EarthLink: A Cash Flow Turnaround Story

EarthLink, Inc. (ELNK) is an emerging turnaround story whose recent Q4 2007 performance, under the leadership of CEO Rolla Huff, has laid the groundwork for a successful 2008 (see conference call transcript).

Current financial metrics on EarthLink suggest that it is undervalued. After a year of restructuring and challenges, the company reported a stellar Q4 2007, generating $59 million of free cash flow and $71 million of EBITDA, which was ahead of company guidance and $40 million improvement from Q4 2006. This momentum is expected to continue in 2008, as the company is guiding EBITDA to range from $230 million to $250 million, which translates to a record $190 million to $220 million of free cash flow.

Since 2007, the stock has fluctuated in a tight trading range from a low of $5.90 to a high of $8.36.

• At a current share price of $7.50, the market cap of the company is $820MM or 3.41x 2008 EBITDA.
• If you add up the $258.7MM at 3.25 % Convertible Debt Note that converts at $9.15, you are talking about an Enterprise Value of $1078MM, or 4.49x 2008 EBITDA.
• Assuming that the $258.7MM at 3.25% Convertible Note will convert 100% at $9.15, that adds 28.27mm shares to the float which would be offset by the remaining buyback program.
• Strong balance sheet with cash of $173.8mm and Marketable securities of $93.204mm.
• Value of Net Tax Loss Ranges between $220mm to $240mm

The company achieved this despite spending $69mm in 2007 to repurchase 10mm shares, leaving it with 109mm shares outstanding. As an added bonus, EarthLink is expected to receive $60mm of cash from the sale of their equity stake in Covad to Platinum Equities which will further strengthen the existing balance sheet.

Why has EarthLink been abandoned by investors?

The strong cash flow from its core access operations has been subsidizing cash outflows into money losing growth initiatives.

The former CEO sought to stem the declining access business by investing in growth ventures in municipal WIFI and Helio, a virtual network operator.

The Municipal Wifi business began with high hopes as cities around the United States sought to provide blanket WIFI access for their local citizens. However a suitable business model was never achieved, as cities expected EarthLink to provide the capital expenditures necessary without providing a way to achieve a return on that investment. This cost the company $32million of write downs, as EarthLink exited the business.

EarthLink also invested $210mm into Helio, a joint venture with SK Telecom (SKM), to start a virtual network operator on the Sprint Network (S) which caters to the wireless social network customer.

While subscriber growth in Q4 2007 for Helio was up 147% over the previous year and 8% over the previous quarter, those numbers continue to trail internal forecasts and represented an uncertain financial liability that dragged down operating earnings. During this period of time, EarthLink continued to experience churn in their core internet access business, resulting in declining revenues. The churn increased as dial-up customers continued to abandon it for alternative forms of broadband access.

What has changed?

The remarkable operational turnaround began with the hiring of Mr. Rolla Huff in June of 2007, who in his first 90 days did a strategic overview of the company to evaluate its priorities.

Mr. Huff's confidence in the company was signaled by his purchase of 100k shares at $7.25.

Recognizing that EarthLink had lost its focus by seeking growth without a commensurate return on investment, Mr. Huff refocused the company on profitability and operating cash flow.

Mr. Huff's analysis determined that not all customers were profitable. In the future, customers would only be added if they were profitable and immediately cash flow positive instead of spending increased marketing dollars seeking the "low" value customer that would only churn in a few months, resulting in a negative return on investment.

The company would no longer manage the business based upon a set goal of subscriber numbers.

A voluntary decline of unprofitable customers would be a positive addition to cash flow.

As a result, EarthLink has significantly reduced spending related to the acquisition of new subscribers resulting in a dial-up base declined of 235,000 in q4 2007 and 21,000 decline in the broadband business.

Any future declines in the subscriber base would be offset by the decreased sales and marketing activities, resulting in improved operating margins and increased free cash flow generation.

EarthLink ended Q4 2007 with 2.6million dial-up customers evenly divided between premium and value, and 1.1 million broadband subscribers.

Over 50% of the combined dial-up revenues were generated by customers with a tenure greater than three years and are churning below 3%. In addition, 66% of the combined dial-up customers are churning in the low to mid 3% with those metrics continuing to improve.

The stable consumer broadband subscriber base has an annual run rate of almost $300 million again with long tenure and low churn rates in the 2% range. Despite revenue decreasing 14% from q4 2006, EarthLink achieved its highest ever adjusted EBITDA of $71 million, a $40 million improvement from q4 2006.

To adjust to this new business model, EarthLink made the difficult decision to lower the fixed operating costs by reducing 50% of the work force. Any future subscriber growth or reduction would not impact the fixed cost base and instead be reflected as a variable cost.

The company also restructured its Helio Joint Venture with SK Telcom to retain a substantial equity stake which will allow EarthLink to participate in any future potential upside without the need for any additional capital investment.

The Opportunity

As a result, the company is poised to generate $240mm per year of EBITDA over the next three years. Even as the dial-up and broadband customers continue to shrink, the company should experience increased margins and profitability as it focuses on retaining more profitable customers with longer tenures and reduced churn, without increasing marketing expenditures. There remains $201mm authorized under the share repurchase program which at current stock prices would retire 26.8mm shares representing 24% of the shares outstanding.

Mathematically, if the company buys back $200mm of stock per year, even with the inclusion of the convertible note, there would be no shares left to buy within 5 years.

However, this is not just a simple cash flow story.

The company has additional avenues of growth that it is currently exploring.

Q4 2007 achieved the first breakeven quarter for EarthLink's New Edge CLEC subsidiary. New Edge reaches 10,000 co-locations around the country which along with its nationwide NPLS network position, allows it to service multi-location businesses. Together with the DSL and T1 circuit business solutions segment serving small and medium business customers, these two businesses have an annualized revenue run rate of $160MM with the profitability inflection point just achieved. This is an undervalued asset that will either grow its revenues and profitability organically and through acquisitions, or serve as an additional asset to be divested to a larger telecommunications company.

In addition, the company continues to look for well clustered groups of stable dial up customers that are complementary to its current customer base. One potential acquisition opportunity that comes to mind is AOL's remaining 8.5MM dial-up customers that have similar churn and stability tenures as EarthLink's.

As the company continues to build upon the momentum from q4 2007 in FY 2008, shareholders will be rewarded, both through the steady share repurchases which shrink the shares outstanding, and through improved financial performance.

Disclosure: Author has a long position in ELNK

Comments

[whisperonth...:]

No stock in the company but I am an Earthlink customer and they have always been very responsive to me when I've had an issue to resolve, even if I'm the one who caused the problem. Very polite tech assistants, and a survey to respond to when the service chat is done, make this an easy company to work with. Add that to a stock that seems to be doing okay, I may have to add to my portfolio!

2008 Mar 11 07:10 PM

[Spiro:]

I used to work at EarthLink (left 6 years ago) and still hold some stock. I think the new strategy is a good one. And with the free cash flow, they can easily start disbursing cash as a healthy dividend: Start with $.50 per share this year and go to $1.00 or more starting in 2009. How about it Mr. Huff?

2008 Mar 13 02:30 PM

[jefbar:]

I read articles from Seeking Alpha almost everday. I find them very informative. I must say that Mr. Tao's analysis of ELNK is one of the most concise, knowledgale articles written to date. Keep up the good work, and hope to read more articles from Mr. Tao.

2008 Mar 14 12:05 AM