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.