EarthLink's Management Presents at Morgan Stanley Technology, Media & Telecom Conference (Transcript)

Feb.27.13 | About: EarthLink, Inc. (ELNK)

EarthLink, Inc. (NASDAQ:ELNK)

February 27, 2013 4:20 pm ET

Executives

Bradley A. Ferguson - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Unknown Analyst

All right. Good afternoon, everybody. It's my great pleasure to introduce Brad Ferguson. Brad's Chief Financial Officer for EarthLink. Before we get started, please note that all important disclosures, including personal holding disclosures and Morgan Stanley disclosures, appear on the Morgan Stanley public website at www.morgan stanley.com/researchdisclosures or at the registration desk.

Brad, welcome. Thank you for coming to San Francisco. Perhaps you could just start. You just reported earnings, put out your guidance for 2013, perhaps you can start by sort of summarizing where you are in the transition period and what your priorities are for the coming year.

Bradley A. Ferguson

Yes, great and it's great to be out here. Yes, EarthLink is certainly going through a pretty large transition right now, going back 3 years or so. We are in a top line decline of about over 20%, have done a series of acquisitions, moving from the consumer business to the business side. So really very business focused now and have really stemmed those declines and do see a path to growth, which we're real excited about.

The -- within our business services, we've got a growth business that's about $140 million of run rate revenue now growing at about 20% and the products in there are MPLS networks, hosted VoIP and IT services and we really think that that's an opportunity and the growth of those products will allow us to grow the total top line for the company. So that's, again, to be able to talk about growth, given where we've come from, we're really excited about that.

Certainly, at the core, there's a lot of cash flow, so we've got a consumer business that's still generating a lot of cash and a legacy business services business that is also generating a lot of cash. And we've really organized to kind of capture that. So we've got a group that is going to be focused on the growth products and we're funding the growth on that side. But then we'll also have a group that's focused on the lower end business services, so a lot of the customers that we got through the acquisitions were lower end CLEC customers and we're going to be organized more running that like the consumer business. So, really, just focused on retention of the base that we have and then maximizing the cash flow from that business to really fund the growth on the other side.

The balance sheet still remains strong. So we have $200 million worth of cash, a low debt profile of $600 million, a lot of tax assets. So $500 million of NOLs, a large fiber network that, certainly, we utilize for our services, but it's really a very unique asset in addition to a nationwide network that allows us to provide our services. So, excited about those pieces.

So the quarter were -- we've done some things, I talked about reorganizing. So we have restructured some of our sales force. We've gotten out of some smaller markets that we really inherited through the acquisition. So probably about 25 smaller markets, things like Akron, Ohio and some places in Maine. I mean just some markets that we didn't really see the growth opportunity. So we've really taken down our direct sales force and again, are investing that back in to the growth products. And we're actually beefing up the sales force in other markets. I mean it's a net reduction on our total direct force, but we're staffing up in markets like Chicago, San Jose, Dallas. So some other markets we hadn't been in, we're going to, again, go to larger markets, because that's really where we think the opportunities are.

Question-and-Answer Session

Unknown Analyst

Great. So help us talk through the guidance and when we really start to see the top line. You obviously talked about reducing the rate of decline, but actually getting the growth assets growing fast enough and being large enough to offset the...

Bradley A. Ferguson

Yes. So certainly -- I mean, really it's the growth part of the business that I talked about, which -- I mean, we're a matter of quarters on the business services side of seeing the growth for the business services segment, which makes up 75% of our revenues. I mean we haven't pinpointed the exact time, but it's either later in '13 or '14 and so we're getting the traction with the growth products and really that the growth there will compensate the declines that we're seeing. And really, the declines that we're seeing in other parts of the business are improving all the time. Our total top line were down at a mid-single digit decline rate, so as the decline -- the parts of the business that are in secular decline improve, it just makes the hurdle that much lower for us to grow. So as a total company, we'll be getting close in 2015 to really getting to a flat point and then the inflection point.

Unknown Analyst

So the telecom business typically has some pretty high operating leverage. How does the profitability shift around with the business mix that you're going through now?

Bradley A. Ferguson

So I talked about how we're kind of segmenting it out with the growth products and the lower end -- I'll talk about how we're thinking about it for each of those. But on the growth products, I mean certainly we're investing there now. I mean the incremental margins are good and we do expect the margins on that business, I mean the IT services we're providing. So we're doing some cloud hosting, application hosting, so those types of products over time will have much better margins that we're seeing now. So EBITDA margins, right now, are around, in the high teens, and really in the mid-teens for the business segment until we'd expect to be able to get some improvements as we get that operating leverage for the growth products. On the lower end business services segment, so really, we'll be managing that for cost and being able to take out cost and looking at where we have fixed cost infrastructure and trying to variablize that over time and certainly, we'll be losing some scale there, but we're doing a lot on the cost side to kind of fight that over time.

Unknown Analyst

Okay. And then you talked a little bit earlier, but how's your capital budget for 2013? And perhaps you can just prioritize what the major focus is on that?

Bradley A. Ferguson

Right. So we announced in the third quarter of last year some data center investments that we were making and look at that as more of an incremental spend. We looked at pursuing some data centers inorganically and just the valuations didn't make sense, I mean, to pay a 16 multiple when we're trading at a 3 multiple, 3-something multiple, just -- we couldn't get there. But having the ability to put more cloud stacks out in different regions and then the ability to provide some collocations made sense and so we pursued an organic path and so we are making some incremental capital investment there. It was about a $45 million incremental investment. We spent $27 million of that in the fourth quarter of 2012, and we'll do another $20 million in 2013. Our total CapEx guidance is $140 million to $155 million, again, which includes that $20 million. So really, as a run rate CapEx, we're looking at $120 million to $130-ish million, $135 million baseline and that's what we kind of expect going forward, 2/3 of that CapEx is just driven by new customer activities. So as we add new customers, we're giving them on a line, giving equipment out there. So that drives the majority of it. The remaining third, is just different projects. So enhancing the network and different system enhancements, things like that.

Unknown Analyst

So when you talk about the data centers, are you going to a wholesale provider?

Bradley A. Ferguson

Exactly. So we're not starting with a piece of dirt and building our own, so we're really partnering with some of the larger providers and putting in a cloud presence. So we've added 4 locations that way, so we have 4 of our own data centers already and then so, getting 4 more, putting the cloud stacks out there and also have the ability to sell collocations. So we wouldn't sell collocation on its own, so that wouldn't be the only thing we sell them, but if our customers want to put some things in the cloud but also have some collocation, we'll be able to provide them that service.

Unknown Analyst

Okay. And can you talk about who your target customers are, where you're seeing the best sort of momentum traction right now?

Bradley A. Ferguson

Yes. So really, we're in a mid-market. So above small and below the Fortune 1000. And...

Unknown Analyst

What -- and how many employees, or...

Bradley A. Ferguson

Yes, so starting probably above 25. But really, when we think of the profile, it's typically businesses with multi-locations and what these customers are dealing with, I mean they have the complexities of a bigger business and have security concerns and have compliance needs but really don't have the resources, especially in the IT department, to deal with them all. And they are having to deal with a lot and it's just certainly the security environment and everything that these people are being asked to do, I mean they're kind of just trying to keep up day to day much less, think about getting their applications in the cloud and things like that. So really, they need a partner and today, it's either them trying to do it themselves, which again, their budgets are not keeping up with, I mean, are not able to keep up with the demands of the business, or they're partnering with kind of the local VAR, and things like that. So they definitely need a partner and we think that's what EarthLink can provide, not only the networking piece of it, but really, these incremental services. So help them get to the cloud, help them get their data secure, if they have like, an outsourced Help Desk, we have that. So we have a whole suite of products that can really help them and be more of a one-stop shop for all their needs. And in terms of AT&T and Verizon and some of these -- the larger companies. I mean, these are definitely below kind of the scale that they'd be on and looking at other companies like Accenture, IBM. I mean, these -- the mid-market customers really don't have the resources to partner with companies of that scale. So that's where we really do think the opportunity is and we've sized it up and it’s like $177 billion market and then the products and services that we have address about $100 billion of that. And again, we wouldn't have to take huge market share of that piece for that to be meaningful. So it really is a large opportunity and unlike what you've seen with the CLEC business, or really the communications piece, which is really a wave that came through about 10 years ago, this is something that's developing and we feel like we're really positioned to kind of ride that wave and hopefully kind of expand from there. So it's an opportunity that we're really excited about.

Unknown Analyst

Are you seeing much from the cable companies? We certainly had Comcast yesterday, Time Warner Cable today, talking about moving up from the small to what they term medium, which may be small for you and maybe not multi-location as much?

Bradley A. Ferguson

Yes. So, I mean that's where the multi-location piece does come in. Based on what we're seeing, I mean, they're still below the type of customer that we're talking to. And really, where they've been successful is at that low end, and that's what we've moved away from, as we paired back some of our sales force and I mean it has kind of given them that low end piece. And if they have to build a network that's outside of their market, that's really where they can compete. And so we think with our nationwide network, the assets we have and then the services we provide, we're well-positioned to tackle that. And then as we think about just our brand, the new EarthLink brand, we think really does resonate with folks, people associate that with customer service and people who know the Internet historically. But certainly, like an IT brand, we think that, that resonates with people versus partnering with a Comcast to really be your IT outsource provider. So I mean we think we kind of differentiate ourselves that way too, and again, that's where the brand really is a strong suit.

Unknown Analyst

So are you mostly signing sort of 2, 3 year contracts? Is that typical?

Bradley A. Ferguson

Yes. 3 years, some longer, some shorter, but 3 years is about the kind of average for the type of contract and customer we're signing.

Unknown Analyst

Okay. So what percentage of spend would you have with your typical customer?

Bradley A. Ferguson

So let me answer that this way. So when we think about where we've historically played, of an IT budget, really the networking piece is about 10% of that and we think these other services get us well into that and using kind of the -- I talked about the market of $100 billion that we can address, out of $177 billion, I mean, that's kind of your mix there. So we're probably 60%, 70% with our products, what we can really address.

Unknown Analyst

But are you the prime vendor in most cases, or are you -- they are giving Verizon the most of it and you're getting a piece of it, or...

Bradley A. Ferguson

It can get that -- and that's, we can kind of go either way, it doesn't have to be -- we don't have to have the network to provide the IT services and we don't have to have the IT services to provide the network. I mean so that -- it really is, we can go either way and have a lot of versatility there, I mean we do think that there's really a land and expand opportunity if we can get our foot in the door with whether it's helping them to the cloud and then the network is just the easy extension from there of getting the network, you really prove yourself that way and getting the cloud is an easy extension from there. And then you can continue to add on things, I mean we really think that we have a lot of ability to go different ways there.

Unknown Analyst

You've talked about breadth of products, you've talked about sort of the service aspect, but if somebody has an incumbent provider, they're going to want to save money, they're going to want to have a price aspect. So what's going on with pricing, both on your new business? Are you coming in, 10%, 20%, below whatever they're paying on renewals?

Bradley A. Ferguson

Yes, I mean price is always a factor but that's certainly not -- we're not going in there saying, "Hey, we can -- we want to be your -- the cheapest solution." I think if people want to cobble things together themselves, they can always find something cheaper and cobble it together. I think what we do -- and again, we provide very cost effective solutions and that's one of the factors, but it's absolutely not the factor. I mean it really is the service we're providing, the solutions that we're bringing, the breadth of the portfolio. And again, as you get higher up on the sophistication of the customer, they can kind of more commoditize some of those things or it can become more of a cost thing, because they have the resources to do it themselves. Right? But kind of in this mid-market where, again, price is a factor, but it really is about the breadth of services that you can bring and making it easier on them, which in the end, I mean that saves them resources.

Unknown Analyst

So the sales force, can you talk about how they're able to sell to your asset, sell to your network and make sure that there's not too much incremental CapEx? How do you sort of factor that all into the sort of the pricing equation?

Bradley A. Ferguson

Well, our model's a little CapEx lighter. We're not building in the buildings, I mean we're definitely -- we have a nationwide network that the last mile we're getting from other providers. But even with that, I mean, certainly every deal we're looking at, with a 3-year term, we're usually -- really, our rule of thumb is cash on cash pay back within 2/3 of the term. And that's really the outer bound of what we look to and certainly try to do it sooner, but that's really how we're making those assessments of the deals. And certainly, there's other ways that we look at it. But that's kind of the easiest rule of thumb to keep in mind.

Unknown Analyst

We heard a lot this week about traffic growth, or that now it's mobile demand and that streaming videos. So do you have any insights into the kind of drivers there, obviously with the cloud, with IT outsourcing, the customers are going to have to use more and more to access their data and to put it out there? So how do you see that? Is that -- I don't know if there's any numbers you can share with us...

Bradley A. Ferguson

Yes, not a lot of numbers, but certainly, I mean the -- I think the themes are consistent with what we're seeing and that's really, again, the complexities of what's happening for our customer segment. I mean, they're having to deal with this but don't really have all the resources to do it. So it's really the demands of their jobs, are outpacing what's happening on their top lines. And so, that's where someone like EarthLink, where they can get -- put some of their applications in the cloud. Put -- do the cloud computing, storage, I mean, there's -- we give them ways to deal with that in a more variable manner. I mean, so they're not having to do everything themselves.

Unknown Analyst

Okay. And then presumably, some of these businesses they may have an office manager, or an IT manager, but they don't have all the resources.

Bradley A. Ferguson

Exactly. And that's where...

Unknown Analyst

But they know they need to do something with the cloud. I mean, what inning do you think we're in, in this kind of -- with that customer base in terms of what they need to do to [indiscernible]?

Bradley A. Ferguson

Second. I mean, it's really -- I feel like we're really early on in the -- again, we know that wave's coming and that's where we feel like we're positioning ourselves to really tackle it, but I think, really, people in that mid-market. Certainly, like the Fortune 1000, they're certainly ahead of that, but I think down in the mid-market customer, I mean they're still trying to figure all this out and what it means and that certainly leads to like longer sales cycles, then traditionally like on the CLEC networking side, which is more of an understood commodity -- not a commodity, but I mean, it's just more understood. So there's a lot more education that goes into the sales process and our salespeople are having to educate the customer more on like what their options are, or why this would be good for them and when it would be good for them and what thing -- and there's a lot of directions you can go in. But, certainly, a lot of people want to understand it, want to -- but I feel like we're really pretty early on.

Unknown Analyst

How are you perceiving the macro environment, a sort of confidence amongst your customers?

Bradley A. Ferguson

It's been tough, I think. We've heard some other people here and it seems to be consistent. It's not like it was ever great. I mean, so it's not like it’s gotten a lot worse, but certainly, the -- just the -- there's still a lot of uncertainty about that. But we've seen decision cycles and things like that. They've been pretty deliberate for, I'd say, the last 3 or 4 years. I mean it’s not like they got a lot better and now they're getting worse. I mean, it's been pretty consistent that there's just a lot of uncertainty in how people deal. People are just kind of remiss to really make big moves quickly and just -- things take longer to kind of get through there. And they don't know exactly how their businesses are going to be impacted, but some of that can work to our favor when people are trying to, like, variablize their cost structure. They don't know if they can hire all these people themselves. So working with a partner to -- where they can really variablize it just as a selling feature. I think overall, probably -- certainly, business growth and job creation and things like that would be better for all people trying to serve businesses, but certainly, there's an element of when the economy's tougher, that it helps.

Unknown Analyst

May we touch on the consumer business for a moment? You talked about how the rate of erosion is moderating and then as part of the overall pie it's less. But it's still an important contributor. So perhaps, just talk about how you think that's going to play out in '13 and I mean you've still got these legacy customers -- it's 2013.

Bradley A. Ferguson

Yes, it's really been just an incredible business in just how predictable it really is. And we had models 3 years ago, that could've told you basically, how many costumers we have and this year -- I mean, and it’s been that spot on. And really, what we've found is that people behave the way they have behaved and the longer people stay with us, the longer they stay with us. And so, really, 10 years, like the biggest predictor of when people will leave and so we can really just look at the age of our overall customer base and get it down by each customer, 10-year cohort and really project out what happens over time and churn just continues to go down. I mean, certainly, 5 years ago, it was close to 6% per month and we've just seen it steadily come down. And in the most recent quarter, it was at 2.3% per month. And...

Unknown Analyst

So you're not really doing -- you're just letting it, kind of...

Bradley A. Ferguson

To say we're not doing a lot, but we're -- I mean, we're -- there's certainly a group of people who are totally focused on providing a good level of service and we still add -- we added 160,000 growth customers, I mean, we're losing on a net basis, but we're still adding a lot of people and 2/3 of our revenue on that side is coming from broadband services. So -- I mean, I think some people think of it as only dial-up, that's really not the case. I mean, there's -- the majority of the revenues is on broadband, but the churn rates and certainly, once someone's with us for a while, the churn rates are just -- continue to go down and we just expect that to continue. Around the margin, I mean, we're doing -- we've got a relationship with Clearwire, so we're going to start selling just this one other alternative. I mean, we're not going to do a big marketing push or invest a lot of sales dollars on the front end, but just when someone calls us and one of the other options is going to be a wireless option...

Unknown Analyst

WiMAX and then TV LTE...

Bradley A. Ferguson

Yes, right, and so we're doing the WiMAX first and then -- yes, so it's just one more thing.

Unknown Analyst

And are you -- is there a device subsidiary? Is that your CPGA or their CPGA?

Bradley A. Ferguson

So, we'll charge the customer upfront, for the device, and we'll see how it works out. And it's just one more thing to kind of elongate the tail.

Unknown Analyst

Is that live now?

Bradley A. Ferguson

It will -- it's kind of like mid, probably third quarter, mid-year in third quarter.

Unknown Analyst

Okay. So they'll have turned on some of the TV?

Bradley A. Ferguson

And we're just working with other partners who are more sophisticated about how they can drive incremental sales. I mean, so we do things around the margin to kind of really just elongate the tail but we're just smart about how we -- it's got to be a low cost of acquisition to do that. And we always just look at what the return or what's the cost -- but it's a very predictable, solid business.

Unknown Analyst

So, I mean, you've done it at the sort of the start of the transition, you did a number of acquisitions and changed the business mix and you talked about the buy versus build on the data center side. But this is certainly an industry -- we had some folks talking yesterday about expecting a lot more consolidation in this space and these synergies are significant. Do you think -- are there other things that you may be looking at or do you see yourself participating?

Bradley A. Ferguson

Yes. We think that consolidation and scale -- scale maters, consolidation over time, makes sense. I think we've been a little kind of backed off a little bit on how we've talked about acquisitions. Certainly, 1 year ago, we were saying, "Hey, we're looking hard." We think that our balance sheet positions us to really take advantage of the M&A environment. I think over time, it's like we've kind of trimmed up our balance sheet, taken down the cash, reduced some of the debt, did some more buybacks and just like M&A is certainly there, I mean we're looking at it, but I mean it's a pretty high hurdle for how we think about things and it's got to be a pretty good deal for us to kind of pursue that. Certainly, as we're integrating all the deals that we have done, I mean you're just kind of sensitive to the burden that, that puts on the organization. But I'd say, we're always looking, but disciplined about how we think about it. It's got to be just really the right combination of cost and value and impact on the organization before we do it.

Unknown Analyst

It sounds like you think the multiples are very rich here in some of the segments.

Bradley A. Ferguson

I mean, certainly for -- yes, on the IT services, that's what we think, just building it ourselves, is a much better risk and return profile. We think the opportunity is there and we think we're making the investments organically to tackle them. I mean, there could be some small capabilities that you could tick up to add to the portfolio and really, a lot of the deals that we have done have been very small and just that for and again, it's kind of a make versus buy, where in that case, we just bought some capabilities. But yes, certainly, at 16x or something like that, it's hard to make the math work for us for sure.

Unknown Analyst

And if you're not a reader, something like that, you don't get that...

Bradley A. Ferguson

Correct.

Unknown Analyst

Okay, good. Time for a couple of questions. Over here. Go ahead.

Unknown Analyst

If you look out over the next 1.5 or 2 years, sort of in 6-month increments, what are the major milestones, operating milestones you're trying to hit? 6 months hence, year-end, next 6 months, year-end 2014, so we can kind of track what it is you're trying to accomplish?

Bradley A. Ferguson

Yes. There's certainly, like with our growth products, I mean, it's just continued traction on the mix of our total sales and then the total sales are increasing. So we've seen our growth products making up. I mean really, we just got these capabilities in our portfolio kind of early 2012 or -- and saw it go from 30% to 40% of our total sales to up to 50% in the fourth quarter, so continue to see more traction on the growth side, more productivity out of our sales force, putting in the new cloud stacks and having new, basically products to sell new capabilities to sell, should help with that piece, the integration piece. So we've got a lot of the integration behind us and we've got a couple other milestones coming up by mid-year, whichever like our big OSS platforms put in, a couple other key metrics just on churn. So certainly, as I've talked about how we're structuring and managing the based churn is a big thing that we'll continue to a, drive the cost out of that lower end but just make sure that we're maintaining as many people as we can. So it's really not that complex. I mean we're looking to sell more and keep more of what we have and do it with a more efficient cost structure. So, also, the benefits of this structure is really driving the costs out of the low end. So we'll look to just getting a lot more effective and cost-effective on how we're supporting the lower end of the business.

Unknown Analyst

Yes, over here.

Unknown Analyst

Do you have a guess at this point as to what the sort of steady-state EBITDA margin model for the company might be looking out a couple of years?

Bradley A. Ferguson

Yes, so we talked about this in our investor day, kind of gave a longer term perspective. But -- so this year, it would have us in the -- or 2013 would have us kind of in the high teens. We think, over time, with the IT services, which should have a better EBITDA profile, once we get a little more scale on the investments we're making, that we should get back over 20% for the total business. So, I mean, that's really the kind of intermediate term objective.

Unknown Analyst

Great. Okay, Brad, I think we're out of time. Thank you very much. We appreciate you taking the time.

Bradley A. Ferguson

Right, yes, thank you. Thanks for having us.

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