EarthLink Q1 2008 Earnings Call Transcript

EarthLink (ELNK)

Q1 2008 Earnings Call

April 24, 2008 8:30 am ET

Executives

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

Kevin M. Dotts- Chief Financial Officer

Mike Allingtine – Investor Relations

Analysts

Heath Terry- Credit Suisse

Srinivas Anantha- Oppenheimer & Co.

James Friedland- Cowen and Company

Bryan Goldberg- Bear Stearns

Cole Kimball- WM Smith Securities

Ali Mogharabi- B. Riley & Company

Youssef Squali- Jefferies & Co.

Jennifer Watson- Goldman Sachs

Presentation

Good morning, my name is Danielle and I will be your conference operator today. At this time I would like to welcome everyone to EarthLink’s First Quarter 2008 Earnings Conference Call. All lines have been placed on hold to prevent background noise. After the remarks there will be a question-an-answer session. If you would like to ask a question during this time, please press * and then the number 1 on your telephone keypad. If you have already done so, please press the # sign now. Then press *1 again to make sure your question is registered. Thank you. I would now like to turn today’s call over to Mr. Kevin Dotts, CFO for EarthLink. Mr. Dotts, please begin the conference.

Kevin 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 Allingtine, to discuss our First 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 risk 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 companies 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 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 reconciliation to the most comparable GAAP measures please refer to our earnings release and the form 8k that has been furnished to the SEC, both of which are available on our website at www.Earthlink.net. Now I will turn things over to Rolla.

Rolla Huff

Thanks Kevin, and thanks to all of you for joining us this morning. As this morning’s earnings release makes clear, our business is performing above the expectations we had as we entered 2008. Our customer revenue was slightly above our expectations, our organic new customer ads were above our expectations, our churn was better than we expected, and our ability to optimize our cost structure was above our expectations. As a result, our company reported record adjusted EBIDTA, record free cash flow, and record net income. Our employees have experienced changes and challenges over the last nine months, but despite our restructuring efforts, they have adapted well to a changed business and more importantly they have remained focused on taking care of our customers. Our financial and operating performance over the past two quarters speaks volumes about the professionalism and the culture that we have here at EarthLink. I think it’s important to note that as we entered 2008, we have lined and planned and set up programs on an individual and departmental level with what we’re trying to do as a company to create shareholder value. Our performance this quarter was not driven by one big silver bullet. Instead, it was the result of many small things being done at a grassroots level. At the end of the day, in my mind, we are simply focusing on running our business in a way that takes care of our customers, whether they are dial-up or broadband, optimizes our cash generation, and positions us to consolidate and maintain internet access to anyone that has a phone line in this country. Kevin will walk everyone through our financial results, so I won’t spend a lot of time on that. Rather than that I will spend a few minutes on some of the operational results and initiatives as well as discuss our ongoing exit from municipal Wi-Fi.

Our company’s access business continues to experience a maturing of our subscriber base. As we’ve discussed with you in the past, as our customers become more and more tenured, our rate of turn drops and they contact us for customer service or technical support less frequently. So, let me tell you a bit more about the trends that we saw in the first quarter. In line with our expectations, EarthLink’s ending subscribers declined by 295,000 subs. I think it’s important to point out, that 50% of subscribers that churned in the first quarter had less than twelve months of tenure. Even though that cohort comprises only 26% of our customer base. As we told you in prior quarterly calls, we fully expected that subscribers acquired in the last twelve months would churn according to their historical cohort profile, so again it wasn’t really a surprise. Also as we expected the majority of this decline is due to our Value-Dial or People PC product, which accounted for 166,000 of our subscriber decline. We’ve reduced our active marketing to focus on active LTD subscribers which as expected. Lowered total gross ads for this value-priced product. In the first quarter of 2008, our overall churn rate in the value dial segment improved over the fourth quarter of 2007 and deteriorated slightly when compared to Q1 of last year. Our premium dial products account for nearly 30% of our total customer base. Our subscriber churn rates in the quarter improved over the prior quarter and over the year earlier period, which is a strong indicator of our belief that churn will continue to moderate as our subscriber base matures. In our broadband product we continue to experience better than expected growth in subscribers with profitable life-time values. This is due to successful optimization of sales channels as well as a stronger than expected path of growth program, i.e. customers growing through our portal. We attribute the latter in particular to the continuing positive impression that the EarthLink brand still enjoys in the access market as well as the momentum of our newer PeoplePC DSL upgrade product launched late last year. There’s no question in my mind at least that our portfolio of broadband offers is an important strength of our business. During the first quarter we saw our average value-added service revenue per engaged user, this is advertising, search, and security products, remain strong. I should also note that earlier this month, we launched a completely re-designed EarthLink homepage and store re-design. In addition we redesigned our EarthLink internet site, which includes a complete re-facing of the front door, all subsequent product pages, and a new customer provisioning tool. We launched a new webmail release that we believe will improve the user interface and further reduce calls into technical support. We are hopeful that these new products will continue to help us retain, engage, and monetize our existing customers, as well as help us to continue to beat our expectations on passive new ads. Our cost structure benefitted in the quarter from lower contact rates into customer service and technical support, and in my mind this was very significant. Since January we have seen a 15-20% improvement in per-subscriber contact rates as our cohort tenure has gone up, and our service optimization programs have delivered the intended results. This is substantial and yet another financial benefit that I see of our customer base becoming more tenured. We should also importantly point out that service quality rates within the call centers trended slightly higher than anticipations in the quarter. Given the concern about the general economy, I should note that we have not seen a substantial impact on our customers’ payment practices. Our bad debt as a percentage of revenue is actually down from last quarter, but we do recognize that this trend could change so we will continue to watch it closely.

As I’ve said many times, we don’t run this business solely around subscriber numbers. The dial access business is not and will not be an organic growth business. It’s a mature business that if run correctly, we believe, can generate meaningful cash flow for many years to come. As I’ve noted in previous calls, despite that fact that Access is not an organic-growth business, we are still actively exploring opportunities to acquire large, tenured, strategic bases of Access subscribers. I can’t really provide any updates on these efforts other than to say it is still a strategic focus of ours, and we are actively engaged in exploring possibilities that could generate future positive returns for our shareholders. We believe we are best positioned to assure customers across the country that dial-up access with great customer service will continue to be available to them in the future.

Let me spend a few minutes now on beginning to update everyone on some business developments related to municipal Wi-Fi. As you know last quarter we classified these assets, discontinued operations, and indicated that we expected to dispose of these assets as soon as practically possible. I am pleased to announce that we have been able to resolve 3 of the 5 municipal Wi-Fi markets. We’ve reached agreements with Corpus Christi and Milpitas to transfer ownership of their respective Wi-Fi networks to the cities. As part of the agreements the cities are releasing us from existing network agreements. We’ve pleased that we have been able to reach this type of agreement and we are now focused on a seamless transition of the network assets to the cities. In New Orleans we were unable to find a buyer of our Wi-Fi network assets, and neither the city nor an outside party was interested in assuming ownership of the network. Consequently we have notified that our Wi-Fi customers in New Orleans that EarthLink will stop operating its wireless network and EarthLink’s Wi-Fi services in New Orleans will terminate on May 18^th. In all three markets we are helping customers through this transition and making several offers on our broad-band and dial-up internet access services. Although we don’t currently have agreements for Philadelphia and Anaheim, it’s our hope that we can reach an agreement with these communities similar to our agreements with Corpus Christi and Milpitas. If those communities don’t want to retain the networks that we’ve built, we will remove them and do as we’re doing in New Orleans. In any case we expect a final resolution in Philadelphia and Anaheim in the very near term.

Now I’d like to make a few comments regarding our progress in our New Edge business. Our optimization efforts over the last three quarters continue to prove EBIDTA improvements in the first quarter versus a year ago period and kept New Edge EBIDTA positive in the quarter. While we are optimizing our cost structure, our sales performance has been softer than expected as the broader Celuck industry is experiencing an industry-wide softness in sales. We’re hopeful that our recently released new product platform will allow us to pick up momentum in sales. Following through on this commitment, New Edge has successfully introduced a new network service that allows business to tag and prioritize applications data traffic with up to five MPLS classes of service over DSL access. This is a telecom industry first service that fills a large pricing gap between DSL and T1 access. Until now, as you probably know, traffic tagging and prioritization with class of service were available only on the more costly high capacity T1 platforms with MPLS technology. This new service is priced very competitively compared to traditional T1s, and in this economy we think this could be very attractive to small and medium business owners. We still like our progress in New Edge, and we still believe that we are going to hit the financial commitments that we have put forward from a profitability standpoint, and we are excited about these new products that are coming out.

I’d like to now turn the call over to Kevin, who will take you through the details of our financial performance and talk a little about guidance. Kevin?

Kevin Dotts

Thanks, Rolla. This is our first quarter post restructuring, and in this quarter alone we estimate the company saved over $50 Million as a result of the restructuring, and was a primary reason we generated the record financial results that we will discuss. We have been consistent with our strategy to pursue only subscribers likely to generate a positive lifetime value. As a result we have seen an expected retrenchment in our subscriber base thus decreasing revenue in the process, but significantly increasing profitability. Our overall revenue for the quarter was $263 Million, a 19% decrease from the first quarter of last year, primarily driven by declines in narrow band subscribers. As the company continues to transition through the group of higher churn subscribers we continue to expect revenue decline that will attenuate in the third and fourth quarters of 2008. However, we expect the cost savings associated with the decreased marketing acquisition activity to offset much of these revenue declines resulting in strong operating margins and significant free cash flow generation.

Related to the improvements in multi-subscriber churn that Rolla previously discussed, we are also seeing the underlying quality and predictability of our subscriber base improving. In the first quarter of 2008, we are realizing the majority of our consumer active service revenue from longer tenured ,lower monthly churn subscribers, both in dial-up as well as broadband. As the long tenured group of our customer base continues to grow the company should benefit from the increased predictability of the customers and our ability to better monetize our actions with them. Since these customers have used our services longer, they tend to be more fully engaged with our value-added products and services. This customer behavior and engagement resulted in the company realizing another strong quarter in our value-added service revenues. Even as subscribers and total revenues decline, this area posted one of its higher revenues on record. Additionally, in terms of value-added services revenue per engaged user, this was our best quarter ever, generating $2.71 per engaged user. This performance reflects enhanced strength in our subscription security offerings as well as enhanced monetization of our user base via advertising and search. We are hopeful that these products will continue to retain, engage, and monetize our existing customers, as well as help us to continue to generate LTV, lifetime positive value, positive customers.

For the first quarter of 2008 New Edge, as part of our business services segment, stayed on its path of profitability. Helping to drive the improvements in business services in the quarter New Edge revenue per average employee improved 20% compared to the same period a year ago. Operating expense in the first quarter of 2008 is down more than 11% compared to the first quarter last year and about 6% less than the fourth quarter 2007. These operating improvements at New Edge helped drive both growth and operating margin expansion compared to the first quarter and fourth quarter 2007 for the business services group. In fact the first quarter of 2008 was the best quarter for income from our operations of our business services segment since we combined our Legacy Soho services with New Edge Networks. As we stated on our last earnings call, we expect New Edge to improve operations margin around $20 Million year-over-year in 2008.

Related to the decrease in gross subscriber additions, EarthLink has refocused its sales and marketing activities and expenditures. Further, with fewer subscribers and redoubled efforts on retaining long-tenured more profitable subscribers the company generated better than expected reductions in support costs associated with access services. Additionally with the significantly reduced growth spending we have seen a dramatic increase in adjusted EBIDTA. For the first quarter the company recorded our highest ever adjusted EBIDTA of $82 Million, a $52 Million improvement from the first quarter of 2007. As a result of this significant improvement in adjusted EBIDTA EarthLink’s income from adjusted operations was $58 Million, or $.52 per share, compared to a loss from continuing operations of $22 Million, or -$.18 per share in the prior year first quarter. The prior year first quarter results also included $29 Million in equity losses related to our proportionate share of **** 19:03 losses which are not included in the first quarter of 2008 results due to the reduction of the carrying value of our investment in Helio to $0. For the first quarter of 2008, EarthLink generated record net income of $52 Million, or $.49 per share compared to a loss of $30 Million, or -$.24 per share in the first quarter of 2007. We used $400,000 of capital expenditures and cash payments for subscriber’s bases in the quarter, compared to $216 Million in the first quarter of 2007. As a result, coupled with the increase of adjusted EBIDTA, we generated a record $82 Million of cash flow during 2008, up significantly from the $8 Million generated in the first quarter of last year. During the first quarter, the company repurchased $1.3 Million shares of its outstanding common stock for $9 Million, and has $192 Million remaining under the authorized share repurchase program. Since the initiation of our share repurchase program in 2002 the company has purchased 77 Million shares, or $611 Million, and we ended the quarter with 110 Million shares outstanding. We ended the first quarter of 2008 with $320 Million of cash and marketable securities, an increase of $31 Million compared to the fourth quarter of 2007. Included in the ending cash and marketable securities is approximately $58 Million of **** 20:42 securities at par as previously noted. These securities are variable rate dead instruments with underlying agreements have contractual maturities of up to forty years. These securities are triple-A rated and secured by pools of student loans guaranteed by state education agencies and re-insured by the U.S. Dept. of Education. Finally, in April 2008, EarthLink received approximately $51 Million from Platinum Partners in repayment of a debt portion of the investment we made in Koved in 2006. We will receive a second payment of approximately $6 Million in May for our equity investment in Koved. Now we would like to 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. EarthLink is revising and increasing its previously issued guidance for the remainder of 2008. As Rolla mentioned, we expect to continually realize improvements in our average monthly churn. However, we also expect to continue to reduce our gross subscriber additions through the remainder of 2008. These actions will result in further quarterly subscriber reductions which will decrease future quarterly revenue. Offsetting these decreases will be reduced sales and marketing expenses coupled with continued better than expected declines in ongoing customer support costs. Accordingly for the year, the company now expects to generate a record $245-250 Million in adjusted EBIDTA. This adjusted EBIDTA should also translate to a record $215-235 Million in cash flow as we now expect to incur $25-30 Million of capital expenditures during the remainder of 2008. Additionally for 2008, EarthLink expects continuing record income from continuing operations of $153-163 Million. I would now like to turn the call back to Rolla for some concluding remarks.

Rolla Huff

I think we are off to a good start in 2008 with our better-than-expected results in the first quarter. This has allowed us to raise our guidance for the second consecutive quarter in a row now as we learn more and more about how our business is going to perform in this restructured environment. Early into our restructuring strategy we continue to see improvements as we’ve mentioned in customer churn coupled with better than expected ability to take our cost structure down. We’re particularly pleased with the customer churn we’ve seen so far and this does give us increased confidence in our expectation for a long and profitable tail to the dial up internet access business. But clearly we will continue to closely monitor our churn results as we do every day. I believe we can make our company better than it is today in both customer service and cost structure. We will continue to evaluate and pursue 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 who do not see access as strategic to their long-term goals. I think you folks know since 1999 EarthLink has purchased and successfully integrated over 120 separate subscriber bases. If you’ve been a long-term analyst covering EarthLink I think you will agree that this is an activity that is one of our core competencies. That’s why I believe that EarthLink is clearly in the best position to be the key player in the ongoing consolidation of this access industry. So with that Operator why don’t we open up the lines and see if anybody has any questions.

Question and Answer Session

Operator

At this time I would like to remind everyone that if you would like to ask a question, press *1 on your telephone keypad. We will pause for just a moment to compile the Q&A roster.

Your first question comes from the line of Jennifer Watson.

Jennifer Watson- Goldman Sachs

Good morning and thank you for taking my question. Just some questions around the line-powered voice product, and now obviously there have been some improvements in provisioning there. Can you just talk about how the limited marketing has been received and what your plans are for going forward?

Rolla Huff

Sure. As a little bit of history, I think the line-powered voice product suffered from some technical issues at the D-slam (?25:53) level as well as because it was the modems that we were using in my judgment just weren’t up to par with what we needed them to be to make the customer satisfied. So we pulled back, we have been working on getting the product right over the last several months. We just recently , in the last two weeks, re-launched the product in one city, in Seattle, where we are limited our investment, we are doing a lot of experimenting. We want to see whether the product has legs, whether the customer is satisfied with it. We’re not going to bet the farm on this because we want to see it first. And then I would see us rolling it out if we are happy with what we have seen we will start rolling it out on a city-by-city basis. It is a very cool product for consumers. To the extent that we can give them both voice and data, in a bundle, it’s a very cool product. And it really works well with our customer base, and I think it would especially work well in an industry that’s more consolidated. But we could tie ourselves to these customers on a stronger basis. I didn’t mention it because frankly I don’t want to get all excited about it with you guys until the numbers prove that it’s a business model that will work for us.

Kevin Dotts

The only thing I would add to that is that we have an offering out there in eleven other markets, but we aren’t actively marketing it today. We are still taking passive subscribers in that product which is continuing to show us that we are getting to these operational improvements that Rolla had talked about.

Rolla Huff

Jennifer we really want to take a thoughtful approach to limit what we’re investing in this until we see that the business model has proved itself out. Even then I you wouldn’t expect that we are going to release it in forty five markets simultaneously. I just don’t think that is the way to do this. I think it would be a city-by-city approach so that we don’t be the farm on something and then have it blow up on us.

Jennifer Watson- Goldman Sachs

OK, great. I don’t know if you’ll be able to disclose this, but can you talk about any of the financial terms around the Wi-Fi transfer agreement?

Rolla Huff

For the two markets that we’ve completed, we’ve basically gave the network to the city in exchange for us walking away from the cost structure. For the most part the Wi-Fi network, I think we did take a small charge with Kevin, maybe4 $2-3 Million a quarter. But beyond that we’ve essentially eliminated any financial exposure on the balance sheet to Wi-Fi. What we’re trying to do is take care of customers, do our best to be as good a partner as we can be with the cities, and in the case of Milpitas and Corpus, they saw enough value in the networks that they wanted it and we passed it to them.

Kevin Dotts

And those transfers will be completed by the end of the second quarter.

Jennifer Watson- Goldman Sachs

Great. Thanks.

Operator

Your next question comes from the line of Heath Terry.

Heath Terry- Credit Suisse

I was just wondering, given the EBIDTA was $82 Million the first quarter, and guidance is for significant acceleration for that, can you give us an idea of what the underlying expectations are around that that would lead us to the lower EBIDTA numbers of subsequent quarters? And as we look at the buy-backs in the quarter, this is one of if not the lowest buy-back’s we have seen, is that a signal that you are at least considering or seriously looking at a significant acquisition of a sub-base or some other use of that capital?

Rolla Huff

Let me get to the fist part of your question. As I said in my comments, this is not a growth business, and there will continue to be churn in our business that we’ve tried very hard, and we continue to work very hard, making as much of our cost-structure variable as possible, but clearly it’s not 100% variable today. So, as our subscribers go down, we will not be able to take an amount equal to the revenue that is being lost, so taking the first quarter results times four, assuming that would be indicative of what we would produce for the year probably wouldn’t make a lot of sense. So I think you can look at the first quarter as being a quarter where we were pleased with the customer churn, but to be clearer, we have 275,000 customers that were paying us less. We’ve taken out an immense amount of cost structure to offset a lot of that, and you saw the performance. But I think the guidance we have suggested, we feel comfortable with. It reflects the fact that there are still improvements that we can make in the business, but it’s why we are very interested in scaling this business through acquisitions. There is no question scale on fixed cost infrastructure generally produce cash. That’s why our strategy is what it is. I didn’t quite understand your comment about this is one of the lowest quarters of stock buy-back. I think if you look at it, we went several quarters without buying back any stock, and we began buying back a little bit of stock in the third quarter, a lot in the fourth quarter, and some in the first quarter. You asked me the question about whether or not the fact that we’re not buying back stock right now indicates something more? I think we’re very mindful of the fact that there are going to be opportunities out there to acquire large bases of customers. That combined with the fact that the markets are rocky, to say the least, we believe that it makes sense for us to do what we’re doing right now. Clearly we’re not going out and wasting this money, but we’re trying to get ourselves positioned to scale our business in ways that will create value for our shareholders.

Heath Terry- Credit Suisse

Great. Can you talk about how you would look at valuing a large basis of subscribers, obviously in the past, the company has talked about what they consider acceptable price-per sub valuations. As the markets change can you give us an idea of where that acceptable level is now?

Rolla Huff

I don’t think that for very large bases of customers that we would necessarily approach it as price-per-subscriber. We would probably be looking at a combination of things: tenure, synergy, the type of revenue that we would be able to get off of each customer. I think there would be a variety of things that we would want to be mindful about as we thought about how to value the bases. When we are out buying a base of 10,000 subscribers, for example, a very small base, then getting to a value per-subscriber makes more sense. That’s generally driven by how tenured the bases is. We have thoroughly complex models here because we have been in the business long enough that we generally have a pretty strong view of what a customer is worth at whatever point they are in their lifecycle. So we would generally, as we buy bases of customers, that’s the way we do it. For a large deal there would probably be some other variables that would have to be considered.

Heath Terry- Credit Suisse

Great, Thank you.

Operator

Your next question comes from the line of Youssef Squali.

Youssef Squali- Jefferies & Company

There are two areas that we saw the biggest kind of delta, where the street was sales and marketing. The other was operations member support. In your prepared remarks you talked to the effect that a lot of these customers were basically contacting you less, and you’ve shown some efficiency there. But there was about a $7-8 Million decline there. Was there any one-time item in that line this quarter that depressed that number further than you thought?

Kevin Dotts

Not really at all Youssef. We’ve been very pleased with the fact that the customer support contact rates have come down fairly dramatically in the past six months. I think we attribute a lot of that to the fact they are becoming longer-tenured, but at the same time the continuing focus that the operating team has on trying to improve the overall customer experience.

Rolla Huff

Certainly no one-time credits or anything like that. As I mentioned in my remarks, Youssef, there really aren’t any big silver bullets here. Our job is to comb that cost structure of this business and constantly look for ways to optimize it. And it’s a target rich environment when you’ve got as many variables in a business as we do here. That’s why I pointedly discussed how we’re compensating our people. I think one of the things that is helping this is that how our folks get compensated is now aligned with how shareholders expect to get a return here.

Youssef Squali- Jefferies & Company

So as you continue to focus on long tenured subscribers, is it fair to assume that that number should be improving going forward? Because on the one hand you have subscribers that continue to churn out, and on the other you have the ones that are staying with you who are longer tenured.

Kevin Dotts

I think that is a fair view. I think that in that line you have our out-sourced customer support activities, so as well as a customer base does come down, that is a variable cost, and so you have a natural expectation that cost will continue to come down.

Rolla Huff

The one thing I would caution you about though is that, just as we said that the customer churn would be an asymptotic curve, the ability to get leverage off of reduced customer contact rates is equally asymptotic. I think it would be a mistake as you are building your models to believe that the improvement rates in our ability to make customers more efficient will be straight-lined, but the churn curves will be more of an asymptotic curve.

Kevin Dotts

There is a mix of variables and costs to that line, and it is asymptotic. Good point Rolla.

Yousef Squali- Jefferies and Company

Ok, and to the M & A activity question. Can you gauge for us the market that is out there that you think you can still go after on the dial up side? We think it is somewhere between 20-30 Million, but I would be curious to see what your thought on that is, and just in terms of buckets, there doesn’t seem to be that many. Obviously AOL is the larges and then MSN comes next. I can’t even think of another group, how many of these large buckets of over a half million subs are out there?

Rolla Huff

There are very few buckets of half-million subs. There are more buckets of 15-20,000 subs. There are lots of buckets of 5-10,000 subs. We have a constant list of people that we are talking to on a regular basis. But obviously the three largest pools of dial-up customers start with AOL, I think United-on-Line would be the second, and MSN would be the third. All of them are varying places with where they think the access business is in terms of how strategic it is to them. I believe that, again, at some point scale will matter to them as much as it does to us, and I think that we are just better positioned all the way around to be that consolidator.

Youssef Squali- Jefferies and Company

OK. And my last question, any updates on Helio? And cutbacks for some reason were really low. CapEx on PPON was $278,000. Your guidance was for $25-30 Million. Can you walk us through that, Kevin?

Kevin Dotts

I think it is just a matter of timing right now. We tend to run through a lot more of the projects through the year end, Yousef. I would say at the same time, if you think about it, the legacy of EarthLink business prior to the New Edge acquisition used to run approximately $20-24 Million a year. That said, as we go into the post-restructuring life of this business obviously we are really trying to look at this CapEx expenditures and really determine if it is worth doing. We want to make sure that our customer satisfaction remains high, and there is stability for the customer’s sake But we really have to look at our products and our product developments to determine if we are going to get that life-time value return on investment that we require. So there is a lot more circumspection around any of the CapEx spending on a go-forward basis. But again we tend to spend more later in the year as projects come through the pipeline. And then New Edge itself adds a new dynamic to it where we said that’s about the $4-5 Million range for it’s net worth, and maybe another $4-5 Million for the success based CPE That’s going to be a little bit driven as well by both their needs on the network as well as any type of commercial process where we can actually lease the equipment. All that said, I think it is more of a timing issue right now, but we continue to manage it pretty tightly.

Rolla Huff

I would say that probably Kevin and I have held up the CapEx process a little bit because it’s important that we be very thoughtful around making sure that we get a return on every dollar that gets spent, whether it is in the P & L or a CapEx expenditure. There is a clear view that we have a lot of questions about how we get returns. That’s probably held things up a little bit. It will probably be a little bit more flow-through but hopefully that will be good for our shareholders.

As far as Helio, really nothing to report there. As you know, we have no financial exposure to Helio at all. SK has really taken over the operational control of the business and I think that everybody is working hard every day to try and create value there.

Yousef Squali- Jefferies and Company

OK, thanks.

Operator

Your next question comes from the line of Ali Mogharabi.

Ali Mogharabi- B. Riley & Company, Inc.

Most of my questions have been answered. Just a couple more. Do you think we could see any additional expansion or improvement in gross margins going forward? Especially on the business services side? I certainly noticed the more than 600 bases point improvement.

Rolla Huff

I think there is an opportunity for us to improve our cost optimization in every part of the company. Some of this is staged. We don’t get to 100% efficiency over night, so I think there are opportunities, but I think also that we recognize that at least some of that opportunity will get offset by the various issues that come down the pipe that we have to deal with, whether they are volume issues, so on and so forth. But believe me it receives a lot of attention. I think there are opportunities, it’s being worked every day.

Ali Mogharabi- B. Riley & Company, Inc.

And regarding churn on the consumer side. I saw the sequential improvement but not of course year-over-year given your strategy. What churn level is attainable for you? Given of course the seasonality of each quarter?

Rolla Huff

I’ll start. Kevin you can weigh in. That’s not a simple question for us because we are uniquely positioned because of the fact that we have three different types of access product. We have a value dial product that has one set of churn metrics. WE have a premium dial that has a second set, and we have a broadband offering that has a very different third set. To answer that question- there’s not one answer. We see tenured churn rates in our broadband customer area in somewhere between 1-2% a month. Once a customer has been with us for a long period of time the churn rates absolutely do come down. Same thing on the premium dial, not to the same extent. I think that we have seen tenured customers churn more in the 2% range. Value dial is just one notch above that. Ultimately as tenure increases that’s where we see this going to. I think that notably as we have taken our cost structure down in terms of how we acquire customers – we’re acquiring customers much more passively. We’re not spending the enormous amounts of money in direct marketing. We’re hopeful that with some of the things that we have done on our portal and web mail and those sorts of things, to really make us even better in terms of having customers be able to get to us passively, i.e. not as expensively. I think we can still see churn higher, because customers will tend to have early life churn. That won’t be as big of an issue for us, because we won’t have made as big of an investment to acquire the customers. I think it’s a little bit too simplistic to just look at what happens to churn, I think churn and how that relates to cost structure is really the balance that we look for every day.

We’re going to try really hard to continue to acquire dial customers. We just want to make sure that we’re making money on them, and that’s the balance that we go through.

Kevin Dotts

I don’t think I have a lot more to add. Basically when you look at churn rate by tenure, then you get out there on the premium base and you see it in the 2-3% range. You say that as subscribers march through that tenure period, that is obviously what we think they are going to continue to go toward. And we’ve seen those churn rates over periods come down, so that tells us that everything that we are working toward is the right direction. PeoplePC as you said is a few basis points above that, probably 20-30 basis points, and then the DSL base is in the single digits.

Ali Mogharabi- B. Riley & Company

Thanks guys.

Operator

Your next question comes from the line of Pat Kesslin.

Pat Kesslin

I am wondering if maybe you can talk a little about how Rolla you came along last year and re-focused the business, implemented a successful restructuring- I am wondering your priorities for 2008, and some of us are wondering why some of these large access acquisitions haven’t occurred yet. Is it a matter of coming to an agreement? Is it a matter of identifying the assets that you want? Maybe you could just give us a little more detail on the kinds of things you are looking for in those?

Rolla Huff

I think it is a combination of all of those things. The biggest one that is out there- Time Warner has announced that it is looking at splitting out it’s access business. I have no doubt that that is a very complex thing for them to do. So it’s hard for me to really comment beyond that.

I would just tell you that we are very committed to the idea. But we are committed only if we can create value for our shareholders. We are not going to do this just because it will be a fun exercise. It has to be something that we believe will create value for both the seller of the lines as well as us as the buyer of the lines. Those very complex things, those very large bases, those are not the types of things that happen over night. You read what I read around Time Warner’s commitment, around that. I think the best thing that we can do is just all stay tuned around that progress. I wish I could be better in my answer, but I can’t.

Pat Kesslin

Maybe just outline priorities for 2008?

Rolla Huff

Sure. I think that the biggest thing that we have been focused on has been we’ve got the ball rolling in this second half of last year. You don’t get it exactly where you want it overnight. Our priorities in 2008 are to continue to optimize our cost structure, begin to look at ways to invest in things like line-powered voice, as an example. And ways that are measured and to look for way to leverage what we are as a business and a big priority , I think there will be movement of some of these large bases of customers. That’s a huge priority for us in 2008.

Pat Kesslin

Obviously there has been a lot of reconstitution of your assets and businesses over the last nine months or so. I am wondering if we should expect to see more of those? Obviously you don’t have as many of those assets and businesses as you once had, but there are still some that people might identify as not potentially associated with EarthLink a year from now. Can you maybe comment on that in a broader sense?

Rolla Huff

We’ve been completely focused on optimizing what we have. We are always in dialogue with people around the idea of what we can buy or sell in terms of businesses. That is an ongoing thing. You’re right from the perspective that EarthLink is a unique collection of businesses. We’ve got a competitive local exchange company, we’ve got an interesting web-hosting business, and we’ve got an investment in MV & O. So we’re constantly looking at ways to create shareholder value with that collection of assets. So far, as you’ve seen, we’ve been trying to optimize the value internally. I don’t think you should assume that because you haven’t seen any announcements that we’re not actively in the market as buyers or sellers around those assets. It’s really what we can do to create value for our shareholders. And we haven’t done a lot of deals, and I think that should tell you that we try to be reasonably thoughtful about not doing anything just for the sake of doing it.

Pat Kesslin

Great, thank you very much.

Operator

Your next question comes from the line of Srinivas Anantha.

Srinivas Anantha- Oppenheimer & Co.

Two questions. I know you guys talked about long tenured subscribers. Within your existing subscribers, can you quantify what percentage of these subscribers are long tenured? Because I am really trying to understand when is the subscriber decline either going to moderate or stop at some point? Second, just for clarification on the operating expenses. Did you say there is additional room for more savings, or the operation expenses we are seeing in Q1 2008 is a good run rate that we can model going forward? Thank you.

Rolla Huff

I am going to have Kevin get at the first part of the question. I don’t want anybody out there believing that our churn rates are just going to stop at some point. That just won’t happen that way. I wish it would, but there will always be some level of churn across our customer base, regardless of how tenured they get, people move, they die, there are any number of things. So, it will never get to the point where there is no churn. That’s an important point. I think that we can be better in terms of operating expenses, I firmly believe that, and we will continue to work that every single day. Part of it is a step process because some of our expenses are part of existing contracts, for example, that have a term on the contract, and when the contracts come due we have a different dialogue with the provider of whatever that service is. So we can’t do everything immediately, but all of the things are being worked. Kevin you might want to talk about the percentage of our base that is tenured.

Kevin Dotts

Roughly we’ve got about 1.2 Million subscribers in our premium product, and about 80% of that might be currently churning over twenty four months, and churning at somewhere a high 2% range. And if you look at it we’ve got over 70% that is churning in the upper 2% range. Those are the things that we look for the remaining 20% that I haven’t talked about, that is eventually going toward those low churn rates, the low 3% and high 2% churn rates. PeoplePC you are talking about roughly 30-35% of the base is over twenty four months, and the churn rates are still about another 50 bases points above what I said the premium dial up churn rates were.

Rolla Huff

That’s why we see such a large percentage of our churn coming out of PeoplePC. It’s a younger base of customers. Our premium dial base is a more tenured base.

Kevin Dotts

Again, you look at the DSL subscribers and there are probably 79-80% of those are beyond twenty four months, and they are probably churning in the low 2% range, or 1% range.

Srinivas Anantha- Oppenheimer & Co.

Thank you guys.

Operator

Your next question comes from the line of Brian Goldberg.

Brian Goldberg- Bear Stearns

Two quick questions. From a bigger picture, your brand is a recognized leader of the dial up universe. It’s supported by your recent JD Power results, and I’m curious in the context of potential M&A, are there other brands out there that would be even more appealing for you, for example AOL and MSN are affiliated with rather large portals. Could rolling your subs into one of these brands be an opportunity here, or would you prefer to operate more than one brand of dial up in such a scenario?

Rolla Huff

We feel very good about the EarthLink brand. I have no doubt that Microsoft feels very good about the MSN brand, and Time Warner feels very good about the AOL brand and what it means to their web business. I think in terms of access, one of the things that we have found as we buy subscriber bases is, we try to make it almost invisible to customers. What that means is, going to EarthLink customers and saying “you are now an AOL customer”, or going to an AOL customer and saying “ you are now an EarthLink customer”, generally isn’t a great thing around churn. We want to keep customers comfortable with the environment they are in, and really focus on leveraging cost structure. That’s really the strategic intent. I would be soft if Microsoft or AOL would not see so much value in maintaining what the brand means to their business that I doubt very seriously that they would feel good about being fast and loose with it, and neither would we. I think our strategy would be more to do the things underneath the brand to optimize cost structures and cash flows. That’s what this business really should be focused on.

Brian Goldberg- Bear Stearns

OK. The second question I guess would be that you mentioned that more than 50% of your sub decline on dial up is coming out of the PeoplePC side. Just curious- do you guys have any sense as to where these customers are going? Is there somebody out there actively spending money on acquiring these customers with high churn characteristics?

Rolla Huff

The vast majority of our customers when they leave go to a broad band player, so they may be leaving us, and we can’t provide a broadband circuit to them, they are going to a LAP or a cable company. Some of them because of the economy decide they will just use their e-mail system at work, that they’re not going to have on at home. So it’s a variety, but the vast majority of the reason for our churn is people looking to move up in terms of speed. But there are still an enormous number of people who are looking to come into the category for some period of time. It’s a very interesting thing. The problem with our category is that due to acquisition costs we needed to hold onto those people historically or twelve to thirteen months. And if they were only here for nine, it was a problem. Our task is if we could break even on them in three months, then a nine-month customer would look very attractive. We spent a lot of time thinking about that.

Brian Goldberg- Bear Stearns

Great, thank you very much.

Rolla Huff

I think we have one more question?

Operator

The next question was withdrawn.

Rolla Huff

I would like to thank everybody for joining us today. Obviously we are going to get back to work now, and continue to optimize the business as best we can. We’ll look forward to reporting back to you in the coming quarter. Take care, everybody.

Operator

This concludes today’s conference call. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: [e-mail]. Thank you!

Comments

[jackooo:]

$37.20 is my cost basis. I have had this stock for 7 years. Over paid personel that know little about making profits.
This is a great short.

2008 Apr 30 12:57 PM