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Saj Karsan
Saj Karsan
Articles (5980) 

EarthLink: Low P/E, But Diverted Earnings

November 11, 2010 | About:
Earthlink (NASDAQ:ELNK) is an Internet Service Provider that trades with a P/E under 4! In addition, the company has very little in the way of debt compared to its cash flow.

Companies will often trade at ridiculously low P/E's due to either a short-term or a long-term issue. Value investors love instances of the former, since it creates a long-term profit opportunity. Unfortunately, Earthlink appears to be an example of the latter, as its business is in secular decline. Nevertheless, the company's P/E is so low that some value investors may be compelled to invest despite the declining industry Earthlink's main business faces.

How can a company in the internet services industry be in decline? Well, Earthlink's major business line is dial-up internet access for US consumers. It doesn't take a clairvoyant investor to realize that broadband internet is rendering dial-up obsolete, at least in this part of the world. The company's revenues over the last four years bear out this problem (in $ millions):


But the company has managed to cut costs in the face of this decline in revenue, as administrative costs have fallen from $770 million to $230 over this same period. Perhaps some value investors would be willing to overlook such declines when the asking price (a P/E of 4) is so low.

Unfortunately, most of the company's earnings are being diverted to other endeavours. While the company does pay a yield corresponding to 7% of its current stock price, that represents only a fraction of the company's earnings. Management appears intent on spending the rest of it on acquisitions that keep the company alive. Following what is effectively a $500 million acquisition (which is half of the company's market cap!), management had this to say on the company's latest conference call:

"After this transaction our company will still be highly unlevered. Our strong balance sheet and ongoing future cash flow will provide us an expanded set of organic and strategic alternatives."

That's fancy wording for "we're probably going to keep throwing good money after more acquisitions". Perhaps these acquisitions will be highly successful, or perhaps they will fail miserably. But value investors don't want even bets of this type. As such, there doesn't seem to be much reason for shareholders of such ilk to get involved, despite the extremely low P/E.

Disclosure: None


Saj Karsan

About the author:

Saj Karsan
Saj Karsan founded an investment and research firm that is based on the principles of value investing. He has an MBA from the Richard Ivey School of Business, and an undergraduate engineering degree from McGill University.

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