Debt Downgrade Buffets Level 3

Warren Buffett aside, Level 3 ( LVLT) still doesn't look like a good bet to some people.

Standard & Poor's cut Level 3's credit rating to CCC from CCC+ Tuesday, citing concerns that poor demand for data-transport services threaten the company's ability to "generate substantial cash flows" and lower its debt levels. The agency also removed Level 3 from its watch list but kept it on negative outlook. The stock fell 8%.

The S&P move comes as a rare setback in what has been a warm summer for the debt-heavy network operator. The company's shares have doubled following Warren Buffett's convertible-debt investment in the company. Investors reasoned that a shot of liquidity would make Level 3 the consolidator of the troubled telecom business, enabling it to swoop in and buy distressed assets at bargain prices.

Last week Level 3 sought to step into that far-fetched role by bidding for Williams Communications, even as Williams Communications prepared to emerge from bankruptcy with the support of its creditors.

In issuing Tuesday's downgrade, S&P set aside the hopes and dreams of tech bulls and focused on the here and now, notably Level 3's massive debt obligations. In the wake of its month-long rally, Level 3's desperation has been all too easy to overlook. In the months leading up to the much-discussed Buffett investment, Level 3 reached beyond its supposedly promising telecom business to acquire a pair of software resellers -- in a bid to avoid defaulting on revenue-generation terms embedded in its debt covenants.

The acquisitions tripled Level 3's annual revenue rate, but the super-thin profit margins mean there's nearly no carryover to earnings. So even after bolstering its top line, Level 3 remains in a tough spot when it comes to generating cash to pay its big bills.

S&P credit analyst Michael Tsao cited this fact and the bleak industrywide outlook for sales in the data transport field in his downgrade.

"The industry is expected to remain weak for many years due to excess capacity, slow demand for long-haul data services, and potentially increased competition from service providers that may emerge from bankruptcy," Tsao wrote. "Given Level 3's substantial leverage, weak interest coverage, and limited liquidity, the company is not well positioned to deal with such weak industry fundamentals."

The downgrade points out the fact that in the long run, Level 3 is fundamentally in no better shape now than it was even before its headline-grabbing cash infusion. Back then, a group of investors including Warren Buffett, Bill Miller's Legg Mason Funds, and Southeastern Asset Management's Longleaf Partners Funds agreed to buy $500 million in convertible bonds from the Broomfield, Colo., fiber optic network operator.

Though the deal was well out of reach of the average investor, it was seen as a critical endorsement of Level 3. Shares immediately shot up 80% in the minutes following the announcement.

Including the cash raised through the convertible deal, Level 3 has about $2.1 billion in cash and credit available. But the company faces $500 million in interest payments this year on its $6.5 billion debt load.

Some analysts have been questioning the company's ability to make the interest payments, considering its operating costs and its capital spending needs. Those questions will loom larger after Tuesday's downgrade.

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