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CASE STUDY Group 8

Sophisticated NPV Analysis at Level 3 Communications, Inc.

Level 3 Communications, LLC, provides integrated telecommunications services including voice, Internet access, and data transmission using rapidly improving optical and Internet protocol technologies (i.e., “broadband”). Level 3 is called a facilities-based provider because it owns a substantial portion of the fiber optic plant, property, and equipment necessary to serve its customers. The company traces its roots to Peter Kiewit Sons,’ Inc., which was incorporated in Delaware in 1941 to continue a construction business founded in Omaha, Nebraska, in 1884. In subsequent years, Kiewit invested a portion of the cash flow generated by its construction activities in  a  variety  of  other  businesses.  Kiewit  entered  the  coal  mining  business  in  1943,  the telecommunications business  [consisting  of Metropolitan Fiber Systems  (MFS) and  related investments] in 1988, the information services business in 1990, and the alternative energy business in 1991. Kiewit has also made investments in several development-stage ventures.

In 1995, Kiewit distributed its MFS holdings to stockholders. In the seven years from 1988 to 1995, the company had invested approximately $500 million in MFS. At the time of the distribution to stockholders in 1995, the company’s holdings in MFS had grown to a market value of approximately $1.75 billion. In December 1996, MFS was purchased by WorldCom in a transaction valued at $14.3 billion, more than a 28:1 payout and a 52% annual rate of return over 8 years for investors. Following its enormously successful investment in MFS, Kiewit decided to sell unrelated assets and focus its energies on the telecommunications business. In December 1997, the company’s stockholders ratified the decision of the Board to effect a split-off from the Kiewit Construction Group. As a result of the split-off, which was completed on March 31, 1998, the company no longer owns any interest in the Construction Group and adopted the name “Level 3 Communications, Inc.” The Kiewit Construction Group changed its name to “Peter Kiewit Sons,’ Inc.” The term Level 3 comes from the layered set of protocols, or standards that are often used in the industry to describe telecommunications networks. The company’s strategy generally calls for services to be provided in the first three levels of these technical specifications.

During the first quarter of 2001, Level 3 completed construction activities relating to its North American intercity network. In 2003, the company added approximately 2,985 miles to its North America intercity network through acquisition of certain assets of Genuity Inc., a Massachusetts-based provider of communications services. Level 3 has also completed construction of an approximately 3,600 mile fiber optic intercity network that connects many major European cities, including Amsterdam, Berlin, Copenhagen, Frankfurt, Geneva, London, Madrid, Milan, Munich, Paris, Stockholm, Vienna, and Zurich. Level 3’s European network is linked to the North American intercity network by a transatlantic cable system that went into service during 2000.

In December 2000, the company signed an agreement to collaborate with FLAG Telecom on the development of the Northern Asia undersea cable system connecting Hong Kong, Japan, Korea, and Taiwan. During the fourth quarter of 2001, the company announced the disposition of its Asian operations in a sale transaction with Reach, Ltd. Although the company believed that Asia represented an attractive longer-term investment opportunity, given current volatile market and economic conditions the company determined that it was necessary to focus its resources, both capital and managerial, on the immediate opportunities provided by the company’s operational assets in North America and Europe. This transaction closed on January 18, 2002. As part of the agreement, Reach and Level 3 agreed that Level 3 would provide capacity and services to Reach over Level 3’s North American intercity network, and Level 3 would buy capacity and services from Reach in Asia. This arrangement allowed Level 3 to continue to service its customer base with capacity needs in Asia and provide Reach access to the Level 3 intercity networks in North America and Europe.

Today, Level 3 has grown to become an international communications and information services powerhouse headquartered in Broomfield, Colorado. Level 3 is one of the largest providers of wholesale dial-up service to Internet service providers (ISPs) in North America, and is the primary provider of Internet connectivity for millions of broadband subscribers through its cable and DSL partners. The company operates one of the largest communications and Internet backbones in the world. Level 3 provides services to the world’s ten largest telecom carriers, the top largest ISPs in North America, and Europe’s ten largest telecom carriers. A key contributor to the company’s success is its highly sophisticated approach to capital budgeting.

To help investors, employees, customers, and the general public understand the economics of its business and the company’s approach to capital budgeting, Level 3 has posted on the Internet what it calls a “Silicon Economics Model” (http://www.level3.com/734.html). Level  3 has developed this model in an effort to demonstrate in a simplified format the dynamic relationships that exist between pricing strategies, cost compression, demand growth, and capital budgeting in an optimized net present value discounted cash flow model. In other words, the model represents an effort to demonstrate the effects of important economic relationships on capital budgeting decisions and the value of the firm. Because of its simplified nature, the Silicon Economics Model should not be interpreted as an attempt to predict Level 3’s future operating performance or financial results. Level 3’s internal optimization model contains tens of thousands of variables and relationships that for the sake of simplicity are not duplicated in this model.

In order to produce a model for public use that is not overly complex, several simplifying assumptions have been made in the Silicon Economics Model. The effects of market competition are not explicitly modeled, and only a single service offering is considered. In practice, Level 3 offers a wide variety of services in various geographic locations that have differing degrees of demand elasticity. The model places no limits on demand growth, such as would be imposed by limitations on Level 3’s internal operating systems or external supply chain requirements. Capital expenditures (CAPEX) are modeled using an initial (one-time) infrastructure cost plus an incremental cost per unit. Cost-saving improvements in technology are modeled as a reduction in unit cost, or annual cost compression rate. Operational expenses (OPEX) are modeled using a fixed annual infrastructure cost, variable cost represented as a percentage of revenue, per-incremental-unit cost (activation related), and per-total-unit cost (support related). Cost reductions over time in these latter two categories can be modeled by specifying an annual productivity improvement factor. Network expenses (NETEX) are modeled as a cost per incremental unit. This unit cost is reduced at the same rate as the activation and support-related operational expenses.

Users can see the effects of varying assumptions on operating and financial performance by choosing different input parameters on the “Data Entry” worksheet. All default input values can be changed. The model will produce the net present value of consolidated cash flow for any choice of input parameters. Details concerning the calculation of expected revenue, capital expenses, operational expenses, and cash flow that are graphed by the model can be reviewed and are displayed on the “Details” tab of the model. Five three-dimensional charts are automatically produced to illustrate the sensitivity of net present value to four primary input parameters, including the annual price reduction rate, price elasticity of demand, annual CAPEX compression (cost- reduction) rate, and annual OPEX and NETEX compression (cost-reduction) rate. For simplicity, all other operating and financial parameters are held constant. The price and elasticity chart displays model sensitivity to the pace of price reduction and price elasticity; price and CAPEX illustrates effects of price reductions on capital spending. Price and OPEX and NETEX shows impacts of the price reduction rate and operational and network expense compression rates; price and total cost shows sensitivity to the price reduction rate and total cost compression rate. CAPEX and OPEX and NETEX, shown in Figure 17.4 gives the relationship between the capital expense compression rate and operational and network expense compression rates. For illustration purposes, input assumptions are an initial demand of 8.5 million units, an initial price of $200, annual price reductions of 25%, a discount rate of 25%, and a 2.25 price elasticity of demand.

Finally, Table 1 below shows the net present value implications of these model input assumptions for the discounted net present value of the enterprise. It is important to remember that these data are for illustration purposes only. They are not predictions of actual operating and financial results for Level 3 or any other company.

1. Describe the essential components of Level 3’s Silicon Economics
2. Explain how Level 3’s Silicon Economics Model differs from more standard and simplified approaches to capital For comparison purposes, you may want to consider valuation spreadsheets compiled and maintained by various independent analysts and investors on the Internet (http://members.fcc.net/codyklen/LVLT/Level_3_Model.htm)
3. How would you judge the effectiveness and usefulness of the Silicon Economics Model?