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Monday, March 24, 2008

IT makes a difference - look at Level 3

Information technology is generally a function that is hidden behind corporate walls. This is true even for technology companies. But IT is too important to be ignored.

OK, I have worked in IT in various stages of my career so perhaps I am predisposed to blowing the IT horn. Sometimes, the horn rings out loud and clear. Other times, however, it sounds with a whimper.

Typcially, it seems like the good news from IT is not widely broadcast but the failures are more well known. Look at Citigroup (C). They announced ambitious plans to reap cost cutting and new efficiencies from major IT simplification and reorganization. So far, IT costs have risen 20% and have stayed at that level. Citi seems to have a ways to go before realizing their IT goals.

Then there is Level 3 (LVLT). Here is a company that has assembled, from a series of acquisitions, one of the largest Internet backbone telecommunication systems in the world. Yet they can't turn a profit. In 2007, the company lost $1.1 billion on $4.3 billion revenue. The company's string of acquisitions have left it with over $6.8 billion of debt.

Level 3 has found that system integration has been a stumbling block on the way to profitability. Decisions on the approach to take have led to occasional missteps and the costs just continue to ratchet up. In 2007 integration costs were well over $100 million. Despite a strategic plan known as Project Unity, Level 3 has found efficiency and cost saving elusive. The work is complex and has proceeded more slowly than expected. Analyst David Holt, in a November 2007 report for market researcher Current Analysis, pointed to Level 3's problems integrating back-office systems for the various acquired carriers as a primary reason "for difficulties in converting high order levels to revenues and a subsequent reduction in the growth of its core communications revenues during the second and third quarters of 2007." These issues continued in the fourth quarter, as well.

Are Level 3's integration issues behind it now? 2008, the company says, will be another year focused on integration. Systems are commonly considered to consist of "layers". The distinction is often made along the lines of front end, middle layer and back end. Typically, the front end is closest to the customer. The back end ties together much of the financial aspects including billing and accounting. The middle layer is where the work is performed.

At Level 3, the front end - opportunity management, quoting tools and order entry - has been well integrated with a single system in use company-wide. There has also been progress on the back end – billing and customer care.

The company has a way to go before the middle layer - provisioning, activation, testing, etc. - is well integrated. In fact, the major activity, consolidating network elements into one common inventory platform, is work that is not likely to be done until sometime in the first half of 2009. When sufficiently integrated, Level 3 can begin to remove portions of the network that are redundant and overlapping. This will result in simplification and direct cost savings. As an example of the simplification potential, the company says that it has approximately 67,000 intercity route miles in North America, which is expected to be reduced to approximately 38,000 intercity route miles after completing the integration of acquired companies. With a more straightforward, unified network it will easier, quicker and cheaper to ramp up new customers and new services. The faster those things can be done, the faster the company can begin to recognize revenue. Maintenance, training and probably staffing costs will be reduced, as well.

Due to the number of acquisitions the company has made, integration is a significant issue. Level 3 has acquired more than 20 companies or business units between 1998 and the present. In 2003, Level 3 acquired substantially all the assets of Genuity (a spin-off of BBN). Since the end of 2005, Level 3 has made further significant acquisitions including Wiltel Communications , Progress Telecom, ICG Communications, Telcove (formerly Adelphia Business Solutions), Looking Glass Networks, Broadwing Corporation, the content delivery network of SAVVIS and, most recently, Servecast Limited. There is obviously plenty of work to be done getting all these systems to play well together.

The question, though, is can investors wait for all this work to be done? The stock has been in a downward trend since early in 2007 and is now trading at a level barely over $2 per share. I have focused on Level 3's IT challenges but the company has other issues on its plate including a business slowdown, high debt service, etc. There are blogs calling for Level 3 to be absorbed by a stronger player. If the company is to survive in its present form, it needs to first get its IT house in order.

Disclosure: author has no position in LVLT

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