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LEVEL 3 COMMUNICATIONS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations
[November 08, 2012]

LEVEL 3 COMMUNICATIONS INC - 10-Q - 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 Level 3 Communications, Inc. and its subsidiaries ("Level 3" or the "Company") consolidated financial statements (including the notes thereto), included elsewhere herein and the Company's Form 10-K, as amended, for the year ended December 31, 2011 filed with the Securities and Exchange Commission.

This document contains forward looking statements and information that are based on the beliefs of management as well as assumptions made by and information currently available to the Company. When used in this document, the words "anticipate", "believe", "plan", "estimate" and "expect" and similar expressions, as they relate to the Company or its management, are intended to identify forward-looking statements. Such statements reflect the current views of the Company with respect to future events and are subject to certain risks, uncertainties and assumptions. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those described in this document. For a more detailed description of these risks and factors, please see the Company's Form 10-K, as amended, for the year ended December 31, 2011 filed with the Securities and Exchange Commission and Item 1A in Part II of this Form 10-Q.

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 up-front payments for services to be delivered for a period of generally up to 20 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.


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"). In addition, after the close of business on October 19, 2011, Level 3 completed a 1 for 15 reverse stock split as previously approved by the Company's stockholders in connection with its announcement to transfer the listing of its common stock to the New York Stock Exchange on October 20, 2011. The reverse stock split automatically combined every fifteen shares of issued and outstanding Level 3 common stock into one share of common stock without any change in the par value per share. All share and per share references for all periods presented have been adjusted to give effect to the reverse stock split.

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 Level 3's balance sheet. 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" as discussed in its Form 10-K, as amended, for the year ended December 31, 2011. In particular, with respect to strategic financial objectives, the Company focuses its attention on the following: • growing Core Network Services revenue by increasing sales; • continually improving the customer experience to increase customer retention and reduce customer churn; • completing the integration of acquired businesses; 39-------------------------------------------------------------------------------- Table of Contents • reducing network costs and operating expenses; • achieving sustainable generation of positive cash flows from operations in excess of capital expenditures; • continuing to show improvement in Adjusted EBITDA (as defined in this Item below) as a percentage of revenue; • 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 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 successful integration of acquired businesses into Level 3, including Global Crossing, is important to the success of Level 3. The Company must identify synergies and integrate acquired networks and support organizations, while maintaining the service quality levels expected by customers to realize the anticipated benefits of any acquisition. Successful integration of any acquired businesses will depend on the Company's ability to manage the operations, realize opportunities for revenue growth presented by strengthened service offerings and expanded geographic market coverage, and eliminate redundant and excess costs to fully realize the expected synergies. If the Company is not able to efficiently and effectively integrate any businesses or operations it acquires, the Company may experience material negative consequences to its business, financial condition or results of operations.

The Company has also been focused on improving its liquidity, financial condition, and extending the maturity dates of certain debt.

In October 2012, Level 3 Financing, Inc. refinanced its existing $650 million Tranche B II and $550 million Tranche B III Term Loans under its existing senior secured credit facility through the creation of a new term loan in the aggregate principal amount of $1.2 billion (the "Tranche B-II 2019 Term Loan"). The Company used the net proceeds from the Tranche B-II 2019 Term Loan, along with cash on hand, to repay Level 3 Financing, Inc.'s $650 million Tranche B II and $550 million Tranche B III Term Loans under the existing credit agreement maturing in September 2018. See Note 13 - Subsequent Events in the notes to the consolidated financial statements for additional information.

In September 2012, the Company fully repaid the outstanding principal of its Commercial Mortgage due 2015 along with accrued interest which was approximately $63 million. See Note 8 - Long-Term Debt in the notes to the consolidated financial statements for additional information.

In August 2012, the Company completed the offering of $300 million aggregate principal amount of its 8.875% Senior Notes due 2019 in a private offering. The net proceeds from the offering of the notes will be used for general corporate purposes, including the potential repurchase, redemption, repayment or refinancing of the Company's and its subsidiaries' existing indebtedness from time to time. See Note 8 - Long-Term Debt in the notes to the consolidated financial statements for additional information.

Also in August 2012, Level 3 Financing, Inc. completed the offering of $775 million aggregate principal amount of its 7% Senior Notes due 2020 in a private offering. The net proceeds from the offering of the notes, along with cash on hand, were used to redeem all of the Company's outstanding 8.75% Senior Notes due 2017, including the payment of accrued interest and applicable premiums. See Note 8 - Long-Term Debt in the notes to the consolidated financial statements for additional information.

40-------------------------------------------------------------------------------- Table of Contents Level 3 Financing, Inc. refinanced its existing $1.4 billion Tranche A Term Loan under its existing senior secured credit facility through the creation of new term loans in the aggregate principal amount of $1.415 billion (the "New Term Loans") in August 2012. The Company used the net proceeds from the New Term Loans, along with cash on hand, to repay Level 3 Financing, Inc.'s $1.4 billion Tranche A Term Loan under the existing credit agreement maturing in March 2014 and used remaining net proceeds to repay $15 million in principal amount plus premium for existing vendor financing obligations. See Note 8 - Long-Term Debt in the notes to the consolidated financial statements for additional information.

In March 2012, the Company exchanged approximately $100 million aggregate principal amount of its outstanding 15% Convertible Senior Notes due 2013 for approximately 3.7 million shares of Level 3's common stock into which the notes were convertible plus an additional 1.7 million shares for a total of approximately 5.4 million shares. See Note 8 - Long-Term Debt in the notes to the consolidated financial statements for additional information.

In January 2012, Level 3 Financing, Inc. issued $900 million aggregate principal amount of its 8.625% Senior Notes due 2020 in a private transaction. A portion of the net proceeds from the offering were used in February 2012 to redeem all of Level 3 Financing's outstanding 9.25% Senior Notes due 2014 in aggregate principal amount of $807 million. See Note 8 - Long-Term Debt in the notes to the consolidated financial statements for additional information.

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 and Service Offering Three Months Ended September 30, Nine Months Ended September 30, (dollars in millions) 2012 2011 2012 2011 Core Network Services: North America - Wholesale Channel $ 381 $ 334 $ 1,144 $ 993 North America - Enterprise Channel 627 341 1,858 995 EMEA - Wholesale Channel 89 51 272 152 EMEA - Enterprise Channel 80 31 240 87 EMEA - U.K. Government Channel 41 - 131 - Latin America - Wholesale Channel 36 1 103 3 Latin America - Enterprise Channel 141 - 415 1 Total Core Network Services $ 1,395 $ 758 $ 4,163 $ 2,231 Wholesale Voice Services and Other 195 169 599 523 Total Revenue $ 1,590 $ 927 $ 4,762 $ 2,754 Total revenue consists of: • Core Network Services revenue from colocation and data center services, transport and fiber, IP and data services, and voice services.

• Wholesale Voice Services and Other revenue from 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 41-------------------------------------------------------------------------------- Table of Contents Other revenue. Management of Level 3 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 must continue to effectively manage gross margin contribution from the Wholesale Voice Services component and the positive cash flows from the Other revenue component of Wholesale Voice Services and Other revenue. The Company believes that trends in its communications business are best gauged by analyzing revenue changes in Core Network Services.

Core Network Services Growth in transport 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 up-front payments for private line, wavelength or dark fiber services. 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.

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 45 countries. These services are secure, redundant and flexible to fit the varying needs of the Company's customers. Services include hosting network equipment used to transport high speed data and voice over Level 3's global network; providing managed IT services (hosting), installation, maintenance, storage and monitoring of enterprise services; and providing comprehensive IT outsource solutions.

IP and data services primarily include the Company's high speed Internet protocol service ("IP"), dedicated Internet access ("DIA") service, virtual private network ("VPN") services, content delivery network ("CDN") service, media delivery service, Vyvx broadcast service, Converged Business Network service, Asynchronous Transfer mode ("ATM") and frame relay 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.

The Company believes that one of the largest sources 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 2011, which has continued in 2012.

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 enterprises and regional service providers who buy services regionally or locally, 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 42-------------------------------------------------------------------------------- Table of Contents 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, 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, the pricing and margins are 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," which was 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 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 Voice Over Internet Protocol ("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 beginning 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 continue in evergreen status (so long as the counterparty allows the same) or negotiating new agreements. The Company earns intercarrier compensation revenue from providing managed modem services, which are declining. The Company also receives intercarrier compensation from its voice services. In this case, intercarrier compensation is reported within Core Network Services revenue.

For a detailed description of the Company's broad range of communications services, please see Item 1. Business - "Our Services Offerings" of the Company's Form 10-K, as amended, for the year ended December 31, 2011 filed with the Securities and Exchange Commission.

43-------------------------------------------------------------------------------- Table of Contents Hurricane Sandy Level 3's business has been affected by Hurricane Sandy in the Northeast region of the United States during the fourth quarter of 2012. Level 3 continues to address issues affecting its network and to restore services to customers affected by the storm. In addition, revenue from Level 3's usage-based services may be adversely affected by storm-related business interruptions affecting its customers. The timing of the installation of services ordered by customers and Level 3's resulting revenue may also be adversely affected by limitations on the ability of third party access providers to provision services in the region on a timely basis. It is not possible at this time to estimate the effect that the storm may have on Level 3's operating results in the fourth quarter of 2012.

Based on information that is available to management on the date of this report, Level 3 does not expect that the direct and indirect effects that the storm has on its operating results in the fourth quarter of 2012 will be significant; however, it is possible that this expectation could change once additional information regarding the effect of the storm damage is available.

Critical Accounting Policies Refer to Item 7 of the Company's Form 10-K, as amended, for the year ended December 31, 2011 for a description of the Company's critical accounting policies.

44 -------------------------------------------------------------------------------- Table of Contents Results of Operations for the Three and Nine Months Ended September 30, 2012 and 2011: Three Months Ended September 30, Nine Months Ended September 30, Change Change (dollars in millions) 2012 2011 % 2012 2011 % Revenue $ 1,590 $ 927 72 % $ 4,762 $ 2,754 73 % Cost of Revenue 642 342 88 % 1,947 1,046 86 % Depreciation and Amortization 185 203 (9 )% 563 612 (8 )% Selling, General and Administrative 619 375 65 % 1,851 1,089 70 % Restructuring Charges 6 - NM 14 - NM Total Costs and Expenses 1,452 920 58 % 4,375 2,747 59 % Operating Income 138 7 NM 387 7 NM Other Income (Expense): Interest income - - NM 2 - NM Interest expense (188 ) (178 ) 6 % (558 ) (495 ) 13 % Loss on extinguishment of debt, net (49 ) (30 ) 63 % (110 ) (73 ) 51 % Other, net (54 ) (1 ) NM (52 ) 5 NM Total Other Expense (291 ) (209 ) 39 % (718 ) (563 ) 28 % Loss Before Income Taxes (153 ) (202 ) (24 )% (331 ) (556 ) (40 )% Income Tax Expense (13 ) (6 ) 117 % (35 ) (36 ) (3 )% Loss from Continuing Operations (166 ) (208 ) (20 )% (366 ) (592 ) (38 )% Income (Loss ) from Discontinued Operations, Net - 1 (100 )% - (1 ) (100 )% Net Loss $ (166 ) $ (207 ) (20 )% $ (366 ) $ (593 ) (38 )% NM - Not meaningful 45-------------------------------------------------------------------------------- Table of Contents Discussion of all significant variances: Total Revenue by Service Offering Three Months Ended September 30, Nine Months Ended September 30, (dollars in millions) 2012 2011 Change % 2012 2011 Change % Core Network Services $ 1,395 $ 758 84 % $ 4,163 $ 2,231 87 % Wholesale Voice Services and Other 195 169 15 % 599 523 15 % Total Revenue $ 1,590 $ 927 72 % $ 4,762 $ 2,754 73 % Revenue increased 72% to $1.590 billion in the three months ended September 30, 2012 from $927 million in the same period of 2011 and increased 73% to $4.762 billion in the nine months ended September 30, 2012 from $2.754 billion in the same period of 2011. The increase is 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, revenue from enterprise customers contributed to the growth in Core Network Services revenue.

The Company experienced growth in each of its service offerings during the three and nine months ended September 30, 2012 compared to the same periods in 2011 as a result of the Global Crossing acquisition. Excluding revenue from the Global Crossing acquisition, revenue growth in IP and data services and voice services during the three and nine months ended September 30, 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 the three and nine months ended September 30, 2012.

Core Network Services revenue increased in the North America, EMEA and Latin America regions during the three and nine months ended September 30, 2012 compared to the same periods of 2011 primarily as a result of the Global Crossing acquisition. Excluding revenue from the Global Crossing acquisition, revenue increased in the North America region during the three and nine months ended September 30, 2012 compared to the same periods of 2011.

Wholesale Voice Services and Other revenue increased in the three and nine months ended September 30, 2012 compared to the same periods in 2011 as a result of the Global Crossing acquisition. Excluding revenue from the Global Crossing acquisition, Wholesale Voice Services and Other revenue decreased in the three and nine months ended September 30, 2012 due to declines in usage. The Company continues to manage its combined wholesale voice services platform for margin growth, and expects continued volatility in revenue as a result of this strategy. In addition, the Company expects managed modem and SBC Contract Services revenue to continue to decline due to an increase in the number of subscribers migrating to broadband services and as a result of the migration of the SBC traffic to the AT&T network, respectively.

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 40% and 41% for the three and nine months ended September 30, 2012 compared to 37% and 38% in the same periods of the prior year. The increase is due to inclusion of costs associated with the Global Crossing business, which has lower gross margins, in the current year periods compared to the same periods of 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.

Additionally, the Company continues to implement initiatives to reduce both fixed and variable network expenses.

46-------------------------------------------------------------------------------- Table of Contents Depreciation and Amortization expense decreased 9% to $185 million in the three months ended September 30, 2012 from $203 million in the same period in 2011 and decreased 8% to $563 million in the nine months ended September 30, 2012 from $612 million in the same period in 2011. The decrease is 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 in the three and nine months ended September 30, 2012 compared to the same periods of 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. 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 September 30, 2011.

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 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 increased 65% to $619 million in the three months ended September 30, 2012 compared to $375 million in the same period of 2011 and increased 70% to $1.851 billion in the nine months ended September 30, 2012 from $1.089 billion in the same period in 2011. The increase is primarily due to SG&A expenses associated with the Global Crossing acquisition, including integration costs of approximately $18 million and $50 million for the three and nine months ended September 30, 2012, higher employee compensation and related costs as the Company continued to increase its sales, support and customer service delivery headcount, and merit increases 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 the three and nine months ended September 30, 2012.

Also included in SG&A expenses in the three and nine months ended September 30, 2012 were $49 million and $102 million, respectively, and in the three and nine months ended September 30, 2011, $26 million and $68 million, respectively, 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 for the 401(k) plan.

Restructuring Charges in the three and nine months ended September 30, 2012 were $6 million and $14 million, respectively, compared to less than $1 million in the same periods of 2011. The increase in the three and nine months ended September 30, 2012 compared to the same periods of 2011 was primarily due to reductions in headcount associated with the Global Crossing acquisition, as the Company had not initiated any significant new workforce reduction plans in 2011.

The Company may initiate additional restructuring activities in future periods in connection with the efforts to optimize its cost structure or in connection with the Amalgamation of Global Crossing. Additional restructuring activities could result in additional headcount reductions and related charges.

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 restructuring charges, (4) depreciation and amortization expense, (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 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.

47-------------------------------------------------------------------------------- Table of Contents 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, 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 (dollars in millions): Three Months Ended September 30, Nine Months Ended September 30, 2012 2011 2012 2011 Net Loss $ (166 ) $ (207 ) $ (366 ) $ (593 ) Income Tax Expense 13 6 35 36 Total Other Expense 291 209 718 563 Depreciation and Amortization Expense 185 203 563 612 Non-Cash Compensation Expense 49 26 102 68 Discontinued Operations of Coal Mining Business - (1 ) - 1 Adjusted EBITDA $ 372 $ 236 $ 1,052 $ 687 Consolidated Adjusted EBITDA was $372 million in the three months ended September 30, 2012 compared to $236 million in the same period of 2011 and was $1.052 billion in the nine months ended September 30, 2012 compared to $687 million in the same period of 2011. The increase in Adjusted EBITDA in the three and nine months ended September 30, 2012 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.

Interest Expense increased 6% to $188 million in the three months ended September 30, 2012 from $178 million in the same period of 2011 and increased 13% to $558 million in the nine months ended September 30, 2012 from $495 million in the same period of 2011. Interest expense increased as a result of higher average debt balance for 2012 compared to 2011, including financing associated with the Global Crossing acquisition, partially offset by lower cost of borrowing on refinanced debt.

The Company expects annual interest expense in 2012 to be approximately $740 million based on the Company's outstanding debt as of September 30, 2012, and taking into consideration the current interest rates on the Company's variable rate debt and the October 2012 incurrence of the $1.2 billion Tranche B-II 2019 Term Loan under the amended and restated credit agreement (along with the repayment of the existing $650 million Tranche B II and $550 million Tranche B III Term Loans). See Note 8 - Long-Term Debt and Note 13 - Subsequent Events of the Notes to Consolidated Financial Statements for more details regarding the Company's financing activities.

48-------------------------------------------------------------------------------- Table of Contents Loss on Extinguishment of Debt, net was $49 million and $110 million in the three and nine months ended September 30, 2012, compared to a loss of $30 million and $73 million in the three and nine months ended September 30, 2011. The loss recorded during 2012 was related to a charge of approximately $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 approximately $40 million as a result of the redemption of the 8.75% Senior Notes due 2017 in August 2012, a charge of approximately $22 million related to the redemption of the 9.25% Senior Notes due 2014 in February 2012 and a charge of approximately $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 stock in March 2012. The loss recorded during 2011 was related to 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 due 2014 redeemed in April 2011 and a $20 million charge recorded in the first quarter of 2011 resulting from the redemption of the 5.25% Convertible Senior Notes due 2011 in February 2011 and the exchange of the 9% Convertible Senior Discount Notes due 2013 in January 2011. See Note 8 - Long-Term Debt, of the Notes to the Consolidated Financial Statements for more details regarding the Company's financing activities.

The Company may enter into additional transactions in the future to repurchase or exchange existing debt that may result in gains or losses on the extinguishment of debt.

Other, net was $54 million and $52 million of expense in the three and nine months ended September 30, 2012, respectively compared to $1 million of expense and $5 million of income in the same periods of the prior year. Other, net is primarily comprised of foreign currency gains and losses, gains and losses on the sale of non-operating assets and other income. Other, net in the three and nine months ended September 30, 2012 was driven by a non-cash loss on the Company's interest rate swaps agreements of approximately $60 million that were deemed "ineffective" under GAAP in connection with the refinancing of the $1.4 billion Tranche A Term Loan. See Note 8 - Long-Term Debt, of the Notes to the Consolidated Financial Statements for more details regarding the Company's financing activities.

Income Tax Expense was $13 million and $35 million in the three and nine months ended September 30, 2012 compared to $6 million and $36 million in the same periods of 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 the nine months ended September 30, 2011 is primarily related to an out of period adjustment due to taxable temporary differences associated with certain indefinite-lived intangible assets that the Company is unable to offset with deductible temporary differences.

The Company also incurs income tax expense attributable to income in various Level 3 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.

Income (Loss) from Discontinued Operations was income of $1 million and a loss of $1 million in the three and nine months ended September 30, 2011, respectively. Level 3 sold its coal mining business in the fourth quarter of 2011, and accordingly, reflected the coal mining business as discontinued operations in 2011.

49-------------------------------------------------------------------------------- Table of Contents Financial Condition - For the nine months ended September 30, 2012 and 2011 Cash flows provided by operating activities, investing activities and financing activities for the nine months ended September 30, 2012 and 2011, respectively, are summarized as follows: Nine Months Ended September 30, (dollars in millions) 2012 2011 Change Net Cash Provided by Operating Activities of Continuing Operations $ 178 $ 199 $ (21 ) Net Cash Used in Investing Activities of Continuing Operations (538 ) (405 ) (133 ) Net Cash Provided by Financing Activities of Continuing Operations 234 54 180 Net Cash Used in Discontinued Operations - (4 ) 4 Effect of Exchange Rates on Cash and Cash Equivalents 1 1 - Net Change in Cash and Cash Equivalents $ (125 ) $ (155 ) $ 30 Operating Activities of Continuing Operations Cash provided by operating activities of continuing operations decreased to $178 million in the nine months ended September 30, 2012 compared with $199 million in the same period in 2011 primarily due to higher interest paid and an increase in the use of cash for working capital items.

Investing Activities of Continuing Operations Cash used in investing activities of continuing operations increased in the nine months ended September 30, 2012 compared to the same period of 2011 primarily as a result of additional capital expenditures, which totaled $545 million in the nine months ended September 30, 2012 compared to $346 million in the same period of the prior year. The increase was primarily driven by the inclusion of Global Crossing in the Company's results since the acquisition date. The increase was partially offset by a decrease of $15 million in restricted cash and securities, net in the nine months ended September 30, 2012 compared to a $63 million increase in the same period in 2011.

Financing Activities of Continuing Operations Cash provided by financing activities of continuing operations increased in the nine months ended September 30, 2012 compared to the same period of 2011 as a result of greater borrowings net of payments on and repurchases of debt and capital leases during 2012. See Note 8 - Long-Term Debt of the Notes to the Consolidated Financial Statements for more details regarding the Company's debt transactions during 2012.

Cash Flows of Discontinued Operations Net cash used in discontinued operations was $4 million in the nine months ended September 30, 2011. The Company completed the sale of its coal mining business on November 14, 2011.

Liquidity and Capital Resources The Company incurred a net loss of $366 million in the nine months ended September 30, 2012 and $593 million in the same period of 2011. In connection with its continuing operations, the Company used $545 million for capital expenditures and $234 million of cash was provided by financing activities in the nine months ended September 30, 2012. This compares to $346 million of cash used for capital expenditures and $54 million of cash flows provided by financing activities in the same period of the prior year.

Net cash interest payments are expected to increase to approximately $695 million in 2012 from the $576 million made in 2011 based on forecasted interest rates on the Company's variable rate debt outstanding as of September 30, 2012 and the October 2012 incurrence of the $1.2 billion Tranche B-II 2019 Term Loan under the 50-------------------------------------------------------------------------------- Table of Contents amended and restated credit agreement (along with the repayment of the existing $650 million Tranche B II and $550 million Tranche B III Term Loans).

Capital expenditures for 2012 are expected to remain relatively consistent as a percentage of revenue with 2011, 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 September 30, 2012, the Company had debt contractual obligations, including capital lease and commercial mortgage obligations, and excluding interest, premium and discounts on debt issuance and fair value adjustments, of $11 million that mature in the remainder of 2012, $210 million in 2013 and $16 million in 2014.

In October 2012, Level 3 Financing, Inc. refinanced its existing $650 million Tranche B II and $550 million Tranche B III Term Loans under its existing senior secured credit facility through the creation of a new Tranche B-II 2019 Term Loan in the aggregate principal amount of $1.2 billion. The Company used the net proceeds from the Tranche B-II 2019 Term Loan, along with cash on hand, to repay Level 3 Financing, Inc.'s $650 million Tranche B II and $550 million Tranche B III Term Loans under the existing credit agreement maturing in September 2018.

In September 2012, the Company fully repaid the outstanding principal of its Commercial Mortgage due 2015 along with accrued interest which was approximately $63 million.

In August 2012, the Company completed the offering of $300 million aggregate principal amount of its 8.875% Senior Notes due 2019 in a private offering. The net proceeds from the offering of the notes will be used for general corporate purposes, including the potential repurchase, redemption, repayment or refinancing of the Company's and its subsidiaries' existing indebtedness from time to time.

Also in August 2012, Level 3 Financing, Inc. completed the offering of $775 million aggregate principal amount of its 7% Senior Notes due 2020 in a private offering. The net proceeds from the offering of the notes, along with cash on hand, were used to redeem all of the Company's outstanding 8.75% Senior Notes due 2017, including the payment of accrued interest and applicable premiums. The Company recognized a loss on extinguishment of debt of $40 million in the third quarter of 2012 as a result of the redemption of the 8.75% Senior Notes due 2017.

Level 3 Financing, Inc. refinanced its existing $1.4 billion Tranche A Term Loan under its existing senior secured credit facility through the creation of new term loans in the aggregate principal amount of $1.415 billion in August 2012.

The Company used the net proceeds from the New Term Loans, along with cash on hand, to repay Level 3 Financing, Inc.'s $1.4 billion Tranche A Term Loan under the existing credit agreement maturing in March 2014 and used remaining net proceeds to repay $15 million in principal amount plus premium for existing vendor financing obligations. The Company recognized a loss on the extinguishment of debt of $9 million in the third quarter of 2012 as a result of refinancing the $1.4 billion Tranche A Term Loan and repayment of existing vendor financing obligations. In addition, in connection with the refinancing of the Tranche A Term Loan, the Company recognized a $60 million non-cash loss on two interest rate swaps that had previously hedged changes in the interest rate on a portion of the Tranche A Term Loan. See Note 7 - Derivative Financial Instruments of the Notes to Consolidated Financial Statements.

In March 2012, the Company entered into an exchange agreement for a portion of its 15% Convertible Senior Notes due 2013. Pursuant to the agreement, approximately $100 million aggregate principal amount of Level 3's outstanding 15% Convertible Senior Notes due 2013 were exchanged for approximately 3.7 million shares of Level 3's common stock into which the notes were convertible plus an additional 1.7 million shares for a total of approximately 5.4 million shares. The consideration was based on the market price for these notes which included an inducement premium and included a payment for accrued and unpaid interest from January 15, 2012 through March 15, 2012 of approximately $2 million. This transaction did not include the payment by the Company of any cash. The Company recognized a loss on extinguishment of $39 million in the first quarter of 2012 as a result of this exchange of the 15% Convertible Senior Notes due 2013. The transaction will reduce cash interest expense by approximately $15 million on an annual basis.

51-------------------------------------------------------------------------------- Table of Contents In January 2012, Level 3 Financing, Inc. issued $900 million aggregate principal amount of its 8.625% Senior Notes due 2020 in a private transaction. A portion of the net proceeds from the offering were used to redeem all of Level 3 Financing's outstanding 9.25% Senior Notes due 2014 in aggregate principal amount of $807 million. The Company recognized a loss on extinguishment of $22 million in the first quarter of 2012 as a result of the redemption of the 9.25% Senior Notes due 2014. The remaining proceeds constitute purchase money indebtedness under the existing senior secured credit agreement and indentures of Level 3 and will be used solely to fund the cost of construction, installation, acquisition, lease, development or improvement of any Telecommunications/IS Assets (as defined in the existing senior secured credit agreement and indentures of Level 3), including the cash purchase price of any past, pending or future acquisitions.

For information related to financing activities that occurred during 2011, see Item 7 of the Company's Form 10-K, as amended, for the year ended December 31, 2011.

Level 3 had $793 million of cash and cash equivalents on hand at September 30, 2012. In addition, $47 million of current and non-current restricted cash and securities are used to collateralize outstanding letters of credit, long-term debt, and certain operating obligations of the Company. 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, Level 3 or its affiliates 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. Level 3 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. Level 3 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.

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