You Are Expected To Select A Company And Three Competitors From The Same Industry And Prepare An Analytical Report In Which You Will Critically Evaluate, Analyse, Discuss And Comment On The Key Issues In The Financial Appraisal.

Introduction

This report is delivered in four parts. Part 1 focusses on Level 3 Communications’ current financial situation. Part 2 compares Level 3 Communication against three of its’ major competitors, namely AT&T Inc., General Communications Inc. and Alaska Communications Systems Inc. In light of the December 6, 2016 announcement that CenturyLink Inc. will acquire Level 3 Communications in 2017, Part 3 analyses CenturyLink financial offer to acquire Level 3 Communications Inc. Part 4 addresses the limitations to accounting analysis. The report uses the latest financial performance as well as historical data, to evaluate and critically analyse the performance of Level 3 Communications Inc.

Level 3 Communications Incorporated

Level 3 Communications is a facilities-based provider of communications services, including Internet Protocol (IP) services, data services, transport and fiber services, voice services, collaboration services, colocation and data center services, and wholesale voice services. Level 3 owns and manages its fiber optic network which connects North America, Europe and Latin America. The company was developed as a capital investment spinoff of the construction company Peter Kiewits Sons’ Inc based on its cable television division. Level 3 still identifies with its roots in that it retains a small coal mining sector as a cash generating component of the incorporation. Its first acquisition was Metropolitan Fibre Systems and expanded into the internet market in 1993. (Level 3 Communications/Our History, 2016)

On December 6, 2016, it was publicly announced that level 3 Communications Inc will be acquired by Century Link Inc. (Sherman & Moritz, 2016). Clay Bailey, Senior Vice President of CenturyLink Operational Transformation, has stated that the transition is scheduled to be completed by the third quarter of 2017 (Picker, 2016).

PART 1

This section of the report analyses Level 3’s financial performance based on financial data for the fiscal year ending September 30, 2015.

An analysis of the current business and financial situation of Level 3 Communications

Level 3 has had a history of negative returns (ROA, ROE, ROI) prior to 2014. In 2014, Level 3 realized its first year of positive results in these ratio categories sand continued that growth through 2015. This has been led by Level 3’s debt management where both Long Term and total Debt to Asset ratios have been increasingly positive since 2013.

Level 3’s Return on Capital Employed (ROCE) is relatively low at 10.09% as shown in Figure 1. This must be considered a positive since assets have been used to reduce financial risks and create a stable financial base for the company’s future operations. Level 3’s Asset Management ratios, with the exception of property, plant and equipment turnover (PPE), have been trending to the positive over the previous ten years. The lower PPE ratio is a result of the company divesting itself of some of its coal mining ventures and the associated equipment and resources.

Figure 1- Level 3 ROCE over time (Zacks, 2016)

Level 3’s working capital ($333M) and debt gearings (0.52%) indicated that an increasingly lower proportion of Level 3’s operations were financed by debt. This can be attributed to improvements in Price to Earnings (PE) ratio, Price to Earnings Growth (PEG) ratio and a significant reduction in Total Debt to Equity (TDE) ratio. Of note, the reduction in Working Capital from its 2014 level ($425M) to its 2015 level ($333M) can be explained by Level 3's acquisition of TW Telecom during FY2014 (Krause, 2016).

The result of these changes is that Level 3 has less financial risk and are in a better position to challenge for an increased share of the telecommunications market without creating unmanageable risk for the company.

Current financial situation for Level 3

Level 3 has been able to grow and solidify its position in the highly competitive telecommunications industry over the past decade. Its current strengths lie in its increased returns (ROA, ROE, ROI), improved quick and current ratios, decreased debt to assets ratio and increased cash flow per share rating. Level 3 entered FY2016 in a solid and reliable financial position and was structured and enabled to make significant gains in its industry sector.

PART 2

A researched evaluation of the industry sector and financial competitor analysis for three listed companies in the same sector (using American Telephone and Telegraph (AT&T), Alaska Communications Systems (ACS) and General Communications as a starting point for financial data)

Profitability Ratios

A closer look at the profitability ratios in Table 3, Level 3’s historical ratios, suggest that Level 3 is currently in a very strong financial position in comparison to its competitors: AT&T Inc., General Communications Inc. and Alaska Communications Systems Inc. Of particular importance is Level 3’s Net Profit Margin ratio and Operating Margin ratios. These specific ratios indicate that Level 3 is using its profit generating resources more effectively than ACS and GCI and is competitive with AT&T Inc. Of note, AT&T, an historic company, operates at a scale that is 17 orders of magnitude larger than Level 3 and operates in many more international markets than Level 3. The fact that Level 3 has reduced its TDE ratio coupled with positive trending in operating margins, while its compared competitors generally rose, is a significant indicator of the company’s stable operating position into the future.

Figure 1 - Profitability Ratios (Kimmel, Kieso, & Irvine, 2014)

Long-term solvency

As seen in Table 3, Level 3 continuously lowered it Total Debt to Equity ratio since 2013, thereby creating a stable economic future for the company, which sets its position well for profitable operations going forward. The fact that Level 3 also has a low gearing ratio (Table 1), contributes to an optimistic outlook for profitability in future years.

In terms of interest cover, a closer look at Table 1 shows that Level 3 is in very favourable positions to pay interest on outstanding debt with a debt cover of $26.25. This has been accomplished by increasing revenue and profits at a rate much higher than the corresponding rise in total debt.

Short-term solvency

As can be seen in Figure 2, Level 3’s quick ratios have previously fallen below the accepted benchmark of 1.0:1. This is a cause for concern because it indicated that Level 3 would have had problems meeting its short-term debt obligation. Interestingly, both AT&T and ACS have remained viable even with consistently low quick ratios over time.

Figure 2 - Current and Quick Ratios (Kimmel, Kieso, & Irvine, 2014)

Altman Z Scores

Figure 3 shows the Altman Z Scores (Altman, 2000) both Z and Z2, for the compared companies since 2006. Z Scores are used primarily for manufacturing companies while Z2 Scores are used for public, noon-manufacturing companies. According to Altman, any Z Score below 2.99 and any Z2 Score below 2.6 should be looked at with caution. Clearly, AT&T, the biggest of the four companies compared, has rejected Altman and has conducted business in Altman’s identified caution range, with continued success. Likewise, General Communications Inc has remained in Altman’s caution range. Using Altman Z2 scoring, all companies have slipped into the caution range since 2014. This may be an indicator of the industries stability and may also be a result of the need to assume risk to remain competitive in this expanding market.

Figure 3 - Altman Z Scores

A critical appraisal and discussion of the financial strengths and weaknesses of Level compared to listed competitors

Level 3’s strengths lie in its solvency and profitability ratios. With solid returns on equity and investments (ROE, ROI), a low debt to asset ratio and a comparable Operating Margin, coupled with a significant Net Profit Margin, Level 3 has been able to consolidate its place in the telecommunications market and grow its market share against much larger direct competitors.

While Level 3 has made great progress in the past decade in carving out its place in the market, there is no doubt that, being a rapidly expanding and changing industry, Level 3 must remain committed to growth levels that manage risk and debt to be able to sustain that growth in times of economic weakening or reversal. Level 3 has consolidated its position by steady growth coupled with conservative risk and needs to remain with that model to be viable over a protracted period.

PART 3

A recommendation of a suitable price range for the shares of Level 3 to be used in the acquisition process

Background

CenturyLink has completed an agreement to acquire Level 3 Communications Inc for a price of $36M USD (Picker, 2016). Both companies are telecommunications providers and are direct competitors to AT&T and Verizon. The acquisition will make CenturyLink the second largest telecommunications provider, behind AT&T. The acquisition deal will involve a combination of cash and stocks in CenturyLink. The valuation is $26.50 and 1.4286 CenturyLink shares per Level 3 share. This equals $69.92 per Level 3 share. The total transaction value includes the approximate $10.9Billion of Level 3 debt to equal the announced $36M pricing to CenturyLink. This price equals a roughly 50% premium on existing Level 3 stocks. As a result, Level 3 stocks have risen 4% while CenturyLink stocks have fallen 12.5% since the deal was announced (Picker, 2016).

Level 3 Premium analysis

The market value of Level 3 shares over the past 52 weeks has ranged from $41.73 to $57.59 with a close on December 9, 2016 of $56.24. The transaction value of $69.92 as offered by CenturyLink equals a premium of between 21 % (high stock value) and 675 (low stock value) with a median of 41%.

Factoring in Level 3 PEG at 4.68 and the lack of dividends paid in 2015, the valuation of CenturyLink’s offer to Level 3 shareholders is positive and should be accepted.

Figure 5 - Current Market Comparison (Zacks, 2016)

PART 4

What factors should be looked for in accounts that may impact the valuation?

Determining an acceptable price during an acquisition must account for current share value, future income potential and a risk assessment of the long-term value of the stock. For example, prior to the acquisition Level 3 stock had enjoyed upward market value but was not paying a dividend. Likewise, Level 3’s PEG was positive and indicated potential for increasing share prices. CenturyLink’s share price, PEG and growth were not a positive as Level 3’s but the acquisition is expected to reverse these trends once CenturyLink completes the acquisition and become a n equal scaler competitor in the telecommunications market. Also, CenturyLink has continued to pay dividends so allows shareholders to profit without sale of stocks.

A critical evaluation of the finance techniques applied in the analysis.

All financial and managerial accounting is undertaken using generally accepted accounting techniques (GAAT). I employed these techniques as outlined in two Wiley Publishing Accounting text; Financial Accounting: Tools for Business Decision Making (Kimmel, Kieso, & Irvine, 2014) and Managerial Accounting: Tools for Business Decision Making (Weygant, Kimmel, Kieso, & Aly, 2015). I chose the data from published sources including Mergent Online, Stockopedia and Zacks Online as well as Level 3 Inc’s own website.

The key limiting factor in any accounting analysis is the credibility and reliability of the source data. The data is provided by the same companies that are being analysed and these same companies report the data as legislated by various government laws and regulations. It is recognized that the data may be provided to enhance the best interests of the company, be it to reduce taxation or to enhance the financial image of the company with its current and potential investors. Perhaps the principal limitation of ratio analysis. My use of accounting techniques, while striving to adhere to GAAT, is limited to producing the necessary data for this analysis of the subject industry and companies. As such, any variances in source data accuracy and correctness will be included into and possibly amplified by my analysis.

I must conclude by advising that this analysis is an indication based on past actions and performance. While I attempt to look at potential future accountability, this analysis is in no way a statement on future financial capabilities of the companies, and the industry, contained in the analysis. There are too many unforeseen possibilities, both at the company level, and in the industry involved, for anyone to make concrete statements on future financial results.

References "Stockopedia Features". (2011, April 13). The Altman Z-Score: Is it possible to predict corporate bankruptcy using a formula? . Retrieved from Stockopedia.com: http://www.stockopedia.com Altman, E. (1968). Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy. Journal of Finance. Journal of Finance, 24(3), 189-209. Altman, E. (2000, July). Predicting financial distress of comapnies: revisiting the z-score and zeta models. Retrieved from Stern School of Business, NYU: http://pages.stern.nyu.edu Kimmel, P. W., Kieso, D. T., & Irvine, W. (2014). Financial Accounting: Tools for Business Decision Making, 6th Cdn. Ed. Toronto: Wiley. Krause, R. (2016, September 22). Level 3 communications, cogent rated outperform. Retrieved from Investor's Daily News: https://ezproxy.royalroads.ca/login?url=http://search.proquest.com/docview/1714456536?accountid=8056 Level 3 Communications. (2016, December 6). Retrieved from Investor's Business Daily: https://ezproxy.royalroads.ca/login?url=http://search.proquest.com/docview/1721785660?accountid=8056 Level 3 Communications/Our History. (2016, November 16). Retrieved from Level 3 Communications: http://www.level3.com/en/about-us/our-history/ Picker, L. (2016, October 31). CenturyLink, a neywork provider, to acquire Level 3, a rival. Retrieved from New York Times: http://www.nytimes.com Sherman, A., & Moritz, S. (2016, October 31). CenturyLink agrees to buy Level 3 for $34 billion in cash, stock. Retrieved from Bloomberg News: https://www.bloomberg.com Weygant, J., Kimmel, P., Kieso, D., & Aly, I. (2015). Managerial Accounting: Tools for Business Decision Making, 4th ed. Toronto: Wiley. Zacks. (2016, December 9). Stck report: Level 3 Comm (LVLT). Retrieved from Zacks.com: https://www.zacks.com

Appendix A

Ratio Formulae

Appendix B

TABLE 1 - LEVEL 3 COMMUNICATIONS - ACCOUNTING RATIOS

Table 2 - LEVEL 3 HORIZONTAL ANALYSIS

TABLE 3 - INDUSTRY COMPARISON