EarthLink, Inc. Q1 2009 Earnings Call Transcript

Apr.28.09 | About: EarthLink, Inc. (ELNK)

EarthLink, Inc. (NASDAQ:ELNK)

Q1 2009 Earnings Call

April 28, 2009 8:30 am ET


Kevin Dotts - CFO

Rolla Huff - Chairman and CEO

Unidentified Company Representative


Youssef Squali - Jefferies & Co.

Jennifer Watson - Goldman Sachs

Edward Einboden - WM Smith Securities

Mike Crawford - B. Riley & Company, Inc.

James Cakmak – Sidoti & Co.


Good morning, everyone, and welcome to EarthLink's first quarter 2009 earnings conference call. Today's call is being recorded.

At this time I would like to turn the conference over to Kevin Dotts, Chief Financial Officer, for opening remarks and introductions. Please go ahead, sir.

Kevin Dotts

Thanks and welcome, everyone, to our call. This morning I'm joined by EarthLink's Chairman and CEO, Rolla Huff, our Vice President of Corporate Communications, Michele Sadwick, and our Vice President, Investor Relations, Louis Alterman, to discuss our first quarter results. Following our comments there will be an opportunity for questions.

Before we continue I'd like to point out that certain statements contained in our earnings release and on this conference call are forward-looking statements rather than historical facts that are subject to risks and uncertainties that could cause actual results to differ materially from those described. With respect to such forward-looking statements the company seeks the protections 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 8-K that has been furnished to the SEC, both of which are available on our website at

Now I would like to turn things over to Rolla.

Rolla Huff

Thanks, Kevin, and good morning, everyone.

This morning EarthLink released its operating results for the first quarter. While the downturn in the U.S. economy is impacting us in certain customer areas, our business I would say for the most part is performing at or above our expectations.

Just to summarize our results for the quarter, we reported $69 million in adjusted EBITDA and $66 million in free cash flow, exceeding our own estimates on these metrics. We continue to run a profitable albeit attenuating subscription business while maintaining solid EBITDA margins.

I feel pretty good about where our Consumer Access business is today. When we restructured the business at the end of 2007 we knew we would face - and I think we told you that we would face - significant revenue churn as we stopped unprofitable marketing motions while the customers we had acquired over the prior 18 months followed their historical cohort churn profiles. Our ability to quickly increase operating margins then hold these higher margins during the height of that revenue churn has actually been above the expectations I had for the business when we announced the restructuring, again, at the end of the third quarter.

I can tell you that it is and will continue to be an every single day effort by the people and leadership in the company to constantly optimize processes and cost structure. We understand that it'll be required that we optimize every part of the business so that we can continue to generate good value in the future. My hat is off to the former and current people of EarthLink who stuck with our customers, with me and our shareholders even though it has often been anything but fun.

Based on the performance of the business in the first quarter and the trend lines we currently see, we're raising our prior guidance for adjusted EBITDA and free cash flow for the full year 2009. Kevin will take you through the details of that in just a few minutes.

While there have been some interesting nuances in our business this quarter, I think it's fair to say that we've not seen any material impact on our business from the economy, positive or negative. It's interesting to note that gross adds in both our value and our premium narrowband products, as well as our broadband products, actually increased over the prior quarter. Total gross adds across all products grew to 116,000 customers versus 114,000 in the fourth quarter. While we're talking about a relatively small number, it's noteworthy given that we continue to limit our marketing investment to only those distribution channels that will present a positive lifetime return on an acquired customer.

From our standpoint, it further demonstrates our belief that narrowband continues to be a relevant product for a portion of the consumer base and there is a significant valuable tail on this business if it's run properly. I should also note that we did a recent study on the credit scores of our gross adds and in spite of the economic downturn, their credit quality has been virtually unchanged in the past year.

Our customer churn during this most pessimistic economic time was flat quarter-over-quarter and is down significantly from the year ago quarter. This is in contrast to many other U.S. businesses, which are losing customers at a much faster clip in this kind of environment.

As we turn the corner into Q2, we've seen early signs that our churn may be decreasing from the levels we have reported over the past two quarters, particularly in the involuntary or non-pay churn category, which is good news given this economy. Clearly, it's impossible to predict whether this trend will continue. In any case, we intend to remain vigilant in our efforts to keep churn as low as possible by providing good customer service and loyalty programs that enhance our customer relationships, extend our customers' tenure with us and deepen their web engagement.

Let's spend just a few minutes getting a little bit deeper into our churn results. First quarter average monthly blended subscriber churn across all products was 3.9%, flat from the prior quarter and an improvement from 4.9% in the first quarter of 2008. Our churn performance was for the most part in line with what we would have expected based on our historical churn by cohort data.

Our historical experience is that our business does see a seasonal uptick in customer churn during the first quarter and we did see that in January and February. In the first two months, narrowband churn, driven primarily by the value dial segment, was actually above historic levels in some cohorts, but I'm pleased to say we saw meaningful improvement in those trend lines during March. Churn trend lines appear to have returned to historic levels during April. DSL and cable churn, on the other hand, were on plan for the entire quarter. As a matter of fact, in total we lost 5% less net subs this quarter than we did in the fourth quarter of 2008.

Let's take a look at churn by product line, all of which showed substantial improvement year-over-year. Average monthly churn for premium dial was 3.3%, an improvement over the 4% churn rate in the first quarter of 2008. Total average monthly broadband churn in the quarter was 2.5% versus 3% in the year ago quarter.

Value dial PeoplePC churn this quarter was 6.8% as compared to 7.7% in the same period last year. We continue to see our lower-priced value dial service account for a disproportionately large part of our churn. These subs represented 51% of our consumer sub decline in the first quarter and now account for just 26% of our Consumer Access subscribers. But I think much more importantly, the represent just 15% of our Consumer Access revenue.

An important factor in our current churn - current and future churn, actually - is the overall continued maturing of our customer base. Simply, our proportional mix of tenured customers continues to increase. At the end of the first quarter customers in the 2-plus year tenure cohort had increased to include 87% of our premium dial base, 75% of our DSL base, and 60% of our value dial base. Across all Consumer Access products combined, 73% have more than 2 years of tenure; that's up from 70% in the fourth quarter of 2008 and 53% in the first quarter of 2008.

What's really interesting is 34% of our Consumer Access customers now have 5 or more years of tenure, up from 32% in the prior quarter and 23% in the year ago quarter. That's important because average Consumer Access churn across all product lines for customers in the 5-plus year cohort has historically been around 2% and that includes narrowband and broadband.

Now let's get into revenue for a few minutes. For the first quarter we reported revenue of $199 million, which is in line with our expectations given our expected seasonal first quarter churn. While the pace of our revenue decline was marginally higher in January and February, it showed significant improvement in March. Clearly, revenue is declining at a slower pace than subscribers due to the disproportional weight PeoplePC customers represent in our subscriber churn results. Our current projection has quarterly revenue declines continuing to attenuate and will approach quarterly single-digit million dollar levels by year end 2009.

Our broadband product line represents 53% of our overall revenue, essentially the same percentage as last quarter and up from 50% of revenue in the first quarter of '08. Shortly, we plan to announce that EarthLink's DSL product will be available in 2.5 million additional households in 34 markets across 15 states. We believe our broadband, DSL and cable footprint as a combination is actually the largest broadband footprint in the U.S., with availability to more than 75 million households.

While overall cable subscribers declined, interestingly our Time Warner affiliate channel, which is our primary cable acquisition channel, experienced solid growth in broadband customers, increasing by 10,000 subscribers year-over-year, 3,000 of those just in the past quarter alone, where active marketing still exists. I've said all along that we would only invest in marketing channels that generate positive IRR and the success of the Time Warner Cable affiliate channel will likely warrant additional investment in sales and marketing given the quality and profitability of the subscribers it's currently generating. So we think that's a very good news story.

Building on that are our value added or VAS service products, which include online search, graphical advertising and products such as security and other web-based services. Despite the well-publicized market and pricing challenges in this industry segment, our VAS ARPU was $2.87 per engaged user in the first quarter, down just $0.03 from the prior quarter due to seasonality in the segment, but $0.15 higher than the first quarter of 2008. We continue to see that our more tenured customers who use our portal or purchase our VAS services have a lower churn profile. In our business, more user engagement on the web means less customer churn overall.

Our year-over-year VAS ARPU increase was principally driven by our web security products, which improved to $1.87 per engaged user in the current quarter, up from $1.82 in the fourth quarter of 2008 and a 16% increase over the $1.62 in the year ago quarter. Search revenue per eligible sub was $0.76 in the quarter compared to $0.82 in the prior quarter and $0.84 in the first quarter of '08. This was driven by lower number of total searches and a decline in RPM which was reduced to $41.38 this quarter versus $43.18 in the prior quarter and $52.79 in the year ago quarter. I should also point out that search revenue was seasonally low in the first quarter.

We launched two new VAS offerings during the quarter. Our new Norton Anti-Virus 2009 products are faster and lighter than the existing version, which will be particularly useful for our dial customers who may have older PCs. Our new PC Fine Tune release provides a scheduling tool which makes actions more visible to the customer and we think that will help further reduce product churn over time.

Now let's more on to the results from our continuous efforts to keep our cost structure in line with revenue. Our cost optimization efforts continue to offset much of the revenue decline in this business. As has been the case for six-plus quarters now, cost savings continue to be across the board and come from a thousand little things - there are no silver bullets here - all of this accomplished while maintaining or improving quality and customer satisfaction. Consequently, adjusted EBITDA margins grew to 34.6%, up from 31.2% in the first quarter of '08 and up from 33.5% in the last quarter.

Further, across all product categories during the first quarter we saw an increase in monthly adjusted EBITDA per average sub, to $8.50 per sub, up from just over $8.00 a sub in the prior quarter and a significant increase from the approximately $7.40 a sub in the first quarter of 2008.

Our customer support organization continues to innovate and recognize operating efficiencies while preserving a customer experience that's uniquely EarthLink. Customer support costs per sub was reduced to $1.29 in the first quarter of 2009, down 18% from the year ago quarter and another 4% improvement from last quarter. Importantly, cost reductions have been executed while achieving even higher customer satisfaction scores, which improved to 84% this quarter versus just under 80% in the year ago quarter and 83% in the prior sequential quarter.

Average combined customer support and technical support contact rates continue to reach historical lows. Contact rates on a per-sub basis were down 29% over the first quarter of 2008 and another 2% from the prior quarter. And remember, these are contact rates on a per-sub basis.

First call resolution for customer care is the common denominator for improvements we're now seeing in customer contact rates, cost structure and customer satisfaction rates. It has been an area of focus and will continue to be an area of focus for us. Customer care is everyone's job and I'm proud of the people at EarthLink for continuing to embrace this philosophy. There is no question they've done a lot more with a lot less.

The customer support team has also made significant progress in negotiating more favorable partnership economics with our customer support partners. Our new agreements will continue to better align our partners' compensation with how we create a better experience for our customers and better value for our shareholders. You know, we've always believed that the best partnerships emanate from an alignment between how a company creates value for itself and how value is created for their partners. We expect to see the bulk of the benefit from these agreements in the second half of this year.

I should note that approximately 70% of our cost structure is now variable, but we believe we have to do even better than that. We're evaluating ways to make our company more virtual in the future. Clearly the technology is emerging more and more every day that makes this possible and financially and operationally more attractive.

Now let's turn to our SMB business, which consists of our New Edge business, our web-hosting business, and our EarthLink Business Solutions customers.

In the first quarter, our SMB business was EBITDA and slightly free cash flow positive, which represents progress from the double-digit annual negative cash flow this segment had not too long ago. Top line revenue challenges continue to persist in this business segment, with soft sales primarily due to the difficult economic environment and associated longer sale cycle in New Edge. However, sales at New Edge were up slightly in the quarter, with new sales primarily comprised of smaller customers with multi-site contracts.

There continues to be interest in our award-winning MPLS over DSL product, which allows small business customers to reduce their telecom expense by replacing T1 circuits with MPLS over DSL. MPLS revenue growth in this quarter was up 28% over the prior quarter. Building on our MPLS network during the first quarter, our New Edge subsidiary announced two new access options - private Ethernet and public IP security - that integrate into our network backbone. Ethernet's an attractive solution for corporate headquarters with large bandwidth requirements, while IP sec is a good way for remote locations to securely access a corporate network.

Churn within the SMB customer base is seeing more pressure in the EBS product line, but is on track overall as marquee customer retention programs are taking hold and additional resources are being allocated to retaining the lower-end EBS customers.

We intend to continue to keep our cost structure in line with revenue trends until the SMB market and the overall economy rebound. There's no doubt in my mind there's going to be an increasing need for products and services that better enable the millions of small businesses out there to leverage the power of the web. In my view, small business will increasingly provide the platform for the reemergence of our economy. We believe the foundation of their reemergence will be web-based business models. I believe we have many of the core capabilities they will require and this could be an interesting area for further strategic investment, and I'll talk a little bit more about that later.

Given the rapid deterioration in the economy, however, we believe the next year or so are going to be difficult for SMB-focused business models, so we intend to continue taking the actions that are required that allow us to weather this storm.

So with that I'd like to turn the call over to Kevin, who'll take you through the details of our financial performance for the quarter. Kevin?

Kevin Dotts

Thanks, Rolla.

Our 2009 first quarter financial results demonstrate once again the success of our strategy to maximize cash generation while ensuring our subscribers maintain a satisfactory experience. Our goal in 2009 will continue to be to maximize the cash generated in our Consumer Access business by keeping our adjusted EBITDA margins consistent with prior year while we seek strategic opportunities to increase long-term stockholder value.

Our overall revenue for the quarter was $199 million, a 24% decrease from the first quarter prior year and a $17 million decrease from last quarter, principally driven by expected declines in the Consumer Access segment and associated value added services.

Revenue was down sequentially slightly more than we have seen over the past couple of quarters for several expected reasons. We normally realize seasonal increases in churn rates in the first quarter, particularly in our narrowband products. Early in the first quarter we sold 7,000 of our satellite subscribers to our partner, Hughes, in exchange for a high-margin bounty relationships going forward. Additionally, as we focus on our Time Warner Cable relationship we realize an increasing percentage on our cable affiliate business, where we book on a net revenue basis but yet realize the same comparable dollar margin on our direct Time Warner Cable business.

Our Business segment declined by approximately $2 million compared to the fourth quarter of 2008 as we continue to experience the effects of the economy in serving customers, primarily in the retail segment, reduce their store location footprints. And while it is early and somewhat premature to be optimistic, as we exited the first quarter we noted improvement in churn rates in both our consumer segment and in our New Edge network products.

Going forward, as EarthLink continues to see subscriber churn at historical rates by cohort, we expect to realize further revenue contraction, but we do expect the declines in revenue to attenuate throughout 2009, approaching the low teens or even single-digit millions of dollars decline in the second half of 2009.

Like everyone else, search traffic was down sequentially and we felt the impact of a challenging ad market, but these trends were somewhat offset by security and Internet utility subscriptions providing a total value added web services revenue of $2.87 per engaged subscriber.

We continue to manage the variable and fixed cost structure to maximize our margins and cash generation. Our cost of revenues declined by approximately $7 million, leaving a gross margin decline of approximately $9 million in the first quarter of 2009 compared to the fourth quarter of 2008. We realized a slightly higher gross margin rate compared to the fourth quarter of 2008 driven by the aforementioned Hughes satellite sales and Time Warner Cable mix to affiliate.

As the proportion of our broadband revenues will continue to increase, we expect the total gross margin rate to modestly decline for the remainder of 2009; however, as I mentioned in our last call, although the change in mix will cause total gross margin rates to decline, broadband has lower churn characteristics, resulting in the cumulative cash flow or lifetime value of our broadband subscribers to be relatively the same, if not better than certain narrowband subscribers.

As previously discussed, we continue to build a smaller but more profitable business and continue to optimize costs and efficiencies across all areas of the company. Total operating expenses, including customer support expenses, operations expenses and general and administrative expenses, but excluding sales and marketing expenses, were $46 million for the quarter, down 28% from the first quarter of 2008 and over $5 million lower than the fourth quarter 2008. Sales and marketing costs were $17 million in the quarter, down $2 million from the prior sequential quarter on slightly increased gross adds, and down 45% from the first quarter of 2008.

These expenditures consist mainly of product management and sales and marketing overheads across both our Consumer and Business segments, with modest [inaudible], sales partnership commissions and Time Warner co-op marketing expenses.

In addition, bad debt and payment processing costs declined by $2 million over prior quarter and $5 million versus prior year same quarter or a decline of approximately 48% over prior year.

As revenue contracted we were able to increase the productivity of our operating margin, defined by total company revenue less cost of revenue, sales and marketing and other operating costs, as previously mentioned, of over 30% for the first quarter of 2009, an improvement from 29% in the fourth quarter and 27% in the first quarter of 2008. While we continue to focus on reducing all costs and making our fixed costs as variable as possible, over time we expect to realize less opportunities to take cost out faster than the revenue decline and we will ultimately see this trend flatten and decline.

For the first quarter of 2009 we generated adjusted EBITDA of $69 million, a decrease of $3 million from the fourth quarter of 2008 and a $13 million decrease from the prior year same quarter.

EarthLink's income from continuing operations during the quarter was $32 million or $0.30 per share compared to $24 million or $0.22 per share in the fourth quarter of 2008 or an improvement of over $8 million.

During the first quarter of 2009 we recorded a $21 million income tax provision at an effective corporate rate of approximately 39%. As this provision is predominantly offset by our net operating loss tax carryforwards, our federal and state effective cash tax rate is expected to remain at approximately 3% to 4% through the end of 2009.

The increase in the income from continuing operations per share number was driven by the aforementioned lower EBITDA, higher non-cash tax rate, which was more than offset by one-time charges recorded in the fourth quarter of 2008 related to goodwill and other asset impairments. Compared to the first quarter of 2008 income from continuing operations declined by $23 million or $0.20 per share, driven by a decline in comparative EBITDA and a larger non-cash tax charge.

For the first quarter of 2009 EarthLink generated net income of $32 million or $0.30 per share compared to the fourth quarter of 2008 of $24 million or $0.22 per share. EarthLink generated net income of $52 million or $0.47 per share in the first quarter of 2008.

We ended the quarter with $566 million of cash and marketable securities, up $32 million from the end of 2008.

In the first quarter of 2009, offsetting the $69 million of adjusted EBITDA, EarthLink repurchased almost 4 million shares or used $22 million. Additionally, we used $3 million for capital expenditures and we realized other expected seasonal reductions in working capital. Management still has the authority, delegated from its Board of Directors, to buy up to an additional $147 million worth of its shares.

We will now provide our outlook for the remainder of 2009.

While in a very challenging economic environment, we realized some seasonal expected increases in churn rates during the first quarter of 2009. As mentioned earlier, the consumer segment and New Edge network churn rates have demonstrated some expected seasonal and mix improvements, respectively. We continue to expect the rates to remain stable and predictable through the remainder of 2009.

Given our confidence on the predictability of the revenue and cost management, we are increasing and narrowing our full year 2009 adjusted EBITDA guidance to $220 million to $230 million. This guidance reflects very modest marketing spend in the second half of 2009 in profitable channels. We expect to spend $10 to $20 million on capital expenditures and thus adjusted EBITDA should translate into $200 to $220 million of free cash flow.

I'd like to turn the call back over to Rolla for some concluding remarks.

Rolla Huff

Well, clearly we're pleased that our Consumer Access business continues to over perform as we continue to see success in retaining our most valuable customers while simultaneously optimizing our operating expenses and cost structures. Those, of course, are the key enablers to our execution in Q1 and our increased guidance for the full year.

To be clear, we're also all too aware that no matter how well we run the access business it's going to get smaller, so we're continuing to actively consider a full range of options to create future value for shareholders, leveraging the company's strong operating culture and financial position. As I've discussed before, these options include stock buybacks, dividends and acquisitions. As we look at these options, understand that we don't view any of these options as being mutually exclusive.

I'll talk for a minute about how we're evaluating the acquisition possibilities. I've been a strong proponent of access industry consolidation to generate more scale economics and I believe that consolidation will happen in some form or fashion. Obviously, the big question is when. As I've said before, a combination with a company like AOL, the largest in the industry, is an example of a transaction that would drive value for shareholders and, who knows, perhaps the separation and/or spin out of AOL under new leadership makes a combination more feasible. We're encouraged by that development.

Obviously, we don't control the timing of when ISP consolidation happens, but I'm confident that we'll be an integral part of it when it does. While ISP consolidation will create improved scale and cost structure, it won't make this a growth industry, so we will still have the same fundamental question that we must solve for. That question revolves around whether there is a path to leveraging our core business capabilities, financial position, and the ongoing dislocation in the capital markets to make an acquisition that gives the company, its shareholders and its people, a better future return than simply returning cash to shareholders in some form or fashion.

In evaluating the consideration, we've been actively looking at the various businesses that we are in to determine whether we can effectively build on them through an acquisition. Beyond the ISP industry, we've taken a close look at the CLEC industry, the web content industry, and the web hosting industry - again, all industries that we're currently operating in.

I won't use this call to take you through our critique of each of them. I think it would be fair to simply say that while each industry has its pros and cons, we're currently focusing on the SMB web hosting industry. We've been particularly interested in the shared and managed or dedicated to some space and we're getting to know the players in these industries and how we can leverage what we have in terms of assets and capabilities with what they have.

Ultimately, whether it's ISP consolidation and/or taking a strong position in an industry like web hosting, I believe our ability to be patient and opportunistic, combined with our continued disciplined approach to evaluating potential acquisitions, is critical to the level of our ultimate value creation. I've been pleased to hear from the vast majority of our investors that they agree with this approach.

In the interim, just as we did in this past quarter when we repurchased over 3% of the outstanding shares of our company, we'll be opportunistic in our approach to buying back our shares when they're clearly a better value than any strategic alternative we're looking at. I would tell you we've consistently held that view - that's nothing new - as illustrated by our repurchase of 14 million shares in 2007, nearly 4 million shares in 2008, and over 3 million so far in just the first quarter of 2009. And as Kevin mentioned, we do retain approximately $147 million of buyback authorization from the Board.

I told you last quarter that nothing was off the table and we still very much believe that. We continue to look for a variety of ways to further leverage our financial strength. Just as an example, we're currently negotiating opportunities to use our cash position to buy down future payments on fixed infrastructure cost obligations that are due over the next four or five years at a meaningful discount to their current present value. Again, everything is on the table and we don't feel rushed to pick a path that eliminates all other alternatives.

I would just conclude by saying that I think this team has worked hard to create a balance sheet and a strong future cash flow that now gives us strategic leverage in this new economic environment. We'll continue to be disciplined in how we manage that strategic leverage. We should and will be very cautious about giving up the very asset that gives us strategic leverage precisely at the time potential value-enhancing opportunities are emerging and becoming available. That's why we're taking a patient, disciplined approach determining the best course or courses to create additional value for shareholders. We're confident that we're well positioned to deliver meaningful value, whether through a series of options or a single significant event.

With that, Operator, let's open up the lines for any questions that might be out there.

Question-and-Answer Session


(Operator Instructions) Your first question comes from Youssef Squali - Jefferies & Co..

Youssef Squali - Jefferies & Co.

I guess starting with the nothing should be off the table thesis, first of all, has anything changed at AOL under the new leadership that you can sense?

And then is there more of a sense of urgency on your part as far as M&A is concerned? I think now you're talking a little more about the hosting opportunity. We haven't heard you talk as openly about it before. Does that mean that you've able to identify attractive candidates that would get you where you want to get?

And then for Kevin, can you just elaborate a little bit on the changes in structure of certain partner relationships? And I guess you're talking about Hughes and Time Warner Cable.

And lastly, if you can share with us the subscriber details because that's what we use to try to drive the model.

Rolla Huff

I'll take the first couple and then, Kevin, you can jump in on the last two.

I think, first of all, Tim Armstrong was just an absolutely stupendous hire for Time Warner. I think he's smart. He knows the ad space cold. And he comes from a great culture at Google. So I think that was truly a homerun for Time Warner and give them all kinds of congrats for that.

I'm pretty confident that they're very focused on what the answer should be ultimately for this business and I think that is maybe, you could argue, a bigger change. I think with the cable spend out of the way they're a lot more focused on what happens around AOL.

I think clearly Tim is coming into a situation that's pretty challenging. The company has made very big investments in growth initiatives that are probably not performing the way everybody thought they would. He has a core business in AOL that's declining but could create, I think, some pretty meaningful stockholder value if it's run the right way. I know the shareholders at Time Warner are pretty focused on what the answer's going to be and as I stop and think about it, that all sounds vaguely familiar to me.

From where I sit they just look to be much more focused on getting to a solution and I think that's key because I said many times I think the enemy is time when it comes to a business that's declining. So I think their increased focus is encouraging because just from a pure shareholder value creation perspective, I think any path that involves EarthLink will create more value at probably a lower risk than a path that doesn't. So I've always believed in this industry consolidation and I've been pretty clear about that.

Finishing up there, I think it just really is going to boil down to what they're solving for and how focused they are on making audience a growth business again.

Getting to the second part, we're going to continue to pursue our other alternatives because time is also EarthLink's enemy, too, because our business is declining. I would not characterize our feeling as having a sense of urgency. I think when you get a sense of urgency you wind up doing deals that maybe you shouldn't do.

I don't feel the need to be rushing through decisions. We're going to continue to run our business. We've got a high hurdle for what we would invest in. We're certainly not wasting money. And we're going to be extraordinarily opportunistic to take advantage of every alternative that presents itself, whether it's an undervalued equity or an acquisition or just using our balance sheet to take out future obligations at a discount to the face value of those obligations. So everything is on the table.

Kevin, you want to talk a little bit about what's happening in terms of the structure with Hughes?

Kevin Dotts

Sure. A couple of things here, Youssef. One was we had a little under 7,000 subscribers, satellite subscribers. We had a fairly complex relationship where we were working with Hughes to supply the equipment to the satellite providers, etc., but, as technology grew within the [inaudible] subscribers, it was difficult for us to kind of upgrade them on an ongoing basis.

So what we agreed to do with Hughes is we sold a subscribers effectively back to them so they were effectively providing the equipment and some of the service activity. And going forward, as we bring on new subscribers we'll turn that into a ongoing bounty type relationship. So that's a pretty small item. Obviously it has an impact on our revenue, but from a margin perspective it's a small change.

From a Time Warner Cable relationship I think what we're talking about there is if you went back and looked maybe two or three years ago at EarthLink when we were spending our dollars, sales and marketing dollars, to stimulate demand in the cable area, again, working with Time Warner and all the Bright House Network MSOs, spending a lot of that money on our own as well as doing cooperative marketing with Time Warner and Bright House Network, so subscribers were either coming on to EarthLink directly through our call centers or they were coming in through the doors with Time Warner, by calling them directly.

When we sign up a sub we book those on a gross revenue basis, say an ARPU of over $40  I think the offer right now is $41.95. We factor out the cost of revenue that we pay back to Time Warner and then we have a gross margin rate. When a subscriber comes in through the Time Warner channel and actually signs up through Time Warner, we actually don't book that on a gross revenue basis; we just book it net revenue. So we net out the actual cost of revenue against the total $42 ARPU that the subscriber's paying and get to the same gross margin.

So what we're saying is that as we've stopped spending a lot of money on our own we're still working through Time Warner on that cooperative marketing activities so now a lot of our gross adds are coming in through Time Warner, thus we're shifting our mix to more affiliate Time Warner relationships as opposed to direct with EarthLink.

Rolla Huff

Youssef, I think it speaks to the power of the brand that when Time Warner is out making offers, customers are choosing EarthLink as the ISP in the Time Warner bundle. As I say, I think that speaks volumes about the strength of our brand and it really incents us to continue to co-market with Time Warner because these are valuable customers.

Kevin Dotts

Right. And beyond that I would also articulate that we've been extremely pleased with the performance that we've seen in the Time Warner markets. You probably remember last year we announced that with the whole Adelphia transaction between Comcast and Time Warner, it allowed us to open up additional markets in Dallas as well as L.A., and we've just been quite frankly thrilled with some of the performance we've seen this year in those markets.

So we're also - I think I mentioned in my script that, as part of our guidance, we're also anticipating spending some marketing dollars in the second half of this year to continue to drive demand because those LTVs are still very good for us.

To your question on subs, just kind of breaking it down, you can see in our release that we have a little over 850,000 consumer broadband subscribers and that roughly breaks down to about 500,000 - 550,000 on cable and the balance on DSL. And when we take that cable, you break that down further, about 55% of that is roughly the affiliate Time Warner mix and the balance is direct Time Warner and there's probably about 50,000 Comcast subscribers in that mix as well.

Youssef Squali - Jefferies & Co.

And the [inaudible]?

Kevin Dotts

Excuse me?

Youssef Squali - Jefferies & Co.

The dial up customer break up?

Kevin Dotts

Oh, the dial up customer break up, I think what we've said in the prepared remarks, if you look at the dial up, you can see here it's just under 1.6 million subscribers; in narrowband I think there are roughly 650,000 of those are PeoplePC subscribers and the balance being the premium.


Your next question comes from Jennifer Watson - Goldman Sachs.

Jennifer Watson - Goldman Sachs

You talked obviously a lot about the relationships with Time Warner Cable and the bounty relationships that you are shifting to within the broadband product. Are there other partners that you can do something like this with or products that you can roll out to kind of mitigate some of the losses that you're seeing within broadband and kind of continue to increase your dependence, essentially, on the broadband revenue there?

And then also if you can just talk about what marketing channels you're found to be most profitable, both on the dial up side as well as broadband.

Rolla Huff

We think that there is traction on the cable side. I think one of the things, Jen, that we had to deal with two or three years ago was the cable companies effectively believing that they were going to get the subscribers whether they worked with us or not. I think what we're experiencing with Time Warner is so evident in the fact that now that L.A. has been opened up through the Adelphia acquisition, what we're meaning to them in terms of customer acquisition. And I think we're using that as an illustrative piece on why the other cable companies should really sort of think again about whether these customers are just going to naturally get to them whether they work with us or not. So we're absolutely pursuing those kinds of partnerships because they're very profitable for us.

In terms of the channels that are most profitable on narrowband, I think at the end of the day you can't make a narrowband customer profitable if you're trying to stimulate growth. All of our narrowband acquisitions now are profitable because we don't spend a lot of money trying to stimulate getting them on. They find us through other ways. As we mentioned, we added a lot of customers - we'll add probably 350,000 customers this year, but it'll be through customers finding us through keyword searches, much lower cost of acquisition types of channels.

But I wouldn't want to ever suggest to you that we think there's a path to getting narrowband to be a growth vehicle for us.

Kevin Dotts

The only thing I would say is, not to sound facetious, but yes, obviously the less profitable subscribers coming in through narrowband marketing channels are the ones that kind of find us. Whether they're being stimulated by our competitors' commercials or some other reason, they just fortuitously sign up through the call center. To Rolla's point, they find us because they buy a new Dell computer so we pay a small bounty to Dell. Those will still be very profitable for us. Our relationship with AARP continues to be a nice little channel for us.

But, again, I don't think, to Rolla's point, a lot of channels out there and certainly we can't put active marketing dollars to work in a narrowband area and expect anybody to be profitable.


Your next question comes from Edward Einboden - WM Smith Securities.

Edward Einboden - WM Smith Securities

I just wanted to ask you really quick, in the last quarter you guys talked about the New Edge business and maybe some pressures with bankruptcies and some of the issues that are going on there. Have you guys seen - you talked about it a little bit - maybe an improvement there? Are you guys seeing that improvement and how are your expectations going forward?

Rolla Huff

Well, we didn't see any bankruptcies in the quarter, unlike the fourth quarter, so that was good.

We do see continued churn that is high relative to the new sales that we're installing, so it's putting pressure on the top line for sure, which winds up causing us to put pressure on the cost structure.

We're seeing the new products that we're releasing having traction, but in addition to just the overall economy - and this is not anything new; I mean, it's something we've been working through for the last two years - the business has been evolving from a legacy technology to an MPLS-based technology, so at the very time we're dealing with the economy, we're also transitioning the revenue stream.

And I think we've made good progress in getting our revenue stream to be more MPLS based, but there is no question in my mind - and I think we've tried to be pretty transparent about it - the CLEC space is a tough space in this kind of environment and I think it will be for some extended period of time.

I like the new product that we've released because I think it plays to the dislocation in the economy and giving people an alternative to expensive T1s, but New Edge is a tough business. There's no question about it.

Kevin Dotts

But, again, we have seen some early signs, as I mentioned, I think, in my area of the prepared scripts - and I think Rolla's as well - where we talked about at the end of the quarter the March timeframe coming into April where the New Edge churn rates are starting to attenuate, more because we're getting through a lot of the mix and a lot of legacy products, wholesale products as well, have churned off at this point. But we're seeing less effect from the economy versus what we saw both in the end of the third quarter through the fourth quarter.

Rolla Huff

Yes, I think that's fair.

Edward Einboden - WM Smith Securities

And I guess on the profitability side you guys saw an improvement in the operating income line despite the reduction in revenue. Can you guys go into where you're seeing that and where you're taking out costs there?

Rolla Huff

When we talk about Business Services, we're seeing sort of flat profitability and cash flow across our SMB business. Our web hosting business continues to hold up reasonably well. Our EarthLink Business Solutions has had the same effect from the economy and that's generally a broadband circuit to Soho-types of customers; clearly there has been pressure there. And the multi-site retail business base that New Edge addresses has also felt the pressure that we had talked about.

So what we're trying to do is just continue to leverage our network and improve operating processes and drive cost structure down to weather the storm. It's a bit frustrating because we know that currently there's no value being given to our New Edge business when we look at our equity. We don't want it to be a drag on our business. But I believe as the economy comes back it's going to come back on the heels of small businesses and I think that business is positioned to take advantage of that.

So what we've got to do is just continue to keep it from hurting us and that's been our strategy all along.

Kevin Dotts

And just to make sure we're on the same page here, so when I looked at our Business segment and our supplemental schedules, you'll see the Business segment [inaudible] where in the fourth quarter of '08 we were about $5.1 million worth of income from operations and this quarter were just over $5 million, so we're down it looks like about $80,000 - $90,000. We're really not up at this point, but we are absorbing a lot of that gross margin decline, which was close to $700,000 or $800,000 through all of the things that Rolla just mentioned.


Your next question comes from Mike Crawford - B. Riley & Company, Inc..

Mike Crawford - B. Riley & Company, Inc.

A couple of financial questions. One, the free cash flow number you gave of $65.7 million and then you subtract out the $22.3 million for buybacks, that still doesn't get you to the net change in cash, so what were the other differences? There's another $20 million.

Kevin Dotts

We haven't provided a lot of detail on that, but I can talk to it. What we normally talk about is as we hit the first quarter we're really paying out bonuses that quarter, so that's probably another chunk of $13 or $14 million. And then I think with the decline of the business overall you're just seeing general working capital reductions because we have less - well, the accruals are coming down because of just the lower volume in general.

Mike Crawford - B. Riley & Company, Inc.

So when you're reducing working capital, you're not including that in your free cash flow metric?

Kevin Dotts

No, that's correct. The free cash flow metric is a simple EBITDA less CapEx and subscriber acquisitions.

Mike Crawford - B. Riley & Company, Inc.

I see. And cash taxes?

Kevin Dotts

No, we have not put that in there. Then again the cash taxes, just so we're clear on that, that's running at about a 2% to 3% rate, so if you went back and looked at the quarter that would translate into a couple million dollars.

Mike Crawford - B. Riley & Company, Inc.

And then on the repurchases, the share count didn't decline very much, so were those made at the end of the quarter?

Kevin Dotts

No, actually they were made probably earlier to mid-quarter, I would say. The stock price ran up towards the end of the quarter, but yes, we were making those kind of throughout the quarter.

Unidentified Company Representative

It's just a weighted average, not an ending balance that we put out there.

Mike Crawford - B. Riley & Company, Inc.

And then you said that you saw a reduction in, I think, churn rate in the PeoplePC business in March and April. Do you think that's just the economy?

Kevin Dotts

Well, I think I'll take the first shot at it. I think that we saw a run up that we were talking about in the last call. We saw a run up in December and January and February that was without question a little bit concerning for us because, as we've talked about, we look at everything against historical cohort levels. So we saw churn in PeoplePC coming up above what we had historically seen on a cohort basis. In March that subsided and in April it's continued to subside. So it could well be that was just when the economy was bottoming out. We know that we've not seen as much non-pay churn, so it's probably a reflection of the economy. I'm just guessing. But I don't know.

Rolla Huff

Right. I mean, it's difficult for us to say for sure.

Kevin Dotts

Yes, exactly. But I think that's dead on. I mean, we're liking the idea that it's not coming through people not paying us.

Mike Crawford - B. Riley & Company, Inc.

And then on New Edge, are you able to break out in direct relative proportion how much of that would be web content revenues and how would be web hosting revenues?

Rolla Huff

What we've talked about is - and you see it in our release - we have a Business Services section and so that includes all of our SMB-focused businesses. You follow me?

Mike Crawford - B. Riley & Company, Inc.


Rolla Huff

So web hosting isn't buried inside of New Edge. New Edge is a part of our broader SMB product portfolio that runs on common networks and infrastructure and that sort of thing.

We sort of see New Edge as a product line as much as anything. It's a channel and a product line.

Kevin Dotts

If you just want to think about this annualized, think about web hosting as roughly 80,000 to 85,000 subscribers and an ARPU of around $20 to $22 times 12 and that'll just kind of give you a view as to the balances, really the rest of this New Edge and our legacy EarthLink Business Solutions.

Mike Crawford - B. Riley & Company, Inc.

So if you find an acquisition or two in this space and maybe the AOL situation gets resolved where there's some consolidation that you are able to participate in and then at that point is that when you would look to start paying down this low-cost capital that you have that seems a little excessive given the large amounts of cash you have?

Rolla Huff

Well, it's hard to say that it's excessive unless you really have a clear view of the opportunities that are on our table. So I think our approach is, as I think about the whole thing in terms of how to evaluate these various alternatives, I think, as I mentioned in my comments, I think we have to stay patient and disciplined. I think we have to - when I think about what and how and how much we do, I think we have to keep our - I'm very focused on continuing to operate the business that we have and keeping our people focused on operating the business.

At the end of the day we have just over $3 a share in net cash today, fair? The business isn't on autopilot and it's very important that we be able to tell not just our shareholders but our Board and our people that there's a reason to hang in with us and we have alternatives to create value for everybody involved in the business.

And we've said that I don't think that these things have to be mutually exclusive, but at this point in time, with all of the dislocation in the markets, our cash is worth more than cash. And I think choosing this particular time to feel like we've got to start pushing large amounts of cash out rather than being opportunistic, we clearly have not hesitated to return cash when we thought it was better than the alternatives we had in front of us. We've done and we'll continue to do that.

But I think that we need to continue to be patient and focused. If things change around us and all of a sudden the debt markets open up and our relative strategic leverage of having this big cash balances goes away, then I think the answer's easy. But that's not the environment that we're operating in right now.


Your next question comes from James Cakmak – Sidoti & Co..

James Cakmak – Sidoti & Co.

You guys have been looking to diversify for quite some time, but given no real opportunities to jump on immediately on the horizon would you say that you're more inclined or how much more inclined are you to run the company for the cash than before?

And secondly, on AOL, assuming Tim Armstrong does entertain a deal, credit markets free up a little bit, would you be willing to take on more debt to finance an acquisition like that or a partnership?

Rolla Huff

Well, let me start with the second question and then I'll go to the first.

Whether I was inclined to take on more debt or not, the markets, for all the reasons I just mentioned for the last question, are not inclined to give us the debt. So that won't be the nature of a deal. So the answer is no. I wouldn't have an interest in leveraging up our business and I don't think that, in fact, even if I wanted to, we could.

To be clear, we've been running the business that we have for cash all along. That's not something that's an alternative for us in the future; it's something that we've been doing all along. And that gets to the point of staying focused on executing the business that we have.

I think that the dislocation in the market is a relatively new phenomenon. I mean, let's face it; everything sort of went sideways and haywire in November. And you're right, we could have been very aggressive about going out and using that to do a deal immediately, but that's just not the way we think about running the business.

So are we more likely or less likely to run it for cash? I think it is incredibly likely that we're going to continue to optimize the cash that the legacy business provides. If I can add scale to that through industry consolidation, I want to do that. We are looking at alternatives that give us a path to growth without us being a venture investor. I don't want to be a venture investor, so I look at things that we're involved in. I'm looking at businesses that are real today, not possibly real next week, but real today and that we can leverage with the DNA of our company. Those are sort of the acquisition criteria that we start with.

And those situations are evolving and they're going to continue to evolve at people out there have debt maturities or finally just give up the ghost in terms of believing that there's going to be a snap back to the economy and we're going to be back to a time when any debt can be refinanced and everything's trading at 12 times. If you believe that that's not going to be the case, then our opportunity is going to continue to emerge. And, again, it makes our cash worth more than cash.

As I sit with our investors, I think the thing that they get is the fact that we're not wasting cash in other ways. We're not leaking cash here. We're accumulating cash and we're running the business like every subscriber's our last one. And I think that's what people need to be and are focused on.

And I guess the last thing that I would point out is when I talk to people that have been in investors in our business, they recognize the fact that since the first quarter of last year, when we've been on this path, our equity is down 3% when the S&P is down 40% and the NASDAQ is down 26%. So whether you're an equity investor, a long-term equity investor, or not, I think people have taken comfort in the fact that we've not been impulsive in what we've done.

Kevin Dotts

Okay, we'll I'd like to thank everybody for joining us on the call today. We'll look forward to talking to you at the end of the next quarter. Thanks so much.


This concludes today's conference. You may now disconnect.

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