In a continuation of a recent series of articles regarding high amounts of free cash flow – today I will be looking at Earthlink. In my previous articles on the subject covering big cash generators (United Online and USA Mobility), each offered tremendous free cash flow generation with very attractive valuation. However, each company had growth concerns for their respective businesses. The same is true for Earthlink. Given that their primary business is dial-up access, we can understand the dirt cheap valuation.
Description:
EarthLink, Inc. is an Internet service provider (ISP), providing nationwide Internet access and related value-added services to individual and business customers. The Company’s primary service offerings are dial-up and high-speed Internet access services and related value-added services, such as ancillary services sold as add-on features to its Internet access services, search and advertising. In addition, through its wholly owned subsidiary, New Edge Networks (New Edge), it builds and manages Internet protocol (IP) based area networks for businesses and communications carriers. The Company operates two reportable segments, Consumer Services and Business Services. The Company’s Consumer Services segment provides Internet access and related value-added services to individual customers. Its Business Services segment provides integrated communications services and related value-added services to businesses and communications carriers.
Highlighted below is segment information from both the income statement and statement of cash flows. Each report provides an interesting contrast for a company in transition.
Financials:
2009 | 2008 | 2007 | 2006 | 2005 | |
Period End Date | 12/31/2009 | 12/31/2008 | 12/31/2007 | 12/31/2006 | 12/31/2005 |
Revenue | 723.73 | 955.58 | 1,215.99 | 1,301.07 | 1,290.07 |
Total Revenue | 723.73 | 955.58 | 1,215.99 | 1,301.07 | 1,290.07 |
Cost of Revenue, Total | 273.76 | 360.92 | 442.7 | 423.24 | 366.65 |
Gross Profit | 449.97 | 594.66 | 773.3 | 877.83 | 923.42 |
Selling/General/Administrative Expenses, Total | 230.31 | 328.89 | 640.96 | 770.41 | 744.58 |
Operating Income | 182.16 | 164.61 | 48.03 | 95.64 | 164.5 |
We notice that the top line is shrinking at an accelerated pace – certainly a concern. Interestingly, profitability (i.e. margins) have improved dramatically. No doubt a consequence of the dial up business going away, but the expense of running that business has shrunk as well.
Now compare to cash flow:
Net Income/Starting Line | 287.12 | 178.58 | -145.1 | 4.99 | 142.78 |
Depreciation/Depletion | 23.96 | 36.33 | 54.17 | 46.29 | 47.14 |
Amortization | 0.0 | 0.0 | 0.0 | 0.0 | 0.0 |
Deferred Taxes | -135.36 | -42.71 | -1.52 | 0.59 | 17.14 |
Non-Cash Items | 52.69 | 118.69 | 212.55 | 122.7 | 13.95 |
Changes in Working Capital | -19.79 | -60.28 | -31.32 | -59.31 | -32.3 |
Cash from Operating Activities | 208.62 | 230.61 | 88.79 | 115.25 | 188.7 |
Capital Expenditures | -13.12 | -6.91 | -60.77 | -47.73 | -40.57 |
Free cash flow has ballooned with very little capital reinvestment into the business. This might be sustainable for the short-term, but the company will eventually need to create a new revenue source. As one would expect, the balance sheet is highly liquid. The net cash position stands at about $450 million, which is pretty amazing considering the entire market cap is at $925 million. At the current FCF run rate (approximately $200 million), one recoup the original investment in just over two years. Obviously, the market is pricing in the likelihood that the current run rate isn’t sustainable and that the core business is in real danger. Normally I would suggest using a trailing five year average, but in this case we should discount future expectations.
A good question for management – what have you been doing with all that cash? It appears most went to share buybacks. While retiring shares at extreme lows may be beneficial, I would prefer management invest for future growth.
Valuation:
EBIT (ttm) yield = 33.8%, 3.0X
FCF (ttm) yield = 41%, 2.5X
Although more work is needed, I actually think that ELNK is worth a closer look. Even if we dramatically lower future cash flow expectation, the downside risk is still modest. The access business won’t evaporate overnight giving management plenty of opportunity to plan for strategic growth. It’s possible they might overpay for a bad acquisition, but the risk / reward is positive.
Disclosures: none.
