Investor Buffett does about-face with Level 3 deal

In past, financier shunned technology companies

July 10, 2002|By Stacey Hirsh and Gus G. Sentementes | Stacey Hirsh and Gus G. Sentementes,SUN STAFF

With the telecommunications sector poised for consolidation, analysts said yesterday that Level 3 Communications Inc. can shop around for bargains, thanks to a $500 million investment from Legg Mason Inc., Longleaf Partner Funds and the holding company of renowned investor Warren Buffett.

Though the Legg Mason investment was no huge surprise to analysts - because the Baltimore-based brokerage firm already had a stake in the telecom company - having the Buffett name attached to a technology company seemed an anomaly.

"He's been quoted historically saying he would never invest in technology," said Jim Friedland, senior telecom services analyst for Robertson Stephens in San Francisco.

Friedland said the deal goes against Buffett's investment style. But he and other analysts - and a Level 3 company official who spoke during a conference call this week - said Buffett's ties to Level 3 go back years.

Level 3 operates fiber-optic networks across North America and Europe. It was founded in Omaha, Neb., where Buffett's Berkshire Hathaway Inc. is based.

Walter Scott Jr., chairman of Level 3, sits on the board of Berkshire Hathaway.

"From the outside, it looks like this is a hometown deal, rather than something that Berkshire is going to look at as a core investment over the next several years," Friedland said.

Berkshire Hathaway did not return calls yesterday.

Level 3 announced Monday that it had agreed to sell $500 million of its convertible notes to Longleaf Partners Funds, Berkshire Hathaway and Legg Mason. Berkshire and Legg's subsidiary, Legg Mason Funds Management, are each investing $100 million, and Longleaf is investing the rest. William Miller, chief executive officer of Legg Mason Funds Management, guided the investment for Legg Mason.

Shares of Level 3 rose 51 percent Monday. They went up 9 cents, or 2 percent, yesterday to close at $4.45. Shares of Legg Mason fell $1.95, or 4 percent, to close yesterday at $44.70.

Rick Grubbs, a senior telecom analyst at Credit Lyonnais Securities in New York, said that outside of the relationship between Scott and Buffett, not much about the Level 3 deal is different from what others are doing these days. With the telecom sector so battered, many investors are seeking bargains.

"Who the heck knows what these guys see," Grubbs said. "There's a tremendous amount of investing of this kind going on ... and eventually somebody's going to be correct."

Level 3 leases space on its telecommunications network to carriers, such as America Online and Verizon. Competitors with similar models - such as Williams Communications Group, Global Crossing Ltd. and 360Networks Inc. - have filed for Chapter 11 bankruptcy protection.

"All these guys were thinking they were going to be the total outsource solution for AT&T, WorldCom, Sprint, people like that," Grubbs said.

The real issue, he said, is whether Level 3 can expand its business profitably.

If the company buys another business at a low price and directs new traffic to its network, the telecom giant can put its $500 million to work, he said.

Alex Mou, a senior analyst at Hotovec, Pomeranz & Co. in San Francisco, said his company expects Level 3 to use the money in a bid to buy Global Crossing or Williams Communications.

"What Level 3 has said is its acquisitions strategy is going to focus more on acquiring customers rather than consolidating network capacity," Mou said.

Minor outlay

Mou said the Level 3 investment is a relatively small one for Buffett - less than 1 percent of his holdings.

Legg Mason owned through its subsidiaries about 35.4 million of Level 3's 400 million shares as of March 31, according to Nasdaq.

"Legg Mason already had an investment in Level 3. They're one of their biggest shareholders," Friedland said.

Rather than purchase a straight equity stake in Level 3 in this deal, Legg Mason, Berkshire Hathaway and Longleaf bought convertible bonds that will earn 9 percent when they mature in 2012. At that time, the bonds can be converted into stock at a price of $3.41.

Looking for security

Analysts said that investors use convertible bonds to provide them with more security in their investments. "It kind of speaks to the conservative nature of Legg Mason," said Robert Hoban, a fixed income analyst who covers financial institutions for Standard & Poor's.

Buying convertible bonds places Legg Mason and the other investors ahead of equity holders, "so they then have a claim on any of the assets in any kind of bankruptcy scenario," said Jeremy Howard, head of U.S. convertible research at Deutsche Bank Securities in New York.

"By structuring it as a convertible bond, they will be able to convert their bonded shares and participate in a significant proportion of the equity upside" if shares of Level 3 increase in value, Howard said. Despite the relative security of convertible bonds, though, analysts called the investment risky.

"Even if you have senior debt or secured debt, you might not get all your money back," said Rachel Barnard, an analyst who covers asset managers and brokers for Morningstar Inc. in Chicago. "It's hard to know how much the debt holders are going to get. I would say it's not really much of a hedge. ... It's better than stock, but it's not risk-free.

Still, Barnard said, it is a "good sign" for Level 3 to have Buffett and Legg Mason behind it.

"I think what's happening now is the market weeding out, and people are making a big bet on who's going to be a survivor," she said. "This is the time that they come in and pick up the companies that are cheap and the ones that are winners. ... To be fair, it's a very good strategy."

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