Why I Am Bearish On Level 3, Windstream

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

With demand for data continuing to grow at breathtaking rate, it should not be surprising that many Internet and communications businesses are trading at high multiples. Ultimately, however, growth is still uncertain against expectations with the economy in limbo. I thus recommend holding out from investments in both Level 3 Communications (NYSE: LVLT) and Windstream (NASDAQ: WIN). Below, I review the fundamentals of both companies.

Level 3

At a 53x forward earnings, Level 3 has been optimistically favored by the market. Analysts forecast annual earnings growth of 4% over the next 5 years. By itself, this warrants holding off. Let's look at the fundamentals to see if there is a reason than that Level 3 could justify its high multiples.

ROA, ROE, and ROI are all negative while volatility is 50% greater than the broader market. Perhaps much of the reason why the multiples are elevated is because of the lucrative multiple year contract it inked with Time Warner, which grants the firm visibility and mitigates challenges in cable. In addition, much of the stock is still in "wait-and-see" mode. Clearly, investors like what they are seeing. After failing as a dot-com stock, Level 3 resurrected itself through the Global Crossing acquisition.

But Level 3 is loaded with debt and liabilities are quickly rising to asset levels. Unfortunately, growth has not really supported the trends in leverage. Core network services' top-line only grew 0.7% sequentially on a constant currency basis. Regional CNS sales were anemic at 1.1% while emerging market opportunities at EMEA actually fell 2.3%. Although gross margins increased by around 500 bps to 59.1% as a result of network expense synergies and lower wholesale voice services, capital expenditures are rising and eating away the growth. I recommend thus holding out before the multiples elevate to more reasonable levels.

Windstream

You may be tempted to then buy competitor Windstream. It too, in my opinion, is overvalued. Trading at a respective 33.3x and 17.5x past and forward earnings, future growth expectations are simply not enough to justify the current market assessment. While the company offers more than a 10% dividend yield (large like other telecom firms), it is because of the limited growth opportunities. In fact, analysts forecast negative annual earnings growth of 1.8% over the next 5 years.

The Street also rates the stock a "hold", which is very bearish against the market consensus at large. Moreover, the forward PE multiple is actually above the historical 5-year average PE multiple of 17.1x! In addition, free cash flow trends do not justify today's premium. FCF for the TTM ending 2Q12 was $604M versus $637M in 2Q11 and $762M in 2Q10. If it's a sinking ship that you want to get in on then you can at least do it when the multiples are low!

Although I am bearish on Windsteam and Level 3, there are communications/telecom stocks that I am bullish about: click here for my picks.


TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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