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Earthlink (ELNK) – Mr. Market Looking Through the Looking Glass

December 13, 2011 | About:
Overview:

- Undergoing restructuring primarily through acquisitions

- Investment community sentiment low for company; holds balanced perception for the industry

- Valuation range of $11.00 to $18.00

Business:

EarthLink (ELNK) operates two reportable segments, Business Services and Consumer Services. The company’s Business Services segment provides a comprehensive suite of communications and technology services, including voice, data, managed network services, cloud hosting and equipment services, to businesses, enterprise organizations and communications carriers. The Company’s Consumer Services segment provides nationwide Internet access and related value-added services to residential customers.

The company’s Business Services segment earns revenue from the provision of retail services, wholesale services and other services. Retail services include data services, including managed IP-based network services and broadband Internet access services; voice services, including local exchange, long-distance, conference calling and hosted VoIP; mobile voice and data services; and data center and managed services provided to businesses and enterprise organizations. Wholesale services include the sale of transmission capacity to other telecommunications carriers. Other services include web hosting and the sale of customer premises equipment. Revenues generally consist of recurring monthly charges for such services; usage fees; installation fees; equipment fees and termination fees. For the last reported nine months 2011, the Business Services segment had $675 million in sales largely attributed to the most recent acquired businesses over the past year.

The company’s Consumer Services segment earns revenue from the provision of access services and related value-added services. Access services include narrowband access services (including traditional, fully-featured narrowband access and value-priced narrowband access) and broadband access services (including high-speed access via DSL and cable and VoIP). Value-added services includes revenues from ancillary services sold as add-on features to EarthLink’s Internet access services, such as security products, premium email only, home networking, email storage and Internet call waiting; search revenues; and advertising revenues. Revenues generally consist of recurring monthly charges for such services; usage fees; installation fees; termination fees; and fees for equipment. For the last reported nine months 2011, the Consumer Services segment had $288 million in sales representing a decline in sales of roughly 19% largely due to a decrease in consumer subscribers.

It is an average business with disciplined management team. Since Rolla P. Huff has come on board as chairman and CEO, he has experienced great headwinds in turning around ELNK, which seemed like a sinking ship if you were standing on the beach. Mr. Huff implemented restructuring plans soon after being appointed to his position. Though, it has not shown in the top-line growth, the restructuring plan has certainly stabilized profit margins. Given the new plan for growth by acquisition, we see operating profits potentially decreasing but hold high confidence in Mr. Huff’s leadership and business acumen in stabilizing business issues as the ELNK continues its transitions. What is found in ELNK is a disciplined and opportunistic managerial team that follows through stated plans, concentrates on quality in personnel, and conducts business as owners of the company.

(in millions)01020304050607080910
Rev($)1244.931357.421401.931382.201290.071301.271215.99955.58723.73622.21
EBITDA(16.068)58.88105.09202.05228.70146.90165.32289.69230.61201.81
EBIT(36.96)45.6680.10172.16194.90108.88111.84284.01217.49177.78
Tangible Capital Employed623.35507.87412.06423.31364.24376.11250.31506.54717.36815.68
R.O.C.(%)(5.93)8.9919.4440.6753.5128.9544.6856.0730.3221.80


(in millions)

01020304050607080910
Op. CF47.3818.96101.73188.15188.70115.2588.79230.61208.62154.45
Zero-Growth CapEx20.8913.2224.9929.8933.8838.0253.485.6813.1224.03
FCF26.49.4276.74158.26154.8277.2335.31224.93195.50130.42
FCF/Rev (%)2.13nil5.4711.4512.005.932.9123.5427.0120.96


Bold indicates Mr. Huff’s time served as chairman and CEO

Price/Value Analysis:

ELNK’s initial rate of return and relative value to government 10-year bond better option. EarthLink, Inc.(ELNK) is estimated to earn pre-tax $1.95 to $2.09 per share for the year end 2011. Dividing $1.95 and $2.09 by our pre-tax yield based on government 10-year bonds for Nov. 25, 2011, approximately 1.97%, and you get a relative equity value ranging between $20 and $22 a share.

For 2011 year-to-date you could have bought a share of ELNK for as low as $6.04 and as high as $8.95. Since estimated per share pretax earnings are $1.95 to $2.09, paying between $5.97 and $8.95 a share your pretax rate of return would be between 12.13% and 25.34%. At today’s price of $6.11 you get an initial pretax rate of return of 22.35% and 24.55%.

So you can ask yourself: What would I rather own - government or corporate 10-year bonds with a static interest yield of 1.97% for a government bond or 3.34% for a corporate A bond versus an ELNK equity/bond with an initial earning/interest yield ranging between 22.35 and 24.55% that is undergoing restructuring to potentially improving both top and bottom-line profits?

ELNK net asset value consideration stands around $8... For the third quarter 2011, ELNK had $910.52 million in long-term debt and lease obligations and $36.18 million in tangible shareholders’ equity. Long-term debt stands at $910 million with ITC^DeltaCom senior secured notes due April 2016. Capital lease obligations for payment up to the year 2015 average out to being $3.42 million. Aside from the portion of current long-term debt due (ample cash to cover the near maturing debt), the amount of debt incurred due the acquisition poses a large enough margin for error to allow the newly acquired businesses ample time to prove their soundness. Despite the changes in capital structure, ELNK net debt leverage ratio and gross debt leverage ratio remain relatively low against peers like TW telecom and Level 3 Communications.

A new outlook on earnings shows a bit of franchise value. Backing out factors of growth, we have average EBIT margins at 15.83% of revenues over the last 10 years. Considering the last four years of what current management has done, we see margins of 24.38%. For the year end, ELNK states EBIT to range between $210 and $225 million. Using $1,112.58 million in revenues as a sustainable measure over the next three years, we estimate EBIT earnings to range between $178.01million/$1.65 per share and $327.54 million/$3.04 per share. We have free cash flow margins averaging 11.14% for the last 10 yrs. and 18.61% for the last 4 yrs. reflecting a basis of $123.94 million/$1.15per share and $207.05 million/$1.92 per share, respectively.

01020304050607080910
EBITDA margin(1.28)4.347.6014.6117.7211.2813.6030.3131.8632.43
EBIT margin(2.97)3.365.7112.4515.108.369.1929.7230.0528.57
FCF margin2.13

NIL
5.4711.4512.005.932.9123.5427.0120.96


Bold indicates Mr. Huff’s time served as chairman and CEO.

Growth is unpredictable at this point. For growth to be calculated at this point would prove useless until a longer time period is allotted to better assess the sustainability of the business model.

Earthlink is certainly not the same company it was prior to Mr. Rolla Huff taking the helm. Being led by a value investing CEO who understands the importance of patience, ELNK is a operating in a relatively competitive industry. Despite the challenges the company faces, the odds favor ELNK. At most, an allocation of 23% and an initial entry allocation of 3.82%. This is what I have calculated based on risk associated with my trading style as well as other macro and micro issues. This is certainly different for others.

"Think about it a little bit more and you'll agree with me, because you're smart and I'm right" - Charlie Munger

About the author:

owen.bernard.ii
My name is Owen Bernard. I started out doing technical analysis and did really well on a small trade, Thornburg Mortgage, which later went bankrupt. I questioned the sustainability of my success with the trade and tried repeating the process with other stocks. It proved unsuccessful. So I searched for other ways of making money in the stock market. I began reading about various investment strategies and it was like an inoculation to follow the value investing strategy. I began immediately putting it to practice by purchasing General Electric's Stock prior to it crashing, losing a substantial amount of my own money. Not discouraged from the loss due to my belief of the value mantra, I plugged away at the process finding great idea like Domtar Corp. (UFS) and Gannet (GCI) conducting DCF analysis. Now, I find myself with a huge database of information with readings about Benjamin Graham, Warren Buffett, Charlie T. Munger(my personal favorite whom I try to emulate), Joel Greenblatt, Philip Fisher, Brian Yacktman, and numerous others. I have a small capital base where my investment approach is as business-like as I can implement where my desire is to purchase an entire company but realize my inability to do so and look for the next best thing in owning shares on the open market.

Visit owen.bernard.ii 's Website


Rating: 4.1/5 (13 votes)

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