Level 3 To Acquire More Backbone

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Level 3 Communications, the struggling Internet-backbone provider that provides nationwide fiber transport to most major cable companies, is buying fellow Internet-backbone provider WilTel Communications — and its Vyvx video-transport subsidiary — for close to $700 million in cash and stock.

The purchase comes the same week as the Federal Communications Commission approved Verizon Communications Inc.’s purchase of MCI Inc. and SBC Communications Inc.’s buy of AT&T Corp. Now, instead of leasing their nationwide backbones, the nation’s two largest telephone companies will fully own them.

IP-TRANSPORT EMERGING

Backbones like those of Verizon, SBC and Level 3 are expected to be an increasingly key component of any service provider’s cost structure as voice, data and video communications are all delivered in Internet-protocol format.

Verizon will shift its voice, video and data traffic over to MCI’s backbone. SBC will gradually winnow itself off Wiltel’s backbone over the next four years, transferring all its traffic to its wholly owned AT&T backbone.

Sprint Nextel Corp. provides backbone services to Time Warner Cable, but wireless and business customers are its primary revenue streams, so it’s not a pure backbone player.

That leaves Level 3, with a market cap of $2 billion, as one of the industry’s largest standalone backbone players, with 23,000 route miles worldwide.

Given the moves by Verizon and SBC, could a cable company, like Comcast, have its sights set on Level 3?

Already, the Philadelphia-based MSO spends $100 million for long-term rights to Level 3’s national fiber network. The 20-year rights agreement covers 19,000 route miles, or 95% of Comcast’s national footprint for fiber capacity and routing and optical equipment. The backbone will be able to carry multiple wavelengths, each capable of 40 Gigabits per second, for a total potential capacity of almost 3 Terabits per second. It will initially be provisioned with multiple 10 Gbps wavelengths, each capable of carrying almost 3,000 video channels.

But Level 3’s economics could pose a problem. The company’s debt would make the transaction a $6 billion deal, more than Comcast would want to stomach, according to CIBC World Markets analyst Tim Horan.

And Comcast can get what it needs today — good rates for nationwide fiber transport — without buying the company, in Horan’s view. “We believe that it will remain a good environment for the buyers of wholesale capacity, such as [regional Bell operating companies], cable companies and emerging service providers, but problematic for Level 3,” Horan wrote in a research note about the Wiltel deal.

In Horan’s view, long-haul networks still have too much capacity to make much money, and Level 3 has the added problem of its debt load. “In the near term, we do not expect other long-haul providers, Global Crossing and Broadwing, to get acquired anytime soon, as there are no natural acquirers,” he added.

This deal will provide Level 3 with some badly needed cash. Level 3 reported a net loss of $204 million in third-quarter 2005, on revenue of $799 million. Conversely, WilTel generated $113 million in profit on $873 million in revenue in the first six months of 2005.

But Wiltel’s projected $1.5 billion to $1.6 billion in 2005 revenue will drop to $900 million in 2007 and $600 million in 2008 because SBC is moving its business to AT&T, Level 3 said. But costs also will drop, lessening the blow from the SBC revenue hit, executives said.

Although Level 3 and Wiltel offer the same services, the acquisition will provide Level 3 3,000 fiber-route miles to add to its existing 23,000-mile network.

Level 3 will also add another 50 smaller tier-two and tier-three markets, chief operating officer Kevin O’Hara said. That would enhance its chances of adding business from telecommunications and Internet companies looking for long-haul transport.

Level 3 will mix and match the best duplicate routes between the two networks, O’Hara said. “It will be a single optimized network,” O’Hara said. “We will harvest and redeploy equipment on the old routes. The physical route will be maintained to support existing dark customers.”

VYVX EYES VOD REVENUE

The deal also includes Vyvx, which will contribute $120 million in revenue to Wiltel this year — and which has designs on expanding into the video-on-demand business.

About two-thirds of Vyvx’s revenue comes from the 250,000 video feeds the company handles each year, O’Hara said. The other third stems from its delivering commercials to 13,000 radio, TV and cable-system outlets each year.

Vyvx wants to add a third revenue stream: VOD traffic. Over the past year, the company has held exploratory talks with cable companies and programmers to enter the on-demand video transport and software business, taking on such established players as In Demand and TVN Entertainment Corp.

The company hopes to leverage its expertise in a growing VOD market that many expect to explode with content in the coming years.

“We don’t have an exact product yet,” said Derek Smith, vice president at Vyvx. “But we are in conversations, we have beta designs on the charts, and we are visiting with customers, talking [about] who are we going to partner with.

“We’re focusing on a full-service model, from ingest to content to workflow management to distribution,” he added. “We want to utilize the resources we have in different end points.”

Vyvx’s nationwide fiber network, a subset of Wiltel’s network, includes 50 video-enabled points of presence, mostly in major cities and often near sports facilities. It backhauls video feeds of live events, and transport commercials to TV and radio stations, plus cable networks. It’s transmitted the Super Bowl for the past 16 years, and added 270 megabit HDTV capabilities last year.

“We’re taken a look at what’s happening with the VOD and cable space and what is happening with the consumer, and what does that mean to the movement of content,” Smith said.

In the past year, Vyvx has upgraded its infrastructure and software, allowing it to transport long-form content beyond 30- and 60-second TV commercials. That content could include 30-minute sitcoms and two-hour movies. “We have the ability to distribute long-form content,” Smith said. “We changed the software used to pitch content out.”

Smith said Vyvx’s talks with operators and programmers center on understanding their “pain points.”

“Some of the really large VOD players have a pretty good grasp of how process is going to work,” he said. “The medium and small providers need greater scale. They want to make sure they can get content out cost-effectively.”

Level 3 has high hopes for Vyvx. “It’s a well-run profitable leader in this space,” said chief financial officer Sunit Patel.

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