EarthLink Q3 2007 Earnings Call Transcript

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

Presentation

Operator

I would like to welcome everyone to the EarthLink third quarter earnings conference call. (Operator Instructions) I will now turn the call over to Mr. Kevin Dotts, Chief Financial Officer. Sir, you may begin your conference.

Kevin Dotts

Welcome everyone to our call. This morning, I am joined by Earthlink's CEO, Rolla Huff, and our Vice President of Investor Relations, Mike Valentine, to discuss our third quarter results. Following our comments there will be an opportunity for questions.

Before we continue, I would 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. Those 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 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 may recall, I first spoke with you just 90 days ago during the second quarter earnings call. On that call, I told you that we had initiated a bottom-up review that we had hoped to complete by the end of the third quarter. I wanted you to know at that time that we had a real sense of urgency about the business.

I shared with you some of the initial observations and thoughts about EarthLink, and if you recall, those observations included the following points. First, I felt there was a lot of opportunity to create value in the EarthLink business. Second, I thought there was real opportunity to generate substantial cash flow in the core business. Third, I felt that the underlying business model for EarthLink's wi-fi business was weak, and needed to be reviewed. Fourth, I believed that the line-powered voice product, while attractive to our customers, needed better operational underpinnings before we invested substantial amounts of time and money in marketing it. Finally, I thought there was real value in Helio, but I recognized that EarthLink was not positioned to be in the venture capital world in a material way.

Well, since our second quarter call, we have taken the following actions. We've undertaken a substantial restructuring of our business. Our intention was to eliminate the spending on acquiring new customers that had negative lifetime value. As part of that restructuring, we made the decision to reorganize more around functional lines.

As a result of those decisions, we announced our intention to reduce headcount by 50%. Further, we decided to reduce our new investment in wi-fi and line-powered voice as we evaluated new business models and business processes that would create positive shareholder value.

Let me just give you a brief update on our progress surrounding our restructuring activities. In our announcement, we indicated that we expected approximately 900 employees would be affected as part of this restructuring. Approximately 60% of the affected employees exited the business last month, with a plan that's now in place to exit the balance of those affected before year end.

We have a substantial effort underway to reorganize our facilities to get a normal work environment back in place, as well as to give us the opportunity to sublet excess space. While restructuring activities of this magnitude generally require two to three quarters to get back to a more normalized operations environment, we're very pleased with the progress to-date.

During the quarter, we also announced that SK Telecom had preliminarily agreed to invest up to $270 million in Helio, and that SK Telecom and EarthLink were in the process of amending the existing agreements between the two of us. While the definitive amended joint venture agreements are still being finalized by our respective lawyers, the key economic provisions have been agreed to in principle. We believe this will result in our Helio investment having future value as Helio continues to grow.

While we all know there's been some disappointing stories in this space, Virgin Mobile hopefully has proven that value can be created with the right business model. While we'll have the option to participate in future funding rounds that might be required, we have stopped our participation in the current funding rounds. We believe our preliminary agreement with SKT will put value in the $210 million that had previously been invested by EarthLink.

Finally during the quarter, we repurchased 3.9 million shares at an average price of $6.37 a share. As you know, we also announced that EarthLink expanded its share repurchase agreement to give us the alternative 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 of confidence from our customers and our employees, coupled with our restructuring efforts, we expect to report $30 million to $40 million of positive net income before facility exit and restructuring charges in the coming quarter, and we expect to report substantial positive net income in 2008.

I'll now spend a few minutes on each of our lines of business and discuss how we're thinking about them today and where we see opportunities for future value creation.

Let's start with the access business. As we have previously said, high customer acquisition costs combined with high early life churn made it difficult to get a positive lifetime return on our investments in sales and marketing. That reality drove a substantial part of our restructuring. While we'll continue to add customers that come to us through our portal and through partners and through the direct marketing campaigns that we've used in the past, the other marketing efforts will be substantially reduced.

We do, however, believe that there's an opportunity to acquire more tenured customer bases from existing ISPs. Acquiring customer bases that have been through the early life churn period and can be consolidated onto our fixed cost infrastructure can create solid shareholder returns on the investments made. There are lots of ISP bases out there, both big and small. We believe our strategy for maintaining and growing this part of the business should be built around acquisition. In many ways, EarthLink was built this way. We believe that the acquisition and integration of ISP customer bases is a core competency of our company.

EarthLink is a brand that is known for Internet access and great customer experience. Our recent JD Power Award is a testament to that fact. We believe our access business can generate meaningful cash for years to come if we refocus our customer acquisition activities. We also think there will be a continuing push for consolidation in the industry and EarthLink is well-positioned to play a substantial role in that push.

Let's now move on to our wi-fi business. As you know, we have been working hard to find a business model that can create a return on our investment in this business. Whether it's the municipalities, chipset makers, equipment manufacturers, or any company that needs robust, cost effective broadband connectivity to their customers, we believe there's a real desire to see these networks exist.

The idea of offering affordable, untethered high speed broadband connectivity to the mass market is certainly compelling. However, the economics 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 will work. We're currently having and will continue to have discussions with current and potential business partners regarding various business models and alternatives that can work for all partners involved.

However, at this time, there's nothing definitive to report about those discussions. In the interim, we've limited our cash consumption on the wi-fi program by eliminating the prior expense structure that was associated with expanding our footprints and products. We'll continue to pursue a path that will make our existing markets more financially attractive.

Now, let's move on to our CLEC businesses. We've been putting substantial focus on our New Edge business and I'm confident that we're moving in the right direction to improve its results. We are currently working to rationalize product platforms and pricing and optimize co-lo infrastructure and network design. We believe this will result in a sustainable improvement over prior operating performance.

New Edge has the potential to be a very strategic CLEC asset. Its reach into 10,000 co-locations around the country, as well as its nationwide NPLS network position it to effectively compete at a national level in multi-location business opportunities. New Edge continues to also garner its share of awards and accolades. For example, in the third quarter, New Edge was included in Gartner's 2007 Magic Quadrant for remote access mobility services, which recognized the value of New Edge's solutions for businesses with distributed workforces. New Edge was also presented with the Frost and Sullivan award for its work in forming and developing the Retail Broadband Alliance.

In addition to New Edge, we also have a business solutions segment that provides DSL and T1 circuits to small business customers. Together with 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'll recall, approximately $45 million in Covad debt that's secured by network-based assets, as well as approximately 6 million shares of their equity. The Covad investment supports the 39,000 customers that we currently have on our line-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 substantial portfolio of CLEC businesses and investments. We'll continue to grow and optimize the performance of our CLEC investments as we look to be opportunistic about unlocking underlying value in these assets.

Let me just spend a few minutes making a couple comments about our line-powered voice business. We continue to believe this business has a place in our product portfolio. While we know it's a business that we can grow, we continue to work our way through improving customer acquisition cost issues, as well as customer provisioning and support issues.

We are making progress. Our provisioning flowthrough and customer churn now are showing real improvement, but I believe we need another one to two quarters before we should begin to increase our investment in customer acquisition activities. So again, we have elected to reduce the cash investment until we've charted a clear path that will allow us to scale this business in a way that creates long-term value for our shareholders. In the interim, line-powered voice can serve as an important tool for many of our dial-up customers.

I'd like to now turn the call over to Kevin to walk you through our third quarter results. I have also asked Kevin to share with you a bit more detail about the make-up of our customer base and their historical churn characteristics. I hope this will help you understand how we think about the subscriber churn we have seen and expect to see and what that means to our business.

Kevin Dotts

Thanks, Rolla. I'll first discuss the customer trends and subscriber results leading to the financials and conclude with some comments on guidance. As Rolla previously indicated, due to changes in new customer behavior toward high churn rates in the initial periods of service, EarthLink will significantly reduce spending related to the acquisition of new subscribers. This change negatively impacts subscribers' end revenue in the near term as these higher churn negative net present value customers churn off and we do not replace them with other unprofitable customers.

However, once these customers churn off of our network we expect to show a much more stable base of tenured customers with monthly churn levels below 2% for broadband and near 3% for narrow band.

As a result of these changes related to the acquisition of new subscribers, the EarthLink narrow band subscriber base declined by 187,000 subscribers in the quarter, while the broadband subscriber base was flat during the quarter. EarthLink ended the quarter with 1.2 million broadband, 2.9 million narrow band and 103,000 web hosting subscribers.

For the narrow band base, it is split between 1.4 million premium and 1.5 million value subscribers. While the total subscribers are evenly split between premium and value dial, the fourth quarter predicted annualized revenue rate of the premium dial-up base will be just under $270 million, versus $150 million for the value base. More importantly, 62% of our premium dial-up base has tenure of four years or more, and has a churn rate of less than 3%. I would also add that the churn rate for the category of customers has actually come down over the last year.

By comparison, the value dial-up base, as mentioned, will have $150 million fourth quarter predicted annualized run rate, with only 4% of that base having a tenure of more than four years. Just over 50% of the value dial-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 of approximately $340 million, with high tenure and churn rates in the low to mid-2% range. We expect high numbers of subscribers will churn off over the next two to three quarters but we expect the biggest part of this churn to be value dial. Once EarthLink moves through this period of churning off more recently acquired value dial subscribers, we expect our narrow band subscriber losses will begin to subside mid-2008 as we transition to a more stable, more tenured and more profitable subscriber base.

So to be clear, not all subscribers have equal value to us and that's why we will focus on contribution margin rather than subscriber counts. We have substantial tenure with much lower churn rates in our largest revenue-producing, most profitable subscribers

Driven by the declines in narrow band subscribers, overall revenue for 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 declines into 2008.

However, we expect the cost savings associated with the decreased acquisition activity to more than offset these revenue declines, resulting in improved operating margins and a significant increase in free cash flow generation. As EarthLink has begun to reduce sales and marketing activities and initiated cost reductions in the associated core access support functions, we have seen an increase in adjusted EBITDA.

In the third quarter, our core access services generated $61 million of adjusted EBITDA compared to $60 million in the same quarter of 2006. Importantly, the majority of these cost reductions have yet to with fully realized. As EarthLink completes its announced restructuring, we expect to save approximately $25 million to $30 million per quarter in 2008, compared to the first and second quarters of 2007.

This restructuring has also significantly impacted the spending attributable to the growth initiatives, both in the form of reduced sales and marketing activity cost, and decreases in the back office cost structures. However, as these changes were initiated late in the third quarter, the benefits have not yet been fully realized in the third quarter. For the third quarter, our adjusted EBITDA increased to $38 million, a $3 million improvement from third quarter of 2006.

As Rolla previously stated, Helio is continuing to roll out and ramp up its innovative wireless services. For the third quarter, Helio generated $52 million of revenues, compared to $13 million in the third quarter of 2006 and generated a net loss of $92 million, compared to $62 million in the third quarter of 2006, as Helio had recently launched service in 2006.

Importantly, under GAAP equity method accounting, EarthLink has been recognizing its proportionate share of the Helio net loss on the company's income statement and decreasing the carrying value of the Helio investment on its balance sheet by an equal amount. The carrying value of the Helio investment was the value of the total EarthLink contribution, less the accumulated Helio losses recognized. At the end of the third quarter of 2007, that investment value recorded on the company's balance sheet was reduced to zero dollars as total accumulated proportionate losses recognized now equal the total gross value of our investment contribution.

As a result, under GAAP equity method accounting, prospectively beginning in the fourth quarter, EarthLink will no longer recognize its proportionate share of Helio loss on the company's income statement as EarthLink's investment contribution has been reduced to zero dollars on its balance sheet in the third quarter of 2007.

Our proportionate share of Helio's loss has increased to $42 million, compared to $26 million in the third quarter of 2006, partially offset by the increase in adjusted EBITDA, EarthLink generated a net loss of $79 million for the third quarter of 2007, compared to net loss of $3 million in the third quarter of 2006. However, excluding facility exit and restructuring charges, EarthLink generated a net loss of $25 million for the third quarter of 2007.

We used $19 million for capital expenditures and cash payments for subscriber bases in the quarter, compared to $11 million in the third quarter of 2006. As a result, we generated $19 million of free cash flow during the third quarter of 2007, down from the $24 million generated in the third quarter of last year.

During the third quarter, EarthLink's board approved an additional $200 million for share repurchases. For the quarter, the company repurchased 3.9 million shares of its outstanding common stock for $25 million and has $270 million remaining under the authorized share repurchase program. Since the initiation of our share repurchase program, the company has purchased 66 million shares for $533 million at an average price of $8.10. We ended the quarter with approximately 120 million shares outstanding.

We ended the third quarter of 2007 with $33 million of cash and marketable securities, an increase of $176 million compared to the third quarter of 2006.

We will now provide our outlook for 2007. These statements are forward-looking and actual results may differ materially. The company undertakes no obligation to update these statements. EarthLink is reiterating previously issued 2007 guidance. Management continues to expect to be $1.190 billion to $1.210 billion revenues and adjusted EBITDA of $135 million to $145 million.

However, as EarthLink will not record a net loss for our equity interest in Helio in the fourth quarter, the company now expect a significant increase in net income, before facility exit and restructuring charges. For the full year, we expect a net loss before facility exit and restructuring charges of $30 million to $40 million.

For 2008, EarthLink is reiterating that we continue to expect to generate $200 million to $240 million in cash from operations. Also for 2008, as I previously indicated, EarthLink will not be required to record any Helio losses. As such, the company expects a significant portion of its cash flow from operations will flow through to net income and EarthLink expect to generate positive net income for 2008.

However, the company does not expect to be a significant cash tax payer due to the significant net operating loss tax benefit EarthLink presently maintains. Management expects to further refine these preliminary financial estimates when the company provides its customary yearly guidance with the release of the full year 2007 results.

Beginning with 2008, EarthLink will modify its guidance practices to better reflect current business realities and more closely align investor focus with the metrics management measures the success of the business by. Accordingly, we will provide yearly guidance on adjusted EBITDA and income from operations. On a quarterly basis, management will either reiterate previously issued yearly guidance or modify as needed. On a quarterly basis, management will continue to report actual subscribers in the same level of detail as present.

I would now like to turn the call back to Rolla for some concluding remarks.

Rolla Huff

Thanks, Kevin. Well this quarter I think we were able to resolve some uncertainty with respect to the future direction of EarthLink. We initiated a significant reduction in future sales and marketing spending reflecting the realities of the value dial industry. In conjunction with that effort, the company also moved to reduce its overhead cost burden on both its mature access services, as well as some of the emerging growth initiatives.

Additionally, EarthLink is restructuring its Helio joint venture agreement with SK Telecom, thus eliminating the need for EarthLink to contribute additional money to that effort while maintaining a significant ownership position in that growing venture.

I believe our company has made tremendous progress in a relatively short amount of time but clearly, there's still a lot to be done. EarthLink continues to review and evaluate various alternatives for longer term growth in shareholder value. While our business today is clearly not a growth business, we believe it's a business with meaningful long-term value and several long-term alternatives.

As we continue to address many of the uncertainties that have made it difficult to assess the underlying value of this business, we're hopeful that the EarthLink picture becomes more clear for our shareholders and potential investors. Further, we hope that we can earn your confidence that we look at this business, we run this business and we make decisions around this business like the long-term shareholders we are.

I can assure you, we'll continue to move and execute to resolve the remaining uncertainties with the same degree of urgency that we have demonstrated in the third quarter.

With that, operator, I would like to open up the lines to see what questions might be out there.

Question-and-Answer Session

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 the timeline on Helio, what do you think is the timeline in terms of the future plans 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 be willing to sell the assets and infrastructure you've built in the near term and what type of value would you ascribe to that business and who could be potential buyers?

Rolla Huff

A pretty long question there. Let me see if I can try to pick through them one at a time. I think as far as the timeline for our agreement with SK Telecom I believe it's very close, although I never try to get too far into trying to be a corporate attorney. They are just going back and forth on language. I feel very comfortable that the key terms of the agreements have been agreed to and clearly, SK Telecom has announced their intent to put this money in and we have clearly not put money in. So I think the key aspects of this are out in the public record.

What is not out is the valuation at which SK Telecom would be putting the money in and those types of details will be released when the definitive agreement is put in place. As I think we commented previously, we feel very good about the ownership stake we'll continue to have in that business and the value of the new money that's being put in.

I think you asked the question about can we sell our Helio stake? Look, I think that the investment that we've made there absolutely has value. We have no plans to go out and sell it. It's a growing business. It's a business that we support. We clearly understood that putting needed cash into that business was not in the best interest of our shareholders from here on out. We're going to continue to be part of the governance structure and I think I've been saying all along, we believe there's value in this business.

I would just point out that there were folks from time to time that were suggesting that what we should have done is just let it hit the wall and I hope that what has happened over the last few weeks and during the third quarter would suggest that we took a more thoughtful approach and that we are trying to create shareholder value.

In terms of the wi-fi business, I'm not going to get into speculating about what we're going to do in the future regarding some sale or who it would get sold to. We're working hard to get the cash burden down on wi-fi and to look for a business model that makes sense for everybody involved. I've tried to be as clear and honest as I can with everybody involved that that's a tall order. So we've taken the cash burn down significantly. We're continuing to look at the markets that we're in and sorting 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-term profitability and I was just wondering with this additional $270 million cash infusion or potential cash infusion from the Koreans, can you talk definitively or not about how close to profitability that will bring it to? Because at the end of the day, there is a potential for further dilution to you, if they needed to come in and spend more money, either themselves or through a third party and you opted again not to invest.

In your prepared comments you talked about a little bit of a change in strategy on the dial-up ISP side which is letting some of these high churners 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 information than we have in terms of their P&L and future breakeven dates. The interesting thing there Youssef, again, I'll just bring this back again, is when I first got here, just the nature of your question is a good thing from my standpoint, because clearly you're now worried about dilution as opposed to whether 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 one centered around the fact that now maybe you see that there could be some value in Helio and you hate to see us give up any of it. I think that's great progress.

Where I am on it is, I don't see us deploying new cash. We have the ability to if we felt like that was the right investment for our shareholders. But at this point, I don't see it that way. I would just rather leave it there. We've got a solid stake in a business that just had a quarter of a billion dollars put into it to help it continue to grow its business and get to 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 would have just, as we were encouraged to do, just let it hit the wall. Because I can tell 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 in strategy at all for us to be thinking about acquiring dial-up bases. We do it all the time. Most of the time, they're small dial-up bases. I guess the biggest change in strategy is not that we're interested in acquiring tenured dial-up bases. The biggest part of the change in strategy is our recognition that most of the dial-up industry now is value dial. The value dial industry has a high and increasing early life churn profile. Getting a return on the acquisition costs of buying value dial customers and then having them churn off before we get a payback on the investment just didn't make any sense. We've seen the churn profile in the value dial area accelerating.

So I think the big strategy change in my judgment is just recognizing that and not continuing to burn cash that we don't believe our shareholders would get a return on in the short term. But acquiring bases is something that I think has been fundamental to EarthLink being what it is today. It's been a series of acquisitions and integrations. So I'm highly confident that that's something this company knows how to do and I think to the extent that we have the ability to buy customers that have tenure profiles that are past the early life churn situation seems like the right thing to do from our perspective.

Youssef Squali - Jefferies

You seem to be putting more emphasis on the CLEC business, in part because it is one of the few areas where you can see growth. Is that an area where you see you guys potentially looking to acquire other assets to consolidate that $160 million run rate you talked about?

Rolla Huff

What I would want you to know is that we think there's a lot more 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 the substantial assets that we have in this business.

I think one of the things that we are focused on is first of all, improving what we have operationally. You're right, it can be a growth business at the right price. But clearly, we can do a lot more to demonstrate the value in the business.

Operator

Your next question comes from the line of Chris Rowen – SunTrust.

Chris Rowen – SunTrust

On the decision to change the guidance practices, I understand that you have a long-term focus and you want to emphasize the long-term focus and you don't want to set quarterly hurdles. But if you don't set them, we're going to set them for you and they're less likely to be where you want them to be. So I suggest you reconsider that.

The question is on the churn. I understand why marketing will slow the replacement of churned-out customers but I don't see why the churn is accelerating.

Kevin Dotts

Let's start with the question and I might want to come back to the comment. From a churn perspective, what we're telling you is when we're looking analytically at the base and we're looking at the tenure periods based on our data of our customer base over time, really what we began to see in the first half of this year is that churn, specifically more pronounced in the dial-up value base, that churn rate beginning to drift outward and being higher than what had had been seen previously.

I think there's a lot of macro economic issues probably out there, where penetration is amongst broadband subscriber groups, and premium, or value dial up bases. With the fact that churn rates were beginning to accelerate at this point within the base as we acquire it, based on tenured accounts, you really had to sit there and say if I buy the subscriber today and if I'm not getting a positive net present value on that customer because they're moving out so quickly, then it does not build shareholder value to continue to invest dollars in those types of subscribers.

So really that is what we're suggesting from that perspective.

Rolla Huff

Let me just throw a point out there, supporting the point that Kevin is making. If you look at our premium 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 the value dial-up base, the flip side is true. Probably something in the neighborhood 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 to accelerate and so that really drove a lot of our decisions and it's because we have a high percentage of the value dial-up base that are relatively new arrivals, less than two years. As those are accelerating from a churn perspective, we feel it and we clearly can't see spending money to buy those kinds of customers.

Kevin Dotts

I am just going to go back on the earlier comment with regard to guidance. I certainly respect your point of view on that. The investors and analysts out there can see what's going on from a run rate perspective and we'll continue to report all the actual information as we see it, as we have always disclosed all o four information.

I think the point though of what we're saying with regard to focusing investors and analysts on EBITDA, is that is the way management is thinking about the business. Right now as we go through this transition into an area where we are buying less narrow band value subscribers at this point, you begin to get into a very difficult area of prognosticating what those churn rates will look like at least as we're in this transitioning period we mentioned in the script over the next three to six months, or the next couple of quarters.

So rather than miss expectations we think the prudent thing to 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 right focus. I understood it to be a change from quarterly guidance to annual guidance and I've just seen that not work before.

Kevin Dotts

Again, I also respect your opinion. I think the thing that I would hope that we could do is we've said that each quarter, if we see our annual outlook that we have put forward changing, we're going to tell you at the quarter that we believe that whatever guidance we put out for the year is different. I would hope that as we get through the quarters, we're going to be able to provide you a perspective on what happened in the quarter that will support our full year guidance and obviously, if we can't support the full year guidance, 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. I don't think that's the nature of our business anyway.

Operator

Your next question comes from the line of Vijay Singh – Janco Partners.

Vijay Singh - Janco Partners

I have a couple of questions, Kevin. If you can tell me what is the size of the NOL currently and how is it divided between federal and state and approximately when are they expiring?

Helio churns, you had directionally pointed to about high single digits in the past. I just wanted to get a sense for whether it has changed 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 $220 million to $240 million. There are no 382 limitations on those or limited 382 limitations. So when we're looking at the net income that we believe we're going to produce over the next couple of years, given the scenario we just talked about, we feel very confident that the $220 million to $240 million of NOL is going to be readily monetized by not paying federal taxes. The state taxes are substantively smaller than that. I don't have the numbers in front of me. That will also be out there. I'd be guessing on what the state numbers are.

With regard to the Helio numbers, Rolla may want to make additional 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 of effort and activity in understanding the credit worthiness of their customer base and the collectibility activity going on. They continue to build that set of data information, make decisions on their offerings and then have made some good progress on working through that.

Rolla Huff

I would only add that we elected to stop participating in the funding rounds, not because we thought that Helio was a bad business. It was 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 SK Telecom just publicly announced that they're looking to invest over a quarter of a billion dollars in additional capital. I would suggest that if they saw something that caused them to believe that there was no future in this business, I'm pretty confident that they wouldn't be making that announcement.

Kevin Dotts

Vijay, I just want to clarify. When we talked about those NOLs, because we've talked about it both ways, the pre-tax value and the after tax value, the $220 million to $240 million that I mentioned was the after0tax effect. 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 tax assets, which get into a whole lot of other timing activity.. When I think about the pure NOLs that will be realized, the $220m to $240 million, that will be the cash saved by not paying federal tax.

Donna Jaegers - Janco Partners

On the flexibility of your cost structure on the dial-up business, you guys are still buying managed modem services from other providers, I'm assuming. How often can you renegotiate those contracts?

Kevin Dotts

I think basically most of those managed modem contracts on the dial-up business are predominantly with our largest vendor there, Level 3. Negotiations occur relatively frequently 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 with dial-up is customer support. As you know, that's outsourced and is ultimately variable for us.

Donna Jaegers - Janco Partners

On New Edge, I know you said $160 million run rate. Can you give us some idea of what's the typical customer size you are dealing with?

Rolla Huff

It's actually evolving. I think New Edge, if you're looking at some of the press releases, increasingly, they are winning these large multi-location deals. So each individual installation, if they're doing 100 location deal, it may only be a T1 or even a DSL and some voice lines that are going into the customer, but it is 100, 200 locations. So big customer size overall, but specific points, relatively small.

Operator

Your next question comes from the line of Srinivasan Anantha - CIBC World Markets.

Srinivasan Anantha - CIBC World Markets

On the CLEC business, I just wanted to understand, how strategic is this portion of the business in the big picture for EarthLink because historically when you look at EarthLink it's always perceived to be as a consumer-focused company. Even if you look at the revenues you are generating, more than 85%, in other words, are you just better off by just selling 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 been resolved? Are you at a state where now you can begin to aggressively market those services in the markets as it is being currently offered?

The last one is, have you talked to any of the additional service providers with respect to reselling the broadband service? I know you have agreements with a couple providers but have you made any effort with the other service providers, especially with broadband access in the industry.

Rolla Huff

The first question is how strategic the CLEC business is for EarthLink. I'm not ready to say that it is going to be highly strategic or it's not going to be strategic. Again, I think there's this bent that it's either sell it for cash -- I think that's the view of many of the short term traders in our stock that just are looking for trades. I believe there is a lot of value in the assets that we have. That's probably the biggest point that I would make.

Given the fact that we don't participate in an industry right now that has huge growth potential, I think it's something that we have to at least look at as a possibility in terms of growing our assets there. I think that's something that we have to do.

What I know for sure is that what we have right now is worth a lot more money than we're being given credit for. I do know that. I'm pretty confident about that. So to the extent that we can bring out that value in different ways and be opportunistic about it, I think that's something that we can't ignore. I think it's something that we've got to do.

Regarding line powered voice, I think the provisioning issues are absolutely getting better. I think we're getting more focused. We've taken out the new number types of issues that we had that were really slowing us down. We're only doing L and P type provisioning and that has really helped our provisioning flowthrough dramatically.

We're still working through a few issues in the customer support and customer operations issue area and we're making good progress there. So we see the metrics of the business improving. For me, as I mentioned in my comments, there is no question, customers find the voice data bundle very attractive.

I just felt like we shouldn't be throwing a lot of money behind marketing it if we couldn't satisfy our customers and the way we were doing it was generating more cost than it should. So we've stepped back over the last 60 or 90 days, in terms of putting a lot of marketing effort into it. We're really focusing on getting the operational aspects of LPV right and then if we get satisfied that we can scale this thing, this could absolutely be a growth platform for our business. I just don't want to throw a lot of marketing money at it and not have satisfied customers and see churn rates that make this a bad business.

I think the last question you had was in general about how we were looking at continuing to expand our portfolio of broadband relationships to sell there. We've got some very strong relationships now and we've got a strong base of broadband subscribers as we speak. I think we're always looking to expand those relationships and not only with the existing providers, but there are new and emerging broadband providers that we talk to on a regular basis. So I think we will always be interested in expanding the channels and the types of technologies to be able to move our customers when they want to from dial-up speeds to broadband speeds and that's something that makes us a little bit unique in the industry that 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 that most, if not all, of the restructuring efforts would be completed at the end of the year, I was just wondering if that in fact was the case?

A related question is, it sounds like you went through a pretty thorough review of all of EarthLink's businesses and investments and I'm wondering if further actions in terms of potential divestitures are possible into 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 the restructuring in the fourth quarter. I think the headcount reductions will be done. But there is a lot to be done. When you take out 50% of your headcount and you really fundamentally re-look at the products that you're out there with, I mean, I wasn't able to do this in the first 60 days. We're going through every product, literally product by product, understanding how we can optimize cost, how we can optimize revenue growth, if that's available to us. So that work will continue well into next year. That's just not something that you can do in 60 days.

But I think one of the things that will be incumbent on this business is that we have to continually keep our cost structure aligned with the trend in revenue and how we think about this business, in my judgment, has to 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 in this 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 just automatically replicate itself and then suddenly discovering some day that we've got to make another extraordinary cut.

We're going to try to do that as best we can. I could never guarantee that if the revenue reduces faster than we're able to attrit our cost structure, we would do an adjustment if we had to do that. But that's not contemplated now.

As far as divestitures next year, I think that what we have tried to do is we're trying to create alternatives for this business that could have us acquiring things that make sense. So we're not going to go out and get into the can opener business, but to the extent that we can grow our business in a way that we're confident shareholders would see value in the short term, we've got to consider that. To the extent that the opportunity exists to divest of a business at a valuation that makes sense for our shareholders and we don't think that we can do better, we will absolutely do that.

I think that our focus has just really been on getting this business back to the point where we can control our own destiny and we do have alternatives and as I said in my closing comments, we think about this business as shareholders. It's how I came into the 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 run the business like shareholders. That's our intention. Long-term shareholders.

In any company like ours, we get lots of short-term traders in the stock and so they encourage us, we get messages all the time, being encouraged to do a lot of very short-term things that we listen very carefully to their thoughts, but we try to do what we think creates long-term value for our shareholders.

Well, I would like to thank everybody for joining us on the call and we'll continue to keep you abreast of developments in the company. We look forward to talking to you during the fourth quarter call. Take care, everybody.

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