Quarterly Report

Table of Contents

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(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, 2010

 

or

 

o	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.)
1025 Eldorado Blvd., Broomfield, CO		80021
(Address of principal executive offices)		(Zip Code)

 

(720) 888-1000

(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), and (2) has been subject to such filing requirements for the past 90 days.  Yes x   No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o   No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer x		Accelerated filer  o
Non-accelerated filer o		Smaller reporting company  o
(Do not check if a smaller reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes o   No x

 

The number of shares outstanding of each class of the issuer’s common stock, as of March 31, 2010:

 

Common Stock: 1,656,411,820 shares

 

 

Table of Contents

 

LEVEL 3 COMMUNICA TIONS, INC. AND SUBSIDIARIES

 

	Part I - Financial Information
Item 1.	Financial Statements:
	Consolidated Statements of Operations	2
	Consolidated Balance Sheets	3
	Consolidated Statements of Cash Flows	4
	Notes to Consolidated Financial Statements	5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	25
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	36
Item 4.	Controls and Procedures	37
	Part II - Other Information
Item 1.	Legal Proceedings	38
Item 1A.	Risk Factors	38
Item 6.	Exhibits	39
Signatures
Certifications

 

Table of Contents

 

LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Operations

(unaudited)

 

		Three Months Ended
(dollars in millions, except per share data)		March 31, 2010			March 31, 2009
Revenue:
Communications		$	900		$	962
Coal Mining		10			18
Total Revenue		910			980
Costs and Expenses (exclusive of depreciation and amortization shown separately below):
Cost of Revenue
Communications		371			390
Coal Mining		12			17
Total Cost of Revenue		383			407
Depreciation and Amortization		225			222
Selling, General and Administrative		343			338
Restructuring Charges		—			1
Total Costs and Expenses		951			968
Operating (Loss) Income		(41		)	12
Other Income (Expense):
Interest income		—			1
Interest expense		(149		)	(146		)
Other, net		(47		)	2
Total Other Income (Expense)		(196		)	(143		)
Loss Before Income Taxes		(237		)	(131		)
Income Tax Expense		(1		)	(1		)
Net Loss		$	(238	)	$	(132	)
Basic and Diluted Loss per Share		$	(0.14	)	$	(0.08	)
Shares Used to Compute Basic and Diluted Loss Per Share (in thousands):		1,647,407			1,620,932

 

See accompanying notes to consolidated financial statements.

 

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LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

(unaudited)

 

(dollars in millions, expect par value)		March 31, 2010			December 31, 2009
Assets
Current Assets:
Cash and cash equivalents		$	639		$	836
Restricted cash and securities		2			3
Receivables, less allowances for doubtful accounts of $19 and $18, respectively		304			323
Other		96			97
Total Current Assets		1,041			1,259
Property, Plant and Equipment, net		5,518			5,687
Restricted Cash and Securities		124			122
Goodwill		1,427			1,429
Other Intangibles, net		443			467
Other Assets, net		109			98
Total Assets		$	8,662		$	9,062
Liabilities and Stockholders’ Equity
Current Liabilities:
Accounts payable		$	345		$	364
Current portion of long-term debt		213			705
Accrued payroll and employee benefits		34			51
Accrued interest		134			140
Current portion of deferred revenue		151			162
Other		64			97
Total Current Liabilities		941			1,519
Long-Term Debt, less current portion		6,211			5,755
Deferred Revenue, less current portion		729			740
Other Liabilities		560			557
Total Liabilities		8,441			8,571
Commitments and Contingencies
Stockholders’ Equity:
Preferred stock, $.01 par value, authorized 10,000,000 shares: no shares issued or outstanding		—			—
Common stock, $.01 par value, authorized 2,500,000,000 shares: 1,656,411,820 issued and outstanding at March 31, 2010 and 1,644,116,265 issued and outstanding at December 31, 2009		17			16
Additional paid-in capital		11,559			11,537
Accumulated other comprehensive loss		(60		)	(5		)
Accumulated deficit		(11,295		)	(11,057		)
Total Stockholders’ Equity		221			491
Total Liabilities and Stockholders’ Equity		$	8,662		$	9,062

 

See accompanying notes to consolidated financial statements.

 

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LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(unaudited)

 

		Three Months Ended
(dollars in millions)		March 31, 2010			March 31, 2009
Cash Flows from Operating Activities:
Net loss		$	(238	)	$	(132	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		225			222
Non-cash compensation expense attributable to stock awards		16			16
Loss on debt extinguishments, net		54			—
Change in fair value of embedded derivative		(2		)	—
Accretion of debt discount and amortization of debt issuance costs		14			14
Accrued interest on long-term debt		(6		)	6
Other, net		(7		)	(6		)
Changes in working capital items:
Receivables		17			(11		)
Other current assets		(7		)	(15		)
Payables		(17		)	(14		)
Deferred revenue		(16		)	(17		)
Other current liabilities		(41		)	(67		)
Net Cash Used in Operating Activities		(8		)	(4		)
Cash Flows from Investing Activities:
Capital expenditures		(82		)	(78		)
Increase in restricted cash and securities, net		—			(1		)
Net Cash Used in Investing Activities		(82		)	(79		)
Cash Flows from Financing Activities:
Long-term debt borrowings, net of issuance costs		613			(2		)
Payments on and repurchases of long-term debt		(714		)	(7		)
Net Cash Used in Financing Activities		(101		)	(9		)
Effect of Exchange Rates on Cash and Cash Equivalents		(6		)	(4		)
Net Change in Cash and Cash Equivalents		(197		)	(96		)
Cash and Cash Equivalents at Beginning of Period		836			768
Cash and Cash Equivalents at End of Period		$	639		$	672
Supplemental Disclosure of Cash Flow Information:
Cash interest paid		$	141		$	126
Income taxes paid, net of refunds		$	(2	)	$	1

 

See accompanying notes to consolidated financial statements.

 

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LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

 

(1) Summary of Significant Accounting Policies

 

Description of Business

 

Level 3 Communications, Inc. and its subsidiaries (“Level 3” or the “Company”) is a facilities based provider (that is, a provider that owns or leases a substantial portion of the plant, property and equipment necessary to provide its services) of a broad range of integrated communications services. The Company has created its communications network generally by constructing its own assets, but also through a combination of purchasing and leasing from other companies and facilities. The Company’s network is an advanced, international, facilities based communications network. The Company designed its network to provide communications services, which employ and take advantage of rapidly improving underlying optical, Internet Protocol, computing and storage technologies.

 

The Company is also engaged in coal mining through its two 50% owned joint-venture surface mines, one each in Montana and Wyoming.

 

Principles of Consolidation and Basis of Presentation

 

The consolidated financial statements include the accounts of Level 3 Communications, Inc. and subsidiaries in which it has a controlling interest, which are enterprises engaged in the communications and coal mining businesses. Fifty-percent-owned mining joint ventures are consolidated on a pro rata basis. All significant intercompany accounts and transactions have been eliminated.

 

As part of its consolidation policy, the Company considers its controlled subsidiaries, investments in the business in which the Company is not the primary beneficiary or does not have effective control but has the ability to significantly influence operating and financial policies, and variable interests resulting from economic arrangements that give the Company rights to economic risks or rewards of a legal entity.  The Company does not have variable interests in a variable interest entity (“VIE”) where it is required to consolidate the entity as the primary beneficiary or where it has concluded it is not the primary beneficiary.  The Company would be required to consolidate entities in which it owns less than a 100% equity interest if the entity is a VIE, and the Company is deemed to be the primary beneficiary in the VIE through having power over significant activities of the entity and having an obligation to absorb losses or the right to receive benefits from the VIE that are potentially significant to the VIE.  The identification of variable interests and the analysis of whether the entity is a VIE requires significant judgment in determining whether certain arrangements were designed to create or absorb variability, the nature of the risks in the legal entity, and which investors and investments are considered at risk.  Circumstances supporting assumptions that indicate whether an entity has incentives or impediments to protect all or a portion of variable interest holders from absorbing a significant amount of variability may change based on the activities between the variable interest holders, the Company and other entities involved with the VIE.  Changes in events or circumstances may be significant enough to merit reconsideration of consolidation under the VIE model.

 

The accompanying consolidated balance sheet as of December 31, 2009, which was derived from audited financial statements, and the unaudited interim consolidated financial statements as of and for the three months ended March 31, 2010 and 2009 have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) for quarterly reports on Form 10-Q and do not include all of the information and note disclosures required by accounting principles generally accepted in the United States (“GAAP”) for complete financial statements.  These financial statements should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. In the opinion of the Company’s management, these financial statements contain all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of financial position, results of operations and cash flows at the dates and for the interim periods presented herein.  The results of operations for an interim period are not necessarily indicative of the results of operations expected for a full fiscal year.

 

The preparation of the consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities and the reported amounts of revenue and expenses during the reported period. Actual results could differ from these estimates.

 

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Recently Issued Accounting Pronouncements

 

In October 2009, the FASB issued a new accounting standard that provides revenue recognition guidance for arrangements with multiple deliverables. Specifically, the new standard requires an entity to allocate consideration at the inception of an arrangement to all of its deliverables based on their relative selling prices. In the absence of the vendor specific objective evidence or third party evidence of the selling prices, consideration must be allocated to the deliverables based on management’s best estimate of the selling prices. In addition, the new standard eliminates the use of the residual method of allocation. This guidance is generally expected to result in revenue recognition for more delivered elements than under the current rules. Level 3 is required to adopt this guidance prospectively for new or materially modified agreements as of January 1, 2011. The Company is evaluating the effect of this guidance, but does not expect adoption to have a material effect on its consolidated results of operations or financial condition.

 

(2) Loss Per Share

 

The Company computes basic net loss per share by dividing net loss for the period by the weighted average number of shares of common stock outstanding during the period. Diluted net loss per share is computed by dividing net loss for the period by the weighted average number of shares of common stock outstanding during the period and including the dilutive effect of common stock that would be issued assuming conversion or exercise of outstanding convertible notes, stock options, stock based compensation awards and other dilutive securities. No such items were included in the computation of diluted loss per share for the three months ended March 31, 2010 and March 31, 2009, because the Company incurred a net loss in each of these periods and the effect of inclusion would have been anti-dilutive.

 

The effect of approximately 672 million and 489 million shares issuable pursuant to the various series of convertible notes outstanding at March 31, 2010 and 2009, respectively, have not been included in the computation of diluted loss per share because their inclusion would have been anti-dilutive to the computation. In addition, the effect of the approximately 45 million and 54 million outperform stock options, restricted stock units and warrants outstanding at March 31, 2010 and 2009, respectively, have not been included in the computation of diluted loss per share because their inclusion would have been anti-dilutive to the computation.

 

(3) Goodwill

 

The changes in the carrying amount of goodwill during the three months ended March 31, 2010 are as follows (in millions):

 

		Communications Segment			Coal Mining Segment			Total
Balance at January 1, 2009		$	1,429		$	—		$	1,429
Accumulated impairment losses		—			—			—
Balance at December 31, 2009		1,429			—			1,429
Effect of foreign currency rate change		(2		)	—			(2		)
Accumulated impairment losses		—			—			—
Balance at March 31, 2010		$	1,427		$	—		$	1,427

 

The Company conducted its annual goodwill impairment analysis at December 31, 2009, and concluded its goodwill was not impaired.  There were no events or changes in circumstances during the first quarter of 2010 that indicated the carrying value of goodwill may not be recoverable.

 

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(4) Acquired Intangible Assets

 

Identifiable acquisition-related intangible assets as of March 31, 2010 and December 31, 2009 were as follows (in millions):

 

		Gross Carrying Amount			Accumulated Amortization			Net
March 31, 2010
Finite-Lived Intangible Assets:
Customer Contracts and Relationships		$	743		$	(427	)	$	316
Patents and Developed Technology		140			(65		)	75
		883			(492		)	391
Indefinite-Lived Intangible Assets:
Vyvx Trade Name		32			—			32
Wireless Licenses		20			—			20
		$	935		$	(492	)	$	443
December 31, 2009
Finite-Lived Intangible Assets:
Customer Contracts and Relationships		$	743		$	(407	)	$	336
Patents and Developed Technology		141			(62		)	79
		884			(469		)	415
Indefinite-Lived Intangible Assets:
Vyvx Trade Name		32			—			32
Wireless Licenses		20			—			20
		$	936		$	(469	)	$	467

 

The gross carrying amount of identifiable acquisition-related intangible assets in the table above is subject to change due to foreign currency fluctuations, as a portion of the Company’s identifiable acquisition-related intangible assets are related to foreign subsidiaries.

 

Acquired finite-lived intangible asset amortization expense was $23 million for both the three months ended March 31, 2010 and three months ended March 31, 2009.

 

As of March 31, 2010, estimated amortization expense for the Company’s finite-lived acquisition-related intangible assets over the next five years and thereafter is as follows (in millions):

 

2010 (remaining nine months)		$	69
2011		91
2012		70
2013		51
2014		40
Thereafter		70
		$	391

 

(5) Restructuring and Contract Termination Costs

 

During the fourth quarter of 2008, the Company initiated a workforce reduction of approximately 400 employees, or 7% of the Company’s total employee base, and incurred a restructuring charge of $12 million, all of which related to the communications business. The workforce reductions related to multiple levels within the organization and across multiple locations within North America. The terms of the workforce reduction, including the involuntary termination benefits to be received by affected employees, were communicated by the Company in the fourth quarter of 2008. In the first quarter of 2009, the Company paid approximately $11 million of involuntary termination benefits for affected employees. The remaining $1 million of involuntary termination benefits were paid in the second quarter of 2009.

 

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The Company has accrued contract termination costs of $40 million at March 31, 2010 and $42 million at December 31, 2009, for facility lease costs, primarily in North America, that the Company continues to incur without economic benefit. Accrued contract termination costs are recorded in other liabilities (current and non-current) in the consolidated balance sheets. The Company expects to pay the majority of these costs through 2018. The Company incurred new contract termination costs of less than $1 million in the three months ended March 31, 2010, and did not incur any new contract termination costs in the three months ended March 31, 2009. The Company records charges for contract termination costs, including accretion expense, within selling, general and administrative expenses in the consolidated statements of operations.

 

(6) Fair Value

 

GAAP defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities required to be recorded at fair value, the Company considers the principal or most advantageous market in which it would transact and considers assumptions that market participants would use when pricing the asset or liability, such as inherent risk, transfer restrictions, and risk of nonperformance.

 

The Company’s financial instruments consist of cash and cash equivalents, restricted cash and securities, accounts receivable, accounts payable, interest rate swaps, embedded derivative contracts and long-term debt including the current portion. The carrying values of cash and cash equivalents, restricted cash and securities, accounts receivable and accounts payable approximated their fair values at March 31, 2010 and December 31, 2009. The interest rate swaps and embedded derivative contracts are recorded in the consolidated balance sheets at fair value. The carrying value of the Company’s long-term debt, including the current portion, reflects the original amounts borrowed net of unamortized discounts, premiums and debt discounts and was $6.4 billion as of March 31, 2010 and $6.5 billion as of December 31, 2009. The estimated fair value of the Company’s long-term debt approximated $6.5 billion at March 31, 2010 and $6.3 billion at December 31, 2009.

 

Restricted cash and securities consists primarily of cash and investments that serve to collateralize outstanding letters of credit, long-term debt and certain performance and operating obligations of the Company, as well as cash and investments restricted to fund certain reclamation liabilities of the Company. Restricted cash and securities are recorded in current or non-current assets in the consolidated balance sheets depending on the duration of the restriction and the purpose for which the restriction exists.

 

The cost and fair value of restricted cash and securities totaled $126 million at March 31, 2010 and $125 million at December 31, 2009.

 

Fair Value Hierarchy

 

GAAP establishes a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The fair value measurement of each class of assets and liabilities is dependent upon its categorization within the fair value hierarchy, based upon the lowest level of input that is significant to the fair value measurement of each class of asset and liability. GAAP establishes three levels of inputs that may be used to measure fair value:

 

Level 1 —Quoted prices in active markets for identical assets or liabilities.

 

Level 2 —Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets with insufficient volume or infrequent transactions (less active markets); or model-derived valuations in which all significant inputs are observable or can be derived principally from or corroborated by observable market data for substantially the full term of the assets or liabilities.

 

Level 3 —Unobservable inputs to the valuation methodology that are significant to the measurement of fair value of assets or liabilities.

 

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The table below presents the fair values for each class of Level 3’s liabilities measured on a recurring basis as well as the input levels used to determine these fair values as of March 31, 2010 and December 31, 2009 (in millions):

 

								Fair Value Measurement Using
		Total Carrying Value in Consolidated Balance Sheet						Quoted Prices in Active Markets for Identical Assets (Level 1)						Significant Other Observable Inputs (Level 2)						Significant Unobservable Inputs (Level 3)
		March 31, 2010			December 31, 2009			March 31, 2010			December 31, 2009			March 31, 2010			December 31, 2009			March 31, 2010			December 31, 2009
		(dollars in millions)
Liabilities Recorded at Fair Value in the Financial Statements:
Derivatives:
Interest Rate Swap Liabilities (included in other non-current liabilities)		$	100		$	92		$	—		$	—		$	100		$	92		$	—		$	—
Embedded Derivatives in Convertible Debt (included in other non-current liabilities)		$	24		$	20		$	—		$	—		$	24		$	20		$	—		$	—
Total Derivative Liabilities Recorded at Fair Value in the Financial Statements		$	124		$	112		$	—		$	—		$	124		$	112		$	—		$	—
Liabilities Not Recorded at Fair Value in the Financial Statements:
Long-term Debt, including the current portion:
Senior Notes		$	2,885		$	2,809		$	2,717		$	2,609		$	—		$	—		$	—		$	—
Convertible Debt		1,762			1,873			674			778			1,346			1,267			—			—
Term Loans		1,678			1,678			1,606			1,577			—			—			—			—
Mortgage Debt		68			68			—			—			78			75			—			—
Other		31			32			31			32			—			—			—			—
Total Long-term Debt, including the current portion:		$	6,424		$	6,460		$	5,028		$	4,996		$	1,424		$	1,342		$	—		$	—

 

Derivatives

 

The interest rate swaps are measured in accordance with the Fair Value Measurements and Disclosures guidance using discounted cash flow techniques that use observable market inputs, such as LIBOR-based forward yield curves, forward rates, and the specific swap rate stated in each of the swap agreements. The embedded derivative contracts are priced using inputs that are observable in the market, such as the Company’s stock price, risk-free interest rate and other contractual terms of certain of the Company’s convertible senior notes.

 

Senior Notes

 

The estimated fair value of the Company’s Senior Notes approximated $2.7 billion at March 31, 2010 and $2.6 billion at December 31, 2009 based on market prices. The fair value of each instrument was obtained by discounting the expected cash flows of such instrument using a risk-adjusted discount rate.  The significant inputs used to estimate the fair value of the Company’s Senior Notes included the March 31, 2010 and December 31, 2009 trading quotes as provided by large financial institutions that trade in the Company’s securities. The pricing quotes provided by these market participants incorporate spreads to the Treasury curve, security coupon (which ranges from LIBOR plus 3.75% to 10%), corporate and security credit ratings, maturity date (ranging from 2014 to 2018) and liquidity, among other security characteristics and relative value at both the borrower entity level and across other securities of similar terms.

 

The Senior Notes are unsecured obligations of Level 3 Financing, Inc.; however, the Senior Notes are fully and unconditionally guaranteed by Level 3 Communications, Inc. and Level 3 Communications, LLC, which is a first tier, wholly owned subsidiary of Level 3 Financing, Inc.

 

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Convertible Debt

 

The estimated fair value of the Company’s actively traded Convertible Notes approximated $674 million at March 31, 2010 and $778 million at December 31, 2009. The fair value of the Company’s actively traded Convertible Notes used the trading quotes as of March 31, 2010 and December 31, 2009 provided by large financial institutions that trade in the Company’s securities.  The estimated fair value of the Company’s Convertible Notes which are not actively traded, such as the 9% Convertible Senior Discount Notes due 2013, the 7% Convertible Senior Notes due 2013, the 7% Convertible Senior Notes due 2015, Series B, and the 15% Convertible Senior Notes due 2013, approximated $1.346 billion at March 31, 2010 and $1.267 billion at December 31, 2009.  To estimate the fair value of the Convertible Notes which are not actively traded, Level 3 used a Black-Scholes valuation model and an income approach using discounted cash flows.  The most significant inputs affecting the valuation are the pricing quotes provided by these market participants which incorporate spreads to the Treasury curve, security coupon (ranging from 7% to 15%), convertible optionality, corporate and security credit ratings, maturity date (ranging from 2013 to 2015), liquidity, and other equity option inputs, such as the risk-free rate, underlying stock price, strike price of the embedded derivative, estimated volatility and maturity inputs for the option component and for the bond component, among other security characteristics and relative value at both the borrower entity level and across other securities of similar terms. The fair value of each instrument is obtained by adding together the value derived by discounting the security’s coupon or interest payment using a risk-adjusted discount rate and the value calculated from the embedded equity option based on the estimated volatility of the Company’s stock price, conversion rate of the particular Convertible Note, remaining time to maturity, and risk-free rate.

 

The Convertible Notes are unsecured obligations of Level 3 Communications, Inc.  No subsidiary of Level 3 Communications, Inc. has provided a guarantee of the Convertible Notes.

 

Term Loans

 

The fair value of the Term Loans was approximately $1.6 billion at both March 31, 2010 and December 31, 2009.  The fair value of each loan is obtained by discounting the expected cash flows of each instrument at a risk-adjusted discount rate and incorporating LIBOR expectations.  The significant inputs used to estimate the fair value of the Company’s Term Loans include the March 31, 2010 and December 31, 2009 trading quotes as provided by large financial institutions that trade in the Company’s loans. The pricing quotes provided by these market participants incorporate LIBOR curve expectations, interest spread, which is LIBOR plus 2.25% for the $1.4 billion in aggregate principal value in Tranche A Term Loan and LIBOR plus 8.5% for the $280 million Tranche B Term Loan (aggregate principal value), LIBOR floor (only applicable to the Tranche B Term Loan at 3.0% minimum), corporate and loan credit ratings, maturity date (March 2014) and liquidity, among other loan characteristics and relative value across other instruments of similar terms.

 

The Term Loans are secured by a pledge of the equity interests in certain domestic subsidiaries of Level 3 Financing, Inc. and 65% of the equity interest in Level 3 Financing, Inc.’s Canadian subsidiary and liens on the assets of Level 3 Communications, Inc. and certain domestic subsidiaries of Level 3 Financing, Inc.  In addition, Level 3 Communications, Inc. and certain domestic subsidiaries of Level 3 Financing, Inc. have provided full and unconditional guarantees of the obligations under the Term Loans.

 

Mortgage Debt

 

The fair value of the Commercial Mortgage was approximately $78 million and $75 million at March 31, 2010 and December 31, 2009, respectively, as compared to the carrying amounts of $68 million and $68 million, respectively.  The Commercial Mortgage is not actively traded and its fair value is estimated by management using a valuation model based on an income approach.  The significant inputs used to estimate fair value of this debt instrument using discounted cash flows include the anticipated scheduled mortgage payments and observable market yields on other actively traded debt of similar characteristics and collateral type.

 

The Commercial Mortgage is a secured obligation of HQ Realty, Inc., a wholly owned subsidiary of the Company.  HQ Realty, Inc.’s obligations under the Commercial Mortgage are secured by a first priority lien on the Company’s headquarters campus located at 1025 Eldorado Boulevard, Broomfield, Colorado 80021 and certain HQ Realty, Inc. cash and reserve accounts.

 

The assets of HQ Realty, Inc. are not available to satisfy any third party obligations other than those of HQ Realty, Inc. In addition, the assets of the Company and its subsidiaries other than HQ Realty, Inc. are not available to satisfy the obligations of HQ Realty, Inc.

 

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(7) Derivative Instruments

 

The Company uses derivative financial instruments, primarily interest rate swaps, to manage its exposure to fluctuations in interest rate movements. The Company’s primary objective in managing interest rate risk is to decrease the volatility of its earnings and cash flows affected by changes in the underlying rates. To achieve this objective, the Company enters into financial derivatives, primarily interest rate swap agreements, the values of which change in the opposite direction of the anticipated future cash flows.  The Company has floating rate long-term debt (see Note 8). These obligations expose the Company to variability in interest payments due to changes in interest rates. If interest rates increase, interest expense increases. Conversely, if interest rates decrease, interest expense also decreases. The Company has designated its interest rate swap agreements as cash flow hedges. Swaps designated as cash flow hedges involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the lives of the agreements without exchange of the underlying notional amount. The change in the fair value of the interest rate swap agreements is reflected in Accumulated Other Comprehensive Income (Loss) and is subsequently reclassified into earnings in the period that the hedged transaction affects earnings, due to the fact that the interest rate swap agreements are designated as effective cash flow hedges. The Company does not use derivative financial instruments for speculative purposes.

 

On March 13, 2007, Level 3 Financing Inc., the Company’s wholly owned subsidiary, entered into two interest rate swap agreements to hedge the interest payments on $1 billion notional amount of floating rate debt. The two interest rate swap agreements are with different counterparties and are for $500 million each. The transactions were effective beginning April 13, 2007 and mature on January 13, 2014. The Company uses interest rate swaps to convert specific variable rate debt issuances into fixed rate debt.  Under the terms of the interest rate swap transactions, the Company receives interest payments based on rolling three month LIBOR terms and pays interest at the fixed rate of 4.93% under one arrangement and 4.92% under the other.  The Company evaluates the effectiveness of the hedges on a quarterly basis. During the periods presented, these derivatives were used to hedge the variable cash flows associated with existing obligations. The Company recognizes any ineffective portion of the change in fair value of the hedged item in the consolidated statements of operations. All components of the interest rate swaps were included in the assessment of hedge effectiveness. Hedge ineffectiveness for the Company’s cash flow hedges was not material in any period presented.

 

The Company also has certain equity conversion rights associated with debt instruments, which are not designated as hedging instruments, but are considered derivative instruments as of March 31, 2010 and December 31, 2009.  Certain of these derivative instruments had to be classified as liabilities during 2010 and 2009 due to a potential requirement to settle the conversion rights in cash, and they are carried at fair value. The Company’s primary objective associated with including such conversion rights in certain of its debt instruments is to reduce the contractual interest rate and related current cash borrowing costs of the debt instruments. The Company recognizes the gains or losses from changes in fair values of these derivative instruments in other income (expense) in the statements of operations. Gains from these derivative instruments were $2 million during the three month period ended March 31, 2010.  There was no effect during the three month period ended March 31, 2009.

 

The Company is exposed to credit related losses in the event of non-performance by counterparties. The counterparties to any of the financial derivatives the Company enters into are major institutions with investment grade credit ratings. The Company evaluates counterparty credit risk before entering into any hedge transaction and continues to closely monitor the financial market and the risk that its counterparties will default on their obligations. This credit risk is generally limited to the unrealized gains in such contracts, should any of these counterparties fail to perform as contracted.

 

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Amounts accumulated in Other Comprehensive Income/Loss (“AOCI”) related to derivatives are indirectly recognized in earnings as periodic settlements occur throughout the term of the swaps, when the related interest payments affect earnings. As of March 31, 2010, the Company had the following outstanding interest rate derivatives that were designated as cash flow hedges of interest rate risk:

 

Interest Rate Derivative		Number of Instruments		Notional (in Millions)
Interest rate swaps		Two		$	1,000

 

The table below presents the fair value of the Company’s derivative financial instruments as well as their classification on the consolidated balance sheets as follows (in millions):

 

		Liability Derivatives
		March 31, 2010					December 31, 2009
Derivatives designated as hedging instruments		Balance Sheet Location		Fair Value			Balance Sheet Location		Fair Value
Cash flow hedging contracts		Other noncurrent liabilities		$	100		Other noncurrent liabilities		$	92

 

		Liability Derivatives
		March 31, 2010					December 31, 2009
Derivatives not designated as hedging instruments		Balance Sheet Location		Fair Value			Balance Sheet Location		Fair Value
Embedded equity conversion rights		Other noncurrent liabilities		$	24		Other noncurrent liabilities		$	20

 

The amount of gains (losses) recognized in Other Comprehensive Income consists of the following (in millions):

 

Derivatives designated as hedging instruments		March 31, 2010			March 31, 2009
Cash flow hedging contracts		$	(8	)	$	(15	)

 

The amount of gains (losses) reclassified from AOCI to Income/Loss (effective portions) consists of the following (in millions):

 

Derivatives designated as hedging instruments		Income Statement Location		March 31, 2010			March 31, 2009
Cash flow hedging contracts		Interest Expense		$	(12	)	$	(8	)

 

Interest rate swaps designated as cash flow hedging contracts offset the changes in the cash flows of the Company’s floating rate debt and qualify as effective hedge relationships, and as a result, hedge ineffectiveness was not material in any of the periods presented.  Amounts currently included in AOCI will be reclassified to earnings prior to the settlement of these cash flow hedging contracts in 2014.  The Company estimates that $47 million of net losses on the interest rate swaps (based on current LIBOR) will be reclassified into earnings within the next twelve months.

 

The effect of the Company’s derivative instruments on net (loss) and income is as follows (in millions):

 

Derivatives not designated as		Location of Gain Recognized in		March 31,
hedging instruments		Income on Derivative		2010			2009
Embedded equity conversion rights		Other Income (Expense)—Other, net		$	2		$	—

 

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(8) Long-Term Debt

 

As of March 31, 2010 and December 31, 2009, long-term debt was as follows:

 

(dollars in millions)		March 31, 2010			December 31, 2009
Senior Secured Term Loan due 2014		$	1,680		$	1,680
Senior Notes due 2011 (10.75%)		—			3
Senior Notes due 2013 (12.25%)		—			550
Senior Notes due 2014 (9.25%)		1,250			1,250
Floating Rate Senior Notes due 2015 (4.0% as of March 31, 2010)		300			300
Senior Notes due 2017 (8.75%)		700			700
Senior Notes due 2018 (10.0%)		640			—
Convertible Senior Notes due 2010 (2.875%)		38			40
Convertible Senior Notes due 2011 (5.25%)		196			199
Convertible Senior Notes due 2011 (10.0%)		172			172
Convertible Senior Notes due 2012 (3.5%)		294			294
Convertible Senior Notes due 2013 (15.0%)		400			400
Convertible Senior Discount Notes due 2013 (9.0%)		295			295
Convertible Senior Notes due 2015 (7.0%)		200			200
Convertible Senior Notes due 2015 Series B (7.0%)		275			275
Convertible Subordinated Notes due 2010 (6.0%)		—			111
Commercial Mortgage due 2015 (6.86%)		68			68
Capital Leases		31			32
Total Debt Obligations		6,539			6,569
Unamortized (Discount) Premium:
Discount on Senior Secured Term Loan due 2014		(2		)	(2		)
Discount on Senior Notes due 2013 (12.25%)		—			(2		)
Premium on Senior Notes due 2014 (9.25%)		8			8
Discount on Senior Notes due 2018 (10.0%)		(13		)	—
Discount on Convertible Senior Notes due 2011 (5.25%)		(33		)	(38		)
Discount on Convertible Senior Notes due 2014 (3.5%)		(42		)	(46		)
Discount on Convertible Senior Notes due 2015 (7.0%)		(4		)	(4		)
Discount due to embedded derivative contracts		(29		)	(25		)
Total Unamortized (Discount) Premium		(115		)	(109		)
Carrying Value of Debt		6,424			6,460
Less current portion		(213		)	(705		)
Long-term Debt, less current portion		$	6,211		$	5,755

 

Issuance of 10% Senior Notes Due 2018

 

On January 20, 2010, Level 3 Financing, Inc., in a private offering, issued $640 million in aggregate principal amount of its 10% Senior Notes due 2018 (the “10% Senior Notes”). The net proceeds from the issuance of the 10% Senior Notes were $613 million after deducting discount and debt issuance costs and were used to fund Level 3 Financing, Inc.’s purchase of its 12.25% Senior Notes due 2013 (the “12.25% Senior Notes”) in a concurrent tender offer and consent solicitation. The net discount of approximately $13 million is reflected as a reduction in long-term debt and is being amortized as interest expense over the term of the 10% Senior Notes using the effective interest method.  The 10% Senior Notes will mature on February 1, 2018 and are guaranteed by Level 3 Communications, Inc. and Level 3 Communications, LLC.  Interest on the notes accrues at 10% per year and is payable on February 1 and August 1 of each year, beginning August 1, 2010.

 

Debt issue costs of approximately $14 million were capitalized and are being amortized over the term of the 10% Senior Notes.

 

The offering of the 10% Senior Notes was not registered under the Securities Act of 1933, as amended, and the 10% Senior Notes may not be offered or sold in the United States absent registration or an applicable exemption from registration requirements. The 10% Senior Notes were sold to “qualified institutional buyers” as defined in Rule 144A under the

 

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Securities Act of 1933, as amended, and non-U.S. persons outside the United States under Regulation S under the Securities Act of 1933, as amended.

 

On January 20, 2010, Level 3, Level 3 Financing, Inc. and the initial purchasers of the 10% Senior Notes entered into a registration rights agreement regarding the 10% Senior Notes pursuant to which Level 3 and Level 3 Financing, Inc. agreed, among other things, to file an exchange offer registration statement with the Securities and Exchange Commission.  The maximum consideration that could be transferred to the initial purchasers pursuant to the registration rights agreement in the event of a Registration Default, as defined, is special interest on the principal amount of the Senior Notes not to exceed 1% per annum.

 

Tender Offer

 

On January 5, 2010, Level 3 Financing, Inc. commenced a tender offer to purchase for cash any and all of the outstanding $550 million aggregate principal amount of its 12.25% Senior Notes for a price equal to $1,080.00 per $1,000 principal amount of the notes, which included $1,050.00 as the tender offer consideration and $30.00 as a consent payment (the “12.25% Tender Offer”). In connection with the 12.25% Tender Offer, Level 3 and Level 3 Financing, Inc. solicited consents to certain proposed amendments to the indenture governing the 12.25% Senior Notes to eliminate substantially all of the covenants, certain repurchase rights and certain events of default and related provisions contained in the indenture.

 

In January 2010, holders of the 12.25% Senior Notes, representing approximately 99.4% of the aggregate principal amount of the outstanding 12.25% Senior Notes, participated in the tender offer. At the expiration of the tender offer on February 2, 2010, an aggregate principal amount of $546,912,000 notes had been tendered.

 

In connection with the 12.25% Tender Offer and consent solicitation, on January 20, 2010, Level 3 Financing, Inc. entered into a supplemental indenture, among Level 3, Level 3 Financing, Inc., Level 3 Communications, LLC and The Bank of New York Mellon, as Trustee (the “Supplemental Indenture”) to effect the amendments to the indenture relating to the 12.25% Senior Notes. On March 15, 2010, the Company redeemed in full the remaining $3 million aggregate principal of the 12.25% Senior Notes, at a redemption price equal to 106.125% of the principal amount thereof, plus accrued and unpaid interest.

 

The Company recognized a loss associated with the 12.25% Tender Offer of approximately $54 million.

 

Debt Repayments and Repurchases

 

In the first quarter of 2010, the Company repaid $111 million aggregate principal amount of its 6% Convertible Subordinated Notes due 2010 that matured on March 15, 2010.  In addition, in various transactions during the first quarter of 2010, the Company repurchased $3 million in aggregate principal amount of 5.25% Convertible Senior Notes due 2011, the remaining $3 million of its 10.75% Senior Notes due 2011, and $2 million aggregate principal amount of 2.875% Convertible Senior Notes due 2010.  Repurchases were made at prices to par ranging from 95% to 100%, and the Company recognized a net loss on these repurchases of less than $1 million.

 

In the first quarter of 2009, the Company repurchased $5 million aggregate principal amount of its 6% Convertible Subordinated Notes due 2009 and $1 million aggregate principal amount of its 11.5% Senior Notes due 2010 at discounts to the principal amounts and recognized a net gain on extinguishment of less than $1 million.

 

Refer to Note 14 Subsequent Event for additional information regarding the Company’s redemption of its 10% Convertible Senior Notes due 2011 in the second quarter of 2010.  The Company has classified these notes within the current portion of long-term debt on the consolidated balance sheet as a result of the irrevocable redemption notice issued on April 27, 2010.

 

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Debt Maturities

 

Aggregate future maturities of long-term debt and capital leases (excluding debt discounts, premiums and fair value adjustments and including the expected redemption of the 10% Convertible Senior Notes due 2011 in May 2010) were as follows as of March 31, 2010 (in millions):

 

2010 (remaining nine months)		$	212
2011		199
2012		298
2013		698
2014		2,934
Thereafter		2,198
		$	6,539

 

(9) Stock-Based Compensation

 

The following table summarizes non-cash compensation expense and capitalized non-cash compensation for the three months ended March 31, 2010 and 2009 (in millions):

 

		Three Months Ended March 31,
		2010			2009
OSO		$	3		$	1
Restricted Stock and Restricted Stock Units		6			8
401(k) Match Expense		2			7
Restricted Stock Unit Bonus Grant		5			—
		16			16
Capitalized Noncash Compensation		—			—
		$	16		$	16

 

The Company capitalizes non-cash compensation for those employees directly involved in the construction of the network, installation of services for customers or development of business support systems. As of March 31, 2010, there were approximately 17 million outperform stock option (“OSO”) units outstanding, of which approximately 3 million were exercisable.  As of March 31, 2010, there were approximately 26 million nonvested restricted stock and restricted stock units (“RSUs”) outstanding.

 

During the first quarter of 2010, the Company revised the eligibility criteria and grant schedule for its non-cash compensation.  Effective April 1, 2010, the Company’s OSOs will be granted quarterly to certain levels of management and its RSUs will be granted annually on July 1 to certain other eligible employees.  There were no changes to the vesting schedule, or any other aspects of the non-cash compensation plans.

 

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(10) Comprehensive Loss

 

The components of total comprehensive loss, net of taxes, were as follows (in millions):

 

		Three Months Ended March 31,
		2010			2009
Net loss		$	(238	)	$	(132	)
Change in cumulative translation adjustment		(47		)	(34		)
Change in unrealized holding loss on interest rate swaps		(8		)	(15		)
Other, net		—			(1		)
Comprehensive loss		$	(293	)	$	(182	)

 

The components of accumulated other comprehensive loss, net of taxes, were as follows (in millions):

 

		March 31, 2010			December 31, 2009
Cumulative translation adjustment		$	86		$	133
Accumulated net unrealized holding gain (loss) on interest rate swaps		(100		)	(92		)
Other, net		(46		)	(46		)
Accumulated other comprehensive loss		$	(60	)	$	(5	)

 

(11)  Segment Information

 

Accounting guidance for the disclosures about segments of an enterprise defines operating segments as 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. The Company’s operating segments are managed separately and represent separate strategic business units that offer different products or services and serve different markets. The Company’s reportable segments include: communications and coal mining (see Note 1). Other business interests, which are not reportable segments, include corporate assets and overhead costs that are not attributable to a specific segment.

 

The Company evaluates performance based upon Adjusted EBITDA, as defined by the Company, as net income (loss) from the consolidated statements of operations before (1) income taxes, (2) total other income (expense), (3) non-cash impairment charges included within restructuring and impairment charges, (4) depreciation and amortization and (5) non-cash stock compensation expense included within selling, general and administrative expenses on the consolidated statements of operations.

 

The data presented in the following tables includes information for the three months ended March 31, 2010 and 2009 for all statement of operations and cash flow information presented.

 

Segment information for the Company’s Communications and Coal Mining businesses is summarized as follows (in millions):

 

		Three Months Ended March 31,
		2010			2009
Revenue from external customers:
Communications		$	900		$	962
Coal Mining		10			18
		910			$	980
Adjusted EBITDA:
Communications		202			$	249
Coal Mining		(2		)	$	1

 

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Communications revenue consists of:

 

1)              Core Network Services includes revenue from transport, infrastructure, data, and local and enterprise voice communications services.

 

2)              Wholesale Voice Services includes revenue from long distance voice services, including domestic voice termination, international voice termination and toll free services.

 

3)              Other Communications Services includes revenue from managed modem and its related reciprocal compensation services and SBC Contract Services, which includes revenue from the SBC Master Services Agreement, which was obtained in the December 2005 acquisition of WilTel.

 

Communications revenue attributable to each of these services is as follows (in millions):

 

		Three Months Ended March 31,
		2010			2009
Core Network Services Revenue		$	701		$	728
Wholesale Voice Services Revenue		165			171
Other Communications Revenue		34			63
Total Communications Revenue		$	900		$	962

 

The following information provides a reconciliation of net loss to Adjusted EBITDA by operating segment, as defined by the Company, for the three months ended March 31, 2010 and 2009 (in millions):

 

Three Months Ended March 31, 2010

 

		Communications			Coal Mining
Net loss		$	(235	)	$	(2	)
Income tax expense		1			—
Total other (income) expense		196			(1		)
Depreciation and amortization expense		224			1
Non-cash compensation expense		16			—
Adjusted EBITDA		$	202		$	(2	)
Total Net Loss for reportable segments					$	(237	)
Unallocated corporate expense					(1		)
Consolidated Net Loss					$	(238	)

 

Three Months Ended March 31, 2009

 

		Communications			Coal Mining
Net loss		$	(133	)	$	—
Income tax expense		1			—
Total other (income) expense		144			—
Depreciation and amortization expense		221			1
Non-cash compensation expense		16			—
Adjusted EBITDA		$	249		$	1
Total Net Loss for reportable segments					$	(133	)
Unallocated corporate expense					1
Consolidated Net Loss					$	(132	)

 

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