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MFI STOCK REVIEW: EARTHLINK INC

May 21, 2010 | About:
Steve Alexander

Steve Alexander

12 followers
EarthLink is a large Internet service provider in the U.S., servicing over 2 million consumer and small business customers. The company provides about 44% of those customers with broadband access, and the rest through premium dial-up, which Earthlink looks to be a leader in. You read that right. Earthlink's strategy is to be the leader in servicing the premium dial-up Internet access market.Obviously, with that strategy revenue growth is not a priority here. Subscriber count was down 22% in the most recent quarter. Revenues for 2009 were down over 24% from 2008 levels. Broadband is a lower margin business, so as more and more dial-up customers convert over, operating margins may take a hit. Growing the dial-up subscriber base will have to be achieved by buying existing customers from legacy providers, most likely MSN (MSFT). Clearly, growth here isn't going to come from the top line. This is a business that will likely see declining sales for the foreseeable future.

Despite this fact, MagicDiligence still gives Earthlink a B+ management grade, because the strategy that is being employed makes the best of a difficult situation. New management in 2007 drastically changed Earthlink's direction. Instead of desperately burning capital trying to enter new businesses like municipal wi-fi and youth branded mobile services (a joint venture to form HELIO), new CEO Rolla Huff is getting back to basics. EarthLink will focus on the business where it can succeed: premium dial-up. The wi-fi business has been divested, and HELIO was sold to Virgin Mobile (since acquired by Sprint (S)). Thousands of jobs have been cut, several facilities were closed, and marketing costs have been cut by 80%. The focus now is on retaining long-time dial-up customers, which are less likely to switch to broadband and require fewer support resources. Examples of these are primarily in rural areas where broadband is still not available. The changes have had a dramatically positive effect on profitability. Operating margins have jumped from about 10% to near 30%. Returns on capital and cash flows improved dramatically. EarthLink is a lean, cash generating machine under the current structure.

Management last year decided to take that cash flow and provide value to their shareholders the proper way for a declining business: pay a dividend. And currently, it's a whopper - a 7.3% yield. Despite the yield, Earthlink's cash flow is plenty strong enough to support it over the next few years. Free cash flow payout is just 26%, and the board hiked the dividend last quarter by 14%.

Given this huge yield, the question is: will the stock price hold up? Obviously, Earthlink appears very cheap. Trailing earnings yield is 29%. However, we have to remember the declining state of the company. MagicDiligence believes Earthlink is going to have to stem its annual revenue decline from the current 20% down into the 7-8% range to be worth the current price of $8.80. There was some hope for this. Last quarter net subscriber loss declined from a year ago, and a large percentage (86%) of current customers have been with the firm for 2 or more years.

Still, the company will need better, so this stock gets nowhere near the Top Buys list. In addition to the bleak growth picture, Earthlink has other risks. Without a dedicated network, EarthLink is dependent on providers like Level 3 (LVLT) or Time Warner Cable (TWC) to renew service contracts. With this relationship, the network providers have the bargaining power, and if they decide to provide their own Internet services (like, for example, Comcast (CMCSA)), EarthLink is out of luck. Traditional landline phone service companies such as Verizon (VZ) are getting into the Internet service game with services like DSL. The company is not losing only dial-up customers, but also broadband customers, illustrating their significant competitive disadvantages.

The company can probably hold on for several years. Financial health is good, with $708 million in cash vs. just $232 million in debt, and very strong free cash flow with margins at 25%. But the fact remains that this is just a business caught in a fast declining market with very poor prospects. The best hope for long-term EarthLink investors is for the company to be acquired for its subscriber base, perhaps by one of the cable providers who contract with it. Outside of that, it's difficult to see EarthLink around in 10 years. Avoid this one.

Steve owns no position in any stocks discussed in this article.

Steve Alexander

http://www.magicdiligence.com/

Rating: 3.3/5 (7 votes)

Comments

hschacht
Hschacht - 4 years ago
Don't you think the current price fully reflects the "declining market with very poor prospects"?

And perhaps (just maybe) the market is ignoring the $500 million in NET cash?

Not to mention that fcf yield? 25%. Where else will you find that? It is a product healthy cash flow and a ridiculously low price. Why not take advantage? And these guys are acknowledging that they are a not a growth company... hence the 7% yield. Seven!

You might have a point about avoiding Earthlink if it was a highly valued outfit, but the market value barely exceeds $900 million?!? And Steel Partners is involved if memory serves. How's that for a potential catalyst?

It may be difficult to see ELNK being around in 10 years, but at this price, it doesn't have to be in order to be a VERY good investment.
MagicDiligence
MagicDiligence - 4 years ago
I would agree if Earthlink had some sort of growth component that would slow revenue declines down to the high single digits (at least) without hurting margins too much . But as it stands, they are clearly operating the company in run-off mode. The only catalyst I can really see is if Earthlink is able to buy someone's dial-up subscriber business. Possibles here include AOL, MSN, and maybe NetZero. But they would have to buy it at a very cheap valuation.

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