EarthLink, Inc. (ELNK)
Q3 2007 Earnings Call
October 25, 2007 8:30 am ET
Executives
Kevin Dotts - CFO
Rolla Huff - CEO
Mike Valentine - IR
Analysts
Jen Watson - Goldman Sachs
Youssef Squali - Jefferies
Chris Rowen - SunTrust
Vijay Singh - Janco Partners
Donna Jaegers - Janco Partners
Srinivasan Anantha - CIBC World Markets
Scott Kessler - Standard & Poor's
Operator
I would like to welcome everyone to the EarthLink thirdquarter earnings conference call. (Operator Instructions) I will now turn the call over to Mr. KevinDotts, Chief Financial Officer. Sir, you may begin your conference.
Kevin Dotts
Welcome everyone to our call. This morning, I am joined byEarthlink's CEO, Rolla Huff, and our Vice President of Investor Relations, MikeValentine, to discuss our third quarter results. Following our comments therewill be an opportunity for questions.
Before we continue, I would like to point out that certainstatements contained in our earnings release and on this conference call areforward-looking statements rather than historical facts that are subject torisks and uncertainties that could cause actual results to differ materiallyfrom those described.
With respect to such forward-looking statements, the companyseeks the protections afforded by the Private Securities Litigation Reform Actof 1995. Those risks include a variety of factors including competitivedevelopments and risk factors listed in the company's SEC reports and publicreleases.
Those lists are intended to identify certain principlefactors that could cause actual results to differ materially from thosedescribed in the forward-looking statements, but are not intended to representa complete list of all risks and uncertainties inherent to the company'sbusiness.
In an effort to provide useful information to investors, ourcomments today also include non-GAAP financial measures. For details on thesemeasures, including why we use them and reconciliations to the most comparableGAAP measures, please refer to our earnings release and the Form 8-K that hasbeen furnished to the SEC, both of which are available at www.EarthLink.net.
Now I will turn things over to Rolla.
Rolla Huff
Thanks, Kevin and thanks everybody for joining us today.Without question the last 120 days at EarthLink have been very busy. As you mayrecall, I first spoke with you just 90 days ago during the second quarterearnings call. On that call, I told you that we had initiated a bottom-up reviewthat we had hoped to complete by the end of the third quarter. I wanted you toknow at that time that we had a real sense of urgency about the business.
I shared with you some of the initial observations andthoughts about EarthLink, and if you recall, those observations included thefollowing points. First, I felt there was a lot of opportunity to create valuein the EarthLink business. Second, I thought there was real opportunity togenerate substantial cash flow in the core business. Third, I felt that theunderlying business model for EarthLink's wi-fi business was weak, and neededto be reviewed. Fourth, I believed that the line-powered voice product, whileattractive to our customers, needed better operational underpinnings before weinvested substantial amounts of time and money in marketing it. Finally, Ithought there was real value in Helio, but I recognized that EarthLink was notpositioned to be in the venture capital world in a material way.
Well, since our second quarter call, we have taken thefollowing actions. We've undertaken a substantial restructuring of ourbusiness. Our intention was to eliminate the spending on acquiring newcustomers that had negative lifetime value. As part of that restructuring, wemade the decision to reorganize more around functional lines.
As a result of those decisions, we announced our intentionto reduce headcount by 50%. Further, we decided to reduce our new investment inwi-fi and line-powered voice as we evaluated new business models and business processesthat would create positive shareholder value.
Let me just give you a brief update on our progresssurrounding our restructuring activities. In our announcement, we indicatedthat we expected approximately 900 employees would be affected as part of thisrestructuring. Approximately 60% of the affected employees exited the businesslast month, with a plan that's now in place to exit the balance of thoseaffected before year end.
We have a substantial effort underway to reorganize ourfacilities to get a normal work environment back in place, as well as to giveus the opportunity to sublet excess space. While restructuring activities ofthis magnitude generally require two to three quarters to get back to a morenormalized operations environment, we're very pleased with the progressto-date.
During the quarter, we also announced that SK Telecom hadpreliminarily agreed to invest up to $270 million in Helio, and that SK Telecomand EarthLink were in the process of amending the existing agreements betweenthe two of us. While the definitive amended joint venture agreements are stillbeing finalized by our respective lawyers, the key economic provisions havebeen agreed to in principle. We believe this will result in our Helioinvestment having future value as Helio continues to grow.
While we all know there's been some disappointing stories inthis space, Virgin Mobile hopefully has proven that value can be created withthe right business model. While we'll have the option to participate in futurefunding rounds that might be required, we have stopped our participation in thecurrent funding rounds. We believe our preliminary agreement with SKT will putvalue in the $210 million that had previously been invested by EarthLink.
Finally during the quarter, we repurchased 3.9 millionshares at an average price of $6.37 a share. As you know, we also announcedthat EarthLink expanded its share repurchase agreement to give us thealternative to retire shares if we believe that's the best use of our excess cash.
I'm pleased to say that with the continuing vote ofconfidence from our customers and our employees, coupled with our restructuringefforts, we expect to report $30 million to $40 million of positive net incomebefore facility exit and restructuring charges in the coming quarter, and weexpect to report substantial positive net income in 2008.
I'll now spend a few minutes on each of our lines ofbusiness and discuss how we're thinking about them today and where we seeopportunities for future value creation.
Let's start with the access business. As we have previouslysaid, high customer acquisition costs combined with high early life churn madeit difficult to get a positive lifetime return on our investments in sales andmarketing. That reality drove a substantial part of our restructuring. Whilewe'll continue to add customers that come to us through our portal and throughpartners and through the direct marketing campaigns that we've used in thepast, the other marketing efforts will be substantially reduced.
We do, however, believe that there's an opportunity toacquire more tenured customer bases from existing ISPs. Acquiring customerbases that have been through the early life churn period and can beconsolidated onto our fixed cost infrastructure can create solid shareholderreturns on the investments made. There are lots of ISP bases out there, bothbig and small. We believe our strategy for maintaining and growing this part ofthe business should be built around acquisition. In many ways, EarthLink wasbuilt this way. We believe that the acquisition and integration of ISP customerbases is a core competency of our company.
EarthLink is a brand that is known for Internet access andgreat customer experience. Our recent JD Power Award is a testament to thatfact. We believe our access business can generate meaningful cash for years tocome if we refocus our customer acquisition activities. We also think therewill be a continuing push for consolidation in the industry and EarthLink iswell-positioned to play a substantial role in that push.
Let's now move on to our wi-fi business. As you know, wehave been working hard to find a business model that can create a return on ourinvestment in this business. Whether it's the municipalities, chipset makers,equipment manufacturers, or any company that needs robust, cost effectivebroadband connectivity to their customers, we believe there's a real desire tosee these networks exist.
The idea of offering affordable, untethered high speedbroadband connectivity to the mass market is certainly compelling. However, theeconomics around that idea have not proven to be nearly as compelling to-date.It's not clear that we're going to ultimately find a business model that willwork. We're currently having and will continue to have discussions with currentand potential business partners regarding various business models andalternatives that can work for all partners involved.
However, at this time, there's nothing definitive to reportabout those discussions. In the interim, we've limited our cash consumption onthe wi-fi program by eliminating the prior expense structure that wasassociated with expanding our footprints and products. We'll continue to pursuea path that will make our existing markets more financially attractive.
Now, let's move on to our CLEC businesses. We've beenputting substantial focus on our New Edge business and I'm confident that we'removing in the right direction to improve its results. We are currently workingto rationalize product platforms and pricing and optimize co-lo infrastructureand network design. We believe this will result in a sustainable improvementover prior operating performance.
New Edge has the potential to be a very strategic CLECasset. Its reach into 10,000 co-locations around the country, as well as itsnationwide NPLS network position it to effectively compete at a national levelin multi-location business opportunities. New Edge continues to also garner itsshare of awards and accolades. For example, in the third quarter, New Edge wasincluded in Gartner's 2007 Magic Quadrant for remote access mobility services,which recognized the value of New Edge's solutions for businesses withdistributed workforces. New Edge was also presented with the Frost and Sullivanaward for its work in forming and developing the Retail Broadband Alliance.
In addition to New Edge, we also have a business solutionssegment that provides DSL and T1 circuits to small business customers. Togetherwith New Edge, these two businesses have an annualized revenue run rate of over$160 million.
Beyond our business oriented CLEC assets, we own as you'llrecall, approximately $45 million in Covad debt that's secured by network-basedassets, as well as approximately 6 million shares of their equity. The Covadinvestment supports the 39,000 customers that we currently have on ourline-powered voice platform that I'll talk about a little bit more in a minute.
My point in all of this is that EarthLink has a substantialportfolio of CLEC businesses and investments. We'll continue to grow andoptimize the performance of our CLEC investments as we look to be opportunisticabout unlocking underlying value in these assets.
Let me just spend a few minutes making a couple commentsabout our line-powered voice business. We continue to believe this business hasa place in our product portfolio. While we know it's a business that we cangrow, we continue to work our way through improving customer acquisition costissues, as well as customer provisioning and support issues.
We are making progress. Our provisioning flowthrough andcustomer churn now are showing real improvement, but I believe we need anotherone to two quarters before we should begin to increase our investment incustomer acquisition activities. So again, we have elected to reduce the cashinvestment until we've charted a clear path that will allow us to scale thisbusiness in a way that creates long-term value for our shareholders. In theinterim, line-powered voice can serve as an important tool for many of ourdial-up customers.
I'd like to now turn the call over to Kevin to walk youthrough our third quarter results. I have also asked Kevin to share with you abit more detail about the make-up of our customer base and their historicalchurn characteristics. I hope this will help you understand how we think aboutthe subscriber churn we have seen and expect to see and what that means to ourbusiness.
Kevin Dotts
Thanks, Rolla. I'llfirst discuss the customer trends and subscriber results leading to thefinancials and conclude with some comments on guidance. As Rolla previouslyindicated, due to changes in new customer behavior toward high churn rates inthe initial periods of service, EarthLink will significantly reduce spending relatedto the acquisition of new subscribers. This change negatively impactssubscribers' end revenue in the near term as these higher churn negative netpresent value customers churn off and we do not replace them with otherunprofitable customers.
However, once these customers churn off of our network weexpect to show a much more stable base of tenured customers with monthly churnlevels below 2% for broadband and near 3% for narrow band.
As a result of these changes related to the acquisition ofnew subscribers, the EarthLink narrow band subscriber base declined by 187,000subscribers in the quarter, while the broadband subscriber base was flat duringthe quarter. EarthLink ended the quarter with 1.2 million broadband, 2.9million narrow band and 103,000 web hosting subscribers.
For the narrow band base, it is split between 1.4 millionpremium and 1.5 million value subscribers. While the total subscribers areevenly split between premium and value dial, the fourth quarter predictedannualized revenue rate of the premium dial-up base will be just under $270million, versus $150 million for the value base. More importantly, 62% of ourpremium dial-up base has tenure of four years or more, and has a churn rate ofless than 3%. I would also add that the churn rate for the category ofcustomers has actually come down over the last year.
By comparison, the value dial-up base, as mentioned, willhave $150 million fourth quarter predicted annualized run rate, with only 4% ofthat base having a tenure of more than four years. Just over 50% of the valuedial-up base has been with us less than 12 months and has averaged about a 9.5%churn rate.
Further, our broadband customers have an annual run rate ofapproximately $340 million, with high tenure and churn rates in the low tomid-2% range. We expect high numbers of subscribers will churn off over thenext two to three quarters but we expect the biggest part of this churn to bevalue dial. Once EarthLink moves through this period of churning off morerecently acquired value dial subscribers, we expect our narrow band subscriberlosses will begin to subside mid-2008 as we transition to a more stable, moretenured and more profitable subscriber base.
So to be clear, not all subscribers have equal value to usand that's why we will focus on contribution margin rather than subscribercounts. We have substantial tenure with much lower churn rates in our largestrevenue-producing, most profitable subscribers
Driven by the declines in narrow band subscribers, overall revenuefor the quarter was $299 million, a 9.8% decrease from third quarter last year.As the company continues to transition through this group of higher churn,negative value subscribers, we expect to experience continued revenue declinesinto 2008.
However, we expect the cost savings associated with thedecreased acquisition activity to more than offset these revenue declines,resulting in improved operating margins and a significant increase in free cashflow generation. As EarthLink has begun to reduce sales and marketingactivities and initiated cost reductions in the associated core access supportfunctions, we have seen an increase in adjusted EBITDA.
In the third quarter, our core access services generated $61million of adjusted EBITDA compared to $60 million in the same quarter of 2006.Importantly, the majority of these cost reductions have yet to with fullyrealized. As EarthLink completes its announced restructuring, we expect to saveapproximately $25 million to $30 million per quarter in 2008, compared to thefirst and second quarters of 2007.
This restructuring has also significantly impacted thespending attributable to the growth initiatives, both in the form of reducedsales and marketing activity cost, and decreases in the back office coststructures. However, as these changes were initiated late in the third quarter,the benefits have not yet been fully realized in the third quarter. For thethird quarter, our adjusted EBITDA increased to $38 million, a $3 millionimprovement from third quarter of 2006.
As Rolla previously stated, Helio is continuing to roll outand ramp up its innovative wireless services. For the third quarter, Heliogenerated $52 million of revenues, compared to $13 million in the third quarterof 2006 and generated a net loss of $92 million, compared to $62 million in thethird quarter of 2006, as Helio had recently launched service in 2006.
Importantly, under GAAP equity method accounting, EarthLinkhas been recognizing its proportionate share of the Helio net loss on thecompany's income statement and decreasing the carrying value of the Helioinvestment on its balance sheet by an equal amount. The carrying value of theHelio investment was the value of the total EarthLink contribution, less theaccumulated Helio losses recognized. At the end of the third quarter of 2007,that investment value recorded on the company's balance sheet was reduced tozero dollars as total accumulated proportionate losses recognized now equal thetotal gross value of our investment contribution.
As a result, under GAAP equity method accounting,prospectively beginning in the fourth quarter, EarthLink will no longerrecognize its proportionate share of Helio loss on the company's incomestatement as EarthLink's investment contribution has been reduced to zerodollars on its balance sheet in the third quarter of 2007.
Our proportionate share of Helio's loss has increased to $42million, compared to $26 million in the third quarter of 2006, partially offsetby the increase in adjusted EBITDA, EarthLink generated a net loss of $79million for the third quarter of 2007, compared to net loss of $3 million inthe third quarter of 2006. However, excluding facility exit and restructuringcharges, EarthLink generated a net loss of $25 million for the third quarter of2007.
We used $19 million for capital expenditures and cashpayments for subscriber bases in the quarter, compared to $11 million in thethird quarter of 2006. As a result, we generated $19 million of free cash flowduring the third quarter of 2007, down from the $24 million generated in thethird quarter of last year.
During the third quarter, EarthLink's board approved anadditional $200 million for share repurchases. For the quarter, the companyrepurchased 3.9 million shares of its outstanding common stock for $25 millionand has $270 million remaining under the authorized share repurchase program.Since the initiation of our share repurchase program, the company has purchased66 million shares for $533 million at an average price of $8.10. We ended thequarter with approximately 120 million shares outstanding.
We ended the third quarter of 2007 with $33 million of cashand marketable securities, an increase of $176 million compared to the thirdquarter of 2006.
We will now provide our outlook for 2007. These statementsare forward-looking and actual results may differ materially. The companyundertakes no obligation to update these statements. EarthLink is reiteratingpreviously issued 2007 guidance. Management continues to expect to be $1.190billion to $1.210 billion revenues and adjusted EBITDA of $135 million to $145million.
However, as EarthLink will not record a net loss for ourequity interest in Helio in the fourth quarter, the company now expect asignificant increase in net income, before facility exit and restructuringcharges. For the full year, we expect a net loss before facility exit andrestructuring charges of $30 million to $40 million.
For 2008, EarthLink is reiterating that we continue toexpect to generate $200 million to $240 million in cash from operations. Alsofor 2008, as I previously indicated, EarthLink will not be required to recordany Helio losses. As such, the company expects a significant portion of itscash flow from operations will flow through to net income and EarthLink expectto generate positive net income for 2008.
However, the company does not expect to be a significantcash tax payer due to the significant net operating loss tax benefit EarthLinkpresently maintains. Management expects to further refine these preliminaryfinancial estimates when the company provides its customary yearly guidancewith the release of the full year 2007 results.
Beginning with 2008, EarthLink will modify its guidancepractices to better reflect current business realities and more closely aligninvestor focus with the metrics management measures the success of the businessby. Accordingly, we will provide yearly guidance on adjusted EBITDA and incomefrom operations. On a quarterly basis, management will either reiteratepreviously issued yearly guidance or modify as needed. On a quarterly basis,management will continue to report actual subscribers in the same level ofdetail as present.
I would now like to turn the call back to Rolla for someconcluding remarks.
Rolla Huff
Thanks, Kevin. Well this quarter I think we were able toresolve some uncertainty with respect to the future direction of EarthLink. Weinitiated a significant reduction in future sales and marketing spendingreflecting the realities of the value dial industry. In conjunction with thateffort, the company also moved to reduce its overhead cost burden on both itsmature access services, as well as some of the emerging growth initiatives.
Additionally, EarthLink is restructuring its Helio jointventure agreement with SK Telecom, thus eliminating the need for EarthLink tocontribute additional money to that effort while maintaining a significantownership position in that growing venture.
I believe our company has made tremendous progress in arelatively short amount of time but clearly, there's still a lot to be done. EarthLinkcontinues to review and evaluate various alternatives for longer term growth inshareholder value. While our business today is clearly not a growth business,we believe it's a business with meaningful long-term value and severallong-term alternatives.
As we continue to address many of the uncertainties thathave made it difficult to assess the underlying value of this business, we'rehopeful that the EarthLink picture becomes more clear for our shareholders andpotential investors. Further, we hope that we can earn your confidence that welook at this business, we run this business and we make decisions around thisbusiness like the long-term shareholders we are.
I can assure you, we'll continue to move and execute toresolve the remaining uncertainties with the same degree of urgency that wehave demonstrated in the third quarter.
With that, operator, I would like to open up the lines tosee what questions might be out there.
Question-and-AnswerSession
Operator
Your first question comes from the line of Jen Watson –Goldman Sachs.
Jen Watson - Goldman Sachs
Two questions regarding Helio and wi-fi. In terms of thetimeline on Helio, what do you think is the timeline in terms of the futureplans for the stake in Helio? Do you have the option to sell it?
On wi-fi, in terms of the wi-fi business, would you bewilling to sell the assets and infrastructure you've built in the near term andwhat type of value would you ascribe to that business and who could bepotential buyers?
Rolla Huff
A pretty long question there. Let me see if I can try topick through them one at a time. I think as far as the timeline for ouragreement with SK Telecom I believe it's very close, although I never try toget too far into trying to be a corporate attorney. They are just going backand forth on language. I feel very comfortable that the key terms of theagreements have been agreed to and clearly, SK Telecom has announced theirintent to put this money in and we have clearly not put money in. So I thinkthe key aspects of this are out in the public record.
What is not out is the valuation at which SK Telecom wouldbe putting the money in and those types of details will be released when thedefinitive agreement is put in place. As I think we commented previously, wefeel very good about the ownership stake we'll continue to have in thatbusiness and the value of the new money that's being put in.
I think you asked the question about can we sell our Heliostake? Look, I think that the investment that we've made there absolutely hasvalue. We have no plans to go out and sell it. It's a growing business. It's abusiness that we support. We clearly understood that putting needed cash intothat business was not in the best interest of our shareholders from here onout. We're going to continue to be part of the governance structure and I thinkI've been saying all along, we believe there's value in this business.
I would just point out that there were folks from time totime that were suggesting that what we should have done is just let it hit thewall and I hope that what has happened over the last few weeks and during thethird quarter would suggest that we took a more thoughtful approach and that weare trying to create shareholder value.
In terms of the wi-fi business, I'm not going to get intospeculating about what we're going to do in the future regarding some sale orwho it would get sold to. We're working hard to get the cash burden down on wi-fiand to look for a business model that makes sense for everybody involved. I've tried to be as clear and honest as I canwith everybody involved that that's a tall order. So we've taken the cash burn downsignificantly. We're continuing to look at the markets that we're in andsorting out our alternatives and I would just leave it at that.
Operator
Your next question comes from Youssef Squali - Jefferies.
Youssef Squali - Jefferies
On Helio, another concern is about its long-termprofitability and I was just wondering with this additional $270 million cashinfusion or potential cash infusion from the Koreans, can you talk definitivelyor not about how close to profitability that will bring it to? Because at theend of the day, there is a potential for further dilution to you, if theyneeded to come in and spend more money, either themselves or through a thirdparty and you opted again not to invest.
In your prepared comments you talked about a little bit of achange in strategy on the dial-up ISP side which is letting some of these highchurners churn and go out and acquire buckets of subscribers from competitors.Could you elaborate on that a little bit?
Rolla Huff
Regarding Helio, we're not going to provide any more informationthan we have in terms of their P&L and future breakeven dates. Theinteresting thing there Youssef, again, I'll just bring this back again, iswhen I first got here, just the nature of your question is a good thing from mystandpoint, because clearly you're now worried about dilution as opposed towhether or not we're going to put it in another $70 million or $80 million.
The good news about your question I think is that it's onecentered around the fact that now maybe you see that there could be some valuein Helio and you hate to see us give up any of it. I think that's greatprogress.
Where I am on it is, I don't see us deploying new cash. Wehave the ability to if we felt like that was the right investment for ourshareholders. But at this point, I don't see it that way. I would just ratherleave it there. We've got a solid stake in a business that just had a quarterof a billion dollars put into it to help it continue to grow its business and getto a size that would be meaningful and I feel good about that point.
I feel a lot better about it than I would have if we wouldhave just, as we were encouraged to do, just let it hit the wall. Because I cantell you we wouldn't be talking about what our dilution would be in the future.
Second point around dial-up, it really is not a change instrategy at all for us to be thinking about acquiring dial-up bases. We do itall the time. Most of the time, they're small dial-up bases. I guess thebiggest change in strategy is not that we're interested in acquiring tenureddial-up bases. The biggest part of the change in strategy is our recognitionthat most of the dial-up industry now is value dial. The value dial industryhas a high and increasing early life churn profile. Getting a return on the acquisitioncosts of buying value dial customers and then having them churn off before weget a payback on the investment just didn't make any sense. We've seen thechurn profile in the value dial area accelerating.
So I think the big strategy change in my judgment is justrecognizing that and not continuing to burn cash that we don't believe ourshareholders would get a return on in the short term. But acquiring bases issomething that I think has been fundamental to EarthLink being what it istoday. It's been a series of acquisitions and integrations. So I'm highlyconfident that that's something this company knows how to do and I think to theextent that we have the ability to buy customers that have tenure profiles thatare past the early life churn situation seems like the right thing to do fromour perspective.
Youssef Squali - Jefferies
You seem to be putting more emphasis on the CLECbusiness, in part because it is one ofthe few areas where you can see growth. Is that an area where you see you guyspotentially looking to acquire other assets to consolidate that $160 millionrun rate you talked about?
Rolla Huff
What I would want you to know is that we think there's a lotmore value in the CLEC assets that we have than is currently being understood.We're looking at bringing some of this value out. That could have us acquiring.It may have us partnering. It could have us doing a lot of different things. Today,I think you would agree that we're not given a lot of credit for thesubstantial assets that we have in this business.
I think one of the things that we are focused on is first ofall, improving what we have operationally. You're right, it can be a growthbusiness at the right price. But clearly, we can do a lot more to demonstratethe value in the business.
Operator
Your next questioncomes from the line of Chris Rowen – SunTrust.
Chris Rowen –SunTrust
On the decision to change the guidance practices, Iunderstand that you have a long-term focus and you want to emphasize thelong-term focus and you don't want to set quarterly hurdles. But if you don'tset them, we're going to set them for you and they're less likely to be whereyou want them to be. So I suggest you reconsider that.
The question is on the churn. I understand why marketingwill slow the replacement of churned-out customers but I don't see why thechurn is accelerating.
Kevin Dotts
Let's start with the question and I might want to come backto the comment. From a churn perspective, what we're telling you is when we'relooking analytically at the base and we're looking at the tenure periods basedon our data of our customer base over time, really what we began to see in thefirst half of this year is that churn, specifically more pronounced in thedial-up value base, that churn rate beginning to drift outward and being higherthan what had had been seen previously.
I think there's a lot of macro economic issues probably outthere, where penetration is amongst broadband subscriber groups, and premium,or value dial up bases. With the fact that churn rates were beginning toaccelerate at this point within the base as we acquire it, based on tenuredaccounts, you really had to sit there and say if I buy the subscriber today andif I'm not getting a positive net present value on that customer becausethey're moving out so quickly, then it does not build shareholder value tocontinue to invest dollars in those types of subscribers.
So really that is what we're suggesting from thatperspective.
Rolla Huff
Let me just throw apoint out there, supporting the point that Kevin is making. If you look at ourpremium dial-up base, which is our historical base, I think something over 80%of our customers have been with us for more than two years. If you look at thevalue dial-up base, the flip side is true. Probably something in theneighborhood of 80% of the customers have been with us for less than two years.We're seeing the value dial-up base churn rates that are high continuing toaccelerate and so that really drove a lot of our decisions and it's because wehave a high percentage of the value dial-up base that are relatively newarrivals, less than two years. As those are accelerating from a churnperspective, we feel it and we clearly can't see spending money to buy thosekinds of customers.
Kevin Dotts
I am just going to go back on the earlier comment withregard to guidance. I certainly respect your point of view on that. Theinvestors and analysts out there can see what's going on from a run rateperspective and we'll continue to report all the actual information as we seeit, as we have always disclosed all o four information.
I think the point though of what we're saying with regard tofocusing investors and analysts on EBITDA, is that is the way management isthinking about the business. Right now as we go through this transition into anarea where we are buying less narrow band value subscribers at this point, youbegin to get into a very difficult area of prognosticating what those churnrates will look like at least as we're in this transitioning period wementioned in the script over the next three to six months, or the next coupleof quarters.
So rather than miss expectations we think the prudent thingto do at this point is just focus on operating margin, operating profitability,focus on EBITDA, focus on cash generation.
Chris Rowen –SunTrust
I definitely agree with that. I think that's the rightfocus. I understood it to be a change from quarterly guidance to annualguidance and I've just seen that not work before.
Kevin Dotts
Again, I also respect your opinion. I think the thing that Iwould hope that we could do is we've said that each quarter, if we see ourannual outlook that we have put forward changing, we're going to tell you atthe quarter that we believe that whatever guidance we put out for the year isdifferent. I would hope that as we get through the quarters, we're going to beable to provide you a perspective on what happened in the quarter that willsupport our full year guidance and obviously, if we can't support the full yearguidance, we're going to tell you that and change the guidance.
So it won't be a guessing game until the end of the year. Idon't think that's the nature of our business anyway.
Operator
Your next questioncomes from the line of Vijay Singh – Janco Partners.
Vijay Singh - Janco Partners
I have a couple of questions, Kevin. If you can tell me whatis the size of the NOL currently and how is it divided between federal andstate and approximately when are they expiring?
Helio churns, you had directionally pointed to about highsingle digits in the past. I just wanted to get a sense for whether it haschanged from that number and which direction it has moved. Thank you.
Kevin Dotts
The NOL you're trying to pin me down to some specifics here,Vijay. The way I think about the NOL now is we're roughly in total federal $220million to $240 million. There are no 382 limitations on those or limited 382limitations. So when we're looking at the net income that we believe we'regoing to produce over the next couple of years, given the scenario we justtalked about, we feel very confident that the $220 million to $240 million of NOLis going to be readily monetized by not paying federal taxes. The state taxes are substantively smaller thanthat. I don't have the numbers in front of me. That will also be out there. I'dbe guessing on what the state numbers are.
With regard to the Helio numbers, Rolla may want to makeadditional commentary on this, but the Helio churn rates continue to come down.They're coming down in the right direction, as they continue to put a lot ofeffort and activity in understanding the credit worthiness of their customerbase and the collectibility activity going on. They continue to build that setof data information, make decisions on their offerings and then have made somegood progress on working through that.
Rolla Huff
I would only add that we elected to stop participating inthe funding rounds, not because we thought that Helio was a bad business. Itwas just the opposite. We clearly thought that it had value in the business,but I think the most ringing endorsement of that point is the fact that SKTelecom just publicly announced that they're looking to invest over a quarter of a billion dollars inadditional capital. I would suggest that if they saw something that caused themto believe that there was no future in this business, I'm pretty confident thatthey wouldn't be making that announcement.
Kevin Dotts
Vijay, I just want to clarify. When we talked about thoseNOLs, because we've talked about it both ways, the pre-tax value and the aftertax value, the $220 million to $240 million that I mentioned was the after0taxeffect. That's the true cash value.
Vijay Singh - Janco Partners
The number is a lot higher, the NOL number.
Kevin Dotts
What you see on our balance sheet is the total deferred taxassets, which get into a whole lot of other timing activity.. When I thinkabout the pure NOLs that will be realized, the $220m to $240 million, that willbe the cash saved by not paying federal tax.
Donna Jaegers - JancoPartners
On the flexibility of your cost structure on the dial-upbusiness, you guys are still buying managed modem services from otherproviders, I'm assuming. How often can you renegotiate those contracts?
Kevin Dotts
I think basicallymost of those managed modem contracts on the dial-up business are predominantlywith our largest vendor there, Level 3. Negotiations occur relativelyfrequently as we look for opportunities. I would not look to those contracts,Donna, and look for large productivity in negotiations on a go-forward basis.
Rolla Huff
Donna, a material part of our cost structure associated withdial-up is customer support. As you know, that's outsourced and is ultimatelyvariable for us.
Donna Jaegers - JancoPartners
On New Edge, I know you said $160 million run rate. Can yougive us some idea of what's the typical customer size you are dealing with?
Rolla Huff
It's actuallyevolving. I think New Edge, if you're looking at some of the press releases,increasingly, they are winning these large multi-location deals. So eachindividual installation, if they're doing 100 location deal, it may only be aT1 or even a DSL and some voice lines that are going into the customer, but itis 100, 200 locations. So big customer size overall, but specific points,relatively small.
Operator
Your next questioncomes from the line of Srinivasan Anantha - CIBC World Markets.
SrinivasanAnantha - CIBC World Markets
On the CLEC business, I just wanted to understand, howstrategic is this portion of the business in the big picture for EarthLinkbecause historically when you look at EarthLink it's always perceived to be asa consumer-focused company. Even if you look at the revenues you aregenerating, more than 85%, in other words, are you just better off by justselling that business and just focus on the consumer segment and be good at it?
The second question is on the line-powered voice service,could you just give us an update there, have those provisioning issues beenresolved? Are you at a state where now you can begin to aggressively marketthose services in the markets as it is being currently offered?
The last one is, have you talked to any of the additionalservice providers with respect to reselling the broadband service? I know youhave agreements with a couple providers but have you made any effort with theother service providers, especially with broadband access in the industry.
Rolla Huff
The first question is how strategic the CLEC business is forEarthLink. I'm not ready to say that it is going to be highly strategic or it'snot going to be strategic. Again, I think there's this bent that it's eithersell it for cash -- I think that's the view of many of the short term traders inour stock that just are looking for trades. I believe there is a lot of valuein the assets that we have. That's probably the biggest point that I wouldmake.
Given the fact that we don't participate in an industryright now that has huge growth potential, I think it's something that we haveto at least look at as a possibility in terms of growing our assets there. Ithink that's something that we have to do.
What I know for sure is that what we have right now is wortha lot more money than we're being given credit for. I do know that. I'm prettyconfident about that. So to the extent that we can bring out that value indifferent ways and be opportunistic about it, I think that's something that wecan't ignore. I think it's something that we've got to do.
Regarding line powered voice, I think the provisioningissues are absolutely getting better. I think we're getting more focused. We'vetaken out the new number types of issues that we had that were really slowingus down. We're only doing L and P type provisioning and that has really helpedour provisioning flowthrough dramatically.
We're still working through a few issues in the customersupport and customer operations issue area and we're making good progressthere. So we see the metrics of the business improving. For me, as I mentionedin my comments, there is no question, customers find the voice data bundle veryattractive.
I just felt like we shouldn't be throwing a lot of moneybehind marketing it if we couldn't satisfy our customers and the way we weredoing it was generating more cost than it should. So we've stepped back overthe last 60 or 90 days, in terms of putting a lot of marketing effort into it. We'rereally focusing on getting the operational aspects of LPV right and then if weget satisfied that we can scale this thing, this could absolutely be a growthplatform for our business. I just don't want to throw a lot of marketing moneyat it and not have satisfied customers and see churn rates that make this a badbusiness.
I think the last question you had was in general about howwe were looking at continuing to expand our portfolio of broadbandrelationships to sell there. We've got some very strong relationships now andwe've got a strong base of broadband subscribers as we speak. I think we'realways looking to expand those relationships and not only with the existingproviders, but there are new and emerging broadband providers that we talk toon a regular basis. So I think we will always be interested in expanding thechannels and the types of technologies to be able to move our customers whenthey want to from dial-up speeds to broadband speeds and that's something that makesus a little bit unique in the industrythat we do that on a fairly regular basis and you see it in our results.
Operator
Your final question comes from the line of Scott Kessler –Standard & Poor’s.
Scott Kessler - Standard & Poor’s
I have two related questions. It sounded like you suggested thatmost, if not all, of the restructuring efforts would be completed at the end ofthe year, I was just wondering if that in fact was the case?
A related question is, it sounds like you went through apretty thorough review of all of EarthLink's businesses and investments and I'mwondering if further actions in terms of potential divestitures are possibleinto next year?
I mean, just give us a sense of the timetable there.
Rolla Huff
I don’t want to say that we will be done with therestructuring in the fourth quarter. I think the headcount reductions will bedone. But there is a lot to be done. When you take out 50% of your headcountand you really fundamentally re-look at the products that you're out therewith, I mean, I wasn't able to do this in the first 60 days. We're going throughevery product, literally product by product, understanding how we can optimizecost, how we can optimize revenue growth, if that's available to us. So thatwork will continue well into next year. That's just not something that you cando in 60 days.
But I think one of the things that will be incumbent on thisbusiness is that we have to continually keep our cost structure aligned withthe trend in revenue and how we think about this business, in my judgment, hasto be driven around contribution margin.
What we can't do is get complacent about our cost structure.That doesn't mean we have to be out laying off people. There is attrition inthis business like any other business. What we've got to make sure that we do,I think, is be very diligent about not letting cost structure justautomatically replicate itself and then suddenly discovering some day that we'vegot to make another extraordinary cut.
We're going to try to do that as best we can. I could neverguarantee that if the revenue reducesfaster than we're able to attrit our cost structure, we would do an adjustmentif we had to do that. But that's not contemplated now.
As far as divestitures next year, I think that what we havetried to do is we're trying to create alternatives for this business that couldhave us acquiring things that make sense. So we're not going to go out and getinto the can opener business, but to the extent that we can grow our business in a way thatwe're confident shareholders would see value in the short term, we've got toconsider that. To the extent that the opportunity exists to divest of abusiness at a valuation that makes sense for our shareholders and we don'tthink that we can do better, we will absolutely do that.
I think that our focus has just really been on getting thisbusiness back to the point where we can control our own destiny and we do havealternatives and as I said in my closingcomments, we think about this business as shareholders. It's how I came intothe business. It's how we run the business. Whether it's share repurchase,acquisitions, divestitures, changes in cost structure, I think we've got to runthe business like shareholders. That's our intention. Long-term shareholders.
In any company like ours, we get lots of short-term traders inthe stock and so they encourage us, we get messages all the time, beingencouraged to do a lot of very short-term things that we listen very carefullyto their thoughts, but we try to do what we think creates long-term value forour shareholders.
Well, I would like to thank everybody for joining us on thecall and we'll continue to keep you abreast of developments in the company. Welook forward to talking to you during the fourth quarter call. Take care,everybody.
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