Description

Earthlink represents a value investment with low odds of capital loss and possible upside of 50% to 100% over the next couple years. Based on the company’s 2008 guidance the FCF yield is currently in range of 23% to 26%. I have not found many other opportunities in this low rate environment to earn yields in this range.

This is a simple story so I will try and keep it that way. Earthlink is one of the largest nationwide ISP’s selling dial up internet access. Up until six months ago it was using the prodigious cash flow from such business in various de-worseification ventures. Not any more. Rolla Huff was hired last June as CEO and in January 2008 added the title of Chairman. Mr. Huff was previously President of MPower Communications a CLEC that was sold in 2006 (I wrote up MPower on VIC in 2004). Somewhere along the line coming out of the telecom bust of early 2000’s Mr. Huff got religion regarding cash flow, capital allocation and cash return on investment as being primary drivers of business value.

Mr. Huff concluded that Earthlink should not put any more money into its two main new business areas, municipal wi-fi and a cellular joint venture with SK Telecom called Helio. In November of 2007 Rolla Huff said the following. “After thorough review and analysis of our municipal wireless business we have decided that making significant further investments in this business could be inconsistent with our objective of maximizing shareholder value”. Earthlink has invested $40 million plus in this business to date. I value the assets at zero to be conservative.

Also in November 2007 Earthlink restructured its Helio joint venture with SK telecom so that Earthlink has no additional financial exposure. To date, Earthlink has invested $220 million into its Helio venture and after a recent $70 million investment by SK telecom owns 39% of the business. Helio is a cellular service targeting a young audience and has special data features like links to My Space. It utilizes some of leading edge wireless technology developed by SK telecom. The company “rents” space on the Sprint network. SK Telecom has agreed to invest up to an additional $200 million in Helio as part of the JV restructuring. I value Earthlink’s investment at zero to be conservative.

What you are left with is an ISP that after recent cost cuts will produce $230 to $250 million in EBITDA in 2008. Earthlink is now running the internet business to maximize cash flow, not a bad concept. To that end they have reduced expenses across the board and are no longer trying to add customers, through high marketing costs, that are not profitable. The company also recognizes that the business will shrink over time and is prepared to change its cost structure as this happens. I compare it to paging companies of a few years ago. At least one (Arch Wireless) was written up on VIC a couple times. What surprised me about the paging companies is how long they were able to maintain steady cash flow as the subscriber base (and sales) shrunk. The companies were able to steadily reduce costs. I believe the same model exists with dial up internet and that in same way the “market” is missing this fact and has prematurely written off these companies for dead. I also think that there is a base of users that will continue to use dial up long into the future. For certain people its price, for others it’s the way in which use internet or its need for dial up in remote locations not served by broadband. Paging also has this characteristic with certain industries such as medical and government were paging continues as preferred communications tool. Again like paging I would expect there to be consolidation leading to further cost reductions etc. All in all I think healthy dynamics to make money in a shrinking industry.

For a very good summary of Earthlink’s new strategy I encourage anyone interested to read the 4^th quarter earnings call transcript. Here is the link:

http://seekingalpha.com/article/63621-earthlink-q4-2007-earnings-call-transcript?source=yahoo

Valuation

Diluted shares 112

Stock Price $7.35

(milllions)

Market Cap $823

Plus:

Debt $258

Less:

Cash ($288)

Covad* ($ 60)

Helio JV $ - 0 -

Wi Fi $ - 0 -

---------

Adjusted EV $733

* Earthlink investment in debt ($47 million) and equity in Covad. Covad being taken private by Platinum Equity Partners.

Company Guidance 2008

EBITDA $230 to $250

FCF $190 to $210

Adjusted FCF * $170 to $190

* Company adds back stock based comp. to get FCF. I adjust it back out as real expense.

Earthlink is trading at and EBITDA multiple in projected 2008 numbers of 3.2X to 2.9X on low high range of guidance.

Earthlink is trading at an adjusted FCF yield based on projected numbers of 23% to 26%.

So what to do with all that cash? Back to Rolla Huff. I think this guy gets it regarding shareholder value. I expect Earthlink to continue buying back large amounts of stock (they purchased 10 million shares in 4^th qtr of 2007 or about 8.25% of the company). They may also take debt out eventually if conversion becomes a factor. Current coupon of 3.25% with conversion at $9.12 share. The Company is hedged through call options 28.4 million shares to be issued. I would also not be surprised to see a special dividend or regular dividend instituted in the future.

Disclaimer:  We own ELNK The information contained in this write-up is believed to be correct, but should not be relied 
upon.  We undertake no obligation to update the write-up if new information arises at a future date. 

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