96 million in 1998 primarily due to the cost of activities
associated with the expanding communications business. The Company incurred
incremental compensation and travel costs for the substantial number of new
employees that have been hired to implement the Business Plan. The total number
of employees of the Company increased to approximately 3,600 at September 30,
1999. Professional fees and other development costs associated with the
Company's plans to expand services offered in the U.S., Europe and Asia,
consulting fees to develop and implement the Company's business support systems,
and advertising, marketing and other selling costs for the Company's new
Internet Protocol products and services also increased selling, general and
administrative expenses. In addition to the costs to expand the communications
and information services businesses, the Company recorded $39 million of
non-cash compensation expense in the third quarter of 1999 under SFAS No. 123
related to grants of stock options and warrants. General and administrative
costs are expected to increase significantly in future periods as the Company
continues to implement the Business Plan.
EBITDA, as defined by the Company, consists of earnings (losses) before
interest, income taxes, depreciation, amortization, non-cash operating expenses
(including stock-based compensation and in-process research and development
charges) and other non-operating income or expenses. EBITDA was $(25) million in
1998 and $(105) million in 1999. The primary reason for the decrease between
periods is the significant increase in cost of revenue and selling, 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 decreased 4% in 1999 to $51 million from $53 million in 1998.
The Company's average cash, cash equivalents and marketable securities balance
increased slightly from approximately $3.7 billion during the third quarter of
1998 to approximately $3.9 billion during the third quarter of 1999. However,
the weighted average yield for the Company's portfolio decreased by
approximately 50 basis points in 1999 primarily due to the funds being invested
in shorter term treasury securities. 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 lower yields on the funds, but is expected
to reduce the risk to principal in the short term prior to using the funds in
implementing the Business Plan.
Interest Expense, net decreased from $46 million in 1998 to $34 million in 1999.
This decrease is a direct result of capitalized interest for network
construction and business support systems increasing from $5 million for the
three months ended September 30, 1998 to $35 million for the corresponding
period in 1999. Interest costs on the Company's outstanding debt increased due
to the issuance in December 1998 of $834 million aggregate principal amount at
maturity of 10.5% Senior Discount Notes due 2008 and the $823 million of 6%
Subordinated Convertible Notes due 2009 issued in September of this year. The
amortization of debt issuance costs associated with the Senior Discount Notes
and Convertible Subordinated Notes also increased interest expense in 1999.
Interest costs will continue to increase due to the Senior Secured Credit
Facilities entered into by the Company on September 30, 1999.
Gain on Equity Investee Stock Transactions was $5 million in 1999. In the third
quarters of 1998 and 1999 RCN issued stock for certain acquisitions which
diluted the Company's ownership of RCN but increased its proportionate share of
RCN's net assets. The increase in the Company's proportionate share of RCN's net
assets resulted in a pre-tax gain of $5 million for the Company in the third
quarter of 1999. In 1998, the Company recognized a $4 million gain in the third
quarter related to RCN stock activity.
Other Expense, net increased in 1999 to $35 million from $31 million. Other
expense consists primarily of the Company's share of losses incurred by the
Company's equity method investees, principally RCN. RCN is incurring significant
costs in developing its business plan including the acquisitions of several
Internet service providers. The Company recorded $37 million of equity losses
attributable to RCN in the third quarter of 1999, as compared to $22 million in
the third quarter of 1998. In 1998, the Company elected to discontinue its
funding of Gateway Opportunity Fund, LP, ("Gateway"), which provided venture
capital to developing businesses. The Company recorded losses of $11 million in
the third quarter of 1998 to reflect Level 3's equity in losses of the
underlying businesses of Gateway. Also included in other expense are equity
earnings in Commonwealth Telephone Enterprises, Inc., and realized gains and
losses on the sale of other assets each not individually significant to the
Company's results of operations.
Income Tax Benefit in 1998 and 1999 differs from the statutory rate of 35%
primarily due to losses incurred by the Company's international subsidiaries
which cannot be included in the consolidated U.S. federal return, nondeductible
goodwill amortization expense and state income taxes.
Nine Months 1999 vs. Nine Months 1998
Revenue for the nine months ended September 30, is summarized as follows (in
millions):
1999 1998
Communications and Information Services $ 168 $ 102
Coal Mining 158 178
Other 16 16
------ -----
$ 342 $ 296
====== =====
Communications and information services revenue increased from $102 million for
the nine months ended September 30, 1998 to $168 million for the nine months
ended September 30, 1999. In May 1999 the Massachusetts Department of Public
Utilities ruled that Bell Atlantic was no longer required to pay the established
reciprocal compensation rates for certain services. As a result, Level 3 elected
not to recognize additional revenue, beginning in the second quarter, from these
agreements until the uncertainties are resolved. The Company reached a tentative
agreement with Bell Atlantic in October 1999. The agreement establishes new
intercarrier or reciprocal compensation rates between the two carriers and
assures that the Company will be paid for the traffic it terminates from Bell
Atlantic. As part of the agreement, the Company and Bell Atlantic have also
settled past disputes over reciprocal compensation billing issues. The
implementation of the new rate structure and reciprocal compensation billing
settlement are contingent upon certain conditions including approval by relevant
regulatory authorities. Revenue attributable to the Bell Atlantic settlement
agreement will not be recognized until the uncertainties related to the
regulatory approvals have been resolved.
Systems integration revenue increased 14% to $48 million in 1999. Revenue for
the computer outsourcing business increased 11% to $51 million in 1999. Revenue
attributable to new customers and additional services for existing customers led
to the increase in computer outsourcing and systems integration revenue.
Mining revenue in 1999 decreased to $158 million from $178 million in 1998 due
to timing of shipments taken by Commonwealth. The purchase agreement with
Commonwealth requires that minimum amounts of coal must be purchased; however,
it does not stipulate when the coal must be purchased. In addition, the
expiration of a long-term contract in late 1998 will result in an approximate
10% decline in 1999 coal sales from 1998 levels.
Other revenue, was consistent with 1998, and is primarily attributable to CPTC.
Cost of Revenue increased $105 million or 76% to $243 million in 1999 as a
result of the expanding communications business. In 1999 network expenses were
$107 million as compared to $4 million in the prior year. The increase in costs
is primarily attributable to the XCOM and GeoNet acquisitions, the costs
associated with the Frontier and IXC Communications leases and costs
attributable to the products the Company began offering in late 1998 and 1999.
The cost of revenue, as a percentage of revenue, for the information services
business increased slightly for the nine months ended September 30, 1999
compared to the same period in 1998. The increase is primarily due to the costs
incurred by the systems integration segment to transition from Year 2000
services to systems and software reengineering for Internet Protocol related
applications. The cost of revenue for the coal business as a percentage of
revenue, increased due to the expiration of the high margin long-term contract
in 1998.
Depreciation Expense increased from $31 million in 1998 to $155 million in 1999.
The significant increase in the amount of assets placed in service during the
last half of 1998 and first nine months of 1999 for the communications business
resulted in the increase in depreciation expense. The acquisitions of XCOM,
GeoNet and BusinessNet in 1998 and 1999 resulted in goodwill amortization
increasing to $26 million in 1999.
Selling, General and Administrative expenses increased significantly to $460
million in 1999 from $199 million in 1998 primarily due to the cost of
activities associated with the expanding communications business. Compensation,
travel and facilities costs increased substantially due to the additional
employees that have been hired to implement the Business Plan. The total number
of employees of the Company increased to approximately 3,600 at September 30,
1999. Professional fees, including legal costs associated with obtaining
licenses, agreements and technical facilities and other development costs
associated with the Company's plans to expand services offered in U.S., European
and Asian markets, consulting fees incurred to develop and implement the
Company's business support systems, and advertising, marketing and other selling
costs contributed to higher selling, general and administrative expenses. In
addition, the Company recorded $86 million of non-cash compensation in the first
nine months of 1999 for expenses recognized under SFAS No. 123 related to grants
of stock options and warrants, up from $23 million in 1998. As the Company
continues to implement the Business Plan, general and administrative costs are
expected to continue to increase significantly.
Write-off of In-Process Research and Development of $30 million in 1998 was the
portion of the purchase price allocated to the telephone network-to-Internet
Protocol network bridge technology acquired by the Company in the XCOM
transaction and was estimated through formal valuation. 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 decreased from $(18) million in 1998 to $(275) million in 1999. The
primary reason for the decrease between periods is the significant increase in
cost of revenue and selling, general and administrative expenses, described
above, incurred in connection with the implementation of the Business Plan.
Interest Income increased substantially from $124 million in 1998 to $158
million in 1999 primarily as a function of the Company's increasing average
cash, cash equivalents and marketable securities balances. The average cash
balance increased from approximately $2.9 billion during the first nine months
of 1998 to approximately $4 billion during the first nine months of 1999. Yields
on the portfolio, however, have declined slightly from 1998. The accelerating
Business Plan has required the Company to shorten the average term of treasury
securities in which it invests in 1999. 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 lower yields on the
funds, but is expected to reduce the risk to principal in the short term prior
to using the funds in implementing the Business Plan.
Interest Expense, net increased $46 million to $132 million in 1999 due to the
completion of the offering of $2 billion aggregate principal amount of 9.125%
Senior Notes Due 2008 in April 1998, $834 million aggregate principal amount at
maturity of 10.5% Senior Discount Notes Due 2008 offered in the fourth quarter
of 1998 and the 6% Convertible Subordinated Notes issued in September 1999. The
amortization of the related debt issuance costs also contributed to the
increased interest expense in 1999. The Company capitalized $65 million and $6
million of interest expense on network construction and business support systems
in the first nine months of 1999 and 1998, respectively.
Gain on Equity Investee Stock Transactions increased to $116 million during the
first nine months of 1999. RCN issued stock in a public offering and for certain
transactions which diluted the Company's ownership of RCN from 41% at December
31, 1998 to 35% at September 30, 1999. The increase in the Company's
proportionate share of RCN's net assets as a result of these transactions
resulted in a pre-tax gain of $116 million from subsidiary stock sales for the
Company in the first nine months of 1999. The Company recognized $25 million of
gains for similar stock transactions of RCN in 1998.
Other Expense, net decreased to $65 million in 1999 from $78 million in 1998.
Other expense consists of the Company's share of losses incurred by the
Company's equity method investees, primarily RCN. RCN is incurring significant
costs in developing its business plan including the acquisitions of several
Internet service providers. The Company recorded $90 million of equity losses
attributable to RCN in the first nine months of 1999, as compared to $75 million
in the first nine months of 1998. The Company also sold 1.2 million shares of
Burlington Resources common stock, resulting in a pre-tax gain of $17 million
for the Company in 1999. In 1998, the Company elected to discontinue its funding
of Gateway Opportunity Fund, L.P., which provided venture capital to developing
businesses. The Company recorded losses of $18 million in 1998 to reflect Level
3's equity in losses of the underlying businesses of Gateway. Equity earnings of
Commonwealth Telephone Enterprises, Inc. and gains on the disposition of other
assets were not individually significant in the first nine months of 1999 or
1998.
Income Tax Benefit in 1998 and 1999 differs from the statutory rate of 35%
primarily due to losses incurred by the Company's international subsidiaries
which cannot be included in the consolidated U.S. federal return, nondeductible
goodwill amortization expense and state income taxes. The income tax benefit in
1998 also differs from the statutory rate due to the $30 million nondeductible
write-off of the research and development costs acquired in the XCOM
acquisition.
Discontinued Operations includes the one-time gain of $608 million recognized
upon the distribution of the Construction Group to former Class C stockholders
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 MidAmerican
on January 2, 1998.
Financial Condition - September 30, 1999
The Company's working capital increased $624 million during 1999 from $3.5
billion at December 31, 1998 to $4.1 billion at September 30, 1999. The increase
was primarily due to the $1.5 billion equity offering completed in March 1999,
the $823 million offering of Convertible Subordinated Notes and the $475 million
proceeds from the $1.375 billion of Senior Secured Credit Facilities, both
completed in September 1999. The proceeds from these offerings were partially
offset by the capital expenditures and operating expenses incurred to implement
the Business Plan.
Cash provided by continuing operations increased from $128 million in 1998 to
$360 million in 1999 primarily due to the changes in components of working
capital and an increase in interest income. Interest income increased in 1999 as
a result of the proceeds received from the Senior Notes, Senior Discount Notes,
Convertible Subordinated Notes and the March 1999 equity offering. The increase
in cash provided by interest income was partially offset by the semi-annual
payment of interest on the Senior Notes. Interest payments on the Senior
Discount Notes are deferred until 2004. An increase in the costs paid to
implement the Business Plan also reduced cash provided by continuing operations.
Investing activities include the purchase and sale of approximately $4.3 billion
and $4.4 billion, respectively, of marketable securities. The Company also
incurred costs of $2.1 billion for capital expenditures, primarily for the
expanding communications business. In addition, the Company realized $11 million
of proceeds from the sale of property, plant and equipment.
Financing sources in the first nine months of 1999 consisted primarily of the
net proceeds of $475 million from the Senior Secured Credit Facilities, net
proceeds of $798 million from the offering of $823 million aggregate principal
amount of 6% Convertible Subordinated Notes Due 2009, net proceeds of $1.5
billion from the issuance of 28.75 million shares of Common Stock and the
exercise of the Company's stock options for $18 million. The proceeds from the
Senior Secured Credit Facilities and prepaid interest have been placed in an
escrow account until the necessary regulatory approvals have been received. The
Company also repaid long-term debt of $5 million during the first nine months of
1999.
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 property, plant and equipment necessary to provide its services)
of a broad range of integrated communications services. To reach this goal, the
Company is expanding substantially the business of its subsidiary, PKS
Information Services, Inc. to create, through a combination of construction,
purchase and leasing of facilities and other assets, an advanced, international,
facilities based communications network. The Company is designing its network
based on Internet Protocol 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, may
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, the actual
construction costs or the timing of the expenditures may deviate from current
estimates. The Company estimates that its capital expenditures in connection
with the Business Plan will approximate $3 billion in 1999. The Company's
current liquidity and the agreement with INTERNEXT 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 $9 and $11 billion over the 10 year
period of the Business Plan. 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 credit facilities and other
borrowings, including the $1.375 billion secured credit facility entered into on
September 30, 1999, and sales or issuance of additional equity securities or
additional debt securities. The 9 1/8% senior notes and the 10 1/2% senior
discount notes were issued under indentures which permit the Company and its
subsidiaries to incur substantial amounts of debt. After the 6% Convertible
Subordinated Notes offering, the Company has approximately $1.1 billion of
securities available for future issuances under the "universal" shelf
registration statement that was declared effective by the Securities and
Exchange Commission in February 1999.
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
fiber optic capacity, or access to its conduits. The Company may not be
successful in producing sufficient cash flow, raising sufficient debt or equity
capital on terms that it will consider acceptable, or selling or leasing fiber
optic capacity or access to its conduits. In addition, proceeds from
dispositions of the Company's assets may not reflect the assets' intrinsic
value. Further, expenses may exceed the Company's estimates and the financing
needed may be higher than estimated. Failure to generate sufficient funds may
require the Company to delay or abandon some of its future expansion or
expenditures, which could have a material adverse effect on the implementation
of the Business Plan.
The Company may not be able to obtain such financing if and when it is needed
and, if available, such financing may not 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.
Year 2000
General
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. The 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, these
products are being tested to confirm they are Year 2000 ready.
PKS Systems Integration LLC ("PKSSI"), a subsidiary of PKS Information Services,
Inc. ("PKSIS") provides a wide variety of information technology services to its
customers. In fiscal year 1998, approximately 57% of the revenue generated by
PKSSI related to projects involving Year 2000 assessment and renovation services
performed by PKSSI for its customers. These contracts generally require PKSSI to
identify date affected fields in certain application software of its customers
and, in many cases, PKSSI 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 PKSSI provides to its customers. This exposes PKSSI to
potential risks that may include problems with services provided by PKSSI to its
customers and the potential for claims arising under PKSSI's customer contracts.
PKSSI 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.
Outlined below is additional information with respect to the Year 2000
compliance programs that are being pursued by Level 3 Communications, LLC and
PKSIS.
Level 3 Communications, LLC
Level 3 Communications, LLC ("Level 3"), uses software and related technologies
throughout its business that may be affected by the date change in the Year
2000. The inability of systems to appropriately recognize the Year 2000 could
result in a disruption of Level 3's operations. Level 3 has one main line of
business: delivery of communications services to commercial clients over
fiber optic cable. The delivery of service will be over Level 3 owned cable
when the network construction is complete. In the interim, services will be
delivered over both owned and leased lines.
Level 3 faces two primary Year 2000 issues with respect to its business. First,
Level 3 must assess the readiness of its systems that are required to provide
its customer's communications services ("Service Delivery Systems"). Second,
Level 3 must evaluate the Year 2000 readiness of its internal business support
systems ("Internal Business Support Systems"). Level 3 must also verify the
readiness of the providers of the leased lines currently in use.
Level 3 has designated a full-time Year 2000 director in addition to
establishing a program office staffed in part by experienced Year 2000
consultants. Level 3 is progressing through a comprehensive program to evaluate
and address the effect of the Year 2000 on its Internal Business Support
Systems, and the Service Delivery Systems. The plans' focus upon Year 2000
issues consists of the following phases:
Phase
(I) Assessment - Awareness, commitment, and evaluation which includes a
detailed inventory of systems and services that the Year 2000 may
impact.
(II) Detailed Plan - Establishment of priorities, development of specific
action steps and allocation of resources to address the issues as
outlined in Phase I.
(III) Implementation - Completion of the necessary changes as delineated
in Phase II.
(IV) Verification - Determining whether the conversions implemented in Phase
III have resolved the Year 2000 problem so that date related
calculations will function properly, both as individual units and on an
integrated basis. This will culminate in an end-to-end system test to
ensure that the customer services being delivered by Level 3 will
function properly and that all support services necessary to business
operations will be Year 2000 compliant.
(V) Contingency Plans - Establishment of alternative plans should any of
the services or suppliers that Level 3 requires to do business fail to
be Year 2000 ready.
With respect to its Year 2000 plans, Level 3 currently has activities underway
primarily in phases IV and V. The current stage of activities varies based upon
the type of component, system, and/or customer service at issue.
Business Functions Operational Effect Current Status
- --------------------------------------------------------------------------------
Customer Delivery Systems Inability to deliver Phases IV to Phase V*
Customer Services
Internal Business
Support Systems Failures of Internal Phases IV to Phase V*
Support Services and
Customer Billing
* Level 3 anticipates this range of activity to continue through 1999 as it
adds new equipment and services while building its infrastructure.
Additionally, the upgrading of service delivery through its proprietary
systems will require that the delivery systems go through verification
with each new innovation.
The expenses associated with this project by Level 3, as well as the related
potential effect on Level 3's earnings, are not expected to have a material
effect on the future operating results or financial condition of Level 3. There
can be no assurance, however, that the Year 2000 problem, and any loss incurred
by any customers of Level 3 as a result of the Year 2000 problem, will not have
a material adverse effect on Level 3's financial condition and results of
operations.
Level 3 has significant relationships and dependencies with regard to systems
and technology provided and supported by third party vendors and service
providers. In particular, the customer delivery systems for the communications
business of Level 3 are dependent upon third parties who provide
telecommunication services while the infrastructure continues to be built. As
part of its Year 2000 program, Level 3 has sought to obtain formal Year 2000
compliance representation from vendors who provide products and services to
Level 3. The vendor compliance process is being performed concurrently with the
Company's ongoing Year 2000 validation activities. This compliance process
consists of obtaining information from disclosures made publicly available on
company websites, reviewing test plans and results made available from
suppliers, and following up with letters and phone calls to any vendors who have
not made such information available to Level 3 as yet.
Because of the aforementioned reliance placed on third party vendors, Level 3's
estimate of costs to be incurred could change substantially should one or more
of the vendors be unable to timely deliver Year 2000 compliant products. Level 3
does not own the proprietary hardware technology or third party software source
code utilized in its business and therefore, Level 3 cannot actually renovate
the hardware or third party software identified as having Year 2000 support
issues. The standard components supplied by vendors for the customer delivery
systems have been tested in laboratory settings and certified as to their
compliance.
With respect to the contingency plans for Level 3, such plans generally fall
into two categories. Concerning the customer delivery systems of Level 3, Level
3 has certain redundant and backup facilities, such as on-site generators. With
respect to systems obtained from third party vendors, contingency plans are
developed by Level 3 on a case by case basis where deemed appropriate.
PKSIS
PKSIS and its subsidiaries use software and related technologies throughout its
business that may be affected by the date change in the Year 2000. The inability
of systems to appropriately recognize the Year 2000 could result in a disruption
of PKSIS operations. PKSIS has two main lines of business: computer outsourcing
and systems integration. The computer outsourcing business is managed by PKS
Computer Services LLC ("PKSCS"). The systems integration is managed by PKSSI.
PKSCS generally faces two primary Year 2000 issues with respect to its business.
First, PKSCS must evaluate the Year 2000 readiness of its internal support
systems. Second, PKSCS must assess and, if necessary, upgrade the operating
environments which PKSCS provides for its outsourcing customers. PKSCS
outsourcing customers are responsible for their own application code
remediation.
PKSCS established a corporate-wide Year 2000 program in 1997, which in relation
to other business projects and objectives has been assigned a high priority,
including the designation of a full-time year 2000 director. PKSCS is
progressing through a comprehensive program to evaluate and address the effect
of the Year 2000 on its internal operations and support systems, and the
operating systems which PKSCS is responsible for providing to its outsourcing
customers. Due to the nature of its business, PKSCS has developed and is
administering approximately twenty separate Year 2000 project plans.
Approximately eighteen of these plans are devoted to the specific operating
systems software upgrades to be undertaken by PKSCS for its outsourcing
customers according to software vendor specifications. The remaining plans
focus upon Year 2000 issues relating to PKSCS internal support systems.
PKSCS is utilizing both internal and external resources in implementing
these plans. These PKSCS plans generally consist of the following phases:
Phase
(I) Assessment - Awareness, commitment, and evaluation, which includes a
detailed inventory of systems and services that the Year 2000 may
impact.
(II) Detailed Plan - Establishment of priorities, development of specific
action steps and allocation of resources to address the issues as
outlined in Phase I.
(III) Implementation - Completion of the necessary changes per vendor
specifications, (that is, replacement or retirement) as outlined in
Phase II.
(IV) Verification - With respect to PKSCS' internal support systems,
determining whether the conversions implemented in Phase III have
resolved the Year 2000 problem so that date related calculations will
function properly, both as individual units and on an integrated basis.
(V) Completion - The final rollout of components into an operational unit.
(VI) Tracking - Monitor vendor specifications to assess ongoing replacement
of components as dictated by the vendors.
With respect to its Year 2000 plans, PKSCS currently has activities underway in
phases V and VI. The current stage of activities varies based upon the type of
component, system, and/or customer service at issue. Some PKSCS customers had
delayed or postponed operating system upgrades to be performed by PKSCS as a
result of the customer's delay in its application code remediation schedule. To
date, PKSCS, as directed and approved by its customer base, has completed
required IBM System 390 operating system upgrades to Year 2000 readiness
software versions. PKSCS continues to monitor vendor Year 2000 version
acceptance specifications to assess ongoing replacement of components as
dictated by the vendors.
PKSSI generally faces two primary Year 2000 issues with respect to its business.
First, PKSSI provides a wide variety of information technology services to its
customers which could potentially expose PKSIS to contractual liability for Year
2000 related risks if services are not performed in a timely or satisfactory
manner. Second, PKSSI must evaluate and, if necessary, upgrade or replace its
internal business support systems which may have date dependencies. PKSSI
believes the primary internal systems affected by the Year 2000 issue which
could have an impact on its business are desktop and network hardware and
software. PKSSI previously completed its Year 2000 assessment of desktop and
network hardware and software, and, based on vendor representations, determined
that some upgrades and replacements are required. PKSIS is in the process of
upgrading and replacing certain desktop and network hardware and software
previously identified as non-Year 2000 ready, which such upgrade and
replacement activities are targeted for completion in November 1999. PKSIS
continues to validate these findings and currently plans to do so throughout
the remainder of 1999. PKSSI is also in the process of communicating with
its vendors to assess its servers and communications hardware for Year 2000
readiness.
In fiscal year 1998, approximately 57% of the revenue generated by PKSSI related
to projects involving Year 2000 assessment and renovation services performed by
PKSSI for its customers. This is a reduction from 80% in 1997. Some of these
contracts require PKSSI to identify date affected fields in certain application
software of its customers and, in many cases, PKSSI undertakes efforts to
remediate those date-affected fields so that Year 2000 data may be processed.
Thus, Year 2000 issues affect certain services PKSSI provides to its customers.
This exposes PKSSI to potential risks that may include problems with services
provided by PKSSI to its customers and the potential for claims arising under
PKSSI's customer contracts. In some cases PKSSI has contractual warranties which
could require PKSSI to perform Year 2000 related services after the year 2000.
PKSSI attempts to contractually limit its exposure to liability for Year 2000
compliance issues. However, there can be no assurance as to the effectiveness of
such contractual limitations.
The following chart describes the status of PKSIS' Year 2000 program with
respect to Computer Outsourcing Services and Systems Integration Services.
Business Current Areas of
Functions Focus Operational Impact Current Status
- -------------------------- ----------------------------- ------------------------- -------------------------
Computer Outsourcing Large & Mid-Range CPU Inability to continue Phase V to Phase VI
Service OEM Software critical processing of
OS Systems customer's systems
Network Equipment
Support Facilities
Internal Support Systems & Failures of critical Phase V to Phase VI
Business Processes Internal Support
Services
Systems Integration Internal Support Systems & Failures of critical Assessment of desktop hardware
Services Business Processes Internal Support and software has been completed
Services and is being validated.
Assessment of services
and communications hardware
is expected to be completed
by November 1999.
PKSIS has significant relationships and dependencies with regard to systems and
technology provided and supported by third party vendors and service providers.
In particular, the computer outsourcing business of PKSCS is dependent upon
third parties who provide telecommunication service, electrical utilities and
mainframe and midrange hardware and software providers. As part of its Year 2000
program, PKSIS has sought to obtain formal Year 2000 compliance representation
from vendors who provide products and services to PKSIS. The vendor compliance
process is being performed concurrently with the Company's ongoing Year 2000
remediation activities. PKSCS is also working with its outsourcing customers to
inform them of certain dependencies which exist which may affect PKSIS' Year
2000 efforts and certain critical actions which PKSIS believes must be
undertaken by the customer in order to allow PKSIS to implement its Year 2000
efforts concerning the operating software system provided by PKSCS for its
customers.
To date, PKSCS has received written responses from approximately 40% of the
vendors from whom it has sought Year 2000 compliance statements. With respect to
those key third party vendors and suppliers who have failed to respond in
writing, PKSIS is following up directly with such vendors and suppliers and
obtaining information from other sources, such as disclosures made publicly
available on company websites. Additionally, PKSCS has contracted with an
independent Year 2000 vendor compliance advisory service to assist with PKSCS'
verification of its understanding of each appropriate vendor's product year 2000
readiness and compliance version statements.
Because of this reliance on third party vendors, PKSIS' estimate of costs to be
incurred could change substantially should one or more of the vendors be unable
to timely deliver Year 2000 compliant products. PKSCS does not own the
proprietary hardware technology or third party software source code utilized in
its business and therefore, PKSCS cannot actually renovate the hardware or
software identified as having Year 2000 support issues.
The expenses associated with PKSIS' Year 2000 efforts, as well as the related
potential effect on PKSIS' earnings, are not expected to have a material effect
on the future operating results or financial condition of Level 3. There can be
no assurance, however, that the Year 2000 problem, and any loss incurred by any
customers of PKS as a result of the Year 2000 problem, will not have a material
adverse effect on Level 3's financial condition and results of operations.
With respect to the contingency plans for PKSCS, such plans generally fall into
two categories. Concerning the internal support systems of PKSCS, PKSCS has
certain redundant and backup facilities, such as on-site generators, water
supply and pumps. PKSCS has undertaken contingency plans with respect to these
internal systems by performing due diligence with the vendors of these systems
in order to investigate the Year 2000 compliance status of these systems, and
such systems are tested on a monthly basis. With respect to the operating
systems obtained from third party vendors and maintained by PKSCS for its
outsourcing customers, contingency plans are developed by PKSCS and its
customers on a case by case basis as requested, contracted and paid for by
PKSCS' customers. However, there is no contingency plan for the failure of
operating system software to properly handle Year 2000 date processing. If the
operating system software provided to PKSIS by third party vendors fails at the
PKSCS Data Center, such vendor supplied software is expected to fail everywhere
and no immediate work around could be supplied by PKSCS. In the event computer
hardware supplied by PKSCS for its outsourcing customer fails, some customers
have contracted for contingency plans through disaster recovery arrangements
with a third party which supplies disaster recovery services.
Costs of Year 2000 Issues
Level 3 currently expects to incur approximately $12.5 million of costs in
aggregate, through the end of 1999. These costs primarily arise from direct
costs of Level 3 employees verifying equipment and software as Year 2000 ready.
However, Level 3 does not separately track the internal employee costs incurred
for its Year 2000 projects. Level 3 does track all material costs incurred for
its Year 2000 projects as well as all costs incurred by the Year 2000 program
office. Level 3 has estimated the time and effort expended by its employees on
Year 2000 projects based on an analysis of Year 2000 project plans.
PKSIS incurred approximately $4.2 million of costs to implement its Year 2000
program through 1998, and currently expects to incur an additional approximately
$6.0 million of costs in aggregate, in 1999. Of these costs, PKSIS expects
to incur $24 million to upgrade its internal network infrastructure, including
servers, desktops and phone systems. The remaining costs primarily arise from
direct costs of PKSCS employees working on upgrades per vendor specifications
of operating system software for PKSCS outsourcing customers and the cost of
vendor supplied operating systems software upgrades and the cost of
additional hardware. However, PKSIS does not separately track the internal
costs incurred for its Year 2000 projects and does not track the cost and time
its employees spend on Year 2000 projects. PKSCS has estimated the time and
effort expended by its employees on Year 2000 projects based on an analysis
of Year 2000 project plans. Labor costs for PKSCS' Year 2000 projects were
estimated to be $2.1 million for 1998 and are estimated to be approximately
one million dollars for 1999, when such projects are currently scheduled for
completion. These labor costs will necessarily increase if such projects take
longer to complete. Costs for software upgrades, additional equipment costs and
a test system for PKSCS' Year 2000 projects were estimated to be $2.1 million
for 1998 and are estimated to be $2.5 million for 1999. Such costs are not
available for PKSSI but are not believed to be material. Year 2000 costs for
PKSSI are believed to be substantially less than PKSCS and focus primarily on
the cost of evaluating and, if necessary, upgrading network and desktop hardware
and software. The costs incurred by PKSSI for performing Year 2000 services for
its customers are included within PKSSI's pricing for such services.
Risks Associated with Year 2000 Issues
Due to the complexity of the issues presented by the Year 2000 date change and
the proposed solutions, and the interdependence of external vendor support
services, it is difficult to assess with any degree of accuracy the future
effect of a failure in any one aspect or combination of aspects of the Company's
Year 2000 activities. The Company cannot provide assurance that actual results
will not differ from management's estimates due to the complexity of upgrading
the systems and related technologies surrounding the Year 2000 issue.
Failure by the Company to complete its Year 2000 activities in a timely or
complete manner, within its estimate of projected costs, or failure by third
parties, such as financial institutions and related networks, software
providers, local telephone companies, long distance providers and electricity
providers among others, to correct their systems, with which the Company's
systems interconnect, could have a material effect on the Company's future
results of operations and financial position. Other factors which might cause a
material difference from management's estimate would include, but not be limited
to, the availability and cost of personnel with appropriate skills and abilities
to locate and upgrade relevant computer systems and similar uncertainties, as
well as the related effects on the Company of the Year 2000 problem on the
economy in general, or on the Company's business partners and customers in
particular.
Market Risk
Level 3 is subject to market risks arising from changes in interest rates,
equity prices and foreign exchange rates. The Company's exposure to interest
rate risk increased due to the $1.375 billion Senior Secured Credit Facilities
entered into by the Company in September 1999. As of September 30, 1999, the
Company had borrowed $475 million under Senior Secured Credit Facilities.
Amounts drawn on the term loan and revolving credit facilities bear interest at
the alternate base rate or reserve-adjusted LIBOR rate plus applicable
margins. As the alternate base rate and reserve-adjusted LIBOR rate fluctuate,
so to will the interest expense on amounts borrowed under the facilities. The
Company continues to evaluate alternatives to limit interest rate risk.
Level 3 continues to hold positions in certain publicly traded entities,
primarily Commonwealth Telephone and RCN. The Company accounts for these two
investments using the equity method. The market value of these investments is
approximately $1.560 billion as of September 30, 1999, which is significantly
higher than their carrying value of $332 million. The Company does not currently
have plans to dispose of these investments, however, if any such transaction
occurred, the value received for the investments would be affected by the market
value of the underlying stock at the time of any such transaction. A 20%
decrease in the price of Commonwealth Telephone and RCN stock would result in
approximately a $312 million decrease in fair value of these investments. The
Company does not currently utilize financial instruments to minimize its
exposure to price fluctuations in equity securities.
The Company's Business Plan includes developing and constructing networks in
Europe and Asia. As of September 30, 1999, the Company has invested significant
amounts of capital in Europe and will continue to expand its presence in Europe
and Asia in 1999 and 2000. To date, the Company has not utilized financial
instruments to minimize its exposure to foreign currency fluctuations. The
Company will continue to analyze risk management strategies to reduce foreign
currency exchange risk in the future.
The change in equity security prices is based on hypothetical movements and is
not necessarily indicative of the actual results that may occur. Future earnings
and losses will be affected by actual fluctuations in interest rates, equity
prices and foreign currency rates.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
In August 1999 the Company was named as a defendant in Schweizer vs. Level 3
Communications, Inc. et. al., a purported national class action, filed in the
District Court, County of Boulder, State of Colorado which involves the
Company's right to install its fiber optic cable network in easements and
right-of-ways crossing the plaintiffs' land. In general, the Company obtained
the rights to construct its network from railroads, utilities, and others, and
is installing its network along the rights-of-way so granted. Plaintiffs in the
purported class action assert that they are the owners of lands over which the
Company's fiber optic cable network passes, and that the railroads, utilities,
and others who granted the Company the right to construct and maintain its
network did not have the legal ability to do so. The action purports to be on
behalf of a national class of owners of land over which the Company's network
passes or will pass. The complaint seeks damages on theories of trespass, unjust
enrichment and slander of title and property, as well as punitive damages.
Although the Company is not aware of any additional similar claims, the Company
may in the future receive claims and demands related to rights-of-way issues
similar to the issues in the Schweizer litigation that may be based on similar
or different legal theories. Although it is too early for the Company to reach a
conclusion as to the ultimate outcome of this litigation, management believes
that the Company has substantial defenses to the claims asserted in the
Schweizer action (and any similar claims which may be named in the future), and
intends to defend them vigorously.
Item 6. Exhibits and Reports on 8-K
(a) Exhibits filed as part of this report are listed below:
Exhibit
Number
10.1 Credit Agreement, dated as of September 30, 1999 among Level 3
Communications, Inc., Level 3 Communications, LLC, Level 3
International, Inc., Level 3 International Services, Inc., BTE
Equipment, LLC, Eldorado Funding, LLC, the Lenders party
thereto and The Chase Manhattan Bank as Administrative Agent
and Collateral Agent.
27 Financial Data Schedule
(b) On September 20, 1999, the Company filed a Current Report on Form 8-K
relating to the offering and the completion of the offering of $823
million of the Company's 6% Convertible Subordinated Notes due 2009, of
which $73 million was related to an over-allotment option granted to the
underwriters.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
LEVEL 3 COMMUNICATIONS, INC.
Dated: November 8, 1999 /s/ Eric J. Mortensen
Eric J. Mortensen
Vice President, Controller
and Principal Accounting Officer
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
INDEX TO EXHIBITS
Exhibit
No.
10.1 Credit Agreement, dated as of September 30, 1999 among Level 3
Communications, Inc., Level 3 Communications, LLC, Level 3
International, Inc., Level 3 International Services, Inc., BTE
Equipment, LLC, Eldorado Funding, LLC, the Lenders party thereto and
The Chase Manhattan Bank as Administrative Agent and Collateral Agent.
27 Financial Data Schedule.