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 March 31, 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.)
3555 Farnam Street, Omaha, Nebraska 68131
(Address of principal executive offices) (Zip Code)
(402) 536-3677
(Registrant's telephone number,
including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports(s)), and (2) has been subject
to such filing requirements for the past 90 days. Yes X No
The number of shares outstanding of each class of the issuer's common stock,
as of April 30, 1999
Common Stock 339,182,456 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 2. Changes in Securities
Item 6. Exhibits and Reports on Form 8-K
Signatures
Index to Exhibits
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Condensed Statements of Operations
(unaudited)
<TABLE>
<S> <C> <C>
Three Months Ended
March 31,
(dollars in millions, except share data) 1999 1998
Revenue $ 102 $ 87
Costs and Expenses:
Cost of revenue 62 42
Depreciation and amortization 41 6
Selling, general and administrative 125 48
------ -----
Total costs and expenses 228 96
------ -----
Loss from Operations (126) (9)
Other Income (Expense):
Interest income 50 26
Interest expense, net (53) (4)
Other, net, principally equity losses of
unconsolidated entities (23) (22)
------ -----
Total other income (expense) (26) -
------ -----
Loss Before Income Taxes and Discontinued Operations (152) (9)
Income Tax Benefit 47 3
------ -----
Loss from Continuing Operations (105) (6)
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) $ (105) $ 926
====== =====
Earnings (Loss) Per Share (Basic and Diluted):
Continuing operations $ (.33) $ (.02)
Discontinued operations $ - $ 3.19
Net earnings (loss) $ (.33) $ 3.17
Net earnings (loss), excluding gain on split-off
of Construction Group $ (.33) $ 1.09
See accompanying notes to consolidated condensed financial statements.
</TABLE>
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Condensed Balance Sheets
(unaudited)
<TABLE>
<S> <C> <C>
March 31, December 31,
(dollars in millions) 1999 1998
Assets
Current Assets:
Cash and cash equivalents $ 862 $ 842
Marketable securities 3,998 2,863
Restricted securities 33 32
Accounts receivable, net 65 57
Income taxes receivable 111 54
Other 37 29
------ ------
Total Current Assets 5,106 3,877
Property, Plant and Equipment, net 1,438 1,061
Investments 300 323
Other Assets, net 262 264
------ ------
$7,106 $ 5,525
====== =======
See accompanying notes to consolidated condensed financial statements.
</TABLE>
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Condensed Balance Sheets
(continued)
(unaudited)
<TABLE>
<S> <C> <C>
March 31, December 31,
(dollars in millions) 1999 1998
Liabilities and Stockholders' Equity
Current Liabilities:
Accounts payable $ 338 $ 276
Current portion of long-term debt 6 5
Accrued payroll and employee benefits 28 16
Accrued interest 78 33
Other 46 40
------- -------
Total Current Liabilities 496 370
Long-Term Debt, less current portion 2,653 2,641
Deferred Income Taxes 78 86
Accrued Reclamation Costs 98 96
Other Liabilities 169 167
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 500,000,000 shares;
338,419,599 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 2,319 765
Accumulated other comprehensive income 2 4
Retained earnings 1,288 1,393
------- -------
Total Stockholders' Equity 3,612 2,165
------- -------
$ 7,106 $ 5,525
======= =======
See accompanying notes to consolidated condensed financial statements.
</TABLE>
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Condensed Statements of Cash Flows
(unaudited)
<TABLE>
<S> <C> <C>
Three Months Ended
March 31,
(dollars in millions) 1999 1998
Cash flows from continuing operations:
Net cash provided by continuing operations $ 55 $ 17
Cash flows from investing activities:
Proceeds from sales and maturities of
marketable securities 518 819
Purchases of marketable securities (1,652) (1,422)
Investments (2) (3)
Proceeds from sale of property, plant and
equipment and other assets 5 20
Capital expenditures (407) (18)
Other 2 -
------- -------
Net cash used in investing activities (1,536) (604)
Cash flows from financing activities:
Payments on long-term debt including current portion (3) (2)
Issuances of common stock, net 1,496 17
Proceeds from exercise of stock options 8 10
Exchange of Class C Stock for Common Stock - 122
------- -------
Net cash provided by financing activities 1,501 147
Cash flows from discontinued operations:
Proceeds from sale of energy operations - 1,159
------- -------
Net cash provided by discontinued operations - 1,159
------- -------
Net increase in cash and cash equivalents 20 719
Cash and cash equivalents at beginning of year 842 87
------- -------
Cash and cash equivalents at end of period $ 862 $ 806
======= =======
Non-cash investing activities:
BusinessNet Ltd. acquisition:
Issuance of stock $ 7 $ -
Assumption of liabilities 8 -
The activities of the Construction Group have been removed from the consolidated
condensed statements of cash flows. 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.
</TABLE>
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Statement of Changes in Stockholders' Equity
For the three months ended March 31, 1999
(unaudited)
<TABLE>
<S> <C> <C> <C> <C> <C>
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 - 1,503 - - 1,503
Stock options exercised - 8 - - 8
Stock option grants - 19 - - 19
Income tax benefit from
exercise of options - 24 - - 24
Net Loss - - - (105) (105)
Other Comprehensive Loss - - (2) - (2)
----- ------- ----- ------ ------
Balance at
March 31, 1999 $ 3 $ 2,319 $ 2 $1,288 $3,612
===== ======= ===== ====== ======
See accompanying notes to consolidated condensed financial statements.
</TABLE>
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Statements of Comprehensive Income
(unaudited)
<TABLE>
<S> <C> <C>
Three Months Ended
March 31,
(dollars in millions) 1999 1998
Net (Loss) Earnings $(105) $ 926
Other Comprehensive (Loss) Income Before Tax:
Foreign currency translation adjustments (2) 1
Unrealized holding (loss) gain arising during period (3) 8
Reclassification adjustment for losses (gains) included
in net earnings (loss) 2 (5)
----- -----
Other Comprehensive (Loss) Income, Before Tax (3) 4
Income Tax Benefit (Expense) Related to Items of Other
Comprehensive Income (Loss) 1 (1)
----- -----
Other Comprehensive (Loss) Income Net of Taxes (2) 3
----- -----
Comprehensive (Loss) Income $(107) $ 929
===== =====
See accompanying notes to consolidated condensed financial statements.
</TABLE>
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 ("IP") 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 statement 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 March 31 1998, were not material to the
overall results of operations and cash flows.
The results of operations for the three months ended March 31, 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 on March 5, 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 on April 1, 1998, 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 month periods ended March 31, 1999 and
1998. Therefore, the 22,473,702 options and warrants outstanding at
March 31, 1999 and 20,064,222 options and warrants outstanding at March
31, 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:
<TABLE>
<S> <C> <C>
Three Months Ended
March 31,
1999 1998
Loss From Continuing Operations (in millions) $ (105) $ (6)
Gain on Split-off of Construction Group - 608
Earnings from Discontinued Energy Operations - 324
------- -------
Net Earnings (Loss) $ (105) $ 926
======= =======
Total Number of Weighted Average Shares Outstanding
Used to Compute Basic and Diluted Earnings Per Share
(in thousands) 316,288 292,325
======= =======
Earnings (Loss) Per Share (Basic and Diluted):
Continuing operations $ (.33) $ (.02)
======= =======
Discontinued operations $ - $ 3.19
======= =======
Net earnings (loss) $ (.33) $ 3.17
======= =======
Net earnings (loss), excluding gain on Split-Off of
Construction Group $ (.33) $ 1.09
======= =======
</TABLE>
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. After completion of certain adjustments, the Company agreed
to issue 396,379 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 396,379 shares Level 3 agreed to issue in connection
with the acquisition, 146,057 shares of Level 3 Common Stock have been
pledged to Level 3 to secure certain indemnification obligations of the
former BusinessNet stockholders. The pledge of these shares will terminate in
approximately 18 months, 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 the Company
believes will provide certain key components necessary for the Company to
develop an interface between its IP-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 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
Company does not believe that the final purchase price allocation will vary
significantly from the preliminary estimates.
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 and local
networks have been placed in service during the first quarter of 1999. These
assets are being depreciated over their useful lives, primarily ranging from
3-20 years. As other segments of the network become operational, 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 cost of
the business support systems are amortized over their useful lives of 3 years.
For the three months ended March 31, 1999, the Company invested $374 million
in its communications business of which $203 million was spent on the U.S.
intercity network, $75 million was spent on international and transoceanic
networks and $60 million on gateway facilities and leasehold improvements.
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.
<TABLE>
<S> <C> <C> <C>
Accumulated Book
(dollars in millions) Cost Depreciation Value
March 31, 1999
Land and Mineral Properties $ 32 $ (11) $ 21
Facility and Leasehold Improvements
Communications 107 (1) 106
Information Services 27 (2) 25
Coal Mining 18 (15) 3
CPTC 91 (7) 84
Operating Equipment
Communications 270 (26) 244
Information Services 54 (32) 22
Coal Mining 177 (154) 23
CPTC 17 (5) 12
Network Construction Equipment 57 (1) 56
Furniture and Office Equipment 67 (18) 49
Other 51 (8) 43
Construction-in-Progress 750 - 750
------ ------- -----
$1,718 $ (280) $1,438
====== ======= ======
December 31, 1998
Land and Mineral Properties $ 32 $ (11) $ 21
Facility and Leasehold Improvements
Communications 80 (1) 79
Information Services 24 (2) 22
Coal Mining 18 (15) 3
CPTC 91 (5) 86
Operating Equipment
Communications 245 (18) 227
Information Services 53 (30) 23
Coal Mining 180 (155) 25
CPTC 17 (4) 13
Network Construction Equipment 46 (1) 45
Furniture and Office Equipment 67 (10) 57
Other 32 (2) 30
Construction-in-Progress 430 - 430
------ ------- ------
$1,315 $ (254) $ 1,061
====== ======= =======
</TABLE>
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. 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 March 31, 1999 Level 3 owned approximately 40% 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 $894 million and $391 million, respectively, on March
31, 1999.
The following is summarized financial information of RCN and Commonwealth
Telephone for the three months ended March 31, 1999 and 1998, and as of March
31, 1999 and December 31, 1998 (in millions):
<TABLE>
<S> <C> <C>
Three Months Ended
March 31,
Operations 1999 1998
RCN Corporation:
Revenue $ 67 $ 40
Net loss available to common stockholders (68) (68)
Level 3's share:
Net loss (27) (31)
Goodwill amortization - -
----- -----
Equity in net loss $ (27) $ (31)
====== =====
Commonwealth Telephone Enterprises:
Revenue $ 61 $ 53
Net income available to common stockholders 5 4
Level 3's share:
Net income 2 2
Goodwill amortization (1) (1)
----- -----
Equity in net income $ 1 $ 1
===== =====
</TABLE>
<TABLE>
<S> <C> <C> <C> <C>
Commonwealth
RCN Telephone
Corporation Enterprises
Financial Position: 1999 1998 1999 1998
Current assets $ 1,009 $ 1,093 $ 73 $ 79
Other assets 871 815 364 354
------- ------- ------ -----
Total assets 1,880 1,908 437 433
Current liabilities 191 178 85 85
Other liabilities 1,305 1,282 223 223
Minority interest 60 77 - -
------- ------- ------ ------
Total liabilities 1,556 1,537 308 308
------- ------- ------ ------
Net assets $ 324 $ 371 $ 129 $ 125
======= ======= ====== ======
Level 3's share:
Equity in net assets $ 123 $ 150 $ 62 $ 60
Goodwill 34 34 55 56
------ ------- ------ ------
$ 157 $ 184 $ 117 $ 116
====== ======= ====== ======
</TABLE>
Investments at March 31, 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 March 31, 1999 and December 31, 1998 other assets consisted of the following:
<TABLE>
(in millions) 1999 1998
<S> <C> <C>
Goodwill:
XCOM, net of accumulated amortization of $21 and $15 $ 93 $ 100
GeoNet, net of accumulated amortization of $2 and $1 19 20
BusinessNet, net of accumulated amortization of
$1 and $- 15 -
Other, net of accumulated amortization of $2 and $1 18 19
Deferred Debt Issuance Costs 65 67
Deferred Development and Financing Costs 15 15
Unrecovered Mine Development Costs 15 15
Leases 7 9
Timberlands 6 6
Other 9 13
----- -----
Total other assets $ 262 $ 264
===== =====
</TABLE>
9. Long-Term Debt
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 three months
ended March 31, 1999 on the Senior Discount Notes of $13 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 $11 million of interest expense and amortized debt
issuance costs related to network construction and business systems development
projects for the three months ended March 31, 1999.
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 18,500 nonqualified stock options ("NQSO") to employees
during the three months ended March 31, 1999. The expense recognized for the
three months ended March 31, 1999 for NQSOs and warrants outstanding at March
31, 1999 in accordance with SFAS No. 123 was $2 million. In addition to the
expense recognized, the Company capitalized less than $1 million of non-cash
compensation costs related to NQSOs for employees directly involved in the
construction of the IP network and the development of the business support
systems. The Company recognized $2 million of expense for NQSO's granted
during the three months ended March 31, 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 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 586,814 OSOs granted
to employees and consultants for services performed for the three months ended
March 31, 1999 was $30 million. The Company recognized $14 million of
compensation expense in the first quarter of 1999 for OSO's granted in 1999 and
1998. In addition to the expense recognized, $1 million was capitalized for
employees directly involved in the construction of the IP network and
development of business support systems.
11. Stockholders' Equity
On March 9, 1999 the Company closed the offering of 28,750,000 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 tables below includes information as of
March 31, 1999 and December 31, 1998 for all balance sheet information
presented, and for the three months ended March 31, 1999 and 1998 for all
income statement and cash flow information presented.
<TABLE>
Communications & Information Services
Computer Systems Coal
(dollars in millions) Communications Outsourcing Integration Mining Other Total
- -----------------------------------------------------------------------------------------------------------------
1999
<S> <C> <C> <C> <C> <C> <C>
Revenue $ 15 $ 16 $ 15 $ 51 $ 5 $ 102
EBITDA (68) 4 (3) 20 (20) (67)
Identifiable Assets 1,434 59 49 350 5,214 7,106
Capital Expenditures 374 3 - - 30 407
Depreciation and
Amortization 25 2 1 1 12 41
1998
Revenue $ - $ 15 $ 14 $ 53 $ 5 $ 87
EBITDA - 4 - 20 (25) (1)
Identifiable Assets 1,072 59 42 362 3,990 5,525
Capital Expenditures 10 5 2 - 1 18
Depreciation and
Amortization - 2 1 1 2 6
</TABLE>
The following information provides a reconciliation of EBITDA to loss from
continuing operations for the three months ended March 31, 1999 and 1998:
<TABLE>
(in millions) 1999 1998
<S> <C> <C>
EBITDA $ (67) $ (1)
Depreciation and Amortization Expense (41) (6)
Non-Cash Compensation Expense (18) (2)
------ -----
Loss from Operations (126) (9)
Other Expense (26) -
Income Tax Benefit 47 3
------ -----
Loss from Continuing Operations $ (105) $ (6)
====== =====
</TABLE>
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 $186 million and
$1 million of construction services related to these projects in the first
quarter of 1999 and 1998, respectively.
In 1999, the Company entered into an agreement with RCN whereby RCN will lease
cross country capacity on Level 3's nationwide network. Revenue attributable
to this agreement was less than $1 million for the three months ended
March 31, 1999. Also in 1999, the Company and RCN announced that it had
reached joint construction agreements in several RCN markets, through
which the companies will share the cost of constructing their respective
fiber optic networks.
Level 3 also receives certain mine management services from Kiewit.
The expense for these services was $7 million and $8 million for the three
months ended March 31, 1999 and 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).
The Company is involved in various lawsuits, claims and regulatory
proceedings incidental to its business. Management believes that any
resulting liability for legal proceedings beyond that provided should not
materially affect the Company's financial position,future results of operations
or future cash flows.
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 sold 28.75 million shares, or $1.5
Billion of the $3.5 billion available under the "universal" shelf registration
statement, through a public offering.
15. Subsequent Events
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, United Kingdom. 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.
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,
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 approximate 3,500 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 U.S. network by the Level 3
transatlantic terabit cable system currently under development, also expected
to be ready for service by September 2000.
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 Level 3's planned European network.
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 of 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.
After completion of certain adjustments, the Company agreed to issue 396,379
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 396,379
shares Level 3 agreed to issue in connection with the acquisition, 146,057
shares of Level 3 Common Stock have been pledged to Level 3 to secure certain
indemnification obligations of the former BusinessNet stockholders. The pledge
of these shares will terminate in approximately 18 months. Liabilities exceeded
assets acquired, and goodwill of $16 million was recognized from the transaction
which is being amortized over five years.
Common Stock Offering
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 March 9, 1999 the Company
closed the offering of 28,750,000 shares of its Common Stock through a 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.
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. This is
subject to approval of the stockholders which will be voted on at the Company's
1999 Annual Meeting.
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,
Netherlands, Germany and the UK. 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
approximate 3,500 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 U.S. network by the Level 3 transatlantic terabit cable system currently
under development, also expected to be ready for service by September 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, Frankfort,
Hamburg, Munich and Stuttgart. In return, Colt will share construction costs of
Level 3's planned European network.
Results of Operations
First Quarter 1999 vs. First Quarter 1998
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 ("IP") technology. Since the Business Plan represents
a significant expansion of the Company's communications and information services
business, the Company does not believe that the Company's financial condition
and results of operations for prior periods will serve as a meaningful
indication of the Company's future financial condition or results of operations.
The Company expects to incur substantial net operating losses for the
foreseeable future, and there can be no assurance that the Company will be able
to achieve or sustain operating profitability in the future.
Revenue for the quarters ended March 31, is summarized as follows (in millions):
<TABLE>
<S> <C> <C>
1999 1998
Communications and Information Services $ 46 $ 29
Coal Mining 51 53
Other 5 5
------ -----
$ 102 $ 87
====== =====
</TABLE>
Communications and information services revenue for the three months ended March
31, 1999 increased 59% compared to the same period in 1998. Revenue from XCOM's
reciprocal compensation agreements with Bell Atlantic and the new IP
related products which the Company began offering in late 1998 and early
1999, including private line, colocation and managed modem services,
provided $15 million of revenue for the communications segment in 1999.
Revenue attributable to the computer outsourcing and systems integration
businesses was $16 million and $15 million, respectively, in 1999 increasing
slightly from $15 million and $14 million, respectively, in 1998.
Coal mining revenue decreased $2 million in the first quarter of 1999
compared to the same period in 1998. The slight decrease was due to
timing of 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 these
long-term contracts begin to expire.
Other revenue, was consistent with 1998, and is primarily attributable to
CPTC, a privately owned tollroad in southern California.
Cost of Revenue increased 48% in 1999 to $62 million primarily as a result
of network expenses of $17 million in 1999 related to the communications
business. The cost of revenue for the systems integration business increased $3
million for the three months ended March 31, 1999 compared to the same period in
1998. The increase is primarily due to the costs incurred to transition from
Year 2000 services to systems and software reengineering for IP related
applications. The cost of revenue for the computer outsourcing and coal
businesses was consistent with that of 1998.
Depreciation and Amortization expense increased to $41 million in 1999 from
$6 million in 1998. The commencement of operations at 19 gateway facilities
and the completion of the installation of 7 local networks in the second
half of 1998 and the first quarter of 1999 resulted in the higher depreciation
expense in 1999. In addition, the amortization of goodwill attributable to
the acquisitions of XCOM, BusinessNet and others contributed to the
higher depreciation and amortization expense in 1999.
Selling, General and Administrative expenses increased significantly in 1999
to $125 million from $48 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 from approximately 1,275 at
March 31, 1998 to approximately 2,700 at March 31, 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. and European cities and
fees to develop and implement the Company's business support systems, also
increased selling general and administrative expenses. In addition to the
costs to expand the communications and information services businesses, the
Company recorded $18 million of non-cash compensation in the first quarter
of 1999 for expenses recognized 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 $(1) million in 1998 and $(67) million in 1999. The primary reason for
the increase between periods is the significant increase in general and
administrative expenses, described above, incurred in connection with
the implementation of the Company's Business Plan. EBITDA is commonly
used in the communications industry to analyze companies on the basis of
operating performance. EBITDA, however, should not be considered an alternative
to operating or net income as an indicator of the performance of the Company's
businesses, or as an alternative to cash flows from operating activities as
a measure of liquidity, in each case determined in accordance with generally
accepted accounting principles. See Consolidated Condensed Statements of Cash
Flows.
Interest Income increased 92% in 1999 to $50 million from $26 million in 1998
as the Company's average cash, cash equivalents and marketable securities
balance increased from approximately $2 billion during the first quarter of
1998 to approximately $3.9 billion during the first quarter of 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 significantly from $4 million in 1998 to
$53 million in 1999. Interest expense increased substantially due to the
completion of the offering of $2 billion aggregate principal amount of 9.125%
Senior Notes Due 2008 issued in April 1998 and $834 million aggregate principal
amount at maturity of 10.5% Senior Discount Notes Due 2008 issued in
December 1998. The amortization of debt issuance costs associated with
the Senior Notes and Senior Discount Notes also increased interest expense in
1999. The Company capitalized $11 million of interest expense on network
construction and business support systems in the first quarter of 1999.
Other Expense, net increased slightly in 1999 to $(23) million from $(22)
million. Other expense primarily consists of the Company's share of losses
incurred by the Company's equity method investees, primarily RCN. RCN
is a facilities-based provider of local, long distance internet and cable
television services to primarily residential users in the densely populated
areas of the northeastern United States and California's San Francisco to
San Diego corridor. RCN is incurring significant costs in developing its
business plan including the acquisitions of several internet service providers.
The Company recorded $27 million of equity losses attributable to RCN
in the first quarter of 1999, as compared to $31 million in the first quarter of
1998. During the first quarter of 1998 RCN acquired Ultranet Communications,
Inc. and Erols Internet, Inc., two Internet service providers with
operations in the Boston to Washington, D.C. corridor. RCN recognized a charge
to earnings with respect to certain costs of the acquisitions associated with
in-process research and development activities. The decrease in the equity
losses of RCN in 1999 are offset by a decrease in gain on sale of
marketable securities from a gain of $6 million in 1998 to a loss of $2
million in 1999.
Also included in other expense are equity earnings in Commonwealth Telephone
Enterprises, Inc., a Pennsylvania public utility providing telephone service,
and realized gains and losses on the sale of investments and other assets each
not individually significant to the Company's results of operations.
Income Tax Benefit in 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 approximates the statutory rate in 1998.
Discontinued Operations in 1998 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 - March 31, 1999
The Company's working capital increased from $3.5 billion at December 31,
1998 to $4.6 billion at March 31, 1999 due primarily to the $1.5 billion
equity offering completed in March 1999, partially offset by capital
expenditures for the communications network.
Cash provided by continuing operations increased from $17 million in 1998
to $55 million in 1999 primarily due to the increase in interest income.
Interest income increased in 1999 as a result of the proceeds received from
the Senior Notes, Senior Discount Notes and equity offering. Payments for
interest on the Senior Notes were not due until May 3, 1999 and the payment of
interest on the Senior Discount Notes is deferred until 2004. Partially
offsetting this increase are the costs paid to implement the Business Plan.
Investing activities include using the proceeds from the equity offering to
purchase marketable securities and $407 million of capital expenditures,
primarily for the expanding communications and information services
business. The Company also realized $5 million of proceeds from the sale of
property, plant and equipment and other assets.
Financing sources in 1999 consisted primarily of the net proceeds of $1.5
billion from the issuance of 28,750,000 shares of Common Stock, and the
exercise of the Company's stock options for $8 million. The Company also
repaid long-term debt of $3 million during the first quarter of 1999 primarily
related to CPTC.
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., ("PKSIS") to create, through a combination of construction, purchase
and leasing of facilities and other assets, an international, end-to-end,
facilities-based communications network. The Company is designing its
network based on IP technology in order to leverage the efficiencies of
this technology to provide lower cost communications services.
The development of the Business Plan will require significant capital
expenditures, a substantial portion of which will be incurred before any
significant related revenues from the Business Plan are expected to be
realized. These expenditures, together with the associated early operating
expenses, will result in substantial negative operating cash flow and
substantial net operating losses for the Company for the foreseeable future.
Although the Company believes that its cost estimates and build-out
schedule are reasonable, there can be no assurance that the actual
construction costs or the timing of the expenditures will not deviate
from current estimates. The Company estimates that its capital
expenditures in connection with the Business Plan will exceed $2 billion in
1999. The Company's current liquidity and the cost sharing 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 $8 and $10 billion over the
next 10 years. The Company's ability to implement the Business Plan and
meet its projected growth is dependent upon its ability to secure
substantial additional financing in the future. The Company expects to
meet its additional capital needs with the proceeds from sales or issuance
of additional equity securities, credit facilities and other borrowings, or
additional debt securities. The Senior Notes and Senior Discount Notes were
issued under an indenture which permits the Company and its subsidiaries to
incur substantial amounts of debt. The Company also has approximately
$2 billion of unissued securities available under the "universal" shelf
registration 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 also sell or lease fiber optic capacity, or access to its
conduits. There can be no assurance that the Company will be successful
in producing sufficient cash flow, raising sufficient debt or equity
capital on terms that it will consider acceptable, or selling or leasing fiber
optic capacity or access to its conduits, or that proceeds from dispositions
of the Company's assets will reflect the assets' intrinsic value. Further,
there can be no assurance that expenses will not exceed the Company's
estimates or that the financing needed will not likewise be higher
than estimated. Failure to generate sufficient funds may require the
Company to delay or abandon some of its future expansion or expenditures,
which could have a material adverse effect on the implementation of the
Business Plan.
There can be no assurance that the Company will be able to obtain such
financing if and when it is needed or that, if available, such financing
will be on terms acceptable to the Company. If the Company is unable to
obtain additional financing when needed, it may be required to scale back
significantly its Business Plan and, depending upon cash flow from its
existing businesses, reduce the scope of its plans and operations.
In connection with implementing the Business Plan, management will continue
reviewing the existing businesses of the Company to determine how those
businesses will complement the Company's focus on communications and
information services. If it is decided that an existing business is not
compatible with the communications and information services business and if a
suitable buyer can be found, the Company may dispose of that business.
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, plans will be put into place to test these products to confirm they
are Year 2000 ready.
PKS Systems Integration LLC ("PKS Systems"), a subsidiary of PKSIS,
provides a wide variety of information technology services to its customers. In
fiscal year 1998, approximately 57% of the revenue generated by PKS Systems
related to projects involving Year 2000 assessment and renovation services
performed by PKS Systems for its customers. These contracts generally require
PKS Systems to identify date affected fields in certain application software of
its customers and, in many cases, PKS Systems undertakes efforts to remediate
those date-affected fields so that Year 2000 data may be processed. Thus, Year
2000 issues affect many of the services PKS Systems provides to its customers.
This exposes PKS Systems to potential risks that may include problems with
services provided by PKS Systems to its customers and the potential for claims
arising under PKS Systems' customer contracts. PKS Systems attempts to
contractually limit its exposure to liability for Year 2000 compliance issues.
However, there can be no assurance as to the effectiveness of these contractual
limitations.
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, L.L.C. ("Level 3 LLC")
Level 3 Communications, LLC, 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 LLC's operations. Level 3 LLC 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 LLC owned
cable when the network construction is complete. In the interim, services
will be delivered over both owned and leased lines.
Level 3 LLC faces two primary Year 2000 issues with respect to its
business. First, Level 3 LLC must assess the readiness of its systems that are
required to provide its customers communications services ("Service
Delivery Systems"). Second, Level 3 LLC must evaluate the Year 2000 readiness
of its internal business support systems ("Internal Business Support Systems").
Level 3 LLC must also verify the readiness of the providers of the
leased lines currently in use.
Level 3 LLC, 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 plan's 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
LLC 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 in each of the five phases above. The current stage of activities
varies based upon the type of component, system, and/or customer service at
issue.
<TABLE>
<S> <C> <C>
Business Functions Operational Effect Current Status
Customer Delivery Systems Inability to deliver Phases I to Phase V*
Customer Services
Internal Business Support Systems Failures of Internal Phases I to Phase V*
Support Services and
Customer Billing
</TABLE>
* 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 PKS Systems Integration LLC ("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 systems 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.
With respect to its Year 2000 plans, PKSCS currently has activities underway
in each of phases III through V. The current stage of activities varies based
upon the type of component, system, and/or customer service at issue.
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 has completed its Year 2000
assessment of desktop hardware and software, and, based on vendor
representations, has determined that material upgrades or replacements are
not required. PKSSI is in the process of communicating with its vendors to
assess its servers and communications hardware for Year 2000 readiness.
This assessment is expected to be completed by approximately May 31, 1999.
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.
<TABLE>
<S> <C> <C> <C>
Business Functions Current Areas of Focus Operational Impact Current Status
- -------------------------- ----------------------------- ------------------------- ---------------------------------
Computer Outsourcing Large & Mid-Range CPU Inability to continue Mid Phase III to Phase V
Service OEM Software critical processing of
OS Systems customer's systems
Network Equipment
Support Facilities
Internal Support Systems & Failures of critical Mid Phase III to Phase V
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
Services completed. Assessment of
services and communications
hardware is expected to be
completed by approximately May
31, 1999
</TABLE>
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.
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 PKSIS 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 PKSC' 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 $3.6 million of costs in aggregate, through the end of 1999.
These 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
through September 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 and
policies regarding interest rate and foreign currency exchange rate risk
has not changed significantly from December 31, 1998.
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 $1,285 million as of March 31, 1999, which is significantly
higher than their carrying value of $274 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 $257 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 change in equity security prices is based on hypothetical movements and are
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 2. Changes in Securities
Pursuant to an acquisition agreement, effective January 5, 1999, the Company
agreed to issue 396,379 shares of Common Stock to the holders of capital
stock of BusinessNet Ltd. in connection with its acquisition by the
Company. The value of the shares, based upon an agreed upon price
between the Company and BusinessNet's stockholders, was $13 million.
This issuance of Common Stock was made pursuant to exemptions from
registration contained in Regulation S and Section 4(2) under the Securities Act
of 1933, as amended.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits filed as part of this report are listed below.
Exhibit
Number
27 Financial Data Schedule.
(b) On February 2, 1999, the Company filed a Current Report on Form 8-K,
excerpts from a conference hosted by the Company on February 2, entitled
"Silicon Economics: The New Math of Communications".
On February 17, 1999, the Company filed a Current Report on Form 8-K/A
amending and restating certain risk factors disclosed on Form 8-K filed
with the SEC on December 7, 1998.
On March 4, 1999, the Company filed a Current Report on Form 8-K
relating to the offering and the completion of the offering of 28,750,000
shares of the Company's Common Stock, of which 3,750,000 was reserved
for an over-allotment option granted to the underwriters.
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
LEVEL 3 COMMUNICATIONS, INC.
Dated: May 10, 1999 \s\ Eric J. Mortensen
Eric J. Mortensen
Controller and Principal
Accounting Officer
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
INDEX TO EXHIBITS
Exhibit
No.
27 Financial Data Schedule.
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND> This schedule contains summary financial information extracted from the
Form 10-Q for the period ending March 31, 1999 and is qualified in its entirety
by reference to such financial statements.
</LEGEND>
<MULTIPLIER> 1,000,000
<S> <C>
<PERIOD-TYPE> 3-mos
<FISCAL-YEAR-END> Dec-31-1999
<PERIOD-START> Jan-01-1999
<PERIOD-END> Mar-31-1999
<CASH> 862
<SECURITIES> 4,031
<RECEIVABLES> 72
<ALLOWANCES> 7
<INVENTORY> 4
<CURRENT-ASSETS> 5,106
<PP&E> 1,718
<DEPRECIATION> 280
<TOTAL-ASSETS> 7,106
<CURRENT-LIABILITIES> 496
<BONDS> 2,653
0
0
<COMMON> 3
<OTHER-SE> 3,609
<TOTAL-LIABILITY-AND-EQUITY> 7,106
<SALES> 51
<TOTAL-REVENUES> 102
<CGS> 23
<TOTAL-COSTS> 62
<OTHER-EXPENSES> 166
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 53
<INCOME-PRETAX> (152)
<INCOME-TAX> (47)
<INCOME-CONTINUING> (105)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (105)
<EPS-PRIMARY> (.33)
<EPS-DILUTED> (.33)
</TABLE>
