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EarthLink, Inc. (NASDAQ:ELNK)

Q4 2007 Earnings Call

February 7, 2008 8:30 am ET

Executives

Kevin M. Dotts - Chief Financial Officer, Executive Vice President

Rolla P. Huff - Chairman of the Board, President, Chief Executive Officer

Analysts

Youssef Squali - Jefferies & Co.

Jennifer Watson - Goldman Sachs

Ali Mokerabi

Sri Anenta

Jim Friedland - SG Cowen & Co.

Christopher Rowen - Soleil/Channel Mark Capital

Harry Demott

Bryan Goldberg - Bear Stearns

Donna Jaegers - Janco Partners

Eram Fukes

Brian Hori

Operator

Good morning. My name is Luanne and I will be your conference operator today. At this time, I would like to welcome everyone to the EarthLink fourth quarter earnings conference call. (Operator Instructions) I would now like to turn the call over to Mr. Kevin Dotts, Chief Financial Officer. Sir, you may begin your conference.

Kevin M. Dotts

Thanks and welcome, everyone, to our call. This morning I am joined by EarthLink's Chairman and CEO, Rolla Huff, and our Vice President of Investor Relations, Mike Gallentine, to discuss our fourth 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. These risks include a variety of factors, including competitive developments and risk factors listed in the company’s SEC reports and public releases. Those lists are intended to identify certain principal 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 risk and uncertainties inherent to the company’s business.

In an effort to provide useful information to investors, our comments today also include non-GAAP financial measures. For details on these measures, including why we use them and reconciliations to the most comparable GAAP measures, please refer to our earnings release and the Form 8-K that has been furnished to the SEC, both of which are available on our website at www.earthlink.net.

Now I’ll turn things over to Rolla.

Rolla P. Huff

Thanks, Kevin and thanks to all of you for joining us this morning. Well, without question, 2007 was a year of tremendous change and challenge for EarthLink. I won’t take everyone through the many challenges this company faced throughout the year but I can tell you there were a bunch of them.

While it probably is not so important to those members of the financial community on this call, I know that many of our folks listen to these calls so I want to begin by letting them know how proud I am of each and every one of them. So much of the progress we made in this business can be attributed to the willingness of EarthLink people to put our customers and our shareholders ahead of themselves.

As you know, over the past five months we reduced our employee headcount by 50% -- actually, a little bit more than that. In most companies, doing that would have created acrimony, confusion, and likely threats. It would have been easy to believe that the company could have quickly melted down.

None of that happened at EarthLink. Instead, our people stayed focused on the customer and as a result, won the J.D. Power and Associates award for being number one in the industry for customer satisfaction in dial-up access in all regions in the country, and I might add number one in broadband access in two of the four regions.

I think the performance of our people has been absolutely amazing and you see it in our fourth quarter financial results, so thanks to all of you guys.

I would like to walk through some of the highlights of the fourth quarter and then take you through how we are thinking about our future and share with you the progress we are making.

I am pleased to report that we outperformed the high end of our own revenue and operating cash flow expectations. It was a record quarter for adjusted EBITDA and a record quarter for free cash flow. We completed our restructuring ahead of our time plan and we were able to take more expense out than we had planned. Very importantly, we didn’t see the churn in our tenured base that we thought we might.

We made hard decisions around getting our cost structure down. We made a very difficult decision to continue making -- to not continue making incremental investments in Helio. We made the difficult but necessary decision to discontinue our WiFi rollout.

During most of the last six months, the public media commentary around EarthLink has been mostly negative and, let’s face it, there was every possibility that our customer reputation could have been impacted. But that didn’t happen and I don’t believe that was out of luck.

We got through this period because of our people, as I mentioned, and our passion for taking care of our customers and the positive reputation EarthLink has earned over the past several years.

I am also pleased to tell you that our core access business is now positioned to produce strong adjusted EBITDA, strong free cash, and strong net income in 2008. We believe and most industry analysts agree that there will continue to be a meaningful percentage of households in the U.S. that will have dial-up circuits in their homes for years to come. It’s our intention to make sure that they always have the choice and ability to have reasonably priced access to the Internet and, at the same time, have award-winning customer service to go with that access, and I’ll talk a little bit more about that in a few minutes.

As expected, value dial customers that were acquired over the past four quarters have exhibited high levels of early life churn and have actually been slightly ahead of their historical cohort rates. Our dial and broadband tenured customer churn was consistent with or lower than prior cohort churn curves.

Our gross new adds exceeded our expectations, especially given the fact that we have substantially reduced marketing spend. As you’ll recall, we discontinued any marketing tactic that resulted in adding customers that we couldn’t generate an acceptable return on, so the customers we did add this quarter will be profitable for us.

We ended the year with 68% of our premium base as an example being in the over four years tenured cohort group. That’s up from 62% in the third quarter. Churn in that category was again down quarter over quarter to less than 2.8%.

As I mentioned earlier, churn in the value dial category with less than one year of tenure continues to be high. As we said in the past, we expect substantial parts of this base to churn off over the next three quarters as these value dial customers continue their propensity to have higher early life churn.

We ended the year with 50% of our value dial customers having more than two years of tenure. It’s interesting to note that even in our value dial segment, churn rates for two-plus year tenured cohorts were down quarter over quarter. The message here is cohort tenure does matter.

Churn in our broadband customer base was consistent with prior levels seen for each tenured cohort.

As I’ve said many times, we don’t run this business around subscriber numbers. Dial access is not an organic growth business and we no longer try to run it like it is. It’s a mature business that if run correctly will generate meaningful cash flow for many years to come, so we run it around contribution margin.

What that means is we will continue to look for opportunities to make our cost structure more variable, anticipating subscriber declines.

As you know, fixed costs will kill you in a mature business that’s declining and lay-offs are not a cost-effective or people-friendly way of bringing down cost structure. So we think a lot about staying ahead of the cost curve.

Our fourth quarter free cash flow was $59 million, ahead of the high end of our guidance. This reflects a couple of things. First, we were able to bring down costs a little quicker from a timeline perspective. Second, we continue to find new opportunities to be more efficient, and third, we are seeing operating improvement in our New Edge business.

I would like to spend a few minutes talking about the other parts of EarthLink beyond the core access business. I just mentioned improvement that we are seeing in New Edge, so let me start with that.

New Edge became EBITDA positive in [inaudible] and -- Operator, is there somebody else on the line?

Operator

No, sir.

Rolla P. Huff

Okay. Sorry. New Edge became EBITDA positive in December and more importantly, we expect New Edge to contribute $4 million to $7 million in positive EBITDA in 2008. That will represent close to a $20 million turnaround over 2007. While we are pleased with the meaningful progress New Edge has made over the last six months, we are not yet satisfied and expect continued margin improvement as we begin to grow this business.

We need to focus on getting more scale on the business, building on our sales momentum, and continuing to bring cost structure down.

In the fourth quarter, New Edge began testing a telecom industry first -- a network service that allows businesses to tag and prioritize applications data traffic over DSL. Now this technology will allow businesses to introduced new data applications like voiceover IP and other latency sensitive services without creating network bottlenecks and importantly without substantially increasing their network costs.

This new service fills the huge gap that exists today between DSL and T1 pricing for network access.

In the fourth quarter, you may have noticed a sampling of announcements about network wins by New Edge. These represent small and mid-sized enterprise customers in various industry segments. We are building on our sales momentum and we are successfully differentiating ourselves based on favorable customer experiences and a growing reputation for quality and performance, but we can be better.

Now let me touch briefly on our DSL and home phone service, otherwise known as line-powered voice. As I told you in late summer, we thought there was a real potential for this unique customer focus product but we were not, however, happy with the provisioning processes, the product quality, and as a result, the support costs.

So we pulled back from aggressively marketing the product until we were confident that it was ready for primetime. We significantly reduced the cash being spent on this product while we work to optimize its performance and its business model. We believe we’ve made substantial progress in getting the technology where it should be and improving the provisioning processes.

In fact, we are beginning to again roll out the service on a limited basis and are now realizing provisioning times of approximately nine days, with provisioning rates of around 80% for porting existing phone numbers.

This is a big improvement from where we were in the summer of ’07 when we were experiencing provisioning cycles of 25 days and cancellation rates approaching 45%.

We’re testing small-scale marketing programs to determine what works and what doesn’t. We’re testing various tactics to determine the optimal way to cost effectively grow line-powered voice.

Now I think it’s still too early to know whether we’ll be successful in these efforts but I am cautiously optimistic that this product offering could work for us. But I can tell you we are not going to bet the farm on this product but rather, we are going to look to prove out the business model with specific market testing as we further evaluate this product. In fact, we’ll roll out our first NFL city as part of this business model test this month.

As part of the corporate restructuring we announced in August, we expressed our concerns about the viability of the municipal WiFi business model. We made the decision to stop any further market rollouts and substantially reduce the cash being spent on this initiative while we search for ways to make the model viable.

It quickly became evident that we would have a really difficult time changing the perception by some of the cities that we owed them a free network rather than the city stepping up to make the business model viable for both them and for our shareholders.

We looked for other partners beyond the cities to provide anchor tenancy in order to make this business model viable for EarthLink.

Ultimately, we made the difficult but necessary decision and publicly announced our intention to pursue other strategic options for our five markets. During this review of our strategic alternatives, we’ve been in contact with the various municipalities and have had good productive dialogs.

As Kevin will detail for you in a few minutes, we’re accounting for our WiFi assets as a discontinued operation. We’ll continue to provide service to people currently on the networks until disposition of the assets in the various communities has been accomplished.

We’re actively working to determine if there are viable outside buyers for the assets or if the cities themselves are interested in the assets. We are looking to come to a solution with the municipalities that work for them and reduces our future spending obligations. We’ll keep you informed as we make final decisions on these properties.

Due to the uncertainty of the ultimate value of these assets, we’ll take an asset impairment charge that Kevin will walk you through.

Now let me make a few quick comments about the status of Helio. For the quarter, Helio continued their aggressive growth of a highly differentiated wireless social networking product. This differentiation is clearly evident in our customer base usage metrics that exceeded industry averages in many areas, such as average revenue per user of over $85 a month compared to an industry average of under $50; an average of over, for example, over 550 text messages per member per month, many times the industry average; instant message penetration, three times the industry average; the fact that 95% of Helio customers access the web through their mobile devices versus an industry average of about 13%; and in December, Helio members uploaded photos from their devices to the web at a rate five times the industry average.

Helio finished the quarter with just over 180,000 subscribers. This represents a 28% growth over the prior quarter. In addition, Helio finished with $56 million of revenue in the quarter which represents 147% growth over prior year and 8% growth over the prior quarter.

As previously announced, during the fourth quarter EarthLink and SKT finalized a new restructured Helio partnership agreement. Under this agreement, SKT agreed to invest up to $270 million in incremental funding in Helio. This agreement was important for EarthLink investors in that it eliminated any future financial exposure to Helio results, did not require us to contribute additional cash, and allowed EarthLink to maintain a meaningful ownership position in Helio with potential investment return in the future.

Additionally, in the first quarter of 2008, Helio announced that Sky Dayton has been named non-Executive Chairman of Helio’s board of directors and Wonhee Sull, formerly Helio’s President and Chief Operating Officer, has been named CEO. Sky has a history of creating and building strong brands and he’s done a great job at that with Helio. We very much appreciate his willingness to be involved in getting Helio to this point in its lifecycle.

In the coming quarters, Helio will be very focused on operational execution, expanding its channels of distribution and continuing to build cost efficiencies while continuing to grow the business.

Because EarthLink continues to own a meaningful stake in Helio, we’ll continue to work closely with our partners at SK to build the value of the Helio business.

So in summary, we feel very good about our performance over the last few quarters and we feel good about how we are positioned entering the year. As a result, we are raising our adjusted EBITDA guidance from a range of $210 million to $240 million to a range of $230 million to $250 million.

I would like to now turn the call over to Kevin and he’ll provide more detail on our financial performance. Kevin.

Kevin M. 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 we indicated on our third quarter earnings call, due to the changes in new customer behavior toward higher churn rates in the initial periods of service, EarthLink has significantly reduced spending related to the acquisition of new subscribers. As a result of these changes related to the acquisition of new subscribers, the EarthLink narrowband subscriber base declined by 235,000 subscribers in the quarter while the consumer broadband subscriber base declined 21,000 during the quarter.

However, the decline in narrowband subscribers was primarily due to a 159,000 decrease in gross subscriber additions rather than higher churn rates. In fact, EarthLink actually experienced lower subscriber churn of 86,000 few subscribers in the fourth quarter of 2007 compared to the third quarter of 2007.

As a result of our restructuring efforts, management continues to expect to experience comparable levels of churn over the next couple of quarters in 2008.

EarthLink ended the quarter with 1.1 million broadband subscribers, 2.6 million narrowband subscribers split evenly between premium and value, and 100,000 web hosting subscribers. While the total narrowband subscriber numbers are evenly split between premium and value dial as Rolla previously indicated, premium is a very tenured subscriber base with low churn and value is less tenured with much higher churn.

Consequently, the annualized revenue contribution from the premium subscriber base is almost $210 million while the value subscriber base annualized revenue is almost $120 million.

So what does this mean? Over 50% of our combined dial revenues are generated by subscribers with a tenure greater than three years and are churning below 3%. Additionally, two-thirds of our combined dial revenues are from subscribers churning in the low to mid 3% range and these metrics are continuing to improve.

Additionally, our very stable consumer broadband subscribers have an annual run-rate of almost $300 million with high tenure and churn rates in the low to mid 2% range. Driven by declines in narrowband subscribers, overall revenue for the quarter was $282 million, a 14% decrease from the fourth quarter of 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 from the decreased marketing acquisition activity to more than offset these revenue declines, resulting in improved operating margins and a significant increase in free cash flow generation.

EarthLink has greatly reduced sales and marketing activities and initiated further cost reductions associated with back office functions related to our corporate restructuring, providing a dramatic increase in adjusted EBITDA.

For the fourth quarter, the company recorded our highest ever adjusted EBITDA of $71 million, a $40 million improvement from fourth quarter of 2006.

For the fourth quarter of 2007, EarthLink recorded an additional $35 million in facility exit and restructuring costs. These costs include $1 million for people related costs, $11 million for facilities related costs, $17 million for asset impairments, $4 million for asset impairments related to purchase intangibles, and $1 million related to a true-up of an estimate from our call center restructuring charges.

Further, in the fourth quarter EarthLink reclassified to discontinued operations $21 million of certain expenses related to municipal WiFi that were previously recorded as facility exit and restructuring costs in the third quarter.

It is important to note in the second half of 2007, EarthLink produced over $70 million of free cash flow exceeding the cash charges related to the restructuring and the municipal WiFi exit cost.

As a result of the significant improvement in adjusted EBITDA, coupled with no longer recording our proportionate sale Helio net losses, partially offset by the facility exit charges just outlined, EarthLink's income from continuing operations was $23 million, or $0.19 per share, compared to a loss from continuing operations of $18 million or $0.15 per share in the prior year fourth quarter.

As Rolla previously indicated, in November 2007 the company announced that it was considering strategic alternatives related to its municipal wireless networks. Based on that analysis, as of December 31st, the company had committed to a plan to sell its municipal WiFi assets. Under GAAP, the company has adjusted the carrying value of the municipal WiFi assets which resulted in a $28 million impairment loss. Coupled with the municipal WiFi operating loss from the quarter, our total loss from discontinued operations was $32 million.

For the fourth quarter of 2007, EarthLink generated a net loss of $9 million or $0.08 per share compared to at net loss of $25 million or $0.20 per share in the fourth quarter of 2006.

We used $12 million for capital expenditures and cash payments for subscriber bases in the quarter, compared to $21 million in the fourth quarter of 2006. As a result, coupled with the increase in adjusted EBITDA, we generated $59 million of free cash flow during the fourth quarter of 2007, up significantly from the $11 million generated in the fourth quarter of last year.

During the fourth quarter, the company repurchased a record 10 million shares of its outstanding common stock for $69 million and has $201 million remaining under the authorized share repurchase program.

Since the initiation of our repurchase program, the company has purchased 77 million shares for $611 million at an average price of $7.92 and we ended the quarter with 110 million shares outstanding.

We ended the fourth quarter of 2007 with $289 million of cash and marketable securities, a decrease of $106 million compared to the fourth quarter of 2006. Now we will provide our outlook for 2008.

These statements are forward-looking and actual results may differ materially. The company undertakes no obligation to update these statements.

As we indicated on our third quarter 2007 earnings call, beginning with 2008 EarthLink will modify its guidance practices to better reflect current business realities and more closely align investors’ focus with the metrics management measures the success of the business by.

Accordingly, we will only provide yearly guidance on adjusted EBITDA and net income. On a quarterly basis, management will either reiterate previously issued yearly guidance or modify as needed.

For the first half of 2008, management expects to continue to experience subscriber and revenue trends similar to those realized in the third and fourth quarters of 2007. In the second half of 2008, management expects subscribers and revenues to begin to level off with only slight decreases in subsequent quarters.

As we have stated previously, we don’t manage EarthLink around subscriber numbers. Rather, management is focused on generating a sustainable cash flow and contribution margin. As a result of our focus, for the full year of 2008, the company expects to generate a record $230 million to $250 million in adjusted EBITDA, with the fourth quarter of 2008 likely being the highest quarter. This adjusted EBITDA should also translate to a record $190 million to $220 million of free cash flow.

For 2008, as we stated previously, the company no longer recognizes Helio losses so the majority of our adjusted EBITDA will result in a significant growth in year-over-year income. For 2008, EarthLink expects record income from continuing operations of $140 million to $155 million, which includes tax expense of $20 million to $25 million, as a result of the utilization of net operating loss carry-forwards. However, the cash impact should only be $3 million to $8 million related to our corporate AMT and monies paid under this simply extend our tax asset.

The company will continue to evaluate the appropriateness of its remaining deferred tax asset valuation on a regular basis going forward.

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

Rolla P. Huff

Thanks, Kevin. So we are off to a good start in 2008 but we have much more that can be done to improve our business and we look forward to the challenge and the opportunities that we believe this year will bring us. We intend to continue pursing opportunities to further scale our business. Where the economics can reasonably provide our shareholders with a risk adjusted rate of return, EarthLink will target strategic acquisitions of existing access line customer bases from companies that don’t see access as strategic to their long-term goals.

EarthLink is a brand name that people trust. It’s a brand name known for being ranked number one in customer service by J.D. Power and Associates. As I mentioned earlier, we scored number one in overall satisfaction for dial and we’re the only ISP with a significantly higher overall satisfaction score than the industry average. We ranked highest in performance and reliability, highest in image, highest in billing, highest in customer service, highest in technical support, and highest in e-mail services.

And it’s interesting to note that even though we don’t own a consumer high-speed platform, we were the highest ranked for customer satisfaction in the high-speed category in the south and east regions.

The J.D. Power scores underscore EarthLink's heritage of being the best in taking care of the customer and we continue to -- we intend to continue to deliver on this level of service for every household that wants the best Internet experience, regardless of access speed or location.

We intend to be a home for U.S. households that don’t have a need for or unable to afford the broadband bundles that are currently being marketed. When they do have a need for or have the ability to have high-speed connectivity, our array of broadband partnerships give us greater flexibility to transition them to broadband in a more customer friendly way.

We believe that not unlike the paging industry, there will be a meaningful segment of U.S. households that will have a dial-up service connection for many years to come. We’ve seen the estimate of U.S. household penetration in 2014 with dial-up range from 6% to 10% of U.S. household.

We aren’t ready to make that prediction but we are ready to predict that this form of Internet connection isn’t going away over night. While we are not an organic growth story today, we are demonstrating that this business can generate substantial free cash flow.

Given the markets we are all looking at today and probably for the foreseeable future, being in a position to generate substantial cash flow with an unleveraged balance sheet doesn’t seem like a bad place to be. Being positioned to scale the business through access line acquisitions makes it feel even a little bit better.

So with that, Operator, why don’t we open up the lines for any questions people might have?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Youssef Squali.

Youssef Squali - Jefferies & Co.

Thank you very much. Good morning. A couple of questions -- Rolla, you seem to be more and more up-front about your strategy of going out and acquiring customer access bases, which is something that you started talking about a little bit after you joined. Can you kind of -- I guess quantify for us the addressable universe of potential acquisitions? And clearly AOL is now talking more openly about splitting their two businesses between access and advertising. What gives you confidence, and this is kind of a broader question, what gives you confidence that at least in the case of AOL, you’ll be able to slow down the bleeding and kind of extract enough value from it to make it worthwhile?

Rolla P. Huff

Well, let me start with the first part of your question, which is the addressable market. We think there’s something in the neighborhood of 15 million access lines thereabout, beyond our own that are out there. And there’s not a long list of people that have those access lines, so I think you probably know the addressable market as well as we do.

You know, this is our -- this is the focus of our business. The access industry is not something that we do on a part-time basis. It’s what we think about every single day and we spend a lot of time thinking about how to keep our customers happy. And I think a lot of what we do and a lot of how we think about putting our customers in front of everything else can apply to any number of access bases out there.

I know that Time Warner made this comment yesterday. I have no doubt that Time Warner and AOL are both extremely conscious about how their customers are taken care of and that will be important to them in the future. And the reality is it is what we do every single day, so I feel very confident that this is the type of business that we would do very well with.

Youssef Squali - Jefferies & Co.

Would your acquisition strategy impact your stock buy-back, which you’ve been pretty aggressive with recently?

Rolla P. Huff

It could, sure. It really would depend on the nature of the acquisition. If it was -- these acquisitions require cash versus equity, then I suspect that it would.

Youssef Squali - Jefferies & Co.

Okay, great. Thanks.

Operator

Your next question comes from the line of Jennifer Watson.

Jennifer Watson - Goldman Sachs

Good morning. Thank you. Can you just comment on your thoughts about the benefits of remaining a public company versus taking yourself private, given the amount of free cash flow that you are generating?

Rolla P. Huff

Honestly, we don’t spend a lot of time thinking about that right this minute. Frankly, we’ve had a lot of things that we needed to do to make this company attractive to any potential investor. I think with the debt markets the way they are, you don’t see those types of transactions happening right now and we think, just for the reasons we were just talking about with the other question, there are a lot of opportunities to create value for our shareholders.

So frankly, I just haven’t had a lot of time to think about that but we’ll continue to look at our business from a shareholder perspective and do the things that we think make the most sense.

Jennifer Watson - Goldman Sachs

Okay, great. Thank you.

Operator

Your next question comes from the line of Ali [Mokerabi].

Ali Mokerabi

Thanks. Actually, to follow-up on the first question, I was wondering, in considering acquisitions of access subs, can you give us an idea of how you value those? What lifetime value are you looking for and how much you might be willing to spend on each subscriber?

Rolla P. Huff

Sure. Well, let me just spend a few seconds talking to you about how we think about it. I probably won’t get into any specific valuations but as we said in our opening comments, the tenure matters in this business and so we’ve had, as you can imagine, over the years we’ve got quite an amount of information about how various cohort groups tend to churn, based on tenure, based on geography -- we have more data than you can shake a stick at here. And so as we look at any base of customers, we look at those customers against our knowledge base of what they are likely to do and we look at what cash we think we’ll generate and then any offers that we have made in the past are based on how we value that set of cash flows.

Ali Mokerabi

I see. So again, based on that first question, then I’m assuming that you would not be open to acquiring the entire AOL, what they have, over 7 million or 8 million subscribers currently. You would probably look at each different region that they serve and as you said, based on -- make your decision based on tenure and how much cash they’ll bring in?

Rolla P. Huff

Well, I’m not prepared to say that we will or won’t consider anything. I’m prepared to say that we’re not going to do anything that we believe isn’t going to provide some sort of return to our shareholders.

Kevin M. Dotts

Obviously, we look at this from an economic perspective and as Rolla just said, the return to shareholders, and we’ve got a nationwide footprint.

Ali Mokerabi

And then one more question -- the current economic conditions, I mean, I’m wondering if there is a downturn, and there are certain indications to that, can you tell us how it might impact your business? I mean, could it in any way actually be positive for you guys?

Rolla P. Huff

Well, clearly as people become more price sensitive, the idea of migrating to a $100 a month bundle will cause people to pause, but the flipside of that point is that we are going to be exposed -- you know, it really depends on how deep the issues go with our economy. We went through, as I think we reported in the third quarter, an issue with some of our customers through credit card billings not being able to re-up for service when their credit card expired automatically. And so we saw a little bit of that. That wasn’t an issue that we felt in the fourth quarter. We felt really good about the cohort churn rates that we were seeing in our more tenured cohort groups.

But clearly any time that the economy is under pressure, I think people are going to be more price sensitive and I think that works to our benefit.

Kevin M. Dotts

And the only other thing I would add is obviously it’s great to be in a position of a company that’s producing so much cash in this type of economic cycle.

Ali Mokerabi

All right. Thanks, guys.

Operator

Your next question comes from the line of [Sri Anenta].

Sri Anenta

Good morning. Thank you. Rolla, you mentioned about focusing on more scale for the New Edge business. Could you actually give us a little more information on that -- what do you mean, just committing more capital for that business? Or would you like to make small acquisitions, maybe selective acquisitions there?

And the second one, on your broadband business, these subscribers continue to decline there but I guess at some point, you guys probably will be thinking of adding subscribers and given the context that every other service provider is talking about a slowdown in subscriber growth, especially in broadband, what’s your strategy there? Thank you.

Rolla P. Huff

Sure. As it relates to New Edge, we are -- we think that we’ve got an opportunity to grow the business organically. We are -- we improved the network over the last six months. That was part of our CapEx spending in 2007. And we didn’t spend a lot of time talking about it but our network has been, in New Edge, has been substantially upgraded. And so it’s allowed us to bring out some of these newer products that I mentioned in my commentary, so we think there’s a good opportunity to scale that way.

I would certainly not rule out acquisitions in that segment but again, we have a real focus around making sure that whatever we commit capital to, we’re going to get a return on and obviously we’ve been here -- I’ve been here seven months now. We’ve not done any of those kinds of acquisitions because we obviously at this point have not felt like there have been opportunities that we thought made sense.

But I don’t want to suggest that that couldn’t possibly happen some time in the future, but I feel like we’ve got an opportunity to grow that business organically and we are making progress there and we are going to stick to our knitting until we find an opportunity that we think is attractive.

As far as broadband growth, you know, most of our broadband growth comes from helping our current customers migrate to higher speed platforms. We’re not out aggressively trying to stimulate growth on the broadband side. For us, it’s part of our -- what we try to do for our customers and we try to make their experience with the web a good experience. So if our customer tells us that it’s time for them to move to high-speed, we try to help them with it as opposed to giving them a hard time about it.

So I think our growth in our core business will be through strategic acquisitions. I think the business model today, unless we can sort out how to bring in customers with a different acquisition cost model, what you’ve been hearing all along is that the churn profile, the early life churn profile of new customers in this category make it very difficult for us to get returns on what we were historically paying to acquire new subs.

So to the extent that we can get that model changed, and we’re certainly -- we think about that but the fact that we are not spending a lot of money suggest that we haven’t figured out how to bring a lot more new customers in and get a pay-back before they churn off.

Sri Anenta

Thanks.

Operator

(Operator Instructions) Your next question comes from the line of Jim Friedland.

Jim Friedland - SG Cowen & Co.

Thanks. Just a question on the demographics of both the dial-up base and the broadband base. One, can you give us a sense of the geographic location? Does your subscriber base look like the general population dispersal of the U.S. or is it more focused on rural or less dense areas? And then also on age demographics -- does it reflect the general Internet user population or does it skew upward? And can you give that both for dial-up and for broadband? Thanks.

Rolla P. Huff

Well, I would say overall our -- the demographics of our base look a lot like the U.S. map. I mean, our customers are really everywhere that there is a phone line, which is one of the real advantages of our product, is if you’ve got a phone line you do have access to the Internet. So the demographics of our base look a lot like that.

I will say that due to the fact that EarthLink had its roots in L.A. and MindSpring had its roots in the Southeast here in Atlanta, we probably have a little overweighting in those two areas but for the most part, we’re spread all over the country.

From an age perspective, I think that there’s no question -- anybody that is a heavy user of the web is going to want a high speed circuit. But there are a significant number of people that are fixed income people, people -- there are people that are high speed customers and whether they retire, whether their economic situation changes, they don’t have the need for high speed. And so the demographics that we have increasingly look like that population.

We’ve got people that enter the category that may not again have the economics to spend more on high speed bundles, and so they are in our category for six or nine months and then they move on. And so to the extent that we can help them with that and still create value for our shareholders, I think there is a market there.

Jim Friedland - SG Cowen & Co.

Great. Thanks.

Operator

Your next question comes from the line of Chris Rowen.

Christopher Rowen - Soleil/Channel Mark Capital

My questions have been answered but Kevin, I wonder, could you -- I think I might have missed, you gave tax rate guidance for the year. Is that right?

Kevin M. Dotts

I think what we said is what you’ll see being booked based on our EBITDA and continuing operating income would be about a $20 million to $25 million expense with the income statement but the cash effect of that is, because of our NOLs, the cash effect is effectively a 2% rate. So we said at most, the cash on that will be somewhere between the $3 million and $8 million range.

Christopher Rowen - Soleil/Channel Mark Capital

Okay. Thanks a lot.

Operator

Your next question comes from the line of Harry [Demott].

Harry Demott

Two quick questions -- can you tell us -- I don’t know if I missed it or not -- whatever happened with the investment, was it the $50 million or so investment that you had in -- I forget the name of the company now.

Kevin M. Dotts

Covad?

Harry Demott

Covad, yeah. What’s happened there?

Rolla P. Huff

Sure. Well, we have roughly as I recall, 5 million or 6 million shares of stock and we have something in the neighborhood of $45 million to $47 million in debt in Covad. As you have probably read, the Covad board is -- I think they are about ready to have a shareholder vote on a private takeout by Platinum Equity Partners, so all other things being equal, I think our company will see a check for just under $60 million.

So that’s -- we’ll continue to look at that investment and have thoughtful discussions with the people involved to see if that’s the best thing for us to do, take the $60 million.

Harry Demott

Was that in any way reflected in your cash and marketable securities?

Kevin M. Dotts

It’s not reflected today in those, in that balance sheet line item.

Harry Demott

Okay. Thanks.

Operator

Your next question comes from the line of Bryan Goldberg.

Bryan Goldberg - Bear Stearns

Thanks. I realize the credit markets aren’t that hospitable right now but in the context of --

Rolla P. Huff

That’s an understatement.

Bryan Goldberg - Bear Stearns

Yeah. In the context of your strategy to possibly grow via M&A, what is your stance towards using the balance sheet and leverage? What would be a sort of -- if the money were available, what would be a target range that you think would be comfortable to place onto the cash flow of the business?

Rolla P. Huff

You know, I think we’d like the opportunity to think a little bit more about that before I just give you a multiple. But I think as I look at it, we’re fortunate to have a completely unleveraged balance sheet. But I’m also thoughtful around the point that while we feel fairly good that we know what our tenured customers are going to do and what cash they will generate, the last thing that I’m going to have an interest in doing is doing anything that leverages myself up to my eyeballs and then I have to worry about liquidity. It’s just -- life is too short for those kinds of experiences.

So I think it would really -- each transaction will be based again on the type of customers that we’re acquiring, what we believe that cash flow profile would look like, how safe it is, and then it’s hard to speculate what we would do. It would really depend on what the credit markets are doing, the cost of the debt, and there are a wide variety of factors.

But I don’t think you can absolutely be certain that we would have to access the debt markets to do some of the things that we have the ability to do.

Kevin M. Dotts

I was just going to add to that, Bryan, that as Rolla was just alluding to, I mean, if some of these acquisition opportunities that are out there would probably, since we are heavily under-leveraged, we just have the convert out there, that we could use the cash in the very near-term, the cash that we have already on the balance sheet and do those. On the other hand, if there was something larger out there, you know, you’re going to look at the combined operations of what that means and if its combined operations looking at that those tenure rates and then the overall value, and suggest whether there are other credit facilities out there that can be utilized.

Rolla P. Huff

I would tell you, I believe that given the variety of ways that we can do transactions, I don’t think that there is any transaction out there that we don’t have the ability to do in a variety of structures, but there is no transaction out there that we would look at and say we just don’t have the ability to do that because of the debt markets or anything of the sort.

Bryan Goldberg - Bear Stearns

Thank you very much.

Operator

Your next question comes from the line of Donna Jaegers.

Donna Jaegers - Janco Partners

A few quick questions -- a follow-up on the investment in Covad. You mentioned, Rolla, that your provisioning for line-powered voice was getting much better. Are you guys still using the Covad network for that line-powered voice?

Rolla P. Huff

We are. We are. Donna, as you know, part of our investment in them was to build out a co-lo infrastructure in the NFL cities with a technology that allowed us to do this. So that is a partnership that if we can get line-powered voice where we want it to be, we’ll leverage. But in any case, we’re not going to roll out line-powered voice aggressively until we know our business model works on it.

Donna Jaegers - Janco Partners

Great, and then on WiFi, since now you’ve made the decision clearly that you are going to exit those networks, has there been any interest in buyers of those networks?

Rolla P. Huff

We’ve talked to a variety of people about it. What I’m focused on -- you know, the way we had negotiated our contracts with the cities, we know there’s a cap on our liability so it’s not an open-ended thing and it’s something that we feel reasonably comfortable about but what’s important to me is anything I can do to reduce that known liability is a good thing for me but just selling it to somebody and us, because of our balance sheet, continuing to have to be a safety net if a buyer doesn’t make it, isn’t nearly as attractive.

Donna Jaegers - Janco Partners

Understood. And then finally on churn, I’m sorry, I’ve been trying to do a few other things this morning so I might not have heard all the details, but did you -- have you seen much economic impact on your churn numbers, similar to what AT&T or AOL mentioned?

Rolla P. Huff

We have -- Kevin can comment on this a little bit more but we are seeing the people PC churn be high. We thought that it would be high. It’s actually running a little bit higher than the tenure cohorts, even for value dial early life churn that we had experienced in the past. So that’s ticked up a little bit but the more tenured cohorts, whether it was in value dial or premium dial, actually came down quarter over quarter.

Kevin M. Dotts

What I mentioned earlier, Donna, I said really of our customer base, it’s over -- for our dial-up business, that’s over three-plus years, 50%, which is effectively 50% of our -- sorry. Yeah, about 50% of our revenues, they are churning below 3% at this point.

Rolla P. Huff

And that’s including value and --

Kevin M. Dotts

That’s the value and premium, and what we’ve seen are those trends, as Rolla just said, continue to improve.

Donna Jaegers - Janco Partners

Great. Well, congratulations, Rolla. You certainly made me eat my words as far as whether you could deliver on this.

Rolla P. Huff

Donna, I spent the last seven months making you eat your words, so thank you for saying that. I appreciate it.

Operator

Your next question comes from the line of [Eram Fukes].

Eram Fukes

I was wondering if you could talk about your lifetime value in the context of the fact that there are no dial-up modems being placed in PCs anymore and very little distribution in after-market retail. Doesn’t this inherently limit your sub base to the PCs they currently own? Thanks.

Rolla P. Huff

I think that you’ve probably overstated the situation. We currently have active distribution agreements with many of the key PC makers, so I think any view that they are not -- that they don’t have modems integrated into the PCs is probably not correct.

Over the next two or three years, it could certainly evolve that way but we are -- we have the ability to put low-priced modem devices out there for customers, for new customers wanting to come into the category. So it’s something that’s overcome-able, but you probably ought to go back and check in with Dell and some of those folks just to verify what you said, because we know that we’ve got active agreements with them right now. It’s where our new customers are coming from.

Eram Fukes

Okay, so I will check on that. They are actually still selling them in some models, is that what you’re saying?

Rolla P. Huff

Of course.

Eram Fukes

Okay. Thanks for your time.

Operator

Your final question comes from the line of Brian Hori.

Brian Hori

Thanks. Rolla, I’m wondering if you can just review what you guys see as the sweet spot for New Edge these days and what tweaks you’ve made to get it profitable and how do you envision the growth opportunity and what does the competitor set look like today based on the way you are running the business?

Rolla P. Huff

Sure. Well, the sweet spot for New Edge is our multi-location customers that are on the small to medium size level, so for example, we’ve just signed a recent deal -- I don’t know that it’s been announced so I’m not going to give you the name, but it’s 450 locations across the country and what they are looking for is combinations of DSL and T1 connectivity and what New Edge has the ability to do between its -- the physical modems, the physical co-los that we own and the partnerships that we have that get us reach into 10,000 more co-los across the country, we have the ability to go to these multi-location accounts and give them an easy way to do a complete rollout.

For example, when I was in the CLAC world not too long ago, we were only able to service those types of accounts in that part of the country that we had presence in. And so it was a bit of a headache for somebody who had locations in every part of the country to have to cobble together those kinds of deals.

So what we -- what New Edge offers is the ability to truly have U.S. coverage at the low to medium size level.

We’ve spent a lot of time really going up and down the whole business model. As you probably know, I was fortunate enough to have Joe Wetzel, our Chief Operating Officer, join us about six months ago and his background, both working with me in the competitive local exchange business as well as his time in the cable industry really just gave him a big leg up in coming in and going through all of the network infrastructure, all of the processes, and it’s still a process underway. That business is not where we want it. It’s getting there but there’s a lot more that we can do to improve it. It’s just -- it’s just basic blocking and tackling. There’s no magic that I can give you. I think we are just running it a little bit differently.

Brian Hori

Okay. Is there any way to help us scale that opportunity at this point?

Rolla P. Huff

I think that we would expect to begin to see growth rates approach where the industry is growing but we are not there right now. As I mentioned in my comments, now that we have reworked the network and got it to the point where we’ve got some new product offerings, I think we’ll be able to give you a much better sense of that in the coming three or four months as we roll out these new products and our funnel activity looks solid, but you know, until we show some results, I think it’s still work under progress, in process.

So I’m not ready to declare victory by any stretch of the imagination. We’ve just done basic blocking and tackling and there’s a lot more that we need to do to improve the business. But it is a business that will grow. I’m just not ready to start talking growth rates with it. It’s still a fairly small part of our business but it is a part of our business that is growing and can continue to grow, both organically and through scaling transactions if they make sense.

Brian Hori

Okay. Thank you.

Rolla P. Huff

Okay, well, I’d like to thank everybody for joining us today. I think there has been a lot of hard work here. Again, I want to thank the EarthLink people so much for getting us to this point. We are very excited about where our business is right now and where we have the opportunity to take it with some of the exciting opportunities that are just now showing themselves.

So thanks for joining us and we’ll talk to you soon. Take care, everybody.

Operator

Thank you for participating in today’s conference call. You may now disconnect.

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Source: EarthLink Q4 2007 Earnings Call Transcript
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