Fitch Upgrades Level 3 Communications' IDR to 'BB'; Outlook Stable

CHICAGO--(BUSINESS WIRE)-- Fitch Ratings has upgraded the Issuer Default Rating (IDR) assigned to Level 3 Communications, Inc. (LVLT) and its wholly owned subsidiary Level 3 Financing, Inc. (Level 3 Financing) to 'BB' from 'BB-'. In addition, Fitch has upgraded specific issue ratings assigned to LVLT and affirmed issue ratings assigned to Level 3 Financing as outlined at the end of this release. LVLT had approximately $11 billion of consolidated debt outstanding on June 30, 2016.

The upgrade of LVLT's IDR reflects the ongoing strengthening of the company's operating and credit profile spurred by enterprise revenue growth, margin expansion and meaningful free cash flow (FCF) generation. Fitch anticipates that LVLT will benefit from the positive secular demand drivers for its services and will capitalize on the operating leverage inherent within its operating model, its network capabilities and broad product and service portfolio to capture incremental market share and drive margin and revenue growth within its enterprise segment.

The ratings also recognize the event risks related to potential acquisitions and shifting capital allocation priorities. Fitch expects that merger and acquisition (M&A) activity will remain a key component of LVLT's overall strategy. M&A is expected to focus on building incremental network and product capabilities and building scale within its Europe and Latin America markets. Additionally, Fitch acknowledges that LVLT's current capital allocation priority remains investing in the business and reducing leverage to the lower end of its 3x to 4x net leverage target. Fitch believes that once the company achieves its leverage target (anticipated sometime during 2017) the company will shift its capital allocation strategy to the benefit of its shareholders. Fitch expects that any potential M&A activity or shift in capital allocation strategy will be funded within the context of the company current financial policy, in particular its 3x to 4x net leverage target.

KEY RATING DRIVERS

Leverage on Target: LVLT remains committed to deleveraging to the low end of its net leverage target of between 3.0x and 4.0x. The enhanced scale and ability to generate meaningful FCF resulting from the tw telecom, Inc. acquisition reinforce Fitch's expectation for further strengthening of LVLT's credit profile. Leverage was 4.0x as of the latest 12 months (LTM) ended June 30, 2016. Fitch forecasts leverage will strengthen further to approximately 3.8x by year-end 2016.

Strengthening Credit Profile: LVLT's credit profile continues to improve in line with Fitch's expectations as the company capitalizes on its ongoing revenue mix transformation and growing high-margin core network services revenues. It is also realizing cost synergies associated with past acquisitions and ongoing cost-management initiatives. Fitch anticipates LVLT's credit profile will continue to strengthen over the rating horizon as the company benefits from anticipated EBITDA growth, strong FCF generation and modest debt reduction.

FCF Enhances Credit Profile: LVLT is poised to generate sustainable levels of FCF (defined as cash flow from operations less capital expenditures and dividends). Fitch believes the company's ability to grow high-margin core network services (CNS) revenues coupled with the strong operating leverage inherent in its operating profile position the company to generate consistent levels of FCF. Fitch anticipates LVLT FCF generation will produce FCF margins exceeding 11.5% and 13.5% of revenues during years ended 2016 and 2017, respectively.

Revenue Mix Transformation Proceeding: LVLT's operating strategies are aimed at shifting its revenue and customer focus to becoming a predominantly enterprise-focused entity. The company's network capabilities -- in particular its strong metropolitan network, and broad product and service portfolio emphasizing IP-based infrastructure and managed services -- provide the company with a solid base to grow its enterprise segment revenues.

Positive Industry Dynamics: Fitch expects LVLT's operating profile will benefit from positive secular demand drivers for its services, as enterprises require network solutions that can address heightened security considerations and operate in an increasingly digitized and connected operating environment. LVLT is well-positioned from a product standpoint, as enterprises capitalize on the compelling economics of cloud computing and migrate IT networks to a hybrid cloud network strategy.

Strong Operating Leverage: The products and services LVLT sells combined with its strategy to sell services "on net" enable the company to generate significant operating leverage. At scale, the services sold within this business segment generate 60% incremental EBITDA margins. Fitch believes the company must be successful in growing the Core Network Services (CNS) revenue base to improve its credit profile and generate FCF.

Overall, the ratings for LVLT reflect the company's improving competitive position highlighted by its metropolitan network facilities capabilities and product and service portfolio relative to alternative carriers. The diversity of the company's customer base and service offering coupled with an expectation for a relatively stable pricing environment for a significant portion of its service portfolio support the ratings. Fitch's ratings incorporate LVLT's improving competitive position while acknowledging its smaller market share and lack of scale relative to larger and better capitalized market participants.

Outside of material change to its financial strategy, ratings concerns center on LVLT's smaller market share and lack of scale relative to larger and better capitalized market participants, event-driven M&A activity and the resultant increase in integration risks, and the sensitivity of the company's operating profile to the effects of a weaker economic outlook or a more competitive operating and pricing environment. Fitch expects that M&A activity will remain a key component of LVLT's overall growth strategy. M&A is expected to focus on building incremental network and product capabilities and building scale in Europe and Latin America.

LVLT's enterprise segment continues to drive overall revenue growth within CNS. The company is positioned to benefit from favorable secular demand trends including explosive bandwidth demand growth (video), the growth in number of devices connected to the Internet, and the increasing globalization of enterprises. Revenues generated from enterprise customers accounted for approximately 73% of CNS revenues during the LTM period ended June 30, 2016. From a regional perspective, North America CNS revenue represented 57% of total CNS revenue during the LTM period.

Leverage and Financial Policy

LVLT remains committed to deleveraging to the low end of its target of between 3x and 4x on a net debt basis. The focus of LVLT's capital structure strategy is to strengthen the company's overall credit profile and efficiently manage its maturity profile. The pace of further deleveraging will largely depend on the company's ability to leverage cost synergies and capitalize on incremental EBITDA growth stemming from the positive operating momentum within LVLT's CNS segment.

Total debt outstanding as of June 30, 2016 was approximately $11.0 billion, relatively unchanged when compared with debt outstanding as of year-end 2015 and a reflecting a modest 3.1% decline relative to the $11.4 billion of debt outstanding as of Dec. 31, 2014. Leverage was 4.0x as of the LTM ended June 30, 2016. Fitch forecasts leverage will strengthen further to approximately 3.8x by year-end 2016 and approach 3.5x by year-end 2017.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case include:

--The base case assumes a continuation of a rational pricing environment and stable macro-economic conditions.

--LVLT is largely successful in capitalizing on operating leverage to expand growth in gross margin and EBITDA margin during the forecast period.

--CNS revenue growth ranging between 2% and 3% driven by continued strong growth within the company's North American Enterprise segment.

--LVLT's network access margin (gross margin) growing to over 67% by year-end 2017.

--Capital expenditures will approximate 15% of consolidated revenues.

--FCF generation exceeding 11.5% and 13.5% during years ended 2016 and 2017, respectively.

--Debt levels are expected to remain relatively consistent and Fitch anticipates that LVLT will repay the floating-rate notes due 2018 ($300 million outstanding June 30, 2016) with available cash on hand.

RATING SENSITIVITIES

What Could Lead to a Positive Rating Action:

Positive rating action would likely coincide with the expectation that Level 3 will maintain leverage at 3.0x or lower while consistently generating positive FCF with FCF/adjusted debt of 10% or greater. Additionally, the company will need to demonstrate positive operating momentum characterized by consistent CNS revenue growth, gross margin expansion, no material delays in achieving anticipated cost synergies, and lack of a material erosion of revenue churn.

What Could Lead to a Negative Rating Action:

Negative rating actions are more likely to coincide with a perceived weakening of LVLT's operating profile, as signaled by deteriorating margins and revenue erosion brought on by difficult economic conditions or competitive pressure. Additionally, negative rating actions could result from discretionary management decisions including, but not limited to, execution of merger and acquisition activity that increases leverage beyond 4.5x in the absence of a credible deleveraging plan.

LIQUIDITY

Fitch believes the company's ability to grow high margin CNS revenues coupled with the strong operating leverage inherent in its operation profile positions the company to generate material levels of free cash flow on a consistent basis. Overall financial flexibility is enhanced by positive FCF generation. The company expects to generate FCF ranging between $1.0 billion and $1.1 billion during 2016, which is in line with Fitch's expectations. LTLV reported $950 million of FCF during the LTM period ended June 30, 2016, marking a 161% increase relative to the $364 million of FCF generation during the LTM period ended June 30, 2015.

FCF generation should accelerate as integration costs diminish and cost synergies materialize. Fitch anticipates LVLT's FCF generation will exceed 13% of consolidated revenues by year-end 2017. In addition to positive operating momentum driving EBITDA growth, additional factors such as interest expense savings derived from capital market activities and ongoing operating cost optimization efforts position the company to grow FCF during the ratings horizon.

Fitch believes that LVLT's liquidity position is adequate given the rating and that overall financial flexibility is enhanced with positive FCF generation. The company's liquidity position was primarily supported by cash carried on its balance sheet, which as of June 30, 2016 totaled approximately $1.3 billion and expected FCF generation. Importantly, there are no restrictions on the company's ability to repatriate foreign cash (other than the conversion and repatriation restrictions existing in Venezuela and Argentina) to fund domestic operations including debt service. The company does not maintain a revolver, which limits its financial flexibility in Fitch's opinion.

LVLT's maturity profile is manageable within the context of FCF generation expectations and access to capital markets. The company does not have material scheduled maturities during the remainder of 2016, and the next scheduled maturity is not until 2018 when approximately $300 million of debt is scheduled to mature.

FULL LIST OF RATING ACTIONS

Fitch upgrades the following with a Stable Outlook:

LVLT:

--IDR to 'BB' from 'BB-';

--Senior unsecured notes to 'BB-/RR5' from 'B+/RR5'.

Level 3 Financing, Inc.:

--IDR to 'BB' from 'BB-';

Fitch affirms the following ratings with a Stable Outlook:

Level 3 Financing, Inc.:

--Senior secured term loan at 'BB+/RR1';

--Senior unsecured notes at 'BB/RR2'.

The Rating Outlook remains Stable.

Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements of the relevant rated entity or obligor are disclosed below:

--No material adjustments have been made that have not been disclosed in public fillings of this issuer.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria

Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)

https://www.fitchratings.com/site/re/885629

Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers (pub. 05 Apr 2016)

https://www.fitchratings.com/site/re/879564

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1012469

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1012469

Endorsement Policy

https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

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Source: Fitch Ratings

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