Welcome to Earthlink’s third quarter 2008 earnings conference call. Today’s call is being recorded. At this time I would like to turn the conference over to Mr. Kevin Dotts, Chief Financial Officer for opening remarks and introductions.
Kevin M. Dotts
Thanks and welcome everyone to our call. This morning I’m joined by Earthlink’s Chairman and CEO Rolla Huff and our Vice President of Corporation Communications Michelle Sadwick and our Vice President of Investor Relations [Lewis Alterman] to discuss our third quarter results. Following our comments there will be an opportunity for questions.
Before we can continue I would like to point out that certain statements contained in our earnings release and on this call are forward-looking statements rather than historical facts that are subject to risk and uncertainties that could cause actual results to differ materially than those described. With respect to such forward-looking statements the company seeks the protection afforded by the Private Securities Litigation Reform Act of 1995.
These risks include a variety of factors including competitive developments and risk factors listed in the company’s SEC reports and public releases. Those lists are intended to identify certain principle factors that could cause actual results to differ materially from those described in the forward-looking statements but are not intended to represent a complete list of all risks and uncertainties inherent to the company’s business.
In an effort to provide useful information to investors our comments today also include non-GAAP financial measures. For details on these measures including why we use them and reconciliations to the most comparable GAAP measures please refer to our earnings release and the Form 8K that has been furnished to the SEC both of which are available on our website at www.Earthlink.net. Now, I will turn things over to Rolla.
Rolla P. Huff
I’m pleased to report that today we announced a solid quarter of operating performance. I think most of you would agree that the current business environment is causing most companies to reassess their cost structures, deleverage their balance sheets and focus on cash generation. As our investors know, Earthlink began following that script in August of last year and it looks to be serving us pretty well.
Our performance has come through our people and in my judgment the most remarkable thing about our performance has been the ability and willingness of our people to stay focused on customers while simultaneously doing the things necessary to create shareholder value. But, I’ve got to tell you it’s not been easy for them but they are the key reason that we’re creating the shareholder value that’s being created today.
As I’ve said before there’s no silver bullet in this business. We create value through a thousand little things and we do it with a team of dedicated people who clearly understand our business priorities. Our top priority is to solve for extending the we call it the tail on our access business for as long as possible while continuing to use better business processes as well as new technology to find creative ways to run our business more efficiently.
We’ve aligned compensation structures with business priorities to make sure everyone is pulling in the same direction. As a result of all of the above, Earthlink is in a good position at a time when underleveraged high cash flow businesses have greater relative strength and value in the technology sector. We are well aware of the substantial volatility in the capital markets. We also recognize this has begun to spill over in to the broader economy.
I’m pleased to tell you that at least as of right now our consumer business has not felt any meaningful impact from the uncertain economic environment. Neither churn nor bad debt has moved outside of historical ranges and we’re actually reporting higher average revenue per subscriber. But, it’s early and we don’t have complete clarity around whether the more difficult economic environment will help or hurt our business.
As we’ve been doing we’ll just continue to watch these metrics very closely. More importantly, well continue to run our business with the discipline we have been with a focus on driving cash flow and an eye towards strategic opportunities that can help us create incremental cash flow through future growth prospects. As I just indicated, our consumer business is operating in bands consistent with and in some cases above our expectations and historical trends.
Revenue continued to be slightly above our expectations due to better than projected organic customer additions. Importantly, broadband now represents 52% of our overall revenue. We know that tenured broadband customers have lower churn rates than tenured dial up customers but they also have lower gross margins. Clearly, our ability to continue to save our dial up customers to our broadband platform rather than simply losing them to a competitor is a key strength of the Earthlink business model.
It’s also a reason that we continue to believe that the tail on our business will be longer than most people give us credit for. We continue to benefit from operating process efficiencies and cost of revenue improvements despite the expected overall decline in reported revenue. We continue to improve our financial performance by our efforts to limit sales and marketing spend to only those activities that create positive shareholder return.
As a result of the above, we reported better than expected adjusted EBITDA, free cash flow and net income. Because we’re currently seeing nothing in data that would suggest that our operating performance will materially reverse in the near term, we’re increasing both the low end and the high end of the 2008 guidance. I’d like to provide a bit more commentary on some of the drivers of our operating results and then Kevin will walk everyone through a more detailed review of our financial performance in the quarter, our revised 2008 guidance and our preliminary guidance for next year.
As anticipated, new subscriber additions continue to decline quarter-over-quarter but are attracting ahead of our plan which we’re pleased to see given our tight controls on marketing spend. Overall, churn for the quarter was 4.25 down from 4.3% in the prior quarter and 150 basis points better than the prior year third quarter. We continue to see our lower price value dial People PC service account for a disproportionately large part of our churn. These subs represented 48% or nearly half of our overall subscriber decline even though that product comprises only 29% of our total subscriber base.
Value dial churn in this past quarter was 6.5% which represents a 220 basis point improvement over the year ago quarter. For the third quarter, value dial represented 17% of our consumer access revenue while our higher value or premium dial base of customers represented 31% of our consumer access revenue. Average monthly churn for premium dial narrow band improved to 3.7% which was 120 basis points better than the third quarter of last year.
As I previously mentioned, broadband now represents 52% of our overall revenue with our two largest broadband products being cable and DSL. Total broadband churn was 2.8%, down from the prior year quarter. While DSL and voice rates have improved over prior year, the cable product which has historically run in the low 3% churn range is now a larger percentage of our base of broadband subs.
As you can see, churn continues to improve across our consumer product lines as the mix of our customer base continues to shift towards increasingly tenured subscribers. At the end of the third quarter 64% of our consumer access customers had been with us for two years or more and had an average churn rate for this tenure cohort of 2.89%. Moreover, 28% of our entire base of access customers have been with us for over five years and that cohort has an average churn of 2.125 this quarter.
These tenure percentages have continued to increase and we expect this aging trend to continue. More importantly, as of the third quarter over 85% of our premium dial subscribers have been with us for more than two years and are churning below 3%. For DSL almost 70% of our subscribers have been with us for more than two years and are churning at approximately 1.5%. These two examples speak to the point that the highly profitable premium dial and DSL basis are well tenured and stable which should provide strong cash flow for the foreseeable future.
Now, let me spend a few minutes talking about our graphical ad, search and we security business. We saw average ARPU from these value added services increase from $2.75 per average subscriber to $2.85 per sub over the prior quarter. This was due in part to our launching our own targeted subscriber advertising engine. Our ad targeting implementation also allowed us to pass through a 17% price increase in our direct sold graphical advertising in Q3 from Q2.
Additionally, ARPU per sub was up in search and subscription due to a 9% higher RPM in our search business. Search ARPU was $0.84 per average sub up from $0.78 in the second quarter. Subscription ARPU from security and other products rose to $1.78 from $1.71 in the prior quarter demonstrating our ability to monetize our subscribers in a variety of ways. Another function of our more tenured customer base has been a notable reduction in the number of refunds, credits and charge backs and that’s contributed to our lower overall support cost structure.
Non-cost of revenue operating expenses improved from 52% of revenue in the third quarter 2007 to 34% at the end of this quarter. I think that’s particularly notable given that we’re seeing a negative scaling in our business because of the subscriber declines that we had planned for. So, we feel pretty good about that. It’s important to point out that while we’re driving more cost efficiencies in to the business we’re not doing so at the risk of our customers.
Our overall network services availability is tracking on target at 99.8%. We’ve put additional measures in place to prevent fraud and abuse which has helped our bad debt. For the quarter, customer support experienced the lowest calls volumes in several years as well as the best quarterly results in our recent history for customer satisfaction, sales close rates and cost per subscriber.
We’ve seen our combined customer and technical service contact rates for consumer services come down 40% on a per subscriber basis since this time last year. Overall our cost to support a subscriber is at its lowest point ever, down 10% versus just this past second quarter. Further cost efficiencies are coming from a variety of areas again, a thousand little things. Things like line migration to more cost effective transport networks, lower rate per minute contracts with outsourcing partners, broader level system consolidation and simplification.
We’re now well down the path of having reduced the complexity of our prior business model. In my experience taking complexity out of a business model generally results in lower cost and high quality and I think that idea is generally working out to be the case here at Earthlink. Joe [Wexel] and his team are certainly proving that point. We’ve reduced sales and marketing expenses by nearly 70% versus the year ago quarter. As we gained increase insight in to the effectiveness of our many loyalty and retention efforts we have the ability to make sure we’re getting better returns on the investments we make in these programs.
The same can generally be said about our efforts to optimize sales and partner relations. The sales and marketing teams have worked hard to test and then retain only those sales programs and partnership arrangements that yield the best acquisition economics. State conversions from narrow band to broad band as well as stronger than expected new subscriber adds in both our cable and our DSL product lines contributed to broadband now accounting for over half our access revenue.
While we are very proud of the highly profitable dial up business that we have, those who believe we are only a dial up business are simply wrong. In early September we announced that we expanded our broadband cable Internet footprint in the Los Angeles and Dallas markets to an additional 5 million households. Nationwide, our high speed Internet services now reach more than 74 million households with cable, DSL and some satellite.
Our ability to migrate many of our customers to a broadband platform, if they require that and if they want that, combined with the reality that not everyone needs or can afford broadband much less a triple or quadruple play price point is a key reason that we believe the tail in this business might be longer than some believe. Longer than some of the people on this call believe actually. It’s also a reason we believe we’re the best consolidation platform for the dial up industry.
Operating this business for a richer mix of tenured customers and a focus on positive lifetime value ultimately generates meaningful cash flow. Our free cash flow has increased to $72 million in this quarter, up from $28 million in the year ago quarter on $67 million less revenue. Kevin will provide more insight in to this metric in just a few minutes. I want to briefly talk about our business services division primarily comprised of our New Edge network subsidiary. As you’ll recall when I arrived a little less than a year and a half ago New Edge was a hot topic of conversation with all of you because it was consuming meaningful amounts of cash and was a drag on our EBITDA.
I told you that the highest priority for us was to first stop the consumption of cash and neutralize the negative EBITDA impact it had on a consolidated Earthlink business. Put another way, essentially we needed to stop the bleeding. That was paramount. We have executed on that strategy. We believe our small and midsize business customers are however, more exposed to a big downturn in the economy than our very tenured consumer base which is not yet showing, as I mentioned earlier, a noticeable impact from that economic downturn.
We’ve seen our retail business customers downsizing their business locations at an increased pace which puts pressure on revenue churn. On the other hand, we’re seeing a positive impact on ARPU in this segment as we continue to gain traction with our new MPLS class of service over our DSL product platform. 34% of all new installs in the quarter were on this platform versus our legacy products. We believe this product represents an attractive price point for prospects who are trying to cut costs.
Given the economic downturn and its impact on small business this seems like it should be the right product at the right price at the right time. To that point we’ve just recently booked a significant new contract in the quarter with UFPC, or Unified Food Service Purchasing Coop, the exclusive central procurement organization for more than 17,000 Yum! Brand restaurants which include KFC, Pizza Hut and Taco Bell. New Edge has been selected as the preferred provider of private high speed wide area networks for UFPC so we’re really pleased with that.
But, to be clear, while our sales teams are gaining some momentum, especially with the new products that I just mentioned, New Edge’s top line growth will remain under pressure. We’ll continue to work aggressively on the cost side of this business to keep expenses in line with the revenue trends. So, while our business services group is currently generating positive EBITDA and is modestly cash flow positive, we expect that things are not going to get easier or materially better over the next several quarters.
Clearly, this part of the business has not been the central part of our strategy or our future outlook. My objective for our business segment will continue to keep it at last neutral to our operating results while we ride out the current economic storm. When this storm passes I believe this business will be much healthier. Our business segment in fact could have real realizable value to our shareholders. Now, more than ever we have to continue our discipline of focusing on cash results in that business.
One last point I’d like to make before I turn the call over to Kevin for a more in depth review of the financial results. I’d like to underscore our very strong cash position. We ended the quarter with $485 million in cash. There’s no question that our cash balance is a strategic weapon especially in this market environment. Now, let’s turn the call over to Kevin who will take you through the details or our financial performance this quarter and our guidance for the remainder of 2008 and next year.
Kevin M. Dotts
Over third quarter and year to date results are recognition of the successful execution of our strategy launched in mid 2007. Over the past 12 months of more we have greatly simplified the consumer access business and eliminated several cash draining initiatives. We have focused our demand creation activities on channels where we can be confident we can add subscribers who tenure and value will be greater than the payback period needed to cover their acquisition costs.
We continue to maximize ARPU and the associated profit on our customer acquisition offers and [inaudible] offers to ensure we are acquiring and maintaining lifetime value positive customers. We have been able to successfully manage our cost structure to keep pace with the decline in the revenue curve. As a result we have increased profitability compared to prior year results and while we have realized results better than we expected coming in to this year we expect that aggregate subscriber revenue and profitability will continue to decline in to the foreseeable future.
Our current objective is to maximize the cash generated by keeping our EBITDA margins generally consistent with these results while we determine if there strategic opportunities available to use that will increase shareholder value. Our overall revenue for the quarter was $230.8 million, a 22.5% decrease from the third quarter of last year and a $14.8 million decrease from last quarter primarily driven by declines in narrow band subscribers.
As the company continues to transition through this group of early life higher churn subscribers that Rolla spoke about earlier we expect to realize further revenue contraction. As churn attenuates we also expect to see reductions in our passive subscriber gross additions. We believe that as a result of subscriber declines revenues could decrease in the same relative range through the next quarter.
While variable costs such as cost of revenue, customer support and bad debt should also decrease to offset some of the revenue declines. As we look forward to 2009 we expect the decline in revenue to attenuate. We also expect our cost structure declines to attenuate as variable costs become a lower percentage of our total cost structure. Related to the improvements in monthly subscriber churn that we previously discussed we continue to see the underlying quality and predictability of our subscriber base perform as expected.
As the maturity or our customer base continues to grow, these customers tend to be more engaged and use more of our service offerings. We were pleased that our value added services which includes search graphical advertising and security products on a per subscriber basis improved to $2.85 per month from $2.68 per month in the third quarter of 2007. The company should benefit from the increased tenure and predictability of the customers’ behaviors and our ability to further monetize our interactions with them helping to offset some of the expected revenue declines.
Earthlink continues to maintain a high quality network access experience while simultaneously reducing network costs. However, gross margin did decrease approximately $10 million in the third quarter compared to the second quarter of 2008. We expect that our gross margin will continue to decline in the coming quarter in a similar range in rate. Earlier on the call Rolla spoke about the continued expected reductions in gross subscriber additions.
This is directly related to the significant reduction in sales and marketing expense which is down to $22 million for the third quarter, a 14% decline from second quarter of 2008 and down $49 million from the third quarter of 2007. However, going forward for the next several quarters as we see the level of gross adds moderate we expect a commensurate decline in sales and marketing expenses as success based bounties are expected to make up the greatest percentage of our spending in this area.
For the third quarter of 2008 this strong and ongoing focus on support costs reduction coupled with the reduced sales and marketing expenses resulted in adjusted EBITDA of $74 million, a $27 million improvement from the third quarter of 2007. As a result of the improvement in adjusted EBITDA this quarter Earthlink’s income from continuing operations was $55 million, or $0.49 per share compared to a loss from the continuing operations of $48 million or -$0.39 per share in the prior year third quarter representing a positive swing of $103 million year-over-year.
The prior third quarter results also included at least $42 million of equity losses for our proportionate share of [HELIO] operations which are no longer applicable to our 2008 results and $34 million of facility exit and restructuring costs related to our 2007 corporate restructuring plan. For the third quarter of 2008 Earthlink generated net income of $55 million or $0.49 per share compared the net loss of $79 million or -$0.65 per share in the third quarter of 2007. We used $2 million for capital expenditures and cash payments.
We used $2 million for capital expenditures and cash payments for subscriber based adds in the quarter compared to $19 million in the third quarter of 2007. Combined with the increase in adjusted EBITDA we generated $72 million of free cash flow during the third quarter 2008, up significantly from the $28 million generated in the third quarter of last year. Because of the free cash flow we generated offset by the $23 million used to repurchase 2.5 million shares our common stock we experienced a cash increase of $43 million in the third quarter 2008.
We ended the third quarter of 2008 with $485 million of cash and marketable securities. We will now provide an update on our outlook for 2008 and preliminary 2009 guidance. I will remind you that these statements are forward-looking and actual results may differ materially. The company undertakes no obligations to update these statements. Earthlink is revising and increasing its previously issued guidance for the remainder of 2008.
For the year, the company now expects to generate $290 million to $300 million in adjusted EBITDA. This adjusted EBITDA should also translate to $270 to $290 million of free cash flow as we now expect to incur between $10 million and $20 million of capital expenditures for the full year of 2008. Additionally, for 2008 Earthlink expects record income from continuing operations of $200 million to $210 million.
Now, I would like to provide our preliminary thoughts on 2009 given the secular trends in the access business, the macroeconomic environment and what we believe is the possibility given our ability to manage the cost structure of the business. Throughout 2008 Earthlink has realized financial results that were above our initial expectations. Much of this was driven by the fact that we entered 2008, we had little experience on what to expect from our customers and our people in a significantly simplified access business focused on maximizing cash flow.
Now with several quarters’ worth of experience we can reflect on the better performance of passive subscriber additions, certain sales channels, the stable trend churn performance of our tenured customers, the cost benefits of a significantly tenured customer base and our peoples’ ability to reduce variable and fixed costs. Thus far the company has been successful in eliminating additional back office support costs to compensate for the declines in revenues and gross margins resulting in strong EBITDA performance.
On a go forward basis we do not anticipate the ability to implement the type of large scale reduction opportunities that we have seen over the past 12 months or so. Additional revenue and gross margin decline will continue to put pressure on Earthlink’s EBITDA compared to the levels the company has generated over the past three quarters. In addition we are currently in a very challenging and uncharted economic environment.
While the core consumer access business has not demonstrated any concerning trends to date our business services segment is seeing some moderate churn impact. As we look forward to 2009 our goal is to manage our adjusted EBITDA margin rate to be generally consistent with 2008 results. Our 2009 preliminary view is that we expect to record $210 million to $225 million in adjusted EBITDA. This adjusted EBITDA should translate to $180 million to $205 million of free cash flow.
For 2009 Earthlink expects income from continuing operations of $135 million to $155 million which includes a tax expense of $20 million to $25 million as a result of the utilization of net operating loss carry forwards. Actual cash taxes related to the alternative minimum tax will be $8 million to $10 million and monies paid under this simply extend our tax asset on a regular basis going forward. In early 2009 when we discuss 2008 final results we’ll revisit these preliminary views for 2009. I would now like to turn the call back over to Rolla for some concluding remarks.
Rolla P. Huff
I wanted to spend a few minutes providing a little more insight in to how we’re thinking about 2009 given the guidance that Kevin just shared with you. As he mentioned, we expect to deliver between $210 million and $225 million dollars in adjusted EBITDA next year. This guidance range reflects a few important points, primarily it represents our intention to keep our EBITDA margins generally in line with 2008.
It’s also based on the belief that churn will continue to be within the historical bands that we have been reporting. In taking in to account the volatility in the overall macroeconomic environment, we believe it’s prudent to build in some potential for increased pressure on the revenue side in two specific areas. First, in a more difficult economy we see potential for increased potential for increased pressure on ARPU. We haven’t seen it yet but we believe there’s clearly that potential.
The second area is within our business services division as I had mentioned earlier in my remarks. While we don’t see any impact on churn currently on the consumer side we are already seeing it within our business services segment where our customer bankruptcies accounted to 30 to 40 basis points of increased churn in this quarter in the business services division. We’re preparing and accounting for the eventuality that this trend may continue in the year ahead.
At a high level next year’s focus is actually the same as this year’s focus, keeping our cost structure in line with revenue trends. Let me make one final point on that, if you recall I started my remarks today attributing our operating performance to the efforts of our employees. I think it’s significant to note that during this third quarter we notified approximately 100 of our people that their positions would be eliminated in the coming months. We continue to make the difficult but essential decisions for our business and we’re doing so by treating our employees with the respect that they have earned and deserve.
We treat our people the right way while they are with Earthlink and we treat them the right way in the event that we need to separate them from the business and we’ve worked hard to create a transparency with our people and with you about what our business currently is and what it’s not. You can’t get through these situations and these times with spend. Our people know that we’re not currently a growth business but that we are a business that has the potential to create meaningful value for them and for our shareholders if first and foremost we’re aligned around taking care of the customers that we have while also being focused on the profitability.
Our people understand that we are not and will not be a venture capital fund regardless of our cash balance. They understand because we talk about it all the time and we talk about it very openly. I’m taking the time to tell you this because you should know that this is the cultural that is sustaining Earthlink. This is the culture that’s allowing us to post the results that we have today and providing us the opportunity to realize the meaningful long term cash creation that exists in this access business.
It’s a culture that I suspect a great many companies are going to have to learn to develop to survive the next several years. I guess you could say that we were blessed with being forced in to this by our business model to get a bit of a head start on this emerging reality. We continue to believe in the value and inevitability of consolidation in the narrow band segment. While we clearly believe Earthlink is the best position and most logical consolidator we support consolidation whether we’re a buyer or a seller because the reality is it’s the best way to maximize shareholder value with these kinds of assets.
But to be clear, until others in the industry are prepared to accept that reality there will not be consolidation and we believe the various shareholder groups will likely realize less value than they otherwise could have. We think that’s unfortunate for all shareholder groups. Earthlink will continue to aggressively exploration adjacent industries that that when combined with our business model and core competencies could create real operating synergies in shareholder value.
I hope by now no one doubts our commitment to running our business with discipline and in a way that creates shareholder value. Through stock buybacks we’ve already returned a meaningful amount of cash to shareholders just in the past 12 to 16 months. We’ve been disciplined in our use of cash. We’ve not been out doing deals that create a risk reward profile that destroys long term shareholder value and believe me, those opportunities have been presented to us.
We’re taking the prudent steps to consider the strategic leverage our cash position creates especially in this time of financial crisis. The world has changed over the past month I think you all would agree, our relative equity valuation gap with others and adjacent industries has been substantially reduced while the relative strength of our balance sheet has substantially increased. Those two realities have expanded our options but have not at all changed by view about the need for us to be disciplined in our approach.
Again, if we can find no alternatives that provide scale, operating synergy and most importantly an acceptable risk adjusted return in a reasonable time frame, we’ll happily pursue the process of continuing to return cash through stock buybacks and/or a more structured dividend process. Given the volatility debt markets the equity markets and actually the overall economy, I have to tell you I feel no rush about making decisions around deals or capital structure changes.
As I said on the last call we’ll update you about our thinking on our year end call and I do expect to have at least a little more firmness around our plans at that time. With that, operator why don’t we go ahead and open up the lines for any questions that might be out there.
(Operator Instructions) Our first question comes from Youssef Squali – Jefferies & Company.
Youssef Squali – Jefferies & Company
A couple of questions, first I guess starting with you Rolla and just following up on the comments you made in closing about kind of going forward and what to do with the business, has the urgency that you’ve had about the consolidation play changed considering what you’ve been seeing in the market from the last three to six months both from potential partners and from the market.
As a corollary to that how long will you wait before you kind of walk away from the consolidation place because obviously there’s really only one large player that makes sense that has any scale and you start considering the recapitalization of the business?
Rolla P. Huff
Youssef I have to say I don’t feel a big sense of urgency other than I believe that the consolidation makes sense for anybody that has an ownership in assets like this. We continue to actively look for ways to make that consolidation take place but I don’t feel like I’m on fire. Our business is performing reasonably well and we’re continuing to look at other things that we can do that might enhance our growth profiles but I think first and foremost we’re really focused on just trying to run our business with excellence.
Youssef Squali – Jefferies & Company
I guess in terms of the adjacent industries in the last year you’ve talked about maybe using New Edge as a kind of spearhead to moving to that area. Now, with that kind of slowing down it doesn’t look like, or is it still kind of an area you consider adjacent? What other areas would you consider adjacent?
Rolla P. Huff
What Earthlink is, is we’ve got strong competencies in consumer business models and small and midsize business customer models. We’re looking at all of the areas that we can leverage our competencies. The link that as I’ve talked to you and others about is one of the things that we’ve suffered from in the past was there was such a substantial difference between our valuation multiples and other decent companies valuations multiples. We had just traded down. The relative strength of our equity has gone up dramatically and the balance sheet of our company relative to a lot of good business models out there is substantially stronger.
So, it really has opened up a lot more things that we could look at but I don’t want anybody to get all spun up around the idea that we’re going to go out and start doing [inaudible] things. As I said earlier in my comments if there’s one thing that I think people would be hard pressed to disagree with, we’ve been pretty disciplined in our approach. We’ve had lots of opportunities to do deals in the last year and we haven’t done any yet because we haven’t seen anything yet that we believe creates a better alternative for putting value to our shareholders than the way we’re running the business right now.
Youssef Squali – Jefferies & Company
Kevin, can you walk us through how you get from the EBITDA to the free cash flow numbers that you put out for ’09? Just cap ex and I guess tax?
Kevin M. Dotts
When we’re thinking about ’09 we talked about our thinking coming from continuing operations of somewhere around $135 million to $155 million. Then, if you put together amortization and depreciation you’re in probably the low $30 range. Stock-based compensation year-over-year is probably slightly down as the employee basis is down this year, we’re saying about $20, it dips in to probably the high teens. Income tax provision as I mentioned was about $20 to $25 then cap ex gets you in to about the $20 to $30 range as an expenditure.
Youssef Squali – Jefferies & Company
So cap ex you’re actually saying is going to go up from ’08?
Kevin M. Dotts
I think cap ex has a potential to go up. I think right now we’re baking in the idea that first of all one of the things that we’re focused on as we talked about in our previous comments is the idea that we really want to put I would call to a degree insurance around the free cash flow that’s coming off of the access business, the consumer access business. So, we continue to look at things in business continuity management, disaster recovery, and I think we’ve got some plans to spend probably something in the higher single digits, call it $8 million to $10 million over the next year or so, some of that will drift in to this year and the majority of that will probably hit next year.
But, beyond that I think that maybe then there’s another, as we normally do Youssef the general maintenance activity is probably in the low teens so you kind of put that together and that kind of puts you over $20.
Rolla P. Huff
Plus, the other big component of that Youssef is that we always have money set aside to buy subscriber bases that might come available, smaller ones and believe me, in this kind of time we’re very sensitized to the idea of passing on a subscriber base because it might push us over our cap ex guidance to you and having everybody get spun up about the fact that we’ve slipped over our guidance. We feel like this guidance gives us the opportunity to have flexibility around acquiring small subscriber bases, continue to run our business. We’re building a smaller business right now. That’s not something that just happens. We can’t let our current cost structure stay in place given the trajectory of our access subscribers so in order to make sure we’ve got a tale that makes sense to our shareholders, we actually have to invest a little bit to make that happen.
Kevin M. Dotts
One other thing I would add and there is some variability in a cap ex spend driven by success especially in the New Edge area so there could be another $4 million to $6 million there depending upon subscriber growth.
Our next question comes from Jennifer Watson - Goldman Sachs.
Jennifer Watson - Goldman Sachs
Rolla, can you talk a little bit about how you perceive issuing dividend versus buying back shares and what you think would be best for Earthlink and the shareholders? And Kevin, if you could just talk a little bit about the fixed versus variable cost structure of the operating expense lines?
Rolla P. Huff
Obviously I think in the 16 months that I’ve been here we have through share repurchases probably returned over $125 million. I have to say in the last month and a half it’s been interesting.
Obviously a lot of people offer me their advice so I’ve gotten advice that has ranged from, “Geez Rolla, why don’t you see if you can leverage your business up as far as it’ll go and send all the money to our shareholders?” to “You need to buy something immediately.” We’ve probably had a little bit of advice around building a safe in the basement and just putting all of our cash in the safe. We’ve been getting a lot of counsel and I’d just tell you I think we’re going to continue to be very thoughtful about how we approach it.
I don’t feel like we need to make big decisions right this minute. I’ve been out there with you guys 90 days ago and said I know that it doesn’t make sense for us to just sit on this cash forever. We either need to find something that makes sense for our shareholders or begin a more structured process to return it. As I think I told you guys, our Board is very thoughtful about this. We spent a lot of time talking about how we should be thinking about it and as I say, we have been returning cash. I think you’ll hear more about it at the end of the year.
Kevin M. Dotts
To your second question on how we’re thinking about fixed versus variable, if you look at the quarterly revenues going back into the second half of ’07 and how we’ve done year-to-date through ’08, you’ll begin to see that the changes as we’ve declined in revenue are becoming less.
So we’re already beginning to see that attenuation on the revenue line and you’ll also see that a little bit in gross margin. I would say as a gross margin rate, we talked about the fact that our mix of our business is oriented more towards broadband so there should be some dilution that will impact the gross margin rate. But gross margin dollars are declining less quarter-over-quarter at this point.
We’ve done really a terrific job I think in the first half of this year of being able to take out costs to a degree and our cost of revenue area we’ve had the success in customer support which is predominantly a variable cost; we’ve had the success we’ve talked about in bad debt and payment processing which has been a variable cost. So we kind of look at those variable cost trends and as we look forward through ’08 and into ’09, we believe that those will trend downward commensurate as revenue does.
On the other side the fixed costs; the back office support costs, IT; that cost we’ve taken out some heads through job eliminations and contract negotiations and we’ve tried to outsource more to make more of our fixed based variable but that fixed cost, we can only take out so much. Last year we took out 1,000 heads. There’s just not another per se 1,000 heads that we can take out. I think right now we’re down to just under 800 heads across the business.
If you look at the core access business at this point we’re right around I want to say about 500, maybe a few less, and that will drift down in ’09 given our current trend of the business but it won’t decline as quickly as what we saw in the first half of ’08.
Our next question comes from Bryan Goldberg - J.P. Morgan.
Bryan Goldberg - J.P. Morgan
I just wanted to follow up on cap ex. With regards to fourth quarter implied guidance given what you’re saying you expect for the year end, what should we be expecting the uptick in cap ex to be on in the fourth quarter? My second question is on the ’09 EBITDA margin. You mentioned there’s no more real step function improvement in cost opportunities but can you talk about other areas you can improve, like customer interactions or network infrastructure improvements?
Kevin M. Dotts
I think the cap ex spend for both the fourth quarter and 2009 is really going to be in large part opportunistic. That’s the way I think you should think about it. There are some basic investments that we’re making in keeping the platform that we have stable and redundant because we believe the cash flow that comes off of the tail of this business is real enough and long enough that it’s worth making sure that we have; it’s a hardened environment.
But beyond that the cap ex that we’re going to spend is going to be on consumer bases, it’s going to be on things in New Edge where we just got the ability to sell into 17,000 Yum! brands. To the extent that we get all 17,000 that would no question pick up our cap ex associated with those.
I think you should really look at our cap ex as opportunistic and as the first half of the year or the first three quarters of the year for that matter demonstrated, we don’t spend cap ex just because we have guidance out there that we will. We do if there’s a good investment but what we don’t want to do is be limited by our guidance to do what we think is right for the business. I think that’s the best way to talk about that.
In terms of areas of improvement going forward, I know it sounds a little bit trite but it’s fundamentally what is happening is we are trying to improve the business in a thousand different areas and none of them, and I would say for the last two quarters, have been step function improvement types of improvements.
We’ve been deploying pretty interesting technology, new technology recently to help us get in and understand quickly what our customers are experiencing when they’re calling into the call centers and what their experience is looking like. That’s allowing us to get offers into their hands substantially more quickly.
At this point the senior management team has the ability on our desktop to take a meaningful sample of calls that, and this is just an example, come into our call center within the last 72 hours and do keyword searches on what we want to find out. For example, “I can’t understand what you’re saying.” I can do a keyword search on that phrase and pull up every call in the sample group and listen to the calls. We know by agent where the call came from and then we can work backwards from that agent.
It’s nothing terribly sexy but it’s just trying to run the business better tomorrow than we did yesterday. There’s no reason to think that that’s going to stop happening. The key thing is keeping our people engaged. As I said in my comments I believe the most remarkable thing about what’s happened at Earthlink is that our people are very engaged around this idea and that’s a cool thing.
Bryan Goldberg - J.P. Morgan
In your consumer broadband net ads for the quarter, I’m just curious, how is that mix trending between cable and DSL relative to the last few quarters of this year?
Kevin M. Dotts
I think actually more of our focus has been on cable given our expansion in the L.A. markets and the Dallas markets based on the markets at Time Warner Cable had picked up, but we’ve actually been pleasantly surprised with our passive DSL subscriber ads. But as a total base our mix has been a little bit more oriented to cable year-over-year as we’ve gone forward. It’s been fairly steady; it’s been low churn; again we’ve been focusing our spend on cable but passive DSL has done better than we expected coming into this year.
Rolla P. Huff
One of the key things is that customers that we acquire, their value to us is all driven by what it costs us to acquire them. We have a relationship with Time Warner where there is marketing spend associated with those customers but our take rates are better, absolutely the economics are positive.
Even though the cable has a little bit higher churn rate than DSL, DSL is great for us because again we don’t spend a lot of money to acquire those customers. We’re not as exposed to early life churn either on the cable or DSL side for that matter and certainly not on the dial-up side. Customers that come to us, as long as we haven’t spent too much money, they’re all good customers to us.
Our final question comes from Ali Mogharabi - B. Riley & Company, Inc.
Ali Mogharabi - B. Riley & Company, Inc.
I think you may have touched on this but I’m looking at the delay that we’re probably seeing in this potential consolidation whether it’s the willingness of the other players or the weakness or volatility in the market. Should we at least expect you guys to more aggressively acquire subscribers, which I think are steps although smaller steps towards that consolidation?
Kevin M. Dotts
Probably not. Honestly I don’t look at the business as a subscriber driven business. I look at it as a cash flow driven business. I can tell you we actively have been working every small base of customers out there to acquire them but only if we get an acceptable return on the investment. Acquiring subscribers just for the sake of doing them, we stopped doing that 15 months ago and I don’t think that anybody should expect that we’ll pick that up. I think that clearly buying them in bulk makes more sense than trying to buy them one at a time. I think it’s fairly clear that that model doesn’t work financially. I don’t see a big change in our approach on that frankly.
Ali Mogharabi - B. Riley & Company, Inc.
Could you give us an idea about the size of that UFPC contract?
Kevin M. Dotts
Basically we were named a preferred provider for them and I can’t remember whether there’s one other or not but it’s 17,000 locations. I think there actually is one other now that I think about it. Basically we’ve been given a license to hunt.
Kevin M. Dotts
I think that the subtlety in the one other is they actually will be buying through us. So it’s direct buy to us or direct through us.
Kevin M. Dotts
We feel good about our position there. Thank you so much everybody for joining us. We will look forward to talking to you at the end of the year. We’re going to continue to work hard at delivering results and continuing to be disciplined in our approach. Take care everybody and we’ll talk to you if not before after the holidays. Have a great holiday.
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