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EarthLink, Inc. (NASDAQ:ELNK)

Q3 2012 Earnings Call

October 30, 2012 8:30 AM ET

Executives

Louis Alterman – VP, Finance

Rolla Huff – Chairman and CEO

Joe Wetzel – President and COO

Brad Ferguson – EVP and CFO

Analysts

Mark Kelleher – Dougherty & Company

Barry McCarver – Stephens Inc

Mike Crawford – B Riley & Co

Donna Jaegers – DA Davidson

Operator

Good morning. My name is Sherit, and I will be your conference operator today. At this time, I would like to welcome everyone to the EarthLink Third Quarter 2012 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session.

I would now like to turn the conference over to Mr. Louis Alterman, Vice President of Finance for EarthLink. Please go ahead, sir.

Louis Alterman

Thanks, and welcome to our call. During today’s call, we will refer to earnings slides that are available for you to view in the Investor Relations section of our website at www.earthlink.net. 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 a reconciliation of the most comparable GAAP measures, please refer to our earnings release and Form 8-K that has been furnished at SEC, both of which are available on our website earthlink.net.

After Rolla’s comments, Joe Wetzel, our President and Chief Operating Officer will provide an integration update; and Brad Ferguson, our Chief Financial Officer will discuss the quarter’s financial results.

Now, I would like to hand things off to Rolla Huff, our Chairman and CEO.

Rolla Huff

Thanks, Louis, and thanks to everyone who is joining us this morning. We know a significant number of people who tune into these calls, live in the Northeast and have been affected by Hurricane Sandy. We just want to express that to all of you that you are on our thoughts and we hope that everyone in your families are out of harm’s way. If you could not tune into this live and are reading a transcript or listening to the replay, please don’t hesitate to reach out after the fact to us with your questions.

In the third quarter, we continued our company’s transformation into being a nationwide provider of IT services for the midmarket business customer. While our transformation began less than two years ago, I think we’ve made substantial progress. I have to tell you I’ve never been more convinced that the need for IT services is rapidly emerging in this marketplace. Customers of all sizes are realizing the opportunity, and in fact the requirement to leverage the power of cloud based services. The need for IT organizations to become more cost-effective while increasing information security and optimizing application performance in an increasingly distributed and mobile world is growing every day. So I have no doubt this is the right opportunity for EarthLink to be pursuing.

The fiber networks that we have acquired have given us an important core foundation on which to build our IT services platform. The IT service companies we acquired have given us the ability to more quickly get products into this marketplace. And of course our base of 150,000 business customers has given us a better understanding of what drives propensity to buy.

Today, as shown on slide two, we announced the next step in the evolution of our IP network and our cloud services platform. We will invest $45 million over the next four quarters to increase the capacity of our core IP network, as well as make our next generation cloud architecture more ubiquitous with superior, underlying performance capabilities. We will expand our application management suite of services, which include hosting, networking, security and support in our existing data center in Rochester, New York, with completion in Q1 of next year.

We will extend these services into four new data centers in San Jose, Chicago, Dallas, and South Florida with completion in Q3 – by the end of Q3 next year. The data center rollouts we discussed at our Investor Day in June are included in this plan, although we have significantly expanded the scope of what we’re building with our new second-generation architecture in five locations, with an enhanced, underlying IP infrastructure.

In addition, we’ll now be able to offer collocation as a component of an IT solution bundle in the four new data centers. We have recognized the need to give customers a path to leveraging our cloud-based services without having to make the decision to go completely virtual in one step.

Importantly, we will not be a builder of data center space. We’ve negotiated arrangements with the largest leading-edge space and power providers to lease colo space as needed. It is not our intention to offer space and power to our customers as a standalone product, but rather to offer it as an element of an IT solution they purchase from us.

With the additional four data centers, EarthLink will have a total of eight geographically dispersed data centers, which will be linked to our nationwide IP network. We also announced today that we’re increasing the capacity on our nationwide IP network, and will add next-generation optical transport capabilities from Miami to Ashburn, Virginia as well as major markets in the Southwest, including Austin, Dallas, San Antonio, Houston and Oklahoma City. This expansion will allow EarthLink to extend our wholesale offering by offering new, native 100 Gig transport services on select key routes on our diverse fiber footprint.

In addition, by integrating our network of data centers and cloud facilities with our expanded IP network, EarthLink is creating an end-to-end fabric to meet the growing demand for performance-optimized cloud solutions, as well as other IT services that include business continuity solutions, virtual desktop, cloud-based security, technical care and colocation.

We spent the past several months actually looking at companies that had data centers and underlying IP networks that could accelerate our business model. This for us was a classic build versus buy decision. We’ve never had a desire, as we’ve shared with you to offer space and power as a standalone product. But it is clear that customers see value in having some ability to colo as part of an integrated IT solution.

We love the idea of buying $75 million or $100 million of revenue that was growing at 15% or 20% a year. But the valuation multiples of the space and power business models have gotten to levels that simply couldn’t work for our shareholders. We believe our hybrid lease build decision is simply a better risk-adjusted bet to make. We don’t have to be a builder of bulk data center space, but rather can commit to it as we have the need. We all know how capital-intensive space and power business models are. This keeps us focused on our cloud strategy in a more capital efficient way. We want to focus on application management and performance as a product, rather than power and real estate as products. Brad will walk you through the details of the quarter, but I’d like to just provide a few high-level comments on our performance.

Starting on slide three, for the fifth consecutive quarter, we improved our revenue profile. As we told you last quarter, the nature of our business is that there’s always some noise and lumpiness from disputes taking place with vendors, customers, tax jurisdictions, and others. Last quarter, we discussed the cost of revenue accrual related to an audit of Universal Service fees. This quarter, the ball bounced the other way; we were able to successfully resolve some vendor disputes resulting in a favorable benefit to our revenue and EBITDA which Brad will talk about in more detail in a few minutes.

Normalizing for these one-time impacts, our pro forma year-over-year Business segment revenue declines improved from 5% last quarter to 4.6%. Our total company declines, including consumer, improved from 7.9% last quarter to 7.3%.

I mentioned last quarter that getting our Business Services segment to grow sequentially this year would be a difficult task, given the seasonality that typically impacts our business in the fourth quarter. However, including the dispute settlements, Q3 business revenues rounded to being equal to Q2 revenues, and on an normalized basis, we came pretty close with sequential declines improving to 0.7%.

These improvements to the top line are primarily a result of the work we’ve done to improve churn and stabilize new bookings. Starting with churn on slide four in the third quarter, Business segment retail revenue churn rounded up to 1.5%. This ticked up five basis points from Q2, but was well below the 2% plus levels we saw pre-acquisition.

Consumer churn followed its normal seasonal pattern where it ticks up in Q3 due to some removers. All the consumer activity at a cohort level was right on plan and we expect churn to continue to decline over time.

On slide five, our sales activity and funnels are increasing, and increasing materially. The dollar value of the opportunities in our retail pipeline grew 72% from June to September and the average deal per – deal size per opportunity in the funnel is up 44%. As our flat retail sales suggest, however, we’re not seeing opportunities convert to deals at the same rate of growth. Now, we’re not seeing deals being lost to competitors. We believe decision cycles are extending because of a combination of larger deal size in our new products and some indecision that’s being caused by macro uncertainties that we hope to get resolved after the elections. We also believe that because our IT solutions have been entirely virtual, the solutions have been a bigger leap for customers who want the flexibility to go virtual in steps.

Over the past 18 months, we’ve seen strong wholesale opportunities on many of our unique fiber routes. Our new monthly recurring bookings for Q3 were up about a third over Q2 and approximately double those from Q1. We knew that our fiber footprint would be relevant to our customers, but our ability to leverage our fiber footprint is outpacing our expectations. We’ll be overbuilding some of these routes and offering some new routes as part of our core IP network enhancement that I discussed earlier.

Brad will discuss the impact these investments have on our guidance in a few minutes. Given the retail sales levels we’ve had in the past quarter or two, the improvements in revenue over the next several quarters will be slower than we had previously modeled. However, revenue will still continue to improve at a measured pace until we begin converting some of the larger deals in our funnels and we begin to bring our new data centers and next gen Cloud stacks online. I strongly believe they will have a meaningful impact on our trend lines over the mid and long-term.

I’d like to finish my comments on slide six by sharing with you how we’re thinking about our capital structure. While we will continue to be open to evaluating inorganic transactions that make strategic and financial sense, in the near-term, at current valuations we’re finding significantly better risk and return by pursuing these organic projects.

As we fund these organic investments and see decreasing likelihood, at least in the immediate term of a sizable, strategic transaction, we’re taking additional steps to adjust and reduce the cost of our capital structure. This morning, we announced plans to redeem 10% of our outstanding 10.5% Deltacom notes, or approximately $33 million. We’re paying $103 per bond to retire the debt.

Next spring we’ll have an option to call the reminder of the Deltacom notes at $105 if we want to. In the interim period between now and next spring we’ll be thoughtful about other options that might be available around these notes. A few other points on our capital allocation strategy. As we’ve said in the past, we’re – we’ll continue to be opportunistic about buybacks and will continue to participate in share repurchases when we believe that’s the best use of our capital. To that point, in the second quarter the company repurchased 1.2 million shares of EarthLink’s stock at an average price of $6.70 taking our total buybacks for the year to just under 2 million shares.

Next, I’d like to ask Joe to walk you through an update on our integration progress. I think it’s important to note that we signed Joe to a consulting arrangement that gives us certainty that he’ll be accessible to us as needed through the third quarter of next year. We very much appreciate Joe’s willingness to see this project through and very much appreciate how much better he’s made our company over the past five years.

This will be Joe’s last call, and I just want to say on a personal note, Joe has been, as I say, incredible for our company, but he’s also been an incredible friend. We continue to make terrific progress on the component pieces of our integration, and we are very focused on the reality that this transformation will change the work processes for 2500 of our 3200 employees.

The amount of training that we need to deliver before the cutover occurs is immense. Pulling people out of their jobs for training in the holiday-rich fourth quarter led to our decision to extend certain OSS system cutovers into next year to allow us to expand user acceptance testing and training. I can’t overstate how eager we’re – we all are to put the major portion of this integration behind us, but it’s imperative that it be done well, and I know Joe is very focused on making sure that happen.

So Joe, if you would walk people through the – where we are in the integration, it’d be terrific.

Joe Wetzel

Thanks Rolla, and thanks for the kind words. As we do each quarter, I’d like to provide you with a sense of how we’re performing against our integration objectives on slide seven. Our original commitment was a timeline of three years to complete the integration, taking us into the second quarter of 2014. We’ve made tremendous progress so far and essentially have two major system milestones remaining; our OSS platform and billing consolidation. As you recall from our discussion last quarter, we are currently working in an environment consisting of five OSS platforms, which is affecting our efficiency across most organizations in the company. The OSS deliverable is in two phases; bulk of the work is in the first phase, which will allow us for a unified quoting environment, customer management platform, and ordering system across the entire EarthLink complete product set. This will greatly improve business processes across multiple functions in several ways. First, they will allow us to quote opportunities more effectively and move a bit faster in the market.

Second, we’ll have a single consolidated order management system to move orders through various OSS components, supporting our network and IT assets. Third, we’ll have the ability to track order progress, both internally and externally in a uniform manner, improving our customer experience, as well as increasing our efficiency.

Lastly, it will allow for a consolidated service management platform and associated care processes nationally. All these things will greatly simplify the process from opportunity, to order, to provisioning and billing, and allow our sales people to spend their time doing what they should be doing, which is selling.

We talked last quarter about having a meaningful part of the new OSS platform in production by the end of this year. While we’ll have milestones along the way, we have added several new upgraded features to our OSS. As a result, we have chosen to build in time for extended user acceptance testing.

We are also rolling out an extended education and training plan, since this affects so many employees. These decisions will push completion of our first transformational phase that I just described until the end of the first quarter of 2013. Phase 2, which focuses on more consolidating the final remaining inventory and provisioning platforms to be completed by the third quarter of 2013. As Rolla said, we want to do this right; we have to do this right. We expect to approach our goal of $40 million annual recurring synergies by the end of this year, well ahead of schedule, and we believe we will realize an additional $8 million or so when it’s all said and done.

These additional synergies will begin to come in the second half of 2013 as we complete each of the remaining objectives, with the final wave coming following the completion of our billing migration in the first half of 2014, on track with a three-year timeline. While we have completed several important milestones in the last 90 days, this quarter was primarily focused on two primary areas.

The first was to add functionality into the common sales management platform, and the second was related to getting major elements – or OSS delivery into testing and development. We delivered new tools for our sales team, including additional CRM capabilities for inside sales force and we are on pace to roll out new campaign management tools in the next 30 days. As I said last quarter, integration is complex work that touch all employees in an organization.

Internally, we termed it transformation because it is so much more than thinking about collapsing IT platforms. It truly gives us the ability to think about how we can better serve customers more effectively and efficiently. It involves process improvements, changes in management practice, corresponding investment in the network, and overall better control over the lifecycle experience that our customers count on. Everyone is looking forward to getting past this stage and on transformation, but in the meantime, we’re heads down and focused on the work ahead.

Now I’ll turn it over to Brad, who will spend a few minutes diving deeper into our financial results and guidance. Brad?

Brad Ferguson

Thanks, Joe. I’ll begin on slide eight. As Rolla mentioned earlier in the call, the nature of the business is that there is typically some level of noise or lumpiness in our results due to items such as vendor or customer disputes, tax or regulatory audits and other legal matters.

Last quarter, we accrued $8 million – an $8 million reserve for an ongoing USAC audit. We did not adjust the USAC audit accrual this quarter and don’t expect to learn more definitive results of the audit until mid next year, but we could adjust the accrual before then to the extent we learn more information that helps us make a better estimate of the final outcome.

In the third quarter, our team was able to successfully resolve several ongoing vendor disputes that resulted in a one-time benefit to revenue of around $1.5 million. Additionally, our team simplified and streamlined certain portions of our legal entity structure resulting in a benefit of $2 million and below adjusted EBITDA income tax savings.

As we’ve said in the past, these one-time items can go either way, but in the near-term we probably see slightly more opportunity than risk due to other disputes that we’re working towards resolution. However, over the long-term, there could be more opportunity as well as risk items including the trend of a growing number and size of patent infringement claims.

Now, more on the results. In the third quarter, we continued to generate meaningful adjusted EBITDA and unlevered free cash flow. We generated adjusted EBITDA of $70 million, which was down from $91 million in the third quarter of 2011 and up from $66 million in the second quarter of 2012, which was negatively impacted by the $8 million USAC accrual. EarthLink’s reported net income during the third quarter of 2012 was $1.4 million or $0.01 per share. Normalizing for the benefits I just described, we had a net loss of approximately $0.02 per share.

Moving to slide nine, you can see that our balance sheet continues to remain strong. We ended the quarter with $310 million of cash and marketable securities and we have $625 million of gross debt outstanding, which will fall to approximately $593 million after we execute the call option on the Deltacom notes that Rolla mentioned.

We have a call option for the remaining 90% of the notes in April of next year and are thinking through our options around that debt. We also have an undrawn $150 million revolving credit line and our net leverage ratio is just over 1.1x adjusted EBITDA. In the second quarter, we repurchased approximately 1.2 million shares at an average price of $6.70 per share and we have $86 million of share repurchase authorization remaining.

The key sources and uses of cash are outlined on slide ten. During the quarter, we utilized $25 million for capital expenditures and also returned $13 million to shareholders through dividends and share repurchases. Year-to-date, we’ve returned just under $30 million. We saw favorable networking capital impacts due to the quarter – during the quarter related to accrued interest expense as well as the normal lumpiness in timing of payments and receipts to and from vendors and large customers.

We do expect cash to decrease in the fourth quarter due to the payment timing of our semiannual interest payments, the 10% reduction of the Deltacom notes, and the increase in our capital spending, which I’ll discuss more in a minute.

Now I’ll discuss some of the operating results and metrics in a little more detail. Moving on to slide 11, total revenue for the third quarter of 2012 was $335 million, which consisted of $257 million of Business Services revenue or 77% of total revenues, and $78 million of Consumer revenue. Normalizing for the $1.5 million in favorable items I described earlier, Business Services revenue decreased less than 1% compared to the second quarter of 2012. Business segment declines are moderating due to improvements in customer churn compared to historical trends, a stabilization of new bookings and a continually improving product mix. However, as Rolla mentioned, the pace of improvement for retail new bookings has been slower than we’d like.

In the Consumer segment, revenue decreased $3 million from the second quarter of 2012, an improvement from the $3.4 million sequential decline a year ago and the $4.4 million sequential decline a year earlier. The consumer business has been flattening for several years now and we expect this trend to continue.

In the third quarter of 2012, business revenue churn ticked up slightly, rounding up to 1.5%, up five basis points from the last quarter and down approximately 16 basis points from the year ago quarter. In the Consumer segment, net subscriber losses were 47,000 in the third quarter of 2012, down from 52,000 in the second quarter of 2012 and 68,000 in the third quarter of 2011.

Consistent with the historical third quarter seasonal patterns, total consumer churn increased sequentially to 2.5% in the third quarter of 2012, which was equivalent to the first quarter of 2012 and below the 2.7% churn from a year ago quarter. We expect seasonality to impact some of the quarterly trends, but expect consumer churn to continue to decrease over time. Our total cost of revenue was $158 million in the third quarter of 2012, yielding a gross margin rate of 53%, which was flat to the normalized rate in the second quarter, excluding the USAC reserve.

Selling, general and administrative expenses were $110 million for the third quarter, up approximately $2 million sequentially after normalizing for the accounting treatment of some expenses, which will reclassify the cost to revenue in the second quarter. We’ve also begun to gain traction with our recruiting efforts and added additional quota-bearing reps that increase people-related expenses within our Business Services segment.

Turning now to slide 12, as Rolla mentioned we’ve seen a lot of success in our wholesale motion as demand for bandwidth increases and carriers’ value the diverse routes we have in place. When combined with the sales from our growth products, which include MPLS, hosted VoIP, and our IT services suite, 50% of total new bookings in the third quarter came from products that are growing. This is up from 40% in the third – first quarter, and 46% in the second quarter of 2012.

Now for the financial outlook for 2012 which begins on slide 13. As we mentioned on last quarter’s call, and consistent with the historical trends in our business, we expect Business segment revenues to decline sequentially by approximately $3 million to $4 million in the fourth quarter due to the favorable item in Q3 and seasonality.

Beyond Q4 we’re not going to try to pinpoint with precise accuracy the quarter-over-quarter revenue changes, but here is what we expect. We’ve now gotten the Business segment to under a 5% year-over-year, and under 1% quarter-over-quarter decline. While there is some lumpiness and noise, these numbers have steadily improved and we think they will continue to improve. We expect the rate of improvement through much of 2013 to be close to the measured pace we have seen so far this year. As the data centers and fiber infrastructure deployed through the year, we expect to book new business. As this business is installed, we expect to further improve the 2014 and 2015 trend lines over current rates. For the full year 2012 we are nearing the range of our adjusted EBITDA projections to $277 million to $283 million.

Going forward, we can expect total company margins to continue to contract in the near-term due to the scale loss from declining revenues, the overall shift in mix to business services and the fact that we are making investments in IT services capabilities in advance of scaling the revenue.

However, as we gain traction on our higher margin IT products like virtualization and security, we believe this can be favorably impacted over time. For the full year 2012 we are projecting a net income range of $3 million to $5 million. A reconciliation of our adjusted EBITDA guidance to our net income guidance is provided on slide 19.

Moving on to CapEx on slide 14, we expect to deploy $215 million to $225 million over the next five quarters. This would have us spending an amount consistent with our most recently issued CapEx guidance for 2012, and spending a similar amount in 2013, plus the $45 million investment that Rolla discussed earlier. The portion of our total spend that we expect to occur in Q4 of this year could be anywhere from $50 million to $80 million.

Now we acknowledge this as a wide range, but we are actively negotiating the best possible deals with our vendors, and some of the timing of when the equipment lands on the dock and is paid for could depend on the terms we agree to in with them. For all the reasons we – for all these reasons, we thought it was most helpful just to provide a five-quarter view.

With that, operator, let’s open up the lines for questions.

Question-and-Answer Session

Operator

(Operator Instructions) And your first question comes from Mark Kelleher with Dougherty & Company.

Mark Kelleher – Dougherty & Company

Great. Thanks for taking the questions. I was just wondering if you could talk about the five OSS platforms that are being somewhat delayed into Q1. I know that was affecting your ability to train your salespeople on those platforms. Can you just talk about what effect that delay will have? Is it affecting your rate of hiring and which platforms – if you’re hiring people now, which platforms are you training them on? Thanks.

Rolla Huff

Mark, it will impact it a little bit. We’re probably – for a lot of reasons we’re looking at what the right number of direct sales people are, but clearly as we push this out another 90 days – 90 to 120 days, it will have an impact. But we weigh that against trying to get the vast majority of our company trained on platforms that are really quite new, and trying to do it during the fourth quarter when there are so many holidays in the mix. And so for all those reasons we really thought that it was smarter to expand user acceptance testing, make sure that we were comfortable before we threw the switch, because this is going to be a substantial change for us – a positive change, but it will be a substantial change.

Mark Kelleher – Dougherty & Company

Okay. And switching topics a little bit, on the data center buildouts, are you going to do those all at once or is there going to be a sequence that you’re going to build them out in?

Rolla Huff

We will – we’ll be working on them simultaneously, but the sequence will be, Rochester first, we think San Jose will be the second to come online, and then Chicago, Dallas and South Florida, within call it 120 days of each other.

Mark Kelleher – Dougherty & Company

Okay, great. Thanks.

Rolla Huff

Thanks.

Operator

And your next question comes from Barry McCarver with Stephens Inc.

Barry McCarver – Stephens Inc

Hi, good morning guys.

Rolla Huff

Hi, Barry.

Barry McCarver – Stephens Inc

On that – on data center expansion on slide two, I noticed you’re also indicating a new fiber expansion, I guess to connect those data centers with some key markets. Is that – is that a biggest piece of the CapEx we’re discussing over the next five quarters or is that something that was already underway?

Rolla Huff

Now, it really is – well it’s – it’s to overbuild some of our wholesale routes, but also clearly put together a bigger IP network that is really focused on connecting our data centers in – with much bigger capacity and higher speeds. We are – the way we’re deploying these data centers, we’re – they’re going to be mated pairs, so that we can do literally hot replication from one site to another. And you only need to look at what’s happening in the Northeast right now to know that there is real value in being able to do hot replication on a real-time basis. But it just takes a big path. So, between what we’re doing on the wholesale side and improving our IP network to support cloud-to-cloud connectivity, that’s the vast majority of the CapEx change.

Barry McCarver – Stephens Inc

Well, with that in mind, can you flush out a little bit, the bit of a – kind of demand you’re seeing for those services today and give us an idea of the revenue generation currently, and then sort of what your expectations are over the course of the next couple of years as a kind of percentage of your total business services.

Rolla Huff

I could see wholesale moving up as a percentage of our business, not in a massive way, but in – a little bit more than what we’ve been seeing. We’ve got – we’ve got some fairly unique routes that have gotten – that have had a lot of demand. And so, in many ways we’re taking the fiber that we have and just putting more electronics on it to expand the capacity, just based out of demand. So I think you could see wholesale as a percentage of our business services revenue increasing over time.

Brad Ferguson

Yes, certainly. It’s 15% of our business services revenue now, and with some of the legacy pieces declining, plus the wholesale piece growing, I mean that factor right there will become a bigger portion over time.

Barry McCarver – Stephens Inc

Okay, and then just lastly, I believe I heard in your prepared remarks the availability of a 100 Gigabyte transit services, is that – was that correct?

Rolla Huff

Correct.

Barry McCarver – Stephens Inc

Is that something you’re actually selling to customers or are you really more referring to just connecting these data centers?

Rolla Huff

Both. There is demand for those kinds of services, but what we’re most focused on is making sure that we’ve got good cloud-to-cloud connectivity. I think a lot of the 100-Gig transport is on the links that I called out and there is clearly demand from customers for those links.

Barry McCarver – Stephens Inc

Great, that’s very helpful. Thanks guys.

Rolla Huff

Sure.

Operator

And your next question comes from Mike Crawford with B Riley & Co.

Mike Crawford – B Riley & Co

Thank you very much. Just on the data center decision to collocate, can you just go into a bit more detail on the tradeoffs in terms of fixed versus variable cost to deliver colo services as opposed to building a data center with all the space and power?

Rolla Huff

Sure. So as we thought about just building data – so there were really three ways to do this; there was, build the data centers ourselves; go out and buy existing data center businesses; or do what we’ve done, which is a hybrid view. What we found is that if we were going to build data centers, building data center space at less than 15,000 to 20,000 square feet at a time just was not going to be efficient, compared to the other business models out there.

We fundamentally don’t want to sell space and power as a standalone product, but we’ve clearly recognized and heard our customers tell us that they want to have the availability of some colo to do dedicated servers for applications that they don’t want to necessarily virtualize immediately. As we were looking at buying data centers – data center businesses, we were seeing valuations that range from – it was – correct, 14 times to 17 or 18 times depending on the business. And so we really just could not find a path that we felt would be reasonable for our shareholders.

What we did find was that some of the very largest providers of space and power were willing to give us space for our cloud – obviously we’re paying for that, but then basically pay per – I call it Pay Per Sip – as we needed colo space, we would – we’ll take it down from them. So that works if – as long as you’re not selling colo as your lead product, because clearly we will not have the same cost structure as existing space and power companies.

But – so we will be very disciplined around, we will only sell space and power as part of a bundled IT solution, where they are taking either our IT services, our MPLS network or some combination of the two. So the economics change dramatically in terms of what it costs, the cash that we have to pay to build out physical data centers versus trying to have a more variable structure around colo space.

Mike Crawford – B Riley & Co

Rolla, if I can just continue that question line. So with New Edge Networks for example you had still the – you had MPLS networks, but one that had some higher cost to deliver to service because you didn’t have your own fiber to run traffics’ over. So, I mean is that something that you think is going to hinder you longer-term? What’s your hybrid data center strategy now, and is something you might revisit in a few years or is this less of a concern in this regard as opposed to what was affecting New Edge previously?

Rolla Huff

What – look, we – any time we can put new – buy networks and drive our cost structure down, we’ll have to be interested in that. But I think we’ve understood forever that we will never have networks into every building and to every customer location. That’s just part of the – that’s just part of the business model that we operate in. I think that the deals that we’ve done today have really given us the foundation for this new strategy.

And if there are networks that we could acquire at valuation multiples that brought our overall cost down in a reasonable way that we thought we could get return, then we’ll obviously look at them. We just have – are not seeing that; we’re seeing valuations still at elevated levels that we just don’t believe makes sense for us. And so I’ve – we’ve been sitting on a lot of cash for a long time waiting for that to break, and we’re not seeing it break. And so, we are going to continue down the IT services path, but I don’t know how long this valuation bubble is going to last, honestly.

Brad Ferguson

Yes, and Mike, if you’re asking us if there is an analogy where we’re going to look up one day and say, oh, we should have built the data centers because colo is huge and we don’t have good economics, I think our view is that colo is really just a bridge; that the long-term place to be isn’t colo, it’s the cloud solutions that we do have (inaudible).

Rolla Huff

Absolutely. We know that the world is going to go virtual. There is an interim step that customers want to take, but I don’t know that in three years or five years or eight years, but we know that the path is to the cloud, if not just the physical structures.

Mike Crawford – B Riley & Co

Okay, thank you. And if I may, just one final question, you talked about some progress on sales front, getting some new salespeople in; there has also been some transition out of the company from some middle management, including Barbara Dondiego and Cardi Prinzi. Are – is there any comment to make on the more senior management changes?

Rolla Huff

Look, Barbara and Cardi, both terrific people and they really were very valuable to our company. I think what you’re seeing is, we are moving not just our infrastructure but our organization structure to support the IT services business that we’re moving towards. And so we’re trying to bring more senior management and that is really focused on that part of our strategy. So this is, love them to death, and I think they would tell you, they love us to death. It’s just we think this is the right way to evolve the organization.

Mike Crawford – B Riley & Co

Okay, thank you very much.

Operator

Your final question comes from Donna Jaegers with D. A. Davidson.

Donna Jaegers – DA Davidson

Hi guys, good quarter.

Rolla Huff

Hi, Donna.

Donna Jaegers – DA Davidson

Can you talk a little bit more on the wholesale side of the business? What sort of deals are you signing? Are these Lit services deals for over a certain term? Are they – do you selling dark fiber on your routes? What exactly are you doing on the wholesale side?

Rolla Huff

We are not selling dark fiber; we are selling Lit services only and we just – as the Googles’ and the very big providers, as more data is traversing these networks, it’s – there is just more capacity required and we’re just – we are seeing it clearly. Also, I would tell you that the wireless companies are continuing to need more and more bandwidth. But we are only selling Lit services.

Donna Jaegers – DA Davidson

And the term of those is usually around a year?

Rolla Huff

No. It’s – it – I would say on average its three years; we are doing some five-year deals, but we are – our pricing is all driven around the term because we sort of – as I have always talked about, we sort of think about how we want to get our cash back within a – within the term of a contract.

Donna Jaegers – DA Davidson

Okay. And then on – talk if you would, what are you seeing on a competitive dynamics in your business. Obviously cable’s continuing to erode sort of the low-end business, so how hard is that hitting you? And then are you seeing anything new in the mid-size and larger customer area?

Rolla Huff

No question, cable is chewing up the low end of the business, as it has been for the last several quarters. We think our IT services are helping a little bit at that end, but for these smaller and smaller accounts that are individual T1’s or even just past customers they are clearly moving over to the cable area.

I think in IT services, Rackspace is a ferocious competitor for sure. We think we’ve got a differentiated offer from them and we’re trying to develop that. But I really feel good that we’ve got a unique offering that people are very interested in. I think our big challenge has just been getting the interest converted into deals, and I think people are just – it’s one thing to buy a circuit; it’s another thing to begin to move mission-critical applications into a virtual world. And everybody knows they got to get there, but it’s just a longer decision cycle. No question.

Donna Jaegers – DA Davidson

Okay. And then it looks like you guys added about 16 people to your retail sales force. Can you – I know Mike Toplisek was trying to hire some sales engineering types too to sort of help with more specialization in the sales force. Where are you guys at as far as that progress?

Rolla Huff

We’re making – Mike is making great progress. He has hired – he is probably at 75% of his – of the hires that he is planning. We’re looking at deploying on a nationwide basis 25 IT solution consultants that will work with our direct sales people to really be the people that are architecting these solutions with customers. So – and we’re seeing, when they are involved, the close rates go up, there is no question about it.

Donna Jaegers – DA Davidson

And then one last question, I haven’t read all the details on the damage in the New York area, but obviously a lot of outages and a lot of flooding. How much of your backlog is in the affected area? So how – and obviously I don’t know – you don’t know how long that’s going to be postponed, but can you give us some flavor on what percentage of your funnel is in the affected area?

Rolla Huff

Boy! I couldn’t Donna. That’s – it’s a great question, but I could not give you the breakdown by – of the funnel. I would, just looking – just thinking about it, I would guess that it would probably be 35%, 40% of the – of our funnel. I’m just thinking about our nation – what’s in our funnel from a – looking at Brad here, what’s in our funnel around nationwide MPLS types of networks and what’s in the Southeast. So I would...

Brad Ferguson

Yes, I mean, I might think it’s a little less than that just based on proportion of where we have our branches too.

Rolla Huff

Yes, that’s...

Brad Ferguson

I mean a small portion of our branches were really impacted by the storm, but certainly a lot of our customers in the Northeast, but I’d say a little less than that.

Rolla Huff

Yes, we were – so far all initial reports are that we were – our network survived quite well. We’ve got four sites on generator. From what we can see, we’ve got under 1,000 customers that we are showing as their sites are down. That could be because they are out of power. So it’s not necessarily a network failure. But as we look into the network we can see 1,000 sites that are down and we’ve got one OC-48 that’s been switched to protect mode, and that’s really the extent that – of the impact that’s come out of our – the reports from our NOC.

Donna Jaegers – DA Davidson

That’s great. Good, thanks so much for your time.

Brad Ferguson

Okay. Thank you.

Rolla Huff

Thanks so much. I want to just thank everybody for listening today. Again, our hearts and prayers go out for everyone in the Northeast. That was devastating, and I can tell you, having two kids there, it’s been top of mind for me.

Needless to say, I am excited about our continually – continued progress towards building a – our growing IT Services business. I love the fact that when I sit down with a customer, I can see that what we’re putting in place is relevant to them. So we’re going to keep working hard and pushing forward. Thanks everybody, and appreciate your joining us this morning. Take care.

Operator

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

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