EarthLink, Inc. Q2 2008 Earnings Call Transcript

EarthLink, Inc. (ELNK)

Q2 2008 Earnings Call

July 29, 2008 8:30 am ET

Executives

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

Kevin M. Dotts - Chief Financial Officer, Principal Accounting Officer

Mike Gallentine - Vice President of Investor Relations

Analysts

Jennifer Watson - Goldman Sachs

Youssef Squali - Jefferies & Co.

Bryan Goldberg - J.P. Morgan

James Friedland - Cowen and Company

Srinivas Anantha - Oppenheimer & Co.

Scott Kessler – Standard & Poors

Presentation

Operator

Welcome everyone to the EarthLink second quarter 2008 earnings conference call. (Operator Instructions) I would now like to turn the call over to Chief Financial Officer, Kevin Dotts.

Kevin M. Dotts

This morning I’m joined by EarthLink’s Chairman and CEO, Rolla Huff, and our Vice President of Investor Relations, Mike Galletine, to discuss our second 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 risks and uncertainties inherent to the company’s business. In an effort to provide useful information to investors our comments today also include non-GAAP financial measures. For details on these measures including why we use them and reconciliations to the most comparable GAAP measures please refer to our earnings release and the Form 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 P. Huff

Thanks to all of you out there for joining us this morning. As you may recall we announced a major restructuring of our business last fall. We outlined the areas that we would focus on and the resulting changes we expected to see in our future performance. First, we said we would focus on loyalty and retention of our existing base. As a result we expected to significantly reduce our sales and marketing expenses and we expected gross subscriber additions would go down. Second, as the tenure of our customer base increased we expected churn would improve. And finally, we told you to expect a meaningful decline in overall net subscribers over the following three or four quarters but with a substantial positive impact on profitability.

I’m pleased to report that thus far our business performance has trended above the expectations that we set for ourselves and with you. As our press release this morning indicated, we reported another solid quarter of operating performance in our company. In the first quarter we spoke about favorable churn and cost trends having a positive impact on our financial performance. And those same trends continued into the second quarter and we were very pleased to see that.

Revenue was slightly above our expectations due to better-than-expected organic or we call them passive new customer ads. In addition as our customer base continues to become more tenured we’re benefitting from lower-than-anticipated churn rates in some of our tenured cohorts. Importantly we entered the second half of the year with approximately 100,000 more customers than we had expected to have at this point in the year.

On the cost side, our ability to further optimize our cost structure also well exceeded our expectation. This is a result of a variety of process improvement initiatives that range from managing customer billing interaction to overall network optimization. Just to give you a perspective, we’ve seen our technical service contact rates come down 25% on a per subscriber basis since the beginning of the year. Similarly our customer service contact rates came down 20% on a per subscriber basis since the beginning of the year. We’ve introduced innovative new tools that allow us to align the compensation structures we have with our outsourced customer service partners with actions and activities that create value for EarthLink customers and shareholders.

As a result of all of these efforts our company reported strong adjusted EBITDA, free cash flow and net income. At this point we see nothing in our customer churn data that would suggest that the cohort churn trends we’re seeing will materially reverse in the near to mid-term. Accordingly we’ve raised our EBITDA, free cash flow and net income guidance for the year.

I’d like to provide a bit more commentary on some of the drivers of our access operating results, then spend a few minutes providing updates on the conclusion of our remaining non-strategic initiatives. Kevin will then walk everyone through a more detailed view of our financial results and our revised 2008 guidance.

Let me begin by focusing a bit more on subscriber trends in the second quarter. As we previously indicated we’ve eliminated any sales channel or marketing motion that cannot add a subscriber but has a positive lifetime value. Accordingly gross subscriber additions declined by 339,000 subs from the year ago quarter. This decline is gross adds is directly correlated to the significant decrease in sales and marketing expense that Kevin will walk you through later on the call. Over the next several quarters we expect gross subscriber additions to continue to decrease slightly from the level experienced in the second quarter. As the price point differential continues to expand between both our narrow band and unbundled broadband products and all of the broadband based bundles that the [Lux] and the cable companies offer, we could see some upside impact on passive adds particularly in this economic climate. Since EarthLink is adding far fewer new subscribers which normally experience high early life churns we’ve walked you through so many times, tenured subscribers continue to become a larger proportionate share of our base. Because of this increase in average tenure, overall average monthly churn improved significantly to 4.3% versus 4.9% in the first quarter of 2008. In fact, for just our premium dial base the average monthly churn came down to 3.4% for the quarter which I believe was the lowest quarterly rate we’ve realized since EarthLink and Mind Spring merged back in February of 2000. With fewer subscriber additions coming in to replace customer churn, we expect our average tenure will continue to increase and the overall customer monthly churn rate should continue to decrease.

Just to give you a perspective, at the end of the second quarter 82% of our premium dial customers had two or more years of tenure with 53% of them having more than five years of tenure. In addition to churning less, these tenured subscribers use our value-added services more, they require less support, and they cause less bad debt. And that really has had a big impact on our results this year.

All this contributes to better profitability which again Kevin will walk you through in a few minutes. As we anticipated with our revised strategic focus, our subscriber levels have decreased. For the second quarter of 2008 EarthLink ending subs declined by 282,000 which is a slight improvement compared to last quarter due to better churn rates partially offset by fewer gross adds that I talked about previously. Consistent with the trends that we’ve discussed during the last few quarters our lower-value People PC service was almost 60% of our overall subscriber decline even though they comprise only 30% of the total subscriber base.

While we expect our subscriber churn to attenuate as the tenure of our base grows, our guidance anticipates that our passive adds will also attenuate as we continue to not invest in stimulating new subscriber growth. If we continue to see passive adds stay at the current levels, we believe there could be further upside but I would caution you not to simply assume that the passive adds will not be affected by our continuing to be relatively dark in advertising. For us we’re in uncharted territory as we enter the third straight quarter of very limited advertising.

As our customer base turns in line with historical cohort levels we expect it to evolve to a richer mix of higher ARPU and lifetime value premium dial and broadband subscribers. This reinforces the value of focusing on loyalty and retention to further build the tenure of our subscriber base and supports our belief that churn will continue to moderate as our subscriber base matures. As I’ve said many times we don’t run the business solely around subscriber numbers. The dial access business is not and will not be a net organic growth business. It’s a mature business that if run correctly we believe will generate meaningful cash flow for many years to come.

Beyond dial-up, broadband remains and important part of our product portfolio and I believe does differentiate us in the market place. In fact, at the end of the second quarter broadband represented 49% of our access revenue and 65% of that revenue is with customers that have been with us for two years or more and who are currently churning at approximately 1.5% a month. As I said, it’s a strategic advantage that we have. As customers band width needs change over time our access alternatives are available to support their entire Internet life cycle requirements. In this competitive market place EarthLink stands out as the unbundler with attractive stand-alone DSL and cable access solutions in many parts of the country.

Now let me briefly mention our business service division that primarily consists of New Edge Networks. While we continue to do a reasonable job of optimizing our cost structure I’ve not been pleased with our revenue performance in this segment to date. We are beginning to see some traction in our MPLS class of service over DSL products that was released during the second quarter of 2008 and most recently won a Frost & Sullivan award. By the end of June business services had booked more than $1 million in new contracts on that new technology. Although our sales teams are beginning to gain some momentum, this business unit’s top line revenue growth remains below my expectations and overall churn is higher particularly among customers with legacy networks. Much work is being done within business services to realign the sales channels, strengthen the network processes and systems to accelerate growth. We’ve been managing the network architecture and business processes and associated cost structures to be more aligned with the current business. In addition we’re continually working to improve our quality of service and customer retention that are so vital to top line growth. While our business services group is generating positive EBITDA now and is essentially cash flow neutral, I expect more from the business than we’re currently getting. We’ve made substantial progress at New Edge but I want to see our process and our product improvement translate into more progress on the top line.

Let me spend a few minutes on developments related to the Wi-Fi and Helio businesses. During the quarter we finalized exit strategies in the remaining Wi-Fi markets that complete the wind-down of this business. We reached an agreement in Philadelphia to transfer ownership of our wireless network to a group approved by the City. In Anaheim we’re decommissioning the Wi-Fi network and assisting our existing customers with alternative offers during the transition period. For the City of New Orleans we completed the removal of the Wi-Fi assets two weeks ahead of schedule. Separately in the second quarter as you know SK Telecom completed negotiations for the sale of Helio to Virgin Mobile USA. Under the agreement with Virgin, EarthLink’s equity and debt in Helio will be exchanged for approximately 2% of the equity of Virgin Mobile. I will remind you that we stopped investing in Helio last year and the value of our Helio investment has been reduced to $0 in our financial statement. In addition I’ll point out that we put no new cash into the deal that got done.

I’d like to now turn the call over to Kevin and he’ll walk you through more detail on our financial performance and guidance.

Kevin M. Dotts

We’ve been consistent with our strategy to pursue our subscribers expected to generate a positive lifetime value. As a result we are seeing expected retrenchment in our subscriber base thus decreasing revenue in the process but significantly increasing profitability compared to prior year results. Our overall revenue for the quarter was $246 million a 21% decrease from the second quarter of last year and decreased $17 million from last quarter primarily driven by declines in narrow band subscribers. As the company continues to transition through this group of early life higher churn subscribers that Rolla spoke about earlier, we expect to realize further revenue contraction. As churn attenuates we expect our passive subscriber gross additions will also continue to decline. Management believes that as a result of the subscriber declines, revenues could decrease in the same relative range for the next one to two quarters. However, we expect moderate cost savings primarily associated with variable costs such as cost of revenue, customer support, and bad debt to offset some of the revenue decline. If passive gross adds perform better than anticipated, this may provide an upside to current guidance.

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. As the maturity of our customer base continues to grow, these customers tend to be more engaged and utilizing more of our service offerings. We are pleased that our value-added services which include search, graphical advertising, and security products on a per subscriber basis improved to $2.75 per month from $2.55 per month in the second quarter of 2007. The company should benefit from the increased tenure and predictability of the customers’ behaviors and our ability to further monetize our interactions with them helping to offset some of the expected revenue declines.

On the support cost side, although we have fully executed on our 2007 restructuring plan to eliminate the very large buckets of low-hanging fruit with respect to support costs, management is still very focused on cost optimization. This is an ongoing process across all departments and functions here at EarthLink with everyone’s focus on driving out costs, improving margins, and maintaining a high quality up service.

Network expense or our cost of goods sold is our largest line item cost and we continue to execute effectively in that area. On the narrow band products we manage our third-party telecommunications partners and expenses through contracts which stipulate our ability to turn down significant numbers of ports as customers disconnect. This allows us to improve network utilization in a timely manner as our narrow band service abates. On broadband we have successfully renegotiated numerous telecom vendor contracts locking in rates as far out as 2011. EarthLink continues to make positive strides to keep network quality high while simultaneously reducing network costs.

Gross margins did decrease approximately $12 million in the second quarter compared to the first quarter 2008 as we were not able to completely offset revenue declines. As revenues continue to decline we expect that our gross margin will continue to decline in the coming quarters in a similar range and rate.

We also have been very focused on the cost optimization related to our back office expense structure. As our customer base becomes more tenured and churn rates continue to decline, we are seeing cost savings benefits as call volumes are coming down. In addition to fewer calls by tenured customers we are seeing an increase in the utilization of online support tools. Online chat now represents over 24% of contacts up from 18.5% in March of 2008. The cost of an online chat runs about $1.00 per chat versus $3.00 to $4.00 per phone call.

Earlier on the call Rolla spoke about the continued expected decline in gross subscriber additions. This is directly related to the significant reduction in sales and marketing expense which is down $26 million for the second quarter a 16.5% decline from the first quarter of 2008 and down $50 million from the second quarter of 2007. However, going forward for the next several quarters as we see the level of gross adds moderate we expect sales and marketing expense declines to moderate.

For the second quarter of 2008 the strong and ongoing focus on support cost reduction coupled with the reduced sales and marketing expenses resulted in adjusted EBITDA of $80 million a $37 million improvement from the second quarter of 2007. Thus far the company has been very successful in eliminating additional back office support costs to compensate for the declines in revenues and gross margins resulting in strong EBITDA performance. Not surprisingly, on a go-forward basis we do not anticipate the ability to implement the type of large scale cost reduction opportunities that we have seen over the past three quarters.

Additional revenue and gross margin declines will continue to pressure EarthLink’s EBITDA from the levels the company has generated over the past two quarters. As a result of the improvement in adjusted EBITDA, EarthLink’s income from continuing operations was $58 million or $0.51 per share compared to a loss from continuing operations of $7 million or -$0.06 per share in the prior year second quarter. The prior year second quarter results also included $40 million of equity losses related to our proportionate share of Helio operations which are not applicable to our second quarter 2008 results.

For the second quarter of 2008 EarthLink generated net income of $53 million or $0.48 per share compared to a net loss of $16 million or -$0.13 per share in the second quarter of 2007. We used $2 million for capital expenditures and cash payments for subscriber-based adds in the quarter compared to $14 million in the second quarter of 2007. Combined with the increase in adjusted EBITDA we generated $78 million of free cash flow during the second quarter of 2008 up significantly from the $30 million generated in the second quarter of last year.

Additionally, during the second quarter EarthLink received the expected $58 million settlement of our previous investment in Covad. Because of the free cash flow we generated during the second quarter coupled with the received Covad investments we experienced a cash increase of $122 million in the second quarter of 2008. We ended the second quarter of 2008 with $442 million of cash and marketable securities. Net of our bond obligations we have net cash and securities of $180 million.

We will now 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. For the year the company now expects to generate $275 million to $290 million in adjusted EBITDA. This adjusted EBITDA should also translate to $250 million to $270 million of free cash flow as we now expect to incur $20 million to $25 million of capital expenditures during 2008. Additionally for 2008 EarthLink expects record income from continuing operations of $180 million to $195 million.

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

Rolla P. Huff

It’s almost exactly one year ago that I joined EarthLink and had my first call with you. On last year’s second quarter earnings call we reported $44 million of EBITDA on $312 million in revenue. I’ll also point out that we had approximately 1,800 people in our core business and we had $383 million in cash and marketable securities. I think it would be fair to say that there was real investor concern about the cash outlays in our growth initiatives which resulted in our reporting a $16 million net loss in the quarter. And if you’ll recall I made the following points during my comments on that first call. I said that I would completely analyze every part of the business and importantly nothing was off the table. I told you that I believed we could substantially increase cash flow if we got our cost structure right and quickly decided what we would do and just as importantly what we were not going to do. And finally I told you that I believed that EarthLink should not be in the venture capital business. I bought shares on the day I started with those three points in mind.

One year later our company has been through an enormous amount of change. We’ve eliminated the cash burn associated with our underperforming growth initiatives, the headcount associated with our core business has been reduced from 1,800 people to fewer than 575 people, and obviously our free cash flow has increased from $30 million in the year ago quarter to $78 million this quarter but on $66 million less revenue.

We’ll continue to improve and innovate around operating our processes because I think we can be better. In a cash flow business like ours you can just never stop trying to redefine your business processes. This will be something that we always have to be focused on. I think as our results demonstrate, thoughtful but decisive action can create substantial value for shareholders. But we understand that being thoughtful about our operating decisions isn’t enough. We recognize the need to be thoughtful about our decisions around the best use of current cash and what we believe to be the substantial future cash flow of this company. So I want to spend a few minutes to share with you how we’re thinking about that point.

Clearly our priority during the first few quarters needed to be sorting through the various initiatives that were underway at EarthLink while determining what the optimal business model should be for the core business. We’re now working to determine if there are business models in adjacent or related industries that when combined with our core access business could create real operating synergy and as a result shareholder value. I believe these opportunities are limited but there are some out there that we’re going to at least look at.

For example, we believe that both the customers as well as the investors in this industry need to see consolidation of the narrow band market segment. When an industry reaches the point of maturation and growth stops, it simply makes good economic sense to consolidate onto one cost platform. Given the strength of the EarthLink brand, our core competency in managing consumer subscription businesses with intensive report requirements, our ability to offer customers a broadband alternative in many cases, and our ability to focus on optimizing customer retention we believe we’re best positioned to be the consolidator in this industry.

It’s estimated there are currently roughly 15 million narrow band subscribers today and that number will be somewhere between 8 million and 10 million subscribers in 2014. In addition there’s expected to be an estimated 2 million customers that will enter the narrow band category in 2008. We have no reason to think that they will not have the same early life churn that customers have traditionally been demonstrating over the last couple years but there will be more subscribers entering the industry. While others are walking away from customers in the narrow band industry we’re not only focusing on this large group of people, we’re providing them a connection to the web that suits their needs and required price points and we’re treating them with respect. If they want an unbundled high speed connection, EarthLink can oftentimes provide that. And as you know we have over 900,000 broadband customers today.

I can’t tell you how quickly we’re going to see industry consolidation or whether the opportunity even when it’s made available to be a consolidator will create enough shareholder value on a risk adjusted basis for EarthLink to be a buyer. But I do believe that our industry is at an inflection point and that EarthLink is well positioned to be a facilitator of what should be done.

We believe that it’s prudent to consider the strategic leverage our cash position creates especially given the current market conditions in the debt markets and giving us the opportunity to scale our business and leverage our core competencies. But we also know that it may not be in our shareholders’ interest to wait for this consolidation indefinitely. If in our judgment there are no alternatives that can provide scale, operating synergy and most importantly an acceptable risk adjusted return in a reasonable timeframe, we’ll resume the process of returning cash through stock buy-backs and/or dividends. We expect to be able to provide you more clarity on our plans around this point by the end of the year.

I hope that by now no one doubts our commitment to cash generation and preservation or our desire to make business decisions that are focused on shareholder value creation. We have no intention of changing that focus.

Finally, I’d like to again thank the EarthLink people, past and present, for staying focused on our customers. I think it would be easy to expect that any business that has gone through the dramatic changes we have as quickly as we have might go off the tracks. In fact, I think that would be the expectation. But our customer satisfaction, our customer retention, and our shareholder value creation has never been higher. Our people continue to manage this business very well every day. It’s the thousand things that our employees achieve every day that’s been the driver of our results to date. I expect that the people of EarthLink will stay completely focused on taking care of our customers and creating value for our shareholders.

Operator, why don’t we now open the lines and see if there are any questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Jennifer Watson - Goldman Sachs.

Jennifer Watson - Goldman Sachs

What is the greatest obstacle that you see to consolidation at this point in time? And does the current market make it more challenging for something to happen in the near term?

Rolla P. Huff

I don’t think that the market is impacting it. I think there are a lot of moving parts that are currently taking place in the industry that we read about every day in the newspaper and I think that we’ve been sort of waiting on some of those things to play themselves out. So I think the biggest obstacle is just sort of a clearing of this inflection point in the industry and we’re as anxious about that as everybody else is, but as I mentioned in my comments there will come a point when it just simply doesn’t make sense for our shareholders to sit on the cash that we have and I would hope that doesn’t affect our ability to be that consolidator and that’s why we’re going to give it a little more time before we change our view on that.

Jennifer Watson - Goldman Sachs

Who else would you see in the industry as being a consolidator?

Rolla P. Huff

I think we’re the best in the industry to do it.

Kevin M. Dotts

We’re certainly I think the best of the strategics.

Rolla P. Huff

Yes, I think there are really two or three players out there, obviously AOL being the largest, us being the second largest, United Online’s access business is probably the third largest group of customers, and then MSN is probably the fourth largest.

Operator

Our next question comes from Youssef Squali - Jefferies & Co.

Youssef Squali - Jefferies & Co.

You talked a little bit about exploring other areas. Can you just help us understand how far out of the access realm you would consider going as you explore uses for your cash? And secondly, philosophically assuming that you basically make a decision between now and year-end as to the best way for you to use the cash, do you have any preference as to strategies for recaps? Do you have a preference for dividends, for stock buy-backs, versus potentially going private? And then I have a follow up for Kevin.

Rolla P. Huff

In terms of the alternatives, we’ve tried to be as thoughtful about that as we have about how we’ve run the business, so as I think about it sort of the overarching answer is that I’d probably would not have a big tolerance for getting too far afield from our core competencies. And that’s the way I look at it. So we’ll look at what we believe are adjacent industries. I mean obviously we’re in the ISP business, we’re in the value-added services business, we’re in the web hosting business, we’re in the SELEC business. Beyond that though from my perspective it really the wisdom of a deal and for me to have the ability to look at our investors in the eye and tell them that we’ve created shareholder value, there has to be real synergy around whatever we do. And as I mentioned in my comments, I would be disingenuous if I said that there were a world of opportunities out there for the type of customer base that we have. There are some, and then it really boils down to whether or not we like the health of the industry, whether it’s the SELEC industry or the web hosting industry, the various industries that we’re in, whether we like the health of the industry, whether we like the core competencies that we can bring to the industry, but above all do we create synergies that create value? Because I’m not going to invest our cash in a business that our shareholders could do just as well if they invested the same cash in. We need to bring something more to the table and I think we’re going to run through that process pretty thoughtfully. I think the clearest purpose for our business would be to consolidate the industry, but we can only do that if there’s somebody on the other side of the table that is selling at a value that we can create value for our shareholders. I don’t want to be the consolidator just to have something to do. We really need to be able to demonstrate that we can create value with any transaction we do.

As far as the second part of your question, I think that if we start returning cash to shareholders, and remember I think we last year bought back even in the second half of the year something in the 12% to 13% of the company, we bought back that many shares. So we’ve obviously demonstrated that we’re willing to do it. The form that that takes I think will really depend on what the situation is at the time. So I don’t have a - my preference will really be driven by the type of return I think I can get to our shareholders using each vehicle.

Youssef Squali - Jefferies & Co.

And Kevin, on the free cash flow generation this quarter, I was just wondering if you could maybe tell us which areas in the P&L exceeded your expectations the most and kind of the sustainability of that? I think you clearly are saying not to expect the same type of synergies or cost savings that we saw in Q1 and Q2 but can you be more specific as to where these cost savings came out in Q2? Because I remember in Q1 you kind of said more or less the same thing. And lastly, what do you expect your cash to be at year end?

Kevin M. Dotts

I think we’ve talked about it to your point use of last quarter as well again this year we continued to see robust savings particularly in our customer support area, our bad debt line. And I think as we talked about before, there are two drivers there, one being the fact that tenured subscribers just don’t call the customer support help desk as frequently. That maybe obvious so that was a bit of a surprise as we went through the first quarter and we continued to realize even better performance in the second quarter. And likewise when customers are churning out and they tend to be as a mixed base more tenured. When they’re leaving us they’re not sticking us with bad debt, so that’s been a positive event. As I mentioned earlier we’re managing our network well so we’ve seen some benefits there. We’ve gotten some contracts renegotiated that will help us more on a go-forward basis so that as well has been a benefit. As I kind of look forward though I kind of see that right now at least for the near term and I mean over the next quarter or two that as we continue to see revenues decline and relatively at the same rates but obviously that’s going to get to be less of an issue as we enter into the first quarter, gross margins will also kind of follow that same path. And we had a nice set of savings of about $5 million quarter-over-quarter in our sales and marketing lines second quarter versus first quarter. I think the sales and marketing line kind of goes relatively flat to very small decline over the next couple of quarters. We’ll see a little bit of benefit in our customer support line of bad debt as I mentioned previously. So you kind of put all that together and we see kind of a graceful decline in the overall EBITDA number over the next quarter which kind of puts us in line with the probably upper level range of guidance that we talked about.

In conclusion to where we expect to end the year at in cash, I think relatively we talked about the total free cash flow being the $255 million to $270 million number, so that kind of gets you into about the $520 million to $530 million range I think for total ending cash and securities.

Rolla P. Huff

I would just add a point. I know it’s easy for everybody to sit back and think that we’ve just been holding out on you guys in terms of the results, but I would tell you this company was extraordinarily focused and thought every single day about growth. It probably had not spent as much time thinking about ways to be just as innovative in terms of getting cost structure down while maintaining customer experience. So as our customer base started to attenuate and we’ve seen more and more tenure in our base, I don’t think any of us understood what the cost structure of a customer in a 3+ year cohort was. We just had never looked at it that way. So again I would remind people we’ve gone from 1,800 to 575 people. You should not expect that we’re going to go from 575 to 15. It’s just not going to happen that way. But I can tell you we clearly understand that we have to continue to innovate in this business to keep our cost structure in line with our revenue. It’s got to be a core competency of ours and I think it’s a core competency that is being developed that wasn’t there a year ago. At the end of the time I’ve got to tell you I don’t think that anybody here is going to let up on trying to make it better and have to apologize for beating the numbers on the upside.

Operator

Our next question comes from Bryan Goldberg - J.P. Morgan.

Bryan Goldberg - J.P. Morgan

You mentioned in your prepared comments you had about 100,000 more subscribers relative to your budget at this point. I’m just wondering what categories of your business are you seeing the upside in? And secondarily, your cap ex guidance for $20 million to $25 million implies a pretty big uptick in second half spending given that you’ve only spent $2 million or $3 million year-to-date. I’m just wondering if you could help us reconcile that?

Rolla P. Huff

Sure. Let me give you a couple of talking points and then Kevin will probably want to jump in. Clearly the 100,000 subs are mostly narrow band subs. We saw upside beyond where we thought we would be in broadband but I think that 90% of the upside roughly would be on the narrow band side versus where we thought it would be.

From a cap ex spend perspective, you do see it ramping up but you’ve got to keep in mind the points that I was just making. We have to continue to innovate around how we take care of our customers, so we will be investing in IT infrastructure that allows us to get everything from maintenance costs down to giving us more flexibility to bring the size of our business down. So clearly you’ll see us making investments in that area. And then also in the New Edge area if the business is growing, we’ll need to and we expect to grow, we’re not going to run that business to be flat. We expect to grow it. And as we grow it that would require more cap ex.

Kevin, I don’t know if you’ve got a more definitive -

Kevin M. Dotts

In breaking down the cap ex, you think about what’s reinvesting into the New Edge Network, let’s say $4 million to $5 million range a year right now consistent with what we did in prior years, and then on top of that you’d have success based CPE cap ex which could be another call it $3 million to $5 million for New Edge alone. And then Bryan you’d kind of come back to the EarthLink consumer side of the business and you come back to our data centers and then as you said we’ve only paced a couple million dollars here in the first half of the year, but we anticipate that there are a couple of projects that will kind of come through in the second half that’ll put another between $5 million to $10+ million of additional cap ex into EarthLink into the data centers, disaster recovery things, a couple of other substantive projects. So I think we’re pretty comfortable that we’re in that $20 million to $25 million range right now. Also included in that $20 million to $25 million is subscriber based acquisitions. We continue to look out there. I don’t have a lot of hope that there’s a huge subscriber base acquisition right in front of us beyond what we’ve talked about with the consolidation of the larger players, but we continue to look for those opportunities and that could be another several million dollars worth of spend.

Rolla P. Huff

One of the things that we’ve probably not, well we haven’t spent a lot of time on, but as we’ve simplified our business and taken a lot of the complexity out of it, we have been taking down a meaningful percentage of our servers for example and we’re repurposing them. And that helped us in the first half of the year. So again there’s not one silver bullet around this point. It’s just a lot of different things that are taking place, but again we’re going to have to continue to evolve the business. We can’t let it stay flat if we’re going to continue to deliver cash flow.

Bryan Goldberg - J.P. Morgan

One quick follow up. I’m just curious, in light of the current economic environment, have you guys seen any change in non-tenured churn? Are these people less apt to move around right now in this environment?

Rolla P. Huff

Actually not really. Our churn by cohort, if we look at it over the last five or six years honestly, it’s remarkably consistent. We’ve obviously spent a lot of time understanding that. There’s not enormous volatility especially as people get more tenured, but I would say the newer people continue to churn at robust early life churn rates. What we try to do is get them transitioned, as many of them as we can, to our broadband platform and that’s an upside for us. So the answer is no, we haven’t seen a big change.

Operator

Our next question comes from James Friedland - Cowen and Company.

James Friedland - Cowen and Company

Two questions. The first is on FiOS, have you looked at it in terms of are you considering reselling the service and have you talked to Verizon about that? And the second question is, when you look at your tenured dial-up subscriber base, the premium customers, the 53% that are 5+ years, what are the demographics of those subscribers in terms of urban location versus rural and age demographics?

Rolla P. Huff

We have talked with Verizon from time to time around FiOS. It’s not something that, obviously we haven’t announced any particular agreement with them, but we’ll always look at adding products to our portfolio. Again I think our position has really evolved to more of the unbundler in the industry as opposed to the bundler. I think it’s becoming an increasing advantage for us to see the price point gap between the low end and the high end expand. As I mentioned in my comments we’re seeing the products like FiOS have price points that are just so far away from what a lot of people can afford, especially in this time period. It’s a strong attribute of ours that we continue to offer unbundled elements, whether it’s dial-up, DSL, cable modems, we’re not trying to bundle everything to the point that they’ve got $120 or $150 price points. Our customers are generally more rural than Tier 1. They tend to be older, they’re not power users of the web, many of them have our product as a back-up to what they might also have at home, they use it as a mobility product, many of our customers live in different places throughout the year and rather than having a broadband circuit in both places they use our product as a mobility product, and a lot of our customers in the interactions we have with them will use broadband at work. And again this is an increasing, you would expect that this could potentially increase given the economic climate. They have broadband at work and they use our service at home to continue to stay up on emails and that sort of thing.

James Friedland - Cowen and Company

And on the customers that are using as sort of a back-up or mobility product, do you have a sense of the percentage that are doing that?

Rolla P. Huff

No because we’re not able to get a statistically relevant sample off of our base. We’re constantly in dialogue with them either online or through surveys, but a lot of our customers they’ve been with us for a long time and just we’re very conscious about not wanting to constantly be barraging them. They’ve sort of made their choice.

Kevin M. Dotts

Jim, there’s one point I wanted to clarify when we talked about it. I think you mentioned the 53% number of the 5+ years or whatever. That is the total EarthLink base. The actual dial-up premium base over three years is 75% of our dial-up premium base so it’s pretty tenured.

Operator

Our next question comes from Srinivas Anantha - Oppenheimer & Co.

Srinivas Anantha - Oppenheimer & Co.

Rolla, just based on your comments on strategic initiatives, could you just talk about are there any things that EarthLink is undertaking just to drive organic growth within the business and if you could just give us an update on what’s going on with line powered voice service? The second one is on the cost front. Given that you guys have substantial information about your tenured customers and what kind of calling, how many times do they usually call. Instead of a run rate of operating expenses, could you guys give us what you expect towards the end of 4Q?

Rolla P. Huff

I’ll let Kevin talk about the run rate of op ex. In terms of the organic growth, as I’ve said we are putting a lot of emphasis on growing the New Edge business. We think that is a business that can and should be grown. We’ve had to work through some of their legacy products and we really have not had a new product introduction for a while, so our new product introduction I think will be helpful from that perspective. I think we’ve run various trials around line powered voice. The first thing that we wanted to do was get it operationally working the way we wanted it to work and I think we’ve done that. What we found is that our customers have a reasonable take rate when we offer the product to them. We’re not as successful in using that product to go out and convince somebody that didn’t already have an EarthLink relationship to drop their relationship and use our products. So it’s a product that we’re going to continue to offer as a save tool. We’re not going to spend a lot of money trying to stimulate the new customers in. And obviously if we had a bigger base of customers through a consolidation, I think that would absolutely be a platform that we would try to leverage against a much larger base of customers. I think the whole issue around looking at adjacent industries is looking for ways that we could get more organic growth into our business while leveraging what we have and what we are. So we’re going to be pretty particular about what we would spend our money on.

Kevin, do you want to talk a little bit about op ex?

Kevin M. Dotts

Sure. Sri, we’ve not provided obviously at this point guidance on cost structure here, but again I’m going to refer to the comments I made earlier, which were if you kind of break it down, we spent about $33 million on op ex as you see in our reported financials, $33.6 million to be exact. And when I think about that $33.6 million I believe that that comes down let’s call it a couple few million dollars over the next couple of quarters because you can’t really take the prior quarter’s worth of experiences and kind of straight line that forward because it has come down more rapidly. It’s due to the idea that there were cost benefits that we realized in the first quarter and in the fourth quarter and we kind of got a lot of that out and now going forward again as well as we both said on this call, it becomes more challenging to get that cost out going forward. So it’s more of a parabolic curve. At this point it’s beginning to attenuate. And again that’s customer support, that’s going to be our bad debt within our G&A area which is another area that could come down a couple million dollars over the next couple of quarters. Again you can’t straight line it but it is a parabolic curve that’s attenuating.

Srinivas Anantha - Oppenheimer & Co.

Rolla, if I’m looking at the gross adds have almost come down by 75% year-over-year and now the 35% sequentially, is there a minimum number of gross adds that you guys would like to add on an ongoing basis or even that’s pretty much an open question at this point of time or we will add as we see incremental demand or need there to be?

Rolla P. Huff

I think our challenge is to get our customer acquisition and processes down low enough that even if a customer only stays with us for six months, we can provide a return on whatever we’ve invested to get to that customer. So I would certainly expect that we should get more than our current market share of new subscribers coming into the industry, but I only want them if we can make them profitable. We’ve got no desire to grow for the sake of growth. What we’re really trying to work right now and it’s a continuing job is getting our business model down so that that early life churn doesn’t cause us to be upside down when we add a customer. And we’re going to continue to work on that. The last point I would make is as we think about how we’re expecting our business to perform is not driven by a lot of new gross adds in the future. As I mentioned in my comments, whether it’s because we’re the only one out there that’s pursuing this business or the economic times, if we wind up being able to bring more passive adds in than we’re expecting, there would be upside to the numbers that we’ve given you.

Srinivas Anantha - Oppenheimer & Co.

Rolla, I think there’s no doubt that it’s a good strategy, but what I was looking at with subscribers still coming down around 200,000 to 250,000 per quarter and as you guys had already mentioned that there’s not a whole lot of room on the cost front, clearly something has to give and at some point you would expect to see the subscribers grow. The cash flow, I’m sure you guys are generating a whole amount of free cash flow at this point of time, but at some point something has to give in here. That’s what I’m trying to -

Rolla P. Huff

Sure. I would love to be able to tell you how we’re going to make a dial-up base of customers grow. Other than strategic acquisitions I simply don’t think that’s going to happen. Clearly there has been the alternative for a while now for us to go out and just buy a business that’s growing with the cash that we have, but we’re just simply not going to do that if we’re going to kill shareholder value because it’s wildly dilutive and the dilution isn’t being offset by synergies. To me it doesn’t make sense. So what we’re going to try to do is continue to manage the business for what it is, we’re going to look for alternatives, but if the business continues to shrink but we’re providing a return to our shareholders, I think that’s what we’ll do.

Operator

Our last question comes from Scott Kessler – Standard & Poors.

Scott Kessler – Standard & Poors

It was earlier mentioned that a number of it sounded like distribution broadband deals were renewed. In your K that was filed at the end of February, there were three indicated as expiring later this year - Verizon in October of 2008, Comcast in December of 2008, and AT&T in December of 2008. Can you specify if any or all of those have been renewed per your comments from earlier?

Kevin M. Dotts

I think the Verizon went out several years Scott into the 2011 range, AT&T has gone out another year or so.

Rolla P. Huff

That was one that did get redone.

Kevin M. Dotts

And Comcast is still under discussion.

Scott Kessler – Standard & Poors

So if I had that correct, then the AT&T one has been renewed for what period of time?

Kevin M. Dotts

That’ll go out to 2009.

Rolla P. Huff

Through 2009.

Kevin M. Dotts

And Verizon out through 2011.

Scott Kessler – Standard & Poors

And then Comcast is still kind of out there if you will.

Kevin M. Dotts

But again if you look the number of subs, that’s obviously the smaller.

Rolla P. Huff

Yes, Comcast has been fairly diminimus for us. The Time-Warner agreement is much more substantial.

Kevin M. Dotts

And that goes out through 2011 as well.

Scott Kessler – Standard & Poors

The second question I had is while you articulated the businesses that you’re currently in, the ISP business, value-added service, web hosting, SELEC, and then you indicated that you would look at potential acquisitions in so-called adjacent industries. If those are your primary industries, then can you give us a sense of what you guys think about when you think about what the adjacent industries are?

Rolla P. Huff

Sure. For example, we talk about the broad category of value-added services. Within value-added services we do graphical advertising, so I don’t know that I would call that our core business. I would call that whole platform more adjacent. I think we’re in the Voice Over IP business but I would call that an adjacent industry, and please don’t take these as any view that we’re going to get into the Voice Over IP business but I’m just trying to give you some examples of how we would look at that. What I just don’t see us doing is going out and doing a deal where we were buying growth just for the sake of growth, but we were not going to be able to leverage who we are, our customers, our infrastructure, the consumer model that is so fundamental to who we are. We’re just not going to do something outside of that.

Scott Kessler – Standard & Poors

And I think that’s appreciated because frankly I think a lot of folks are wondering if like one of your primary competitors and peers if you’re going to pursue the strategy where you’re buying a social networking business or an ecommerce operation, so it’s good to hear that you’re presumably not going to do that.

Rolla P. Huff

I wouldn’t get too far afield from ecommerce. That is something that we would consider an adjacent industry. I don’t think given our customers and what we do social networking I would consider that adjacent for us. I’m not commenting on what anybody else has done, but for us I don’t see it. But ecommerce is a big space so there are things that we’ve looked at there but we’re going as I say be thoughtful about how we do this, but nothing is imminent, let’s just put it that way.

Operator

There are no further questions at this time. Do you have any closing remarks?

Rolla P. Huff

I’d like to thank everybody for spending a few minutes with us this morning. We’re going to continue to keep our heads down, operate the business for what we believe the potential is for it. We absolutely will be looking for alternatives that could get us started down the path of growth, but we’ve tried to be clear over the last 12 months that we are very focused on shareholder value creation. And I just don’t think that you should expect that that focus is going to change. So thanks everybody and we look forward to talking to you soon.

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