Editor's note: This Stocks Under $10 alert was originally sent to subscribers Oct. 18 at 3:32 p.m. EDT. It's being republished as a bonus for TheStreet.com and RealMoney.com readers. Larsen Kusick is part of the TheStreet.com Stocks Under $10 Team.
The universe of stocks under $10 is home to a number of tech-related companies that were investor favorites in the late 1990s. One of the most interesting is
Level 3 Communications
, which at one point, had to quash investor fears that it would file for bankruptcy protection. Today, this former highflier is well-positioned to benefit from the surge in Internet video content, but it still faces some steep hurdles.
Level 3 was one of the first major international telecom-infrastructure plays when the company went public in 1998. Its aggressive strategy to provide much-needed bandwidth capacity using a rapidly expanding system of intercity networks in North America, Europe and Asia sent its shares soaring in the bubbly stock market of the late '90s. When Level 3 shares hit an all-time high of $132.25 on March 10, 2000, "irrationally exuberant" investors did not seem to care that the company had posted a net loss of $191 million on revenue of just $173 million in its most-recently announced quarter.
Unfortunately for Level 3, it was not alone in its plans to create an extensive broadband network. Before long, the supply of broadband capacity reached levels beyond what anyone would need anytime soon. The term "dark fiber" soon entered the vocabulary of telecom investors, referring to the hundreds of thousands of miles of fiber-optic cables that had been laid but had never been "lit up" for usage.
By June 2001, Level 3's stock had plummeted 97% in the 15 months since its March 2000 highs. Investors suspected that the company would collapse, along with other telecom companies, under the weight of its own debt.
Fighting for survival in a difficult environment, Level 3 CEO Jim Crowe displayed an uncanny ability to restructure the company's debt load in the following years. Despite consistent earnings-per-share losses that continue even today, the company has been able repeatedly to push back its obligations, reduce interest expenses and maintain some financial flexibility, thanks in part to a series of convertible bond offerings that were scooped up by reputable investment firms like Warren Buffett's Berkshire Hathaway and Legg Mason.
Today, Level 3 makes an interesting investment case due to its significant assets and strong position in a market with high barriers to entry.
The telecommunications landscape has shaken out into a group of about 10 companies that represent the backbone of the Internet (also known as Tier 1 players) and a number of smaller Internet service providers (ISPs) that pay to send traffic onto these larger networks. As a member of the elite Tier 1 group, Level 3 stands to benefit from accelerating demand for Internet content such as video and other applications, which require large amounts of bandwidth to be transmitted.
On Sept. 12, 2006, one of the fastest-growing Web sites on the Internet, video-sharing site YouTube.com, announced it had selected Level 3 to support the company's online video service. The selection made sense because of Level 3's gigantic network capacity, which was originally built for bandwidth-intensive applications like video.
If the rise of YouTube -- which allows users to watch hours of videos available on its site -- is only the beginning of a long-term revolution toward bandwidth-intensive content, Level 3 stands to see its revenue accelerate more quickly than had been expected.
But the company's debt still looms, frightening off many investors. There's no question Level 3's $6.6 billion in debt is pretty alarming. And then there is the concern that the company is likely to give away more of its equity, thereby diluting shareholder value, if it can't generate enough cash flow to pay off its debt obligations.
Still, Level 3's story is intriguing. No one seems to know for certain what the telecom industry will look like 10 years from now, and the potential changes are widespread -- from consolidation of the many networks to varying estimates of just how much of the excess broadband capacity, i.e., that dark fiber, will end up being used. Just as important is the question of when such progress will occur.
Uncertainty often creates buying opportunities for patient and risk-tolerant investors, but the ultimate question for investors is: At what price does the potential upside justify the risks?
Level 3 is an extremely volatile name, which would not necessarily make us shy away from adding it to the Stocks Under $10 model portfolio if we felt the upside was sufficiently attractive. Shares of Level 3 have swung from a low around $2 to a high of $6 in the past year alone. This wide range is a result of the difficulties involved in valuing a large company with significant assets and equally significant debt, whose growth potential is enormous but far from certain.
We believe that one of the most important parts of beating the market is initiating positions at favorable entry points. This strategy makes us reluctant to recommend purchases of companies where most of the potential catalysts are already priced in.
Shares of Level 3, currently trading at $5.80, rallied to a 52-week high after the company announced the acquisition of rival
for $1.45 billion in cash and stock.
This announcement, in the wake of September's YouTube deal win, leads us to believe that investors are currently focused on the bright side of the Level 3 story. Market sentiment and risk tolerance play a large role in what investors are willing to pay for shares, and we believe the best entry points occur when investors take the risks and potential bad news for a stock into consideration. Level 3 is a good example of a company that has already benefited from a shift in investor sentiment from negative to positive.
For example, look at the shift in analyst initiations and upgrades over the past year. Just one year ago, of the seven analysts covering Level 3, there were zero buy ratings, zero outperform ratings, one hold rating, three underperform ratings, and three sell ratings, according to Reuters. Now there are 15 analysts covering the stock, with four buys, four outperforms, six holds, and one sell rating.
So while we are fans of Level 3 and its long-term story, we would not look to initiate a position in the shares until the market refocuses on the remaining hurdles and inherent risk in the company. We would be more inclined to recommend a buy when Level 3 comes back down to the mid-$4 range, especially if we see analysts taking a more cautious stance on the stock.
In addition, our analyses on other companies in the under-$10 sector show us that better opportunities exist right now, where the potential upside for a stock is much greater than the downside. This favorable risk/reward ratio is what we focus on at Stocks Under $10 in order to generate profit-making ideas for subscribers.
In keeping with TSC's editorial policy, Larsen Kusick doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Kusick is a research associate at TheStreet.com, where he works closely with Jim Cramer and works on TheStreet.com Stocks Under $10. Prior to joining TheStreet.com, he worked in options trading and management consulting. He appreciates your feedback;
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