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ELNK > SEC Filings for ELNK > Form 10-Q on 31-Oct-2012All Recent SEC Filings

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Form 10-Q for EARTHLINK INC


31-Oct-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.

Certain statements in this Quarterly Report on Form 10-Q are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. The words "estimate," "plan," "intend," "expect," "anticipate," "believe" and similar expressions are intended to identify forward-looking statements. These forward-looking statements are found at various places throughout this report. EarthLink disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Although EarthLink believes that its expectations are based on reasonable assumptions, it can give no assurance that its goals will be achieved. Important factors that could cause actual results to differ from estimates or projections contained in the forward-looking statements are described under "Cautionary Note Concerning Factors That May Affect Future Results" in this Item 2.

Management's Discussion and Analysis of Financial Condition and Results of Operations is intended to provide a reader of our financial statements with a narrative from the perspective of management. The following Management's Discussion and Analysis should be read in conjunction with the accompanying unaudited Condensed Consolidated Financial Statements and related Notes thereto and with Management's Discussion and Analysis of Financial Condition and Results of Operations and the audited Consolidated Financial Statements and the Notes thereto contained in the Annual Report on Form 10-K for the year ended December 31, 2011. Management's Discussion and Analysis of Financial Condition and Results of Operations is presented in the following sections:

• Overview

• Consolidated Results of Operations

• Segment Results of Operations

• Liquidity and Capital Resources

• Non-GAAP Financial Measures

• Cautionary Note Regarding Factors That May Affect Future Results

Overview

EarthLink, Inc. ("EarthLink" or the "Company"), together with its consolidated subsidiaries, is a leading network, communications and IT services provider to business and residential customers in the United States. We operate two reportable segments, Business Services and Consumer Services. Our Business Services segment provides a broad range of data, voice, equipment and IT services to retail and wholesale business customers. Our Consumer Services segment provides nationwide Internet access and related value-added services to residential customers. We operate an extensive network including approximately 28,800 route miles of fiber, 90 metro fiber rings and four enterprise-class data centers that provide IP coverage across more than 90 percent of the United States.

Third Quarter 2012 Highlights
• Total revenues were $334.8 million, a 6% decrease compared to the three months ended September 30, 2011, consisting

of a $13.8 million decrease in Consumer Services revenue and a $8.7 million decrease in Business Services revenue
• Net income was $1.4 million, compared to net income of $7.5 million during the three months ended September 30, 2011

• Adjusted EBITDA (a non-GAAP measure, see "Non-GAAP Financial Measures" in this Item 2) was $69.5 million, a decrease from $90.5 million during the three months ended September 30, 2011 due to the decrease in total revenues and an increase is costs to expand our Business Services, offset by cost synergies from integrating acquisitions

• Net cash provided by operating activities was $90.1 million for the three months ended September 30, 2012, an increase from $71.0 million during the comparable period in 2011

• Unlevered free cash flow (a non-GAAP measure, see "Non-GAAP Financial Measures" in this Item 2) was $45.0 million during the three months ended September 30, 2012, a decrease from $60.0 million during the three months ended September 30, 2011

• Cash used in investing activities and cash used in financing activities were $24.4 million and $13.4 million, respectively, for the three months ended September 30, 2012, compared to cash used in investing activities of $35.2 million and cash used in financing activities of $11.0 million during the three months ended September 30, 2011


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Business Strategy

Our business strategy is to continue our transformation into a national managed communications and IT services provider. We believe we are positioning EarthLink to be a trusted managed communications and IT services partner in the small and medium-sized enterprise marketplace for businesses with IT and network security needs. The key elements of our business strategy are as follows:
Offer a complete package of IT services and managed communications products. In December 2011, we launched a nationwide suite of business voice, data and Internet solutions. In February 2012, we launched a suite of IT services solutions, which includes virtualization services, managed security services, connectivity services, application services, managed desktop support and data center services. We believe the launch of these IT services enables customers to streamline their internal IT resources and offerings by leveraging a comprehensive mix of IT and security services in our enterprise-class data centers. We are focused on continuing to broaden our suite of products and services to offer a complete package of network connectivity and IT services and to design and implement solutions to address the evolving business and infrastructure needs of our customers.
Add new customer relationships. We are focused on adding new customers through new and existing channels, leveraging distribution channels and positioning our business to take advantage of important trends in the markets for our products and services. We believe we have a comprehensive solution to offer business customers. We are continually upgrading and evolving our go to market strategy. This includes investment to improve the quality of our sales force, investment in alternative sales motions, both inside sales and through partner relationships, and investment in the EarthLink brand.
Leverage our existing customer relationships. We are focused on leveraging our existing customer relationships, favorable brand image and experience in providing IP communication and managed services in order to profitably grow our business services revenue. We believe that upselling our new suite of products and services to existing customers is an important opportunity for revenue growth and customer retention. In addition, certain of our business service revenues have been declining due to competitive pressures in the industry, and we expect revenues from certain aspects of these businesses to continue to decline. We are focused on managing this decline by executing on opportunities to leverage these customer relationships by migrating these customers to our new technology platform.
Provide a superior customer experience. We are committed to providing high-quality customer service and continuing to monitor customer satisfaction in all facets of our business. We believe focusing on the customer relationship increases loyalty and reduces churn. We believe that our customizable communications portfolio, blend of access technologies for connectivity and diverse portfolio of cloud, managed security and IT services are key differentiators that can help us build long-term customer relationships. Our secure customer portal, myLink™, provides customers with a centralized tool for 24/7 self-service applications, including account management, billing, reporting and service management. We are focused on creating a consistent nationwide approach to offering and supporting EarthLink products and services. Successfully integrate acquisitions. We are focused on successfully integrating our acquisitions in order to realize synergies and cost benefits and increase the scale and scope of our product offerings, especially integrating our new IT services capabilities. This includes the integration of operating support systems, networks, sales forces, marketing channels, product offerings and personnel. To date, we have consolidated and integrated network operations centers, sales platforms, financial systems and certain billing platforms, as well as launched a nationwide product portfolio. We are currently involved in the integration of additional billing platforms and other operating support systems. We believe that our competitive positioning with existing and potential customers will be strengthened by our ability to continue to successfully integrate past and potential future acquisitions.
Selectively pursue potential strategic acquisitions. We will continue to selectively evaluate and consider potential strategic transactions that we believe will complement and grow our business. Our acquisition strategy may include investments or acquisitions of new product and services capabilities, network assets or business customers to achieve greater national scale. Challenges and Risks

The primary challenge we face in executing our business strategy to successfully transition into a national managed IT services and communications provider is to grow revenues from our evolving Business Services product portfolio on a timely basis to offset declining revenues from other Business Services products and from our Consumer Services segment. Contributing to this challenge are the following: providing products and services that meet changing customer needs on a timely and cost-effective basis, responding to competitive and economic pressures, managing the rate of decline in certain revenue streams, successfully integrating our acquisitions to achieve expected synergies and cost savings, implementing operating efficiencies and adapting to regulatory changes and initiatives. Our future success for growth depends on the timing and market acceptance of our new products and services, our ability to market our services in a cost-effective manner to new customers, our ability to employ an effective sales model and ensure sales force training and product knowledge, our ability to differentiate our services from those


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of our competitors, our ability to maintain and expand our sales to existing customers, our ability to strengthen awareness of our brand and the reliability and quality of our services. The factors we believe are instrumental to the achievement of our business strategy may be subject to competitive, regulatory and other events and circumstances that are beyond our control. For a more detailed list of all risks and uncertainties inherent in our business, please refer to the detailed cautionary statements and risk factors referred to under "Risk Factors" in Item 1A of Part II and under "Cautionary Note Concerning Factors That May Affect Future Results" in this Item 2.

Trends in our Business

Our financial results are impacted by several significant trends, which are described below.

Industry factors. We operate in the communications and IT services industry, which is characterized by intense competition, industry consolidation resulting in larger competitors, an evolving regulatory environment, changing technology and changes in customer needs. We expect these trends to continue. In addition, merger and acquisition transactions and other factors have reduced the number of vendors from which we may purchase network elements that we leverage to operate our business.
Legacy business services revenues. Our legacy business service revenues, specifically traditional voice services, have been declining due to competitive pressures in the industry, and we expect this trend to continue. In addition, we expect revenues to be adversely impacted as a result of rules adopted by the FCC in late 2011 regarding intercarrier compensation. The rules include the elimination of terminating switched access rates and other per-minute terminating charges between service providers by 2018, through annual reductions in the rates. To counteract trends in our legacy business services revenues, we are focused on building long-term customer relationships through our customizable communications portfolio, blend of access technologies for connectivity and diverse portfolio of cloud, managed security and IT services. We are also focused on developing the optimal sales model and internal sales processes appropriate for our changing product portfolio.
Economic conditions. Our business customers are particularly exposed to a weak economy. We believe that the financial and economic pressures faced by our customers in this environment of diminished consumer spending, corporate downsizing and tightened credit have had, and may continue to have, an adverse effect on our results of operations, including longer sales cycles and increased customer demands for price reductions in connection with contract renewals. Additionally, our consumer access services are discretionary and dependent upon levels of consumer spending. Unfavorable economic conditions could cause customers to slow spending in the future, which could adversely affect our revenues and churn.
Emergence of IT services. The industry for cloud, managed security and IT services is relatively new and continues to evolve. The IT services market is growing as security needs, compliance requirements and IT costs increase. IT services currently represents the smallest proportion of our business services revenues. However, we believe this represents a significant growth area for our business and there is opportunity for EarthLink to address this market nationally for small and medium-sized enterprises.
Consumer access declines. Our consumer access subscriber base and revenues have been declining and are expected to continue to decline due to the continued maturation of the market for Internet access and competitive pressures in the industry. In addition, we have implemented, and expect to continue to implement, targeted price increases, which could negatively impact our churn rates. The mix of our consumer access subscriber base has been shifting from narrowband access to broadband access customers. Consumer broadband access revenues have lower gross margins than narrowband revenues due to the costs associated with delivering broadband services. This change in mix has negatively affected our profitability and we expect this trend to continue. To counteract trends in our consumer revenues, we are focused on customer retention, operational efficiency and adding customers through marketing channels that we believe will produce an acceptable rate of return.
Revenue Sources

Business Services. Our Business Services segment earns revenue by providing a broad range of data, voice, equipment and IT services to retail and wholesale business customers. We present our Business Services revenue in the following three categories: (1) retail services, which includes data, voice and IT services provided to business customers; (2) wholesale services, which includes the sale of transmission capacity to other telecommunications carriers; and
(3) other services, which includes the sale of customer premises equipment and web hosting. Our IT services, which are included within our retail services, include data centers, virtualization, security, applications, premises-based solutions, managed solutions and support services. Revenues generally consist of recurring monthly charges for such services; usage fees; installation fees; equipment fees; and termination fees.

Consumer Services. Our Consumer Services segment earns revenue by providing nationwide Internet access and related value-added services to residential customers. We present our Consumer Services in two categories: (1) access services, which


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includes narrowband access services and broadband access services; and
(2) value-added services, which 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 equipment fees.

Consolidated Results of Operations

The following comparison of statement of operations data is affected by our acquisition of One Communications Corp. ("One Communications") on April 1, 2011. The results of operations of One Communications are included in our operating results beginning on the acquisition date. The following comparison of statement of operations data is also affected, to a lesser extent, by our other acquisitions completed during 2011 including Saturn Telecommunication Services Inc. and affiliates ("STS Telecom"), Logical Solutions.net, Inc. ("Logical Solutions") and Business Vitals, LLC, among others.

The following table sets forth statement of operations data for the three and nine months ended September 30, 2011 and 2012:

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