In the following analysis, we will reevaluate a company previously identified for the Lakshmi Capital Income portfolio after their completion of several acquisitions.
EarthLink (ELNK) used to be an attractive income stock because of its fat dividend yield of 7.5%. The company managed to keep squeezing value from dial-up services, a market that has been declining for the past decade. Over several months the company made a shift towards the business services segment by acquiring DeltaCom on October 1 and One Communications on December 20. With the second acquisition EarthLink announced a quarterly dividend cut from $0.16 to $0.05, justifying this by the firm’s strategy to become a leader in IP infrastructure and managed services.
The question becomes – is the potential growth due to Earthlink’s shift to business services enough to make up for the loss in value because of the dividend cut?
ELNK Consumer Services Segment: A Lost Cause
EarthLink is recognized as the best dial-up Internet service provider in the US, although this is not much of an accomplishment considering that the percentage of American adults using dial-up has plunged almost 5 times over the past four years to just 5% in May 2010. The portion of adults using broadband increased more than 50% over the past four years and stood at 66% in May.
Dial-up Internet may still be around for another decade, mainly because of a lack of broadband penetration in the rural areas and the reluctance to switch by the older demographic, but it is quite evident that dial-up will be virtually extinct beyond 2020. The US government is making a push towards broadband adoption, with the FCC making recommendations in February to boost broadband rates in urban areas. Moreover, Earthlink’s principal provider of narrowband communications is Level 3 Communications (LVLT), a company that is rated Caa1 on Moody’s and has posted negative earnings for the past five quarters. Its stock is down 40% in 2010 and is currently trading around a dollar; it will not be surprising to see Level 3 go bankrupt in several years.
We note that Earthlink’s dial-up service customer base has been experiencing an exponential decay for the last twelve quarters. At this rate, EarthLink will have less than 300,000 customers using narrowband in four years.
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With the recent trend of increasing broadband usage among US households, EarthLink has attempted to increase or at least maintain its broadband customer base, but has completely failed. In 2006 the company launched municipal Wi-Fi in the major US metropolitan areas. Lack of demand, insufficiently reliable service, and change in the company’s senior management brought the projects to a halt in 2007, resulting in an $80 million loss. EarthLink’s investments into broadband over powerline (BPL) in 2006 were also unsuccessful due to potential interference with emergency radio and insufficient speeds.
Earthlink’s latest attempt to increase its presence in the broadband consumer market is to force Comcast (CMCSA) into line sharing as part of its merger with NBC Universal. Earthlink even hired FCC Chief Economist Simon J. Wilkie to produce a report stating that the merger will be harmful to most customers. However, there is little chance that the FCC will listen to Earthlink’s arguments over Comcast’s army of 78 former government employees lobbying for the merger.
Earthlink is just unable to compete in the high-speed Internet market against the giants Comcast, Verizon (VZ), AT&T (T), and Time Warner (TWX). At the end of Q3 2010 these four companies held 68% of the broadband market, while EarthLink’s share was under 1%. Furthermore, EarthLink has been steadily losing its customers over the past eight quarters, which is not the case for the big players:
Finally, in its latest quarterly release, EarthLink did not mention any plans to grow its consumer Internet service business, but rather to “reposition the company as a leading IP infrastructure and managed services provider with long-term strategic relevance.”
ELNK Business Services: Not Efficient Enough
EarthLink made two large acquisitions of integrated communications services providers in the past three months. The first is DeltaCom, which serves 32,000 small and mid-sized business customers in South-Eastern US. The second is One Communications, which serves 113,000 small and mid-sized business customers in the North-East, Mid-Atlantic, and Upper Mid-West. With the acquisitions Earthlink Business will operate a fiber network spanning 28,000 miles across 27 states. Earthlink, DeltaCom, and One together serviced 274,000 business customers at the end of Q3 2010. EarthLink has also indicated that it plans more acquisitions of similar type in the future.
Sounds pretty good so far, but let us look at EarthLink’s operating margins in its Consumer and Business Service units:
First, we see that during the past eight quarters EarthLink’s consumer operating margin have been mostly increasing, however this growth will eventually stop. Considering the decreasing customer base quarter-over-quarter, we expect declining revenues from consumer services as well. The improving operating margins will not be enough, and income from operations in this segment will keep decreasing at a significant rate.
A more serious concern is the drastic drop in operating margin in the firm’s Internet business services. In Q3 2010, the margin was just 4.7%, compared to 12.5% in Q4 2008. As a result EarthLink’s income form operations in the Business Services segment was just 2.9% of the income from the Consumer Services segment. The recent acquisitions of DeltaCom and One Communications better improve this margin, otherwise EarthLink’s profits will keep declining, the company will keep losing customers, and eventually be out of business.
If we look at DeltaCom’s financial statements, there is still some hope. The company’s operating margin was 6.4% in Q3 2010, more than 4 times the 1.5% level in Q4 2008. However, this is not that much higher than the 4.7% for EarthLink. Like EarthLink, DeltaCom has seen a steady decline in total revenue, although its revenue from wholesale services has been increasing.
There is no public information about One Communication’s operating margins because it is a privately held company. However, One was purchased for around 3.7 times adjusted EBIDTA, compared to 4.7 times adjusted EBITDA for the DeltaCom acquisition. This suggests that One’s operating margins were probably worse than those of One Communications.
With DeltaCom’s and One’s management still in place after the acquisition, it is unreasonable to expect a miracle jump in operating margins. Despite the apparent $20M in synergies to be realized from One’s acquisitions, this will not be enough to offset the losses in EarthLink’s consumer services profits. We also do not expect the firm’s business segment revenue to keep increasing after the acquisition.
AT&T’s revenue from business solutions has been declining quarter-over-quarter since Q4 2008. In its latest SEC filing, Verizon reported a decline of 4.6% in small business retail access lines, partly because of “a shift to both IP and high-speed circuits”. (Although Comcast posted a 55% increase in revenue in this segment in Q3 2010 compared to the same quarter a year ago).
Despite its recent acquisitions, EarthLink is still no match for Comcast and Verizon. Comcast’s fiber network spans 145,000 miles, more than 5 times that of EarthLink. Verizon’s FiOS Internet is currently rated the best in customer satisfaction, providing the fastest upload speeds in US. The service has gained huge popularity, with the number of subscribers up 24% in Q3 2010 compared to the same quarter a year ago.
We do not see any innovation from EarthLink, other than buying up troubled CLECs. Like its consumer services segment, we expect EarthLink’s business services unit to keep losing customers to larger competitors.
ELNK Trade Recommendation:
EarthLink is hopelessly losing its consumer services subscribers across both the narrowband and broadband markets. The company’s recent buying spree is not expected to be efficient enough to achieve long-term business services revenue growth. As a result, the possible increase in earnings from business services is not enough to offset the declining profits from the consumer segment. The company’s sharp dividend cut will not result in long-term growth and the stock will not provide long-term value. We recommend to sell EarthLink, and have sold all positions for client accounts.
Disclosure: We have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. We held ELNK as part of our income portfolio for clients but recently sold our entire position.