Level 3 Communications Upgraded: What You Need to Know

Four years ago, I made a bad call on Level 3 Communications (NYSE: LVLT).

And I mean hugely bad. Epically bad. So bad that I promptly erased it from my memory (although I left it on my CAPS scorecard, just in case Mr. Market would like to prove me right over time). That didn't happen. Instead, over the four years since I rated Level 3 Communications stock an underperformer, the shares instead proceeded to double in value, and beat the performance of the broader S&P 500 by more than 70 percentage points.

So boy, was I ever wrong. And today, I might very well be wrong again. This morning you see, analysts at New York-based equity research firm MoffettNathanson announced they are upgrading Level 3 Communications stock to buy. And that provides us with a perfect excuse to revisit Level 3, and see if the stock is, perhaps, a better business than it first looked to me four years ago.

So once again, let's dive in. Here are three things you need to know.

Is there a light at the end of Level 3 Communications' tunnel? A blue, fiber-optic light? Image source: Getty Images.

1. Hopes dashed, followed by more high hopes

Level 3 didn't have a great second quarter. Although pro forma profits at the integrated telecommunications services provider beat estimates, revenue fell shortof estimates and declined year over year. Level 3 shares tumbled 7% in the immediate aftermath of the earnings report, and continued falling to a recent low of about $48 -- down 15% from the pre-earnings high.

And yet, according to MoffettNathanson, this steep sell-off has provided investors with a chance to capitalize on the rebound. Quoted on StreetInsider.com this morning, Moffett's analysts admit that Level 3's revenue performance last quarter was "really quite bad." But at the same time, Moffett argues that "times like these sometimes present buying opportunities," and Moffett sees here a chance to earn as much as a 16% profit as Level 3 shares climb toward its target price of $58 a share.

2. $58? Why?

That's an excellent question. MoffettNathanson predicts that Level 3 shares will climb to $58. But in defense of this prediction, the most the analyst will say is that Level 3's "long-term outlook remains intact, and the valuation is appealing."

Those are pretty bold assertions, but lacking in much detail to support them. So here's what we know: In the four years since I rated Level 3 Communications stock an underperformer, the company has gone on to grow its revenue 29%, more than double its operating profits to $1.4 billion, and cease losing money on the bottom line. In fact, over the past 12 reported months, Level 3 has reported total net profits of $3.6 billion (all data as provided by S&P Global Market Intelligence).

Simply put, Level 3 is on a roll.

3. Caveats and provisos

Most of that $3.6 billion profit came in the form of a $3 billion one-time tax benefit, however. This year's earnings are expected to be closer to $600 million, climbing to $880 million by 2018. Even more importantly, the company -- which was burning cash and heavily indebted four years ago -- is today producing positive free cash flow at the rate of $950 million a year.

If Level 3 can keep that up, it should be able to make some real headway in working down its debt load (currently at $9.6 billion, net of cash, and above 2012 levels), and building up its balance sheet.

The most important thing: Valuation

Given the huge difference between Level 3's apparent, trailing profits, and its likely GAAP earnings total for this current year, the best way to value the enterprise may be to measure Level 3's debt-adjusted market cap against these strong free cash flows instead. If we do that, then we find that Level 3 has an enterprise value of $27.3 billion today, $950 million in free cash flow, and thus an EV/FCF ratio of 28.7.

Despite the stock's 18.6% projected long term earnings growth, and despite Level 3's impressive performance over the past four years, I cannot help but conclude that at an EV/FCF/growth ratio of 1.5, Level 3 Communications -- while much healthier from a free cash flow standpoint -- is still overvalued today.

But then again...I've been wrong before.

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Fool contributorRich Smithdoes not own shares of, nor is he short, any company named above. You can find him onMotley Fool CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 301 out of more than 75,000 rated members.

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