Monday, February 15, 2010

Are Longleaf and Fairfax Visionaries Or Just Stuck?

Years ago, like nearly everyone else who resided in Omaha, Nebraska, I drank the Level3 Kool-Aid. Level3 was an offshoot of Kiewit Construction and everything the Kiewit guys touched turned to gold. They built roads, tunnels, big buildings and mined coal and aggregates. They bought the failed Continental Can Company, stripped it and came out with huge profits. They started a fiber optic company that became the forerunner of MCI and sold it to WorldCom. Level3 was a do-over of a business that they had already made billions in and directed by the same management team that led the former success. Additionally, the managers and accountants of Kiewit would once again make sure the venture was run soundly. But Kiewit was a private company. You could only envy, you couldn't participate unless you worked there.

Level3 eventually went public. We could all get in and become Kiewit millionaires. Omaha did. In the dot-com bubble it hit $158 per share. It became not only the darling of Omaha, but the high tech investing world. It has been all downhill from there. Paper fortunes have been lost and many margined fortunes sunk real fortunes. The devastation has been significant on Omaha Kiewit wannabes. I thank my lucky stars that I wasn't a pig as I often am. I made a few dollars and have watched the saga from the sidelines.

Walter Scott, Level3's Chairman and former Kiewit CEO, has a great business reputation, in spite of Level3's performance. He has an engineers mind, a businessman's nose, and integrity. Those qualities have attracted some quality associates: Warren Buffett, Leucadia Financial, Mason Hawkins of Longleaf, and Prem Watsa of Fairfax Financial Holdings. The first two have done bond financings while the latter two have done both bonds/convertibles and common stock. To the best of my knowledge Berkshire and Leucadia are not involved with Level3 at the present time.

Southeastern Asset Management, Hawkins' company owns 429 million shares and Watsa's Fairfax owns 139 million shares. Both Fairfax and Southeastern each own about a $100 million in a convertible issue paying 15%! I'm not sure if the potential convertible shares are factored into the ownership totals and it really doesn't matter. Included or not, these two guru investors have placed a huge bet on Level3's future. They own approximately 35% of the company, possibly more. While respected value investors, they must be betting on the company's franchise value and moat. LVLT sells at over 4 X Book and has virtually no tangible book value, it's $6 Billion of debt dwarfs it's equity, interest charges gobble up over $1/2 Billion per year, and net earnings have been rare over it's lifespan. It doesn't fare well under almost any value investing metrics. Yet, two guys smarter than me have parked lots of money here. Additionally, both have the bulk of their net worth tied up in their companies, so they aren't some Wall Street hotshot playing with other peoples money while skimming large fees. They must believe.

It's obvious that they too have drunk the LVLT Kool-Aid. Will the result be different from the losses sustained by many of the Omaha faithful? Buffett and Leucadia were attracted by the generous terms offered by LVLT, made a well calculated investment and have exited. Hawkins and Watsa have the bulk of their money at risk in common stock. Their 15% yields on the convertibles is attractive, but the majority of their investment pays no interest. Whether they are under or above water on their positions, they are believers. They still own a ton of LVLT shares.

None of the other security companies are even close in their devotion to Level3, in fact, many other holders are indexers and smaller institutional positions. Analysts aren't impressed. The stock is the province of penny stock speculators and two, well respected value investors. Not the usual bedfellows. When the share price moves it is the result of rumors touting a Google or Sprint acquisition, not any improvement in financial condition. Why do Hawkins and Watsa stay and should I join them?

I think I'm going to keep watching this drama from the sidelines. I had a taste of the Kool-Aid, but have been able to kick the habit. With $6 Billion of junk debt, declining revenue, and poor operating results, I see lots of dilution ahead. LVLT has been masterful at balance sheet management as they have restructured, refunded, converted, and issued securities along their route to telecom survival. But, more of their debt will get turned into equity. Even at a discount, more shares equals dilution.

If Level3 doesn't work out well for Fairfax and Longleaf it won't sink their funds, but individual investors would be better off staying away from dilution prone balance sheets.

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