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LEVEL 3 COMMUNICATIONS INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read in conjunction with the Company's consolidated financial statements (including the notes thereto) included elsewhere herein and the description of its business in Item 1, "Business". Executive Summary Overview The Company is a facilities-based provider of a broad range of communications services. Revenue for communications services is generally recognized on a monthly basis as these services are provided. For contracts involving private line, wavelength and dark fiber services, Level 3 may receive upfront payments for services to be delivered for a period of generally up to 25 years. In these situations, Level 3 defers the revenue and amortizes it on a straight-line basis to earnings over the term of the contract. At December 31, 2013, for contracts where upfront payments were received for services to be delivered in the future, the Company's weighted average remaining contract period was approximately 12 years. On October 4, 2011, a wholly owned subsidiary of Level 3 completed its amalgamation with Global Crossing and the amalgamated entity became an indirect wholly owned subsidiary of the Company through a tax free, stock for stock transaction (the "Amalgamation"). Level 3, through its two 50% owned joint-venture surface mines, one each in Montana and Wyoming, sold coal primarily through long-term contracts with public utilities. In November 2011, Level 3 completed the sale of its coal mining business to Ambre Energy Limited as part of its long-term strategy to focus on core business operations. The financial results of the coal mining business are included in the Company's consolidated results of operations through the date of sale, and all periods presented have been revised to reflect the presentation within discontinued operations. Business Strategy and Objectives The Company pursues the strategies discussed in Item 1. Business, "Business Overview and Strategy." In particular, with respect to strategic financial objectives, the Company focuses its attention on the following: • growing revenue by increasing sales generated by our Core Network Services; • focusing on our Enterprise customers, as this customer group has the largest potential for significant growth; • continually improving the customer experience to increase customer retention and reduce customer churn; • launching new products and services to meet customer needs, in particular for enterprise customers; • reducing network costs and operating expenses; • achieving sustainable generation of positive cash flows from operations; • continuing to show improvement in Adjusted EBITDA (as defined in this Item below) as a percentage of revenue; 68-------------------------------------------------------------------------------- Table of Contents • localizing certain decision making and interaction with our mid-market enterprise customers, including leveraging our existing network assets; • concentrating its capital expenditures on those technologies and assets that enable the Company to develop its Core Network Services; • managing Wholesale Voice Services for margin contribution; and • refinancing its future debt maturities. The Company's management continues to review all existing lines of business and service offerings to determine how those lines of business and service offerings enhance the Company's focus on the delivery of communications services and meeting its financial objectives. To the extent that certain lines of business or service offerings are not considered to be compatible with the delivery of the Company's services or with meeting its financial objectives, Level 3 may exit those lines of business or stop offering those services in part or in whole. The Company has also been focused on improving its liquidity and financial condition, and extending the maturity dates of certain debt, as described below and in greater detail in Note 12 - Long-Term Debt in the notes to the consolidated financial statements. In November 2013, the Company notified the holders of its 6.5% Convertible Senior Notes that the Company would be redeeming these notes on December 26, 2013 for a redemption price equal to 100% of their principal amount, plus accrued but unpaid interest up to, but not including, the redemption date. The holders of the 6.5% Convertible Senior Notes converted approximately $200 million aggregate principal amount of the notes into 10,814,264 shares of Level 3 common stock, par value $0.01 per share. On December 26, 2013, approximately $1 million aggregate principal amount of the remaining 6.5% Convertible Senior Notes was redeemed at a price equal to 100% of the principal amount plus accrued but unpaid interest. In November 2013, the Company completed the offering of $300 million aggregate principal amount of its Floating Rate Senior Notes due 2018. The net proceeds from the offering of the notes, together with cash on hand were used to redeem all of the Company's outstanding Floating Rate Senior Notes due 2015 in December 2013, including accrued interest and expenses. The Floating Rate Notes due 2018 were priced at 100% of their principal amount and will mature on January 15, 2018. Interest on the notes will be payable on May 15 and November 15 of each year, beginning on May 15, 2014. Also in November 2013, the Company completed the offering of $640 million aggregate principal amount of its 6.125% Senior Notes due 2021. The net proceeds from the offering of the notes, together with cash on hand were used to redeem all of the Company's outstanding 10% Senior Notes due 2018 in December 2013, including accrued interest, applicable premiums and expenses. The 6.125% Senior Notes were priced at 100% of their principal amount and will mature on January 15, 2021. Interest on the notes will be payable on April 15 and October 15 of each year, beginning on April 15, 2014. In October 2013, the Company refinanced its existing $1.2 billion Tranche B-II 2019 Term Loan under its existing senior credit facility by increasing the borrowings under the Tranche B 2020 Term Loan by an aggregate principal amount of $1.2 billion. The Tranche B 2020 Term Loan new aggregate principal amount is $1,795.5 million. The $1,795.5 million Tranche B 2020 Term Loan will bear interest at LIBOR plus 3.00%, with a minimum LIBOR of 1.00%, and will mature on January 15, 2020. The additional portion of the Tranche B 2020 Term Loan was priced to lenders at par, with the payment to the lenders of an upfront 0.25% fee at closing. The prior Tranche B-II 2019 Term Loan had an interest rate of LIBOR plus 3.25%, with a minimum LIBOR of 1.50% and matured on October 4, 2019. 69 -------------------------------------------------------------------------------- Table of Contents In August 2013, the Company refinanced its $595.5 million Tranche B 2016 Term Loan under its existing senior credit facility through the creation of a new Tranche B 2020 Term Loan in the aggregate principal amount of $595.5 million. The Tranche B 2020 Term Loan has an interest rate of LIBOR plus 3.00%, with a minimum LIBOR of 1.00%, and will mature on January 15, 2020. The previous Tranche B 2016 Term Loan had an interest rate of LIBOR plus 3.25%, with a minimum LIBOR of 1.50%, and matured on August 1, 2016. Also in August 2013, the Company refinanced its $815 million Tranche B 2019 Term Loan under its existing senior credit facility through the creation of a new Tranche B-III 2019 Term Loan in the aggregate principal amount of $815 million. The Tranche B-III 2019 Term Loan has an interest rate of LIBOR plus 3.00%, with a minimum LIBOR of 1.00%, and will mature on August 1, 2019. The previous Tranche B 2019 Term Loan had an interest rate of LIBOR plus 3.75%, with a minimum LIBOR of 1.50%, and matured on August 1, 2019. In January 2013, the Company repaid at maturity approximately $172 million of its 15% Convertible Senior Notes. The Company will continue to look for opportunities to improve its financial position and focus its resources on growing revenue and managing costs for the business. Revenue by Channel: Year Ended December 31, (dollars in millions) 2013 2012 Core Network Services: North America - Wholesale Channel $ 1,478 $ 1,541 North America - Enterprise Channel 2,471 2,299 EMEA - Wholesale Channel 354 364 EMEA - Enterprise Channel 403 372 EMEA - U.K. Government Channel 131 175 Latin America - Wholesale Channel 160 156 Latin America - Enterprise Channel 594 556 Total Core Network Services 5,591 5,463 Wholesale Voice Services and Other 722 913 Total Revenue $ 6,313 $ 6,376 Total revenue consists of: • Core Network Services revenue from colocation and data center services; transport and fiber; IP and data services; and local and enterprise voice services. • Wholesale Voice Services and Other revenue from sales of long distance voice services, revenue from managed modem and its related intercarrier compensation services and revenue from the SBC Master Services Agreement, which was obtained through an acquisition in 2005. Core Network Services revenue represents higher margin services and Wholesale Voice Services and Other revenue represents lower margin services. Core Network Services revenue requires different levels of investment and focus and provides different contributions to the Company's operating results than Wholesale Voice Services and Other revenue. Management believes that growth in revenue from its Core Network Services is critical to the long-term success of its business. The Company also believes it 70 -------------------------------------------------------------------------------- Table of Contents must continue to effectively manage gross margin contribution from the Wholesale Voice Services component and the positive cash flows from the Other revenue component. The Company believes that trends in its communications business are best gauged by analyzing revenue changes in Core Network Services. Core Network Services Colocation and data center services allow customers to place their network equipment and servers in suitable environments maintained by the Company with high-speed links providing on-net access to more than 55 countries. These services are secure, redundant and flexible to fit the varying needs of the Company's customers. Services, which vary by location, include hosting network equipment used to transport high speed data and voice over Level 3's global network; providing managed IT services, installation, maintenance, storage and monitoring of enterprise services; and providing comprehensive IT outsource solutions. Growth in transport (such as private line and wavelengths) and fiber revenue is largely dependent on increased demand for bandwidth services and available capital of companies requiring communications capacity for their own use or in providing capacity as a service provider to their customers. These expenditures may be in the form of monthly payments or, in the case of private line, wavelength or dark fiber services, either monthly payments or upfront payments. The Company is focused on providing end-to-end transport and fiber services to its customers to directly connect customer locations with a private network. Pricing for end-to-end metropolitan transport services have been relatively stable. For intercity transport and fiber services, the Company continues to experience pricing pressure in locations where a large number of carriers co-locate their facilities. An increase in demand may be offset by declines in unit pricing. Internet Protocol ("IP") and data services primarily include the Company's Internet services, Virtual Private Network ("VPN"), Content Delivery Network ("CDN"), media delivery, Vyvx broadcast, Converged Business Network ("CBN"), and Managed Services. Level 3's IP and high speed IP service is high quality and is offered in a variety of capacities. The Company's VPN service permits businesses of any size to replace multiple networks with a single, cost-effective solution that greatly simplifies the converged transmission of voice, video, and data. This convergence to a single platform can be obtained without sacrificing the quality of service or security levels of traditional ATM and frame relay offerings. VPN service also permits customers to prioritize network application traffic so that high priority applications, such as voice and video, are not compromised in performance by the flow of low priority applications such as email. Voice services comprise a broad range of local and enterprise voice services using Voice over Internet Protocol ("VoIP") and traditional circuit-switch based technologies, including VoIP enhanced local service, SIP Trunking, local inbound service, Primary Rate Interface service, long distance service and toll-free service. The Company's voice services also include its comprehensive suite of audio, Web and video collaboration services. The Company believes that a source of future incremental demand for the Company's Core Network Services will be from customers that are seeking to distribute their feature rich content or video over the Internet. Revenue growth in this area is dependent on the continued increase in demand from customers and the pricing environment. An increase in the reliability and security of information transmitted over the Internet and declines in the cost to transmit data have resulted in increased utilization of e-commerce or Web-based services by businesses. Although the pricing for data services is currently relatively stable, the IP market is generally characterized by price compression and high unit growth rates depending upon the type of service. The Company experienced price compression in the high-speed IP and voice services markets in 2012, which has continued in 2013. 71 -------------------------------------------------------------------------------- Table of Contents The following provides a discussion of the Company's Core Network Services revenue in terms of the enterprise and wholesale channels. • The enterprise channel includes large, multi-national enterprises requiring large amounts of bandwidth to support their business operations, such as financial services companies, healthcare companies, content providers, and portal and search engine companies. It also includes medium sized enterprises, as well as government markets, including the U.S. federal government, the systems integrators supporting the U.S. federal government, U.S. state and local governments, academic consortia, and certain academic institutions. Included in the enterprise channel, but broken out separately in the table above, is the U.K. government channel, which includes revenue primarily from the government sector in the U.K. • The wholesale channel includes revenue from incumbent and alternative carriers in each of the regions, global carriers, wireless carriers, cable companies, satellite companies, regional service providers and voice service providers. The Company believes that the alignment of Core Network Services around channels should allow it to drive growth while enabling it to better focus on the needs of its customers. Each of these channels is supported by dedicated employees in sales. Each of these channels is also supported by non-dedicated, centralized service delivery and management, product management and development, corporate marketing, global network services, engineering, information technology, and corporate functions, including legal, finance, strategy and human resources. Wholesale Voice Services and Other The Company offers wholesale voice services that target large and existing markets. The revenue potential for wholesale voice services is large; however, pricing is expected to continue to decline over time as a result of the new low-cost IP and optical-based technologies. In addition, the market for wholesale voice services is being targeted by many competitors, several of which are larger and have more financial resources than the Company. The Company also has other revenue derived from mature services that are not critical areas of emphasis for the Company, including revenue from managed modem and its related intercarrier compensation services and SBC Contract Services, which includes revenue from the SBC Master Services Agreement, obtained in the December 2005 acquisition of WilTel Communications Group, LLC. The Company and its customers continue to see consumers migrate from narrow band dial-up services to higher speed broadband services as the narrow band market matures. The Company has discontinued its managed modem services. The Company expects ongoing declines in the other revenue component of Wholesale Voice Services and Other similar to what has been experienced over the past several years. The Company receives compensation from other carriers when it terminates traffic originating on those carriers' networks. This intercarrier compensation is based on interconnection agreements with the respective carriers or rates mandated by the Federal Communications Commission ("FCC"). The Company has interconnection agreements in place for the majority of traffic subject to intercarrier compensation. Along with addressing other matters, on November 18, 2011, the FCC established a prospective intercarrier compensation framework for terminating switched access and VoIP traffic, with elements of it becoming effective beginning on December 29, 2011. Under the framework, most terminating switched access charges and all intercarrier compensation charges are capped at current levels, and will be reduced to zero over, as relevant to Level 3, a six year transition period which began July 1, 2012. Several states, industry groups, and other telecommunications carriers filed petitions in federal court for reconsideration of the framework with the FCC, although the outcome of those petitions is unpredictable. A majority of the Company's existing intercarrier compensation revenue is associated with agreements that have expired terms, but remain effective in evergreen status. As these and other interconnection agreements expire, the Company will continue to evaluate simply allowing them to 72 -------------------------------------------------------------------------------- Table of Contents continue in evergreen status (so long as the counterparty allows the same) or negotiating new agreements. The Company earned intercarrier compensation revenue from providing managed modem services, which it has discontinued. The Company also receives intercarrier compensation from its voice services. In this case, intercarrier compensation is reported within Core Network Services revenue. Seasonality and Fluctuations The Company continues to expect business fluctuations to affect sequential quarterly trends in revenue, margins and cash flow. This includes the timing, as well as any seasonality of sales and service installations, usage, rate changes and repricing for contract renewals. Historically, the Company's revenue and expense in the first quarter has been affected by the slowing of our customers' purchasing activities during the holidays and the resetting of payroll taxes in the new year. The Company's historical experience with quarterly fluctuations may not necessarily be indicative of future results. Because revenue subject to billing disputes where collection is uncertain is not recognized until the dispute is resolved, the timing of dispute resolutions and settlements may positively or negatively affect the Company's revenue in a particular quarter. The timing of disconnections may also affect our results in a particular quarter, with disconnections early in the quarter generally having a greater effect. The timing of capital and other expenditures may affect our margins or cash flow. The convergence of any of these or other factors such as fluctuations in usage, increases or decreases in certain taxes and fees or pricing declines upon contract renewals in a particular quarter may result in the Company's revenue growing more or less than previous trends, may affect the Company's margins and other financial results and may not be indicative of future financial performance. 2014 Revenue Reporting In 2014, the Company is maintaining its current reporting of revenue by service offering as disclosed in the table above but will be making some adjustments between current geographical and channel reporting categories, primarily collapsing the U.K. government channel in EMEA into the EMEA enterprise channel, to more appropriately reflect the revenue attribution by region. Critical Accounting Policies and Estimates The Company's discussion and analysis of its financial condition and results of operations are based upon the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, equity, revenue, expenses and related disclosures. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. The Company evaluates these estimates on an ongoing basis. Actual results may differ from these estimates under different assumptions or conditions. While the Company has other accounting policies that involve estimates such as the allowance for doubtful accounts, valuation allowance for deferred tax assets, and unfavorable contracts recognized in purchase accounting, management has identified the policies below, which require the most significant judgments and estimates to be made in the preparation of the consolidated financial statements, as critical to its business operations and the understanding of its results of operations. Revenue Revenue for communications services, including colocation and data center services, transport and fiber, IP and data services, voice services and managed modem, is recognized monthly as the services 73 -------------------------------------------------------------------------------- Table of Contents are provided based on contractual amounts expected to be collected. Communications services are provided either on a usage basis, which can vary period to period, or at a contractually committed amount. Intercarrier compensation revenue is recognized when an interconnection agreement is in place with another carrier, or if an agreement has expired, when the parties have agreed to continue operating under the previous agreement until a new agreement is negotiated and executed, or at rates mandated by the FCC. For certain sale and long-term indefeasible right of use ("IRU") contracts involving private line, wavelengths and dark fiber services, the Company may receive upfront payments for services to be delivered for a period of up to 25 years. In these situations, the Company defers the revenue and amortizes it on a straight-line basis to earnings over the term of the contract. Termination revenue is recognized when a customer disconnects service prior to the end of the contract period and for which Level 3 had previously received consideration and for which revenue recognition was deferred. Termination revenue also is recognized when customers make termination penalty payments to Level 3 to settle contractually committed purchase amounts that the customer no longer expects to meet or when a customer and Level 3 renegotiate a contract under which Level 3 is no longer obligated to provide product or services for consideration previously received and for which revenue recognition has been deferred. Termination revenue is reported in the same manner as the original product or service provided. Accounting practice and guidance with respect to the accounting treatment of revenue continues to evolve. Any changes in the accounting treatment could affect the manner in which the Company accounts for revenue within its business. Revenue Reserves The Company establishes appropriate revenue reserves at the time services are rendered based on an analysis of historical credit activity to address, where significant, situations in which collection is not reasonably assured as a result of credit risk, potential billing disputes or other reasons. The Company's significant estimates are based on assumptions and other considerations, including payment history, credit ratings, customer financial performance, history of billing disputes and industry financial performance. Cost of Revenue for Communications Services The Company disputes incorrect billings from its suppliers of network services. The most prevalent types of disputes include disputes for circuits that are not disconnected by the supplier on a timely basis and usage bills with incorrect or inadequate information. Depending on the type and complexity of the issues involved, it may and often does take several quarters to resolve the disputes. The Company establishes appropriate cost of revenue reserves for disputed supplier billings based on an analysis of its historical experience in resolving disputes with its suppliers. In determining the amount of the cost of network service expenses and related accrued liabilities to reflect in its financial statements, the Company considers the adequacy of documentation of disconnect notices, compliance with prevailing contractual requirements for submitting these disconnect notices and compliance with its interconnection agreements with these carriers. Judgment is required in estimating the ultimate outcome of the dispute resolution process, as well as any other amounts that may be incurred to conclude the negotiations or settle any litigation. Actual results may differ from these estimates under different assumptions or conditions and such differences could be material. 74 -------------------------------------------------------------------------------- Table of Contents Non-Cash Compensation The Company recognizes stock-based compensation expense for all share-based payment awards in accordance with fair value recognition provisions. Under the fair value recognition provisions, the Company recognizes stock-based compensation expense net of an estimated forfeiture rate, recognizing compensation cost for only those awards expected to vest over the requisite service period of the awards. Determining the appropriate fair value model and estimating the fair value of share-based payment awards require subjective assumptions, including the assumption for stock price volatility for outperform stock options and the achievement of performance criteria for performance based awards. The Company estimates the stock price volatility using a combination of historical and implied volatility, as Level 3 believes it is consistent with the approach most marketplace participants would consider by using all available information to estimate expected volatility. The Company has determined that expected volatility is more reflective of market conditions and provides a more accurate indication of volatility than using solely historical volatility. In reaching this conclusion, the Company has considered many factors including the extent to which its future expectations of volatility over the respective term is likely to differ from historical measures, the absence of actively traded options for the Company's common stock and the Company's ability to review volatility of its publicly traded convertible debt with similar terms and prices to the options the Company is valuing. The Company issued outperform stock options in which the value received is based on a formula involving a multiplier related to the level by which the Company's common stock outperforms the S&P 500® Index. The Company utilized a modified Black-Scholes model due to the additional variables required to calculate the effect of the success multiplier for its outperform stock options, including estimating the expected volatility of the S&P 500® Index. The assumptions used in estimating the fair value of share-based payment awards represent management's best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and the Company uses different assumptions, stock-based compensation expense could be materially different in the future. In addition, the Company is required to estimate the expected forfeiture rate and recognize expense only for those shares expected to vest. If actual forfeiture rates are materially different from the Company's estimate, stock-based compensation expense could be significantly different from what the Company has recorded in the current period. Valuation of Long-Lived Assets The Company performs an assessment of its long-lived assets, including finite-lived acquisition-related intangible assets, for impairment when events or changes in circumstances indicate that the carrying value of assets or asset groupings may not be recoverable. This review requires the identification of the lowest level of identifiable cash flows for purposes of grouping assets subject to review. The estimate of undiscounted cash flows includes long-term forecasts of revenue growth, gross margins and operating expenses. All of these items require significant judgment and assumptions. An impairment loss may exist when the estimated undiscounted cash flows attributable to the assets are less than their carrying amount. If an asset is deemed to be impaired, the amount of the impairment loss recognized represents the excess of the long-lived asset's carrying value as compared to its estimated fair value, based on management's assumptions and projections. The Company conducted a long-lived asset impairment analysis in the fourth quarter of 2013 and 2012 and in each case concluded that its long-lived assets, including its finite-lived acquisition-related intangible assets, were not impaired. To the extent that future changes in assumptions and estimates cause a change in estimates of future cash flows that indicate the carrying amount of the Company's long-lived assets, including finite-lived acquisition-related intangible assets, may not be recoverable, the Company may incur impairment charges in the future to write-down the carrying amount of the Company's long-lived assets to their estimated fair value. 75 -------------------------------------------------------------------------------- Table of Contents Useful Lives of Long-Lived Assets The Company performs internal reviews to evaluate the depreciable lives of its property, plant and equipment annually or more frequently if new facts and circumstances arise that may affect management's original estimates. Due to the rapid changes in technology and the competitive environment, selecting the estimated economic life of telecommunications property, plant, and equipment requires a significant amount of judgment. The Company's internal reviews take into account input from the Company's global engineering and network services personnel, actual usage, the physical condition of the Company's property, plant, and equipment, industry data, and other relevant factors. In relation to its most recent annual review of estimated useful lives, the Company considered the expected use of assets in each of the categories as well as any legal, regulatory, or contractual provisions that may limit the remaining useful lives. The Company expects to extend the lives associated with IP equipment and certain of its facility equipment in connection with the analysis expected to be completed in the first quarter of 2014. This will be a change in estimate that will be accounted for prospectively. Goodwill The Company performs an annual impairment assessment of its goodwill during the fourth quarter, or more frequently if the Company determines that indicators of impairment exist. The Company's impairment review process considers the fair value of each reporting unit relative to its carrying value. The Company assesses the fair value of each of its reporting units using an income approach (also known as a discounted cash flow) and a market multiple approach. The income approach utilizes cash flow projections discounted using an appropriate Weighted Average Cost of Capital (WACC) rate for each reporting unit. The market multiple approach uses a multiple of a company's Earnings Before Interest, Taxes, and Depreciation and Amortization expenses (EBITDA). If the fair value of the reporting unit exceeds its carrying value, goodwill is not impaired and no further testing is performed. If the carrying value of the reporting unit exceeds its fair value, then a second step must be performed, and the implied fair value of the reporting unit's goodwill must be determined and compared to the carrying value of the reporting unit's goodwill. If the carrying value of a reporting unit's goodwill exceeds its implied fair value, then an impairment loss equal to the difference will be recorded. In accordance with recently issued accounting guidance, prior to performing the two step evaluation, an assessment of qualitative factors may be performed to determine whether it is more likely than not that the fair value of a reporting unit exceeds the carrying value. If it is determined that it is unlikely that the carrying value exceeds the fair value, the Company is not required to complete the two step goodwill impairment evaluation. The selection and assessment of qualitative factors used to determine whether it is more likely than not that the fair value of a reporting unit exceeds the carrying value involves significant judgments and estimates. In the second quarter of 2013, the Company changed the date of its annual assessment of goodwill impairment from December 31 to October 1. This was a change in method of applying an accounting principle which management believes is a preferable alternative as the new date of the assessment provides additional time prior to the Company's year-end to complete the goodwill impairment testing and report the results in the Company's Annual Report on Form 10-K, and is more closely aligned with the Company's strategic planning process. The change in the assessment date does not delay, accelerate or avoid a potential impairment charge. In 2013 and 2012, the Company's reporting units consist of its three regional operating units in: North America; Europe, the Middle East and Africa ("EMEA"); and Latin America. Goodwill assigned to the North America, EMEA and Latin America reporting units at December 31, 2013 totaled $2.577 billion and was $1.835 billion, $0.147 billion and $0.595 billion, respectively. Goodwill assigned to the North America, EMEA and Latin America reporting units at December 31, 2012 totaled $2.565 billion and was $1.826 billion, $0.144 billion and $0.595 billion, respectively. 76 -------------------------------------------------------------------------------- Table of Contents In 2013 and 2012, the Company conducted its goodwill impairment analysis and determined that it was more likely than not that the fair value of its reporting units exceeded the carrying value and concluded that goodwill was not impaired. As of December 31, 2013, the estimated fair value of the reporting units substantially exceeded their carrying value. To the extent that future changes in the Company's assumptions and estimates cause a change in the related fair value estimates that indicate the carrying amount of the Company's goodwill may exceed its fair value, the Company may incur impairment charges in the future to write-down the carrying amount of the Company's goodwill to its estimated fair value. Asset Retirement Obligations The Company's asset retirement obligations consist of legal requirements to remove certain of its network infrastructure at the expiration of the underlying right-of-way ("ROW") term and restoration requirements for leased facilities. The initial and subsequent measurement of the Company's asset retirement obligations require the Company to make significant estimates regarding the eventual costs and probability or likelihood that the Company will be required to remove certain of its network infrastructure and restore certain of its leased properties. In addition, the Company must estimate the periods over which these costs will be incurred and the present value of such costs using the Company's estimate of its credit-adjusted risk-free interest rate upon initial recognition. As a result of a strategic review of the Company's real estate portfolio in the fourth quarter of 2012, the Company completed an updated analysis and revised its estimated future cash flows of its asset retirement obligations. The analysis required estimating the probability or likelihood that the Company will be required to remove certain of its network infrastructure and restore leased properties, and the timing and amount of eventual costs. The analysis resulted in the downward revision of the Company's asset retirement obligation liability. This change in the estimated cash flows resulted in a non-cash gain of $49 million recorded within selling, general and administrative expense, and depreciation expense during the year ended December 31, 2012. In conjunction with its review of the ROW obligation, the Company identified an error in its assumptions used to estimated its ROW obligation related to the extension of the useful lives of its conduit assets effective October 1, 2011 (See Note 1 - Organization and Summary of Significant Accounting Policies in the notes to the consolidated financial statements). The Company recorded a non-cash benefit of approximately $21 million recorded within selling, general and administrative expense during the fourth quarter of 2012 for the change in the ROW term used to estimate its ROW obligation. The reduction in the asset retirement obligations liability includes the change in estimate of the ROW term that arose in prior periods, which did not materially affect any of the Company's previously reported results of operations or financial condition, or the current period results of operations or financial condition. At December 31, 2012, as a result of the total revisions in estimated amount and timing of cash flows for asset retirement obligations, the Company reduced its asset retirement obligations liability by $73 million with an offsetting reduction to property, plant and equipment of $24 million, selling, general and administrative expenses of $47 million and depreciation and amortization of $2 million. The Company first reduced property, plant and equipment to the extent of the carrying amount of the related asset initially recorded when the asset retirement obligations were established. The amount of the remaining reduction to the asset retirement obligations were recorded as a reduction to depreciation expense to the extent of historical deprecation of the related asset and then to selling, general and administrative expenses. The Company periodically evaluates its asset retirement obligations to determine if the amount and timing of its cash flow estimates continue to be appropriate based on current facts and circumstances. 77 -------------------------------------------------------------------------------- Table of Contents Assessment of Loss Contingencies The Company has legal, tax and other contingencies that could result in significant losses upon the ultimate resolution of such contingencies. The Company has provided for losses in situations where its has concluded that it is probable that a loss has been incurred and the amount of the loss is reasonably estimable. Further, with respect to loss contingencies, where it is probable that a liability has been incurred and there is a range in the expected loss and no amount in the range is more likely than any other amount, the Company accrues at the low end of the range. A significant amount of judgment is involved in determining whether a loss is probable and reasonably estimable due to the uncertainty involved in predicting the likelihood of future events and estimating the financial impact of such events. Accordingly, it is possible that upon the further development or resolution of a contingent matter, a significant charge could be recorded in a future period related to an existing contingent matter. For additional information, see Note 17 - Commitments, Contingencies and Other Items in the notes to the consolidated financial statements. Business Combinations The accounting guidance for business combinations requires an acquiring entity to recognize all of the assets acquired and liabilities assumed at the acquisition date fair value. The allocation of the purchase price to the assets acquired and liabilities assumed from Global Crossing (and the related estimated lives of depreciable tangible and identifiable intangible assets) required a significant amount of judgment and is considered a critical estimate. Such allocation of certain aspects of the purchase price to items that are more complex to value was performed by management, taking into consideration information provided to management by an independent valuation firm. Results of Operations 2013 vs. 2012 Year Ended December 31, Change (dollars in millions) 2013 2012 % Revenue $ 6,313 $ 6,376 (1 )% Cost of Revenue 2,471 2,602 (5 )% Depreciation and Amortization 800 749 7 % Selling, General and Administrative 2,376 2,450 (3 )% Total Costs and Expenses 5,647 5,801 (3 )% Operating Income 666 575 16 % Other Income (Expense): Interest income - 2 NM Interest expense (649 ) (733 ) (11 )% Loss on modification and extinguishment of debt, net (84 ) (160 ) (48 )% Other, net (4 ) (58 ) (93 )% Total Other Expense (737 ) (949 ) (22 )% Loss Before Income Taxes (71 ) (374 ) (81 )% Income Tax Expense (38 ) (48 ) (21 )% Net Loss $ (109 ) $ (422 ) (74 )% NM - Not meaningful 78-------------------------------------------------------------------------------- Table of Contents Discussion of all significant variances: Revenue by Service Offering: Year Ended December 31, (dollars in millions) 2013 2012 Change % Core Network Services Revenue: Colocation and Datacenter Services $ 585 $ 561 4 % Transport and Fiber 1,962 1,950 1 % IP and Data Services 2,106 2,002 5 % Voice Services (Local and Enterprise) 938 950 (1 )% Total Core Network Services Revenue $ 5,591 $ 5,463 2 % Wholesale Voice Services and Other Revenue 722 913 (21 )% Total Revenue $ 6,313 $ 6,376 (1 )% Revenue decreased 1% to $6.313 billion in 2013 compared to $6.376 billion in 2012. The change was driven by declines in Wholesale Voice Services and Other revenue partially offset by growth in Core Network Services revenue from enterprise customers. The Company experienced growth in its IP and data services and colocation and data center services during 2013 compared to 2012 driven primarily by end user customer demand for content delivery over the Internet and enterprise bandwidth. The Company also experienced modest growth in transport and fiber services in 2013. Core Network Services revenue for voice services declined in 2013, primarily due to the anticipated attrition of certain U.K. Government channel voice services. Core Network Services revenue increased in the North America and Latin America regions in 2013 compared to 2012, as a result of growth in services provided to the existing enterprise customer base and the acquisition of new customers in the enterprise channel. These increases were partially offset by (i) a decrease in the EMEA region's Core Network Services revenue primarily as a result of lower U.K. Government and wholesale channel revenue and (ii) a decrease in wholesale channel revenue in North America. Wholesale Voice Services and Other revenue decreased in 2013 compared to 2012 primarily as a result of declines in usage as customers transition to IP voice services. The Company continues to manage its combined wholesale voice services platform for margin contribution. In addition, the Company expects SBC Contract Services revenue to continue to decline as a result of the migration of the SBC traffic to the AT&T network. The Company has discontinued its managed modem services. Wholesale Voice Services revenue decreased in the North America and EMEA regions in 2013 compared to 2012, due to competitive pressures and the Company's focus on maintaining or growing its margin percentage. Wholesale Voice Services revenue in Latin America was flat in 2013 compared to 2012. Cost of Revenue includes leased capacity, right-of-way costs, access charges, satellite transponder lease costs, and other third-party costs directly attributable to the network, but excludes depreciation and amortization and related impairment expenses. Cost of revenue as a percentage of total revenue was 39% in 2013 compared to 41% in 2012. The decrease is primarily due to an improving gross margin mix of higher margin on-net Core Network 79 -------------------------------------------------------------------------------- Table of Contents Services and a decline in lower margin Wholesale Voice Services and Other Revenue. Additionally, the Company continues to implement initiatives to reduce both fixed and variable network expenses. Depreciation and Amortization expense increased 7% to $800 million in 2013 from $749 million in 2012. The increase is primarily attributable to new capital expenditures in 2013 in support of the network with asset lives less than the average remaining life of all existing assets as of the beginning of the year. Selling, General and Administrative ("SG&A") expenses include salaries, wages and related benefits (including non-cash, stock-based compensation expenses), property taxes, travel, insurance, rent, contract maintenance, advertising, accretion expense on asset retirement obligations, restructuring charges and other administrative expenses. SG&A expenses also include certain network related expenses such as network facility rent, utilities and maintenance costs. SG&A expenses decreased 3% to $2.376 billion in 2013 compared to $2.450 billion in 2012. The decreases are primarily due to lower employee compensation and other employee related costs, professional fees and vendor services and other discretionary costs. Employee cash compensation and other employee related costs decreased as the Company continued to achieve cost synergies as a result of the integration of the Global Crossing business, workforce reductions primarily focused on labor cost savings and organizational effectiveness and higher capitalization of labor costs related to the implementation of information technology systems, network deployment and customer installation activities. Professional fees and vendor services and other discretionary costs decreased primarily due to the rationalization and renegotiation of vendor services and lower travel and entertainment costs. In addition, the Company incurred approximately $47 million in 2012 of integration costs related to the Global Crossing acquisition. The integration was substantially complete by the end of 2012. Also included in SG&A expenses in 2013 and 2012, respectively, were $151 million and $135 million of non-cash, stock-based compensation expenses related to grants of outperform stock options, restricted stock units, accruals for the Company's annual discretionary bonus, incentive and retention plans and shares issued for the Company's matching contribution to the 401(k) plan. The increase in non-cash, stock-based compensation expense is primarily due to accruing the annual discretionary bonus at a higher target rate in 2013 than in 2012 as well as the vesting of long-term incentive awards in connection with James Q. Crowe's departure from the Company, as described below. On April 11, 2013, the Company announced that Jeff K. Storey had been appointed by the Board of Directors, effective immediately, to be the Company's President and Chief Executive Officer. As a result of the departure of James Q. Crowe, the Company incurred an SG&A charge of approximately $23 million in the second quarter of 2013, consisting of $6 million of additional cash compensation expenses and $17 million in non-cash compensation expenses related to the vesting of certain of Mr. Crowe's long-term incentive awards payable under the terms of his employment agreement. Additionally in 2013, the Company implemented certain workforce reductions. Restructuring charges in 2013 and 2012 were $47 million and $34 million, respectively, recorded in SG&A. Adjusted EBITDA, as defined by the Company, is net income (loss) from the consolidated statements of operations before (1) income tax benefit (expense), (2) total other income (expense), (3) non-cash impairment charges included within selling, general and administrative expenses, (4) depreciation and amortization expense and (5) non-cash stock compensation expense included within selling, general and administrative expenses and (6) discontinued operations. Adjusted EBITDA is not a measurement under generally accepted accounting principles ("GAAP") and may not be used in the same way by other companies. Management believes that Adjusted EBITDA is an important part of the Company's internal reporting and is a key measure used by management to evaluate profitability and operating performance of the Company and to make resource allocation decisions. Management believes such measurement is especially important in a capital-intensive industry 80 -------------------------------------------------------------------------------- Table of Contents such as telecommunications. Management also uses Adjusted EBITDA to compare the Company's performance to that of its competitors and to eliminate certain non-cash and non-operating items in order to consistently measure from period to period its ability to fund capital expenditures, fund growth, service debt and determine bonuses. Adjusted EBITDA excludes non-cash impairment charges and non-cash stock compensation expense because of the non-cash nature of these items. Adjusted EBITDA also excludes interest income, interest expense and income tax benefit (expense) because these items are associated with the Company's capitalization and tax structures. Adjusted EBITDA also excludes depreciation and amortization expense because these non-cash expenses reflect the effect of capital investments which management believes are better evaluated through cash flow measures. Adjusted EBITDA excludes net other income (expense) because these items are not related to the primary operations of the Company. There are limitations to using non-GAAP financial measures such as Adjusted EBITDA, including the difficulty associated with comparing companies that use similar performance measures whose calculations may differ from the Company's calculations. Additionally, this financial measure does not include certain significant items such as interest income, interest expense, income tax benefit (expense), depreciation and amortization expense, non-cash impairment charges, non-cash stock compensation expense and net other income (expense). Adjusted EBITDA should not be considered a substitute for other measures of financial performance reported in accordance with GAAP. The following information provides a reconciliation of Net Loss to Adjusted EBITDA as defined by the Company: Year Ended December 31, (dollars in millions) 2013 2012 Net Loss $ (109 ) $ (422 ) Income Tax Expense 38 48 Total Other Expense 737 949 Depreciation and Amortization Expense 800 749 Non-Cash Compensation Expense 151 135 Non-Cash Impairment 7 - Adjusted EBITDA $ 1,624 $ 1,459 Consolidated Adjusted EBITDA was $1.624 billion in 2013 compared with $1.459 billion in 2012. The increase in Adjusted EBITDA is primarily attributable to growth in the Company's higher incremental margin Core Network Services revenue, continued improvements in cost of revenue and lower SG&A expenses. Adjusted EBITDA increased in the North America, EMEA and Latin America regions in 2013 compared to 2012, as a result of growth in core network services revenue in North America and Latin America and initiatives resulting in reduced fixed and variable network expenses in all three regions. These increases were partially offset by (i) a decrease in the EMEA region's Core Network Services revenue primarily as a result of lower U.K. Government and wholesale channel revenue and (ii) a decrease in wholesale channel revenue in North America. See Note 16 - Segment Information in the notes to consolidated financial statements for additional information on Adjusted EBITDA by region. Historically, the Company has paid a portion of employee annual bonuses with shares of its common stock. Beginning in 2014, the Company will accrue the entire bonus compensation within SG&A as cash compensation, which will be paid in 2015. 81 -------------------------------------------------------------------------------- Table of Contents Interest Expense decreased 11% to $649 million in 2013 from $733 million in 2012. Interest expense decreased as a result of lower cost of borrowing on refinanced debt in 2013 compared to 2012 as well as the repayment of the Company's 15% Convertible Senior Notes in 2013. The Company expects annual interest expense in 2014 to approximate $600 million based on current interest rates on the Company's debt outstanding as of December 31, 2013. See Note 12 - Long-Term Debt in the notes to consolidated financial statements for additional information on Level 3's financing activities. Loss on Modification and Extinguishment of Debt, net was $84 million in 2013 compared to a loss of $160 million in 2012. The loss recorded during 2013 was related to a charge of approximately $1 million related to the refinancing of the Floating Rate Senior Notes due 2015 in December 2013, $56 million related to the refinancing of 10% Senior Notes due 2018 in December 2013, $10 million related to the refinancing $1.2 billion Tranche B-II 2019 Term Loan in October 2013, $8 million related to the refinancing $595.5 million Tranche B 2016 Term Loan in August 2013 and $9 million related to the refinancing the $815 million Tranche B 2019 Term Loan in August 2013. The loss recorded during 2012 was related to a charge of $50 million related to the refinancing of the $650 million Tranche B II Term Loan and $550 million Tranche B III Term Loan in October 2012, a charge of $9 million related to the refinancing of the $1.4 billion Tranche A Term Loan in August 2012 and the repayment of existing vendor financing obligations, a charge of $40 million as a result of the redemption of the 8.75% Senior Notes due 2017 in August 2012, a charge of $22 million related to the redemption of the 9.25% Senior Notes due 2014 in February 2012, and a charge of $39 million as a result of the exchange of a portion of the 15% Convertible Senior Notes due 2013 for approximately 5.4 million shares of Level 3 common stock in March 2012. See Note 12 - Long-Term Debt in the notes to the consolidated financial statements for more details regarding the Company's financing activities. Other, net was $4 million of expense in 2013 compared to $58 million of expense in 2012. Other, net is primarily comprised of gains and losses on the sale of non-operating assets, foreign currency gains and losses and other income and expense. Other, net expense in 2013 is primarily due to foreign currency fluctuations of local currencies relative to the U.S. dollar, including foreign currency losses attributable to the devaluation of the Venezuelan bolivar as discussed below, partially offset by net foreign currency gains. The Other, net expense in 2012 was driven by a non-cash loss on the Company's interest rate swap agreements of approximately $60 million that were deemed "ineffective" hedges under GAAP in connection with the refinancing of the $1.4 billion Tranche A Term Loan. Effective February 13, 2013, the Venezuelan government devalued the Venezuelan bolivar by increasing the official rate from 4.30 Venezuelan bolivares to the U.S. dollar to 6.30 Venezuelan bolivares to the U.S. dollar. This devaluation reduced the Company's net monetary assets by $22 million based on the bolivar balances as of February 13, 2013, resulting in a charge of $22 million that was recognized in Other, net in the consolidated statement of operations in 2013. Income Tax Expense was $38 million in 2013 compared to $48 million in 2012. Income tax expense in all periods is primarily related to taxes in foreign jurisdictions. The Company incurs tax expense attributable to income in various subsidiaries that are required to file state or foreign income tax returns on a separate legal entity basis. The Company also recognizes accrued interest and penalties in income tax expense related to uncertain tax benefits. Our tax rate is volatile and may move up or down with changes in, among other things, the amount and source of income or loss, our ability to utilize foreign tax credits, changes in tax laws, and the movement of liabilities established for uncertain tax positions as statutes of limitations expire or positions are otherwise effectively settled. 82 -------------------------------------------------------------------------------- Table of Contents Results of Operations 2012 vs. 2011 Year Ended December 31, Change (dollars in millions) 2012 2011 % Revenue $ 6,376 $ 4,333 47 % Cost of Revenue 2,602 1,706 53 % Depreciation and Amortization 749 805 (7 )% Selling, General and Administrative 2,450 1,770 38 % Total Costs and Expenses 5,801 4,281 36 % Operating Income 575 52 NM Other Income (Expense): Interest income 2 1 100 % Interest expense (733 ) (716 ) 2 %Loss on modification and extinguishment of debt, net (160 ) (100 ) 60 % Other, net (58 ) (23 ) 152 % Total Other Expense (949 ) (838 ) 13 % Loss Before Income Taxes (374 ) (786 ) (52 )% Income Tax Expense (48 ) (41 ) 17 % Loss from Continuing Operations (422 ) (827 ) (49 )% Income from Discontinued Operations, Net - 71 NM Net Loss $ (422 ) $ (756 ) (44 )% NM - Not meaningful Discussion of all significant variances: Revenue by Service Offering: Year Ended December 31, (dollars in millions) 2012 2011 Change % Core Network Services Revenue: Colocation and Datacenter Services $ 561 $ 404 39 % Transport and Fiber 1,950 1,556 25 % IP and Data Services 2,002 1,075 86 % Voice Services (Local and Enterprise) 950 531 79 % Total Core Network Services Revenue $ 5,463 $ 3,566 53 % Wholesale Voice Services and Other Revenue 913 767 19 % Total Revenue $ 6,376 $ 4,333 47 % Revenue increased 47% to $6.376 billion in 2012 compared to $4.333 billion in 2011. The increase was primarily driven by the additional revenue associated with the Global Crossing acquisition completed in the fourth quarter of 2011. Excluding revenue from the Global Crossing acquisition, growth in Core Network Services revenue, particularly from enterprise customers, was partially offset by declines in Wholesale Voice Services and Other revenue. 83 -------------------------------------------------------------------------------- Table of Contents The Company experienced growth in each of its service offerings during 2012 compared to 2011 as a result of the Global Crossing acquisition. Excluding revenue from the Global Crossing acquisition, Core Network Services revenue growth in IP and data services and voice services during 2012 was driven primarily by end customer demand for content delivery over the Internet and enterprise bandwidth, as well as increased usage for voice services. Growth in transport and fiber services and colocation and data center services was more modest during 2012. Core Network Services revenue increased in the North America, EMEA and Latin America regions during 2012 compared to 2011 primarily as a result of the Global Crossing acquisition. Excluding revenue from the Global Crossing acquisition, revenue increased in the North America region and to a lesser extent the EMEA region during 2012 compared to 2011. Wholesale Voice Services and Other revenue increased in 2012 compared to 2011 as a result of the Global Crossing acquisition. Excluding revenue from the Global Crossing acquisition, Wholesale Voice Services and Other revenue decreased in 2012 due to declines in usage. Wholesale Voice Services revenue increased in the North America, EMEA and Latin America regions during 2012 compared to 2011 primarily as a result of the Global Crossing acquisition. Cost of Revenue as a percentage of total revenue was 41% in 2012 compared to 39% in 2011. The increase was due to the inclusion of costs associated with the Global Crossing business, which has lower gross margins, in 2012 compared to 2011. This increase was partially offset by an improving gross margin mix from higher margin on-net Core Network Services and a decrease in lower margin Wholesale Voice Services and Other. Depreciation and Amortization expense decreased 7% to $749 million in 2012 from $805 million in 2011. The decrease was attributable to a change in the estimated useful lives of certain of the Company's property, plant and equipment that resulted in a reduction of depreciation expense of $74 million in 2012 compared to 2011. The change in accounting estimate was applied on a prospective basis effective October 1, 2011 as required under the accounting standard related to changes in accounting estimates (See Note 1 - Organization and Summary of Significant Accounting Policies - Property, Plant and Equipment in the notes to the consolidated financial statements). Since this change was applied prospectively, it affected the full year 2012 and only the fourth quarter 2011. This decrease was partially offset by additional depreciation and amortization as a result of the Global Crossing acquisition and property, plant and equipment additions since January 1, 2012. SG&A expenses increased 38% to $2.450 billion in 2012 compared to $1.770 billion in 2011. The increase was primarily due to SG&A expenses associated with the Global Crossing acquisition, although transaction and integration costs decreased to approximately $47 million in 2012 from $70 million in 2011. In addition, there was higher employee compensation and related costs, as the Company continued to increase its sales, support and customer service delivery headcount, and merit salary increases became effective in the first quarter of 2012. These increases were partially offset by cost synergies achieved as a result of the Global Crossing acquisition in 2012 and a $47 million non-cash benefit as a result of a revision to the Company's estimated future asset retirement obligations (see Note 6 - Asset Retirement Obligations in the notes to the consolidated financial statements). Also included in SG&A expenses in 2012 and 2011, respectively, were $135 million and $101 million of non-cash, stock-based compensation expenses related to grants of outperform stock options, restricted stock units, accruals for the Company's discretionary bonus, incentive and retention plans and shares issued for the Company's matching contribution to the 401(k) plan. The increase in non-cash, stock-based compensation expense is primarily due to an increase in the number of stock grants, including the Company's matching contribution for the 401(k) plan during 2012, primarily as a result of the Global Crossing acquisition. 84 -------------------------------------------------------------------------------- Table of Contents Additionally, restructuring charges recorded in SG&A in 2012 and 2011 were $34 million and $11 million, respectively. The increase was primarily due to an increase of reductions in headcount associated with the integration of the Global Crossing acquisition. Adjusted EBITDA. The following information provides a reconciliation of Net Loss to Adjusted EBITDA as defined by the Company: Year Ended December 31, (dollars in millions) 2012 2011 Net Loss $ (422 ) $ (756 ) Income Tax Expense 48 41 Total Other Expense 949 838 Depreciation and Amortization Expense 749 805 Non-Cash Compensation Expense 135 101 Income from Discontinued Operations, Net - (71 ) Adjusted EBITDA $ 1,459 $ 958 Consolidated Adjusted EBITDA was $1.459 billion in 2012 compared with $958 million in 2011. The increase in Adjusted EBITDA is primarily attributable to Adjusted EBITDA associated with the Global Crossing acquisition and growth in the Company's higher incremental margin Core Network Services revenue and continued improvements in cost of revenue. Adjusted EBITDA increased in the North America, EMEA and Latin America regions during 2012 compared to 2011 primarily as a result of the Global Crossing acquisition. Excluding Adjusted EBITDA from the Global Crossing acquisition, Adjusted EBITDA increased in the North America region and to a lesser extent the EMEA region during 2012 compared to 2011, primarily due to increased CNS revenues. See Note 16 - Segment Information in the notes to consolidated financial statements for additional information on Adjusted EBITDA by region. Interest Expense increased 2% to $733 million in 2012 from $716 million in 2011. Interest expense increased as a result of a higher average debt balance for 2012 compared to 2011, including financings associated with the Global Crossing acquisition, partially offset by lower cost of borrowing on refinanced debt. Loss on Modification and Extinguishment of Debt, net was $160 million in 2012 compared to a loss of $100 million in 2011. The loss recorded during 2012 was related to a charge of $50 million for the refinancing of the $650 million Tranche B II Term Loan and the $550 million Tranche B III Term Loan in October 2012, a charge of $9 million related to the refinancing of the $1.4 billion Tranche A Term Loan in August 2012 and the repayment of existing vendor financing obligations, a charge of $40 million as a result of the redemption of the 8.75% Senior Notes due 2017 in August 2012, a charge of $22 million related to the redemption of the 9.25% Senior Notes due 2014 in February 2012, and a charge of $39 million as a result of the exchange of a portion of the 15% Convertible Senior Notes due 2013 for approximately 5.4 million shares of Level 3 common stock in March 2012. The loss recorded during 2011 was related to a charge of approximately $27 million recognized in the fourth quarter of 2011 for the redemption of the 3.5% Convertible Senior Notes due 2012 and prepayment of the Tranche B Term Loan that was outstanding under the existing Senior Secured Term Loan, a charge of approximately $29 million recognized for the July 2011 conversion of the 15% Convertible Senior Notes due 2013, a charge of less than $1 million for the 3.5% Senior Notes due 2012 repurchased in August 2011, a $23 million charge recognized for the portion of the 9.25% Senior Notes 85 -------------------------------------------------------------------------------- Table of Contents due 2014 retired in April 2011 and a $20 million charge recorded in the first quarter of 2011, which was the result of the redemption of the 5.25% Convertible Senior Notes due 2011 and the exchange of the 9% Convertible Senior Discount Notes due 2013. See Note 10 - Long-Term Debt in the notes to the consolidated financial statements for more details regarding the Company's financing activities. Other, net was $58 million of expense in 2012 compared to $23 million of expense in 2011. Other, net is primarily comprised of gains and losses from the change in the fair value of certain derivative investments, as well as gains and losses on the sale of non-operating assets, foreign currency gains and losses and other income. Other, net in 2012 was driven by a non-cash loss on the Company's interest rate swap agreements of approximately $60 million that were deemed "ineffective" hedges under GAAP in connection with the refinancing of the $1.4 billion Tranche A Term Loan. See Note 12 - Long-Term Debt in the notes to the consolidated financial statements for more details regarding the Company's financing activities. The expense recognized in 2011 is primarily related to a charge of approximately $20 million related to the impairment of certain wireless spectrum licenses (See Note 8 - Acquired Intangible Assets in the notes to consolidated financial statements). Income Tax Expense was $48 million in 2012 compared to $41 million in 2011. The income tax expense in 2012 was primarily related to income taxes for Latin American entities acquired as part of the Global Crossing acquisition. The income tax expense during 2011 is primarily related to an out of period adjustment to recognize deferred tax liabilities for taxable temporary differences associated with certain indefinite-lived intangible assets that the Company is unable to offset with deductible temporary differences associated with its deferred tax assets as well as income tax expense associated with the post-acquisition results of Global Crossing. See Note 1 - Organization and Summary of Significant Accounting Policies in the notes to the consolidated financial statements. Income (Loss) from Discontinued Operations was net $71 million of income in 2011. Level 3, through its two 50% owned joint-venture surface mines, one each in Montana and Wyoming, sold coal primarily through long-term contracts with public utilities. In November 2011, Level 3 completed the sale of its coal mining business to Ambre Energy Limited as part of its long-term strategy to focus on core business operations. As a result of the transaction, all of the assets and liabilities associated with the coal mining business have been removed from the Company's balance sheet and a gain on the transaction of approximately $72 million was recognized in 2011. Financial Condition-December 31, 2013 Cash flows provided by operating activities, investing activities and financing activities for the years ended December 31, 2013 and 2012, respectively, are summarized as follows: Year Ended December 31, (dollars in millions) 2013 2012 Change Net Cash Provided by Operating Activities $ 713 $ 578 $ 135 Net Cash Used in Investing Activities (745 ) (725 ) (20 ) Net Cash (Used in) Provided by Financing Activities (294 ) 207 (501 ) Effect of Exchange Rates on Cash and Cash Equivalents (22 ) 1 (23 ) Net Change in Cash and Cash Equivalents $ (348 ) $ 61 $ (409 ) Operating Activities Cash provided by operating activities increased to $713 million in 2013 compared to $578 million in 2012. The increase in cash provided by operating activities was primarily due to growth in earnings and lower interest payments. 86 -------------------------------------------------------------------------------- Table of Contents Investing Activities Cash used in investing activities increased to $745 million in 2013 compared to $725 million in 2013, primarily as a result of additional capital expenditures, which totaled $760 million in 2013 and $743 million in 2012. The increase is primarily due to additional investment in the network, which includes higher capitalized labor. Financing Activities Cash used in financing activities of $294 million in 2013 compared to cash provided by financing activities of $207 million in 2012 relates to greater net payments of debt and capital leases during 2013, primarily as a result of the repayment at maturity of the 15% Convertible Notes due January 15, 2013 as compared to greater net borrowings in 2012. See Note 12 - Long-Term Debt in the notes to the consolidated financial statements for more details regarding the Company's debt transactions during 2013. Effect of Exchange Rates on Cash and Cash Equivalents The effect of exchange rates on cash and cash equivalents in 2013 was primarily due to the devaluation of the Venezuelan bolivar. This devaluation reduced the Company's unrestricted cash and cash equivalents by $21 million in the first quarter of 2013. Liquidity and Capital Resources The Company incurred a net loss of $109 million in 2013 and $422 million in 2012. In connection with its continuing operations, the Company utilized cash of $760 million for capital expenditures and $294 million for financing activities in 2013. This compares to $743 million of cash used for capital expenditures and $207 million of cash flows provided by financing activities in 2012. Net cash interest payments are expected to decrease to approximately $560 million in 2014 from $674 million in 2013 based on forecasted interest rates on the Company's variable rate debt outstanding as of December 31, 2013. Capital expenditures for 2014 are expected to be 12% to 13% of revenue from 12% of revenues in 2013, as the Company invests in base capital expenditures (estimated capital required to keep the network operating efficiently and support new service development) with the remaining capital expenditures expected to be partly success-based, which is tied to a specific customer revenue opportunity, and partly project-based where capital is used to expand the network based on the Company's expectation that the project will eventually lead to incremental revenue. As of December 31, 2013, the Company had contractual debt obligations, including capital lease obligations, and excluding interest, discounts on debt issuance and fair value adjustments, of $31 million that mature in 2014, $483 million in 2015, which includes the Company's $475 million 7% Convertible Senior Notes due 2015 that are convertible at a price of approximately $27 per share, and $7 million in 2016. The Company had $631 million of cash and cash equivalents on hand at December 31, 2013. The Company also had $30 million of current and non-current restricted cash and securities used to collateralize outstanding letters of credit and certain performance and operating obligations of the Company and other deposits at December 31, 2013. In addition, $65 million of the Company's total cash and cash equivalents as of December 31, 2013 was held in Venezuelan bolivares by a Venezuelan subsidiary. In light of the Venezuelan exchange control regime, none of such $65 million may be transferred to the Company in the form of loans, advances or cash dividends without the consent of the Venezuelan government. The $65 million value of the Company's bolivar balance reflects the February 13, 2013 devaluation of the bolivar that resulted from the increase in the official exchange rate from 4.30 87 -------------------------------------------------------------------------------- Table of Contents Venezuelan bolivares to the U.S. dollar to 6.30 Venezuelan bolivares to the U.S. dollar. That devaluation reduced the Company's unrestricted cash and cash equivalents by $21 million, based on the bolivar balances as of February 13, 2013. The Company currently has the ability to repatriate cash and cash equivalents into the United States without paying or accruing U.S. taxes. Level 3 does not currently intend to repatriate any of its foreign cash and cash equivalents from entities outside of Latin America. The Company has no restrictions on its ability to repatriate foreign cash and cash equivalents, other than conversion and repatriation restrictions in Venezuela, as needed to fund operations in the United States, including debt service. Based on information available at this time, the Company believes that its current liquidity and anticipated future cash flows from operations will be sufficient to fund its business for at least the next twelve months. The Company may need to refinance all or a portion of its indebtedness at or before maturity and cannot provide assurances that it will be able to refinance any such indebtedness on commercially reasonable terms or at all. In addition, the Company may elect to secure additional capital in the future, at acceptable terms, to improve its liquidity or fund acquisitions. In addition, in an effort to reduce future cash interest payments as well as future amounts due at maturity or to extend debt maturities, the Company may, from time to time, issue new debt, enter into debt for debt, debt for equity or cash transactions to purchase its outstanding debt securities in the open market or through privately negotiated transactions. The Company will evaluate any such transactions in light of the existing market conditions and the possible dilutive effect to stockholders. The amounts involved in any such transaction, individually or in the aggregate, may be material. In addition to raising capital through the debt and equity markets, the Company may sell or dispose of existing businesses, investments or other non-core assets. Consolidation of the communications industry may continue. The Company will continue to evaluate consolidation opportunities and could make additional acquisitions in the future. Off-Balance Sheet Arrangements Level 3 has not entered into off-balance sheet arrangements. Contractual Obligations The following table summarizes the contractual obligations and other commercial commitments of the Company at December 31, 2013, as further described in the Notes to Consolidated Financial Statements. 88 -------------------------------------------------------------------------------- Table of Contents Payments Due by Period Less than 2 - 3 4 - 5 After 5 Total 1 Year Years Years Years (dollars in millions) Contractual Obligations Long-Term Debt, including current portion $ 8,392 $ 31 $ 490 $ 12 $ 7,859 Interest Obligations (1) 3,215 572 1,085 1,055 503 Asset Retirement Obligations 56 - 18 - 38 Operating Leases 1,567 268 421 325 553 Right of Way Agreements 700 119 117 99 365 Purchase and Other Obligations 1,406 800 454 55 97 Other Commercial Commitments Letters of Credit 29 7 2 7 13 (1) Includes the Company's future cash flows related to interest rate swap obligations of $12 million in 2014 included in Other Current Liabilities presented in Note 10 - Fair Value of Financial Instruments in the notes to consolidated financial statements. The Company's debt instruments contain certain covenants which, among other things, limit additional indebtedness, dividend payments, certain investments and transactions with affiliates. If the Company should fail to comply with these covenants, amounts due under the instruments may be accelerated at the note holder's discretion after the declaration of an event of default. The Company's debt instruments do not have covenants that require the Company or its subsidiaries to maintain certain levels of financial performance or other financial measures such as total leverage or minimum revenues. These types of covenants are commonly referred to as "maintenance covenants." Long-term debt obligations exclude issue discounts. Interest obligations assume interest rates on $2.911 billion of variable rate debt do not change from December 31, 2013. In addition, interest is calculated based on debt outstanding as of December 31, 2013. The Company's asset retirement obligations consist of legal requirements to remove certain of its network infrastructure at the expiration of the underlying right-of-way ("ROW") term and restoration requirements for leased facilities. The initial and subsequent measurement of the Company's asset retirement obligations require the Company to make significant estimates regarding the eventual costs and probability or likelihood that the Company will be required to remove certain of its network infrastructure and restore certain of its leased properties. Due to uncertainty regarding the completion of tax audits and possible outcomes, the remaining estimate of the timing of payments related to uncertain tax positions and interest cannot be made. See Note 15 - Income Taxes in the notes to consolidated financial statements for additional information regarding the Company's uncertain tax positions. 89 -------------------------------------------------------------------------------- Table of Contents Certain right of way agreements include provisions for increases in payments in future periods based on the rate of inflation as measured by various price indexes. The Company has not included estimates for these increases in future periods in the amounts included above. Certain non-cancelable right of way agreements provide for automatic renewal on a periodic basis. The Company includes payments due during these automatic renewal periods given the significant cost to relocate the Company's network and other facilities. Certain other right of way agreements are cancelable or can be terminated under certain conditions by the Company. The Company includes the payments under such cancelable right of way agreements in the table above for a period of 1 year from January 1, 2014, if the Company does not consider it likely that it will cancel the right of way agreement within the next year. Purchase and other obligations represent all outstanding purchase order amounts of the Company as of December 31, 2013 ($430 million), contractual commitments with third parties to purchase network access services ($744 million) and maintenance payments for portions of the Company's network ($232 million). The table above does not include other long-term liabilities, such as liabilities recorded for legal matters that are not contractual obligations by nature. The Company cannot determine with any degree of certainty the years in which these liabilities might ultimately be paid. |