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ELNK > SEC Filings for ELNK > Form 10-K on 25-Feb-2014All Recent SEC Filings

Show all filings for EARTHLINK HOLDINGS CORP.

Form 10-K for EARTHLINK HOLDINGS CORP.


25-Feb-2014

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.

Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is intended to provide a reader of our financial statements with a narrative from the perspective of management. The following MD&A should be read in conjunction with audited Consolidated Financial Statements and notes thereto included elsewhere in this Annual Report on Form 10-K. Certain statements in this MD&A are forward-looking statements. 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 7.

Change in Organization Structure

On December 31, 2013, through the creation of a new holding company structure (the "Holding Company Reorganization"), EarthLink, Inc. merged into EarthLink, LLC, which became a wholly-owned subsidiary of a new publicly traded parent company, EarthLink Holdings Corp. We expect the new holding company design will enhance our corporate structure and provide greater flexibility and efficiency from a management, operations, customer, regulatory, accounting, financial and tax perspective. As the Holding Company Reorganization occurred at the parent company level, the remainder of our subsidiaries, operations and customers were not affected. Accordingly, the historical financial statements reflect the effect of the reorganization for all periods presented. Following the Holding Company Reorganization, EarthLink Holdings Corp. became the primary obligor on our outstanding debt obligations and EarthLink, LLC became a guarantor and a restricted subsidiary. The Holding Company Reorganization was effected under
Section 251(g) of the Delaware General Corporation Law which provides for the formation of a holding company structure without a stockholder vote. Existing shares of EarthLink, Inc. common stock were converted into the same number of shares of common stock of EarthLink Holdings Corp.

Overview

EarthLink Holdings Corp. ("EarthLink" or the "Company"), together with its consolidated subsidiaries, is a leading communications and IT services provider, empowering businesses with a fully-managed, end-to-end communications, IT and virtualization portfolio including cloud computing, IT security, colocation, enterprise-class hosted applications, secure network connectivity and IT support services. We operate two reportable segments, Business Services and Consumer Services. Our Business Services segment provides a broad range of data, voice 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 more than 28,000 route miles of fiber, 90 metro fiber rings and eight secure enterprise-class data centers that provide data and voice IP service coverage across more than 90 percent of the United States.

Business Strategy
Our business strategy is to be the premier communications and IT services provider for mid-market and enterprise customers. We believe IT services is an emerging market with significant opportunity for growth. Our goal is to use our nationwide network and newly developed and acquired IT services to be a one-stop ubiquitous provider of these services to larger and multi-location enterprise customers. We are also focused on maximizing the cash flow generated by our traditional voice and data products. The key elements of our business strategy are as follows:
Offer a complete package of communications and IT services products. We provide a nationwide suite of business voice, data and IT services. We are focused on maintaining a broad suite of products and services and offering solutions to address the evolving business and infrastructure needs of our customers. In 2012 and 2013, we expanded our IT solutions footprint with four additional data centers and invested capital to extend our core fiber IP network. We also acquired CenterBeam in July 2013 to further grow our IT services portfolio, specifically around customer end-point management. We believe our broad suite of products allows us to compete for larger and more complex customers.

Increase revenues from growth products and services. Revenues from some of our products and services have been declining due to economic, competitive, technological and regulatory developments and we expect some of these revenues to continue to decline. We are attempting to manage this decline by working with our customers to replace or augment declining products with our growth products, where financially and technically feasible to do so. Our growth products are MultiProtocol Label Switching ("MPLS"), hosted voice and IT services such as virtualization and virtual tech care. We are also focused on growing revenues for these products by enhancing our sales force efforts and increasing brand awareness for our IT services. We also aim to grow our wholesale services as we capitalize on unique and new fiber routes within our footprint.


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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 exceeding customers' expectations for service increases loyalty and reduces churn. We also believe that our broad communications and IT services portfolio and blend of access technologies for connectivity enable us to provide high-quality customer service by solving a wide range of issues faced by our customers and prospects. We are focused on creating a customer-focused organization that will provide a quality approach to offering and supporting EarthLink products and services.

Optimize our cost structure. We are currently focused on optimizing the cost structure of our business by reducing network costs, streamlining our internal processes and operations and maximizing the cash flows generated from traditional voice and data products. The success of our operating efficiency and cost reduction initiatives is necessary to align costs with declining revenues for some of our products as non-variable costs place further pressure on margins.

Opportunistically consider potential strategic acquisitions. We continue to evaluate acquisition opportunities as we become aware of them. We believe that targeted corporate acquisitions, when available at the right economics, can be an effective means to improve our product, network, and data center capabilities or to accelerate revenue growth. 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 is executing on our business strategy to be the premier communications and IT services provider, and more specifically to continue to grow revenues from our growth products and services. Contributing to this challenge are the following: responding to competitive and economic pressures, reducing churn in our existing customer base, providing products and services that meet changing customer needs on a timely and cost-effective basis, and adapting to regulatory changes and initiatives. Another primary challenge is managing the rate of decline in revenues for our traditional products. To address these challenges, we are targeting larger customers who have lower churn profiles, focusing efforts on customer retention, upselling additional growth products and services to existing customers, implementing cost efficiencies in order to maximize cash flows and seeking to make costs more variable. Our future success for growth depends on the timing and market acceptance of our new products and services, our ability to market our services to new customers, our ability to differentiate our services from those of our competitors, our ability to maintain and expand our sales to existing customers, our ability to strengthen awareness of our brand, our ability to provide quality implementation and customer support for these products and the reliability and quality of our services.

Revenue Sources

Business Services. Our Business Services segment earns revenue by providing a broad range of data, voice 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 businesses; and (3) other services, which primarily consists of 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; termination fees; and administrative 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 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 and email storage; search revenues; and advertising revenues. Revenues generally consist of recurring monthly charges for such services.


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General Developments in our Business

Key developments in our business during 2013 are described below:

Issued $300.0 million aggregate principal amount of 7.375% Senior Secured Notes due 2020 (the "Senior Secured Notes") in May 2013 and used the net proceeds, together with available cash, to fund a tender offer and redemption of our ITC^DeltaCom 10.5% Senior Secured Notes due April 2016 (the "ITC^DeltaCom Notes"), which had been assumed in connection with our acquisition of ITC^DeltaCom, Inc. ("ITC^DeltaCom"). The debt issuance and redemption will reduce the amount of interest we will pay going forward.

Acquired substantially all of the assets of CenterBeam, Inc. ("CenterBeam"), a privately-held information technology managed service provider delivering cloud computing and hosted IT services to mid-sized businesses, in July 2013 for a total consideration of approximately $23.5 million to further grow our IT services portfolio by adding IT services customer scale, expanded IT support center resources and complementary products and capabilities.

Sold our ITC^DeltaCom telecom systems business in August 2013, which was a low margin business that generated mostly non-recurring revenue streams.

Completed the roll out of four additional data centers, launched our next generation cloud hosting platform in five of our eight data centers and expanded our fiber network with additional unique routes.

Made progress in the integration of our operating support systems and began to leverage some of these new capabilities in pursuing our business strategy.

Generated revenues of $1.2 billion in 2013, a 7% decrease during the year consisting of a $53.2 million decrease in Business Services revenue and a $41.3 million decrease in Consumer Services revenue. The decreases were primarily driven by declines in traditional voice and data products. However, partially offsetting these declines was an increase in sales of growth products for our Business Services and a decrease in churn for our Consumer Services.

Generated a net loss of $538.8 million in 2013, which reflects a $255.6 million goodwill impairment and related tax impact, a $265.3 million increase to our income tax provision due to the recording of a full valuation allowance against our deferred tax assets, an increase in restructuring, acquisition and integration costs and a decrease in Adjusted EBITDA, as described below.

Generated Adjusted EBITDA (a non-GAAP measure, see "Non-GAAP Financial Measures" in this Item 7) of $227.1 million in 2013, a decrease from $283.9 million in the prior year primarily due to the decrease in revenues from traditional voice and data products, as well as increased costs to grow our business.

Made $20.8 million of dividend payments to shareholders and repurchased 1.2 million shares of common stock for $6.1 million during the year.

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.
Traditional business services revenues. Our traditional voice and data business service revenues, specifically traditional voice and lower-end, single site broadband services, have been declining due to competitive pressures and changes in the industry, and we expect this trend to continue. We have also experienced an increase in churn for these retail products, especially as customers come out of contract term. To counteract trends in our Business Services revenues, we are focused on building long-term customer relationships, offering customers a bundle that includes our growth services and focusing on larger, more complex customers who have a lower churn profile. As a result, sales in our growth products have increased and the mix of new sales is shifting towards our growth products. We are also taking steps to lower the cost structure of our Business Services operations.


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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. As a result, we have been taking steps to accelerate our transition into an IT services company. Specifically, we are focusing on larger geographic markets where there are more customers with a propensity to buy IT services, increasing our efforts in Search Engine Marketing to drive leads for our inside sales force, increasing brand awareness for our IT services and adding additional technical talent in the field to support our IT services sales efforts. Economic conditions. Many of our customers are small and medium-sized businesses. We believe these businesses are more likely to be affected by economic downturns than larger, more established businesses. 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. 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. 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. Business Outlook

We expect continued declines in Business Services revenues from traditional voice and data products. Revenues may also be adversely impacted by churn, competition, regulatory changes, timing and market acceptance of our newer products and services, shifting patterns of use, convergence of technology and general economic conditions. However, to counteract these pressures, we continue to emphasize our diverse portfolio of communications and IT services and are focused on growing our suite of growth and IT services. We are also focused on growing our wholesale services as we capitalize on new and unique fiber routes within our footprint. As a result, we expect the mix of our retail Business Service revenues to change over time, from traditional products to growth products and services. As our product mix shifts towards growth products, revenues may be impacted in the near term by longer sales cycles and installations and higher costs to deliver these services. We expect our consumer access subscriber base and revenues to continue to decrease due to limited sales and marketing activities, competition from cable, DSL and wireless providers, declines in gross broadband subscriber additions and the continued maturation of the market for narrowband Internet access. However, we expect the rate of churn and revenue decline to continue to decline as our customer base becomes longer tenured.


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Consolidated Results of Operations

The following comparison of statement of operations data is affected by our acquisition of 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 and transactions completed during 2011 including STS Telecom, Logical Solutions and Business Vitals, LLC, among others, and our CenterBeam transaction completed during 2013.

The following table sets forth statement of operations data for the years ended December 31, 2011, 2012 and 2013:

                                                       Year Ended December 31,
                                                2011             2012             2013
                                                            (in thousands)
Revenues                                   $  1,300,543     $  1,335,135     $  1,240,606
Operating costs and expenses:
Cost of revenues (exclusive of
depreciation and amortization shown
separately below)                               581,264          632,616          600,742
Selling, general and administrative
(exclusive of of depreciation and
amortization shown separately below)            397,574          429,087          426,070
Depreciation and amortization                   159,993          183,165          183,114
Impairment of goodwill                                -                -          255,599
Restructuring, acquisition and
integration-related costs                        32,068           18,244           40,030
Total operating costs and expenses            1,170,899        1,263,112        1,505,555
Income (loss) from operations                   129,644           72,023         (264,949 )
Interest expense and other, net                 (70,640 )        (63,416 )        (60,686 )
Income (loss) from continuing operations
before income taxes                              59,004            8,607         (325,635 )
Income tax (provision) benefit                  (21,731 )          1,331         (211,231 )
Net income (loss)                                37,273            9,938         (536,866 )
Loss from discontinued operations, net of
tax                                              (2,706 )         (2,418 )         (1,961 )
Net income (loss)                          $     34,567     $      7,520     $   (538,827 )

Revenues

The following table presents our revenues for the years ended December 31, 2011,
2012 and 2013:
                                Year Ended December 31,                     2012 vs 2011                2013 vs 2012
                         2011            2012            2013          $ Change      % Change      $ Change      % Change
                                                             (dollars in thousands)
Business Services
Retail services      $   766,098     $   845,664     $   793,940     $   79,566         10  %     $ (51,724 )       (6 )%
Wholesale services       136,224         151,910         151,071         15,686         12  %          (839 )       (1 )%
Other                     22,376          19,851          19,216         (2,525 )      (11 )%          (635 )       (3 )%
Total revenues           924,698       1,017,425         964,227         92,727         10  %       (53,198 )       (5 )%
Consumer Services
Access services          323,998         269,533         231,448        (54,465 )      (17 )%       (38,085 )      (14 )%
Value-added services      51,847          48,177          44,931         (3,670 )       (7 )%        (3,246 )       (7 )%
Total revenues           375,845         317,710         276,379        (58,135 )      (15 )%       (41,331 )      (13 )%
Total revenues       $ 1,300,543     $ 1,335,135     $ 1,240,606     $   34,592          3  %     $ (94,529 )       (7 )%


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Business Services

Retail Services. Retail services include data, voice and IT services (including
data centers, virtualization, security, applications, premises-based solutions,
managed solutions and support services) provided to business customers. The
following table presents the primary reasons for the changes in Business
Services retail revenues for the years ended December 31, 2012 and 2013 compared
to the prior years:
                                                           2012 vs 2011      2013 vs 2012
                                                                    (in millions)
Due to acquisitions (a)                                   $       104.3     $         8.6
Due to growth products (b)                                            -              18.7
Due to IT services (c)                                             12.2              13.5
Due net favorable settlements and reserve adjustments (d)           9.4              (9.4 )
Due to decline in traditional voice and data products (e)         (46.3 )           (83.1 )
  Total change in Business Services retail revenues       $        79.6     $       (51.7 )


______________

(a) Increase in 2012 due to the inclusion of revenues from One Communications for a full year in 2012 compared to a partial period in 2011, as the acquisition occurred on April 1, 2011. Increase in 2013 due to the inclusion of revenues from CenterBeam beginning in July 2013.

(b) Increase in 2013 due to sales of growth products, including MPLS and hosted voice. During 2012, this amount was included in the decline in traditional voice and data products as we were still integrating our reporting systems and were not able to capture this detail separately.

(c) Increase due to IT Services transactions entered into during 2011 and new product launches to expand our IT services portfolio.

(d) Change due to net favorable settlements and reserve adjustments of $9.4 million during 2012.

(e) Decrease due to decline in certain traditional voice and data products, including traditional voice, lower-end, single site broadband services and web hosting. Revenues for these traditional voice and data products have been decreasing due to competition in the industry, the migration of customers to more advanced services and a decreased emphasis on selling these services. The decrease in 2012 was partially offset by sales of growth products, including MPLS and hosted voice.

Wholesale Services. Wholesale services includes the sale of transmission capacity to other telecommunications carriers and businesses. The increase in wholesale services revenues during the year ended December 31, 2012 compared to the prior year was primarily due to the inclusion of revenues from One Communications for a full year in 2012 compared to a partial period in 2011. The decrease in wholesale services revenues during the year ended December 31, 2013 compared to the prior year was primarily due to an increase in customer churn in the current year and a favorable settlement with a telecommunications carrier recorded during the prior year. This was partially offset by a $1.2 million favorable adjustment associated with the One Communications acquisition recognized during the year ended December 31, 2013 and an increase in transport and usage revenues as we capitalize on unique fiber routes.

Other Services. Other services consists primarily of web hosting and certain equipment-related revenue. The decreases in other services revenues during the years ended December 31, 2012 and 2013 compared to the prior years were primarily due to a decrease in average web hosting accounts.

Consumer Services

Access services. Access services include narrowband access services (including traditional, fully-featured narrowband access and value-priced narrowband access) and broadband access services (including high-speed access via DSL and cable and VoIP). Access service revenues consist of recurring monthly charges for narrowband and broadband access services; usage fees; installation fees; termination fees; and fees for equipment.

The decreases in consumer access revenues during the years ended December 31, 2012 and 2013 compared to the prior years were due to decreases in narrowband access and broadband access revenues. This was primarily due to a decrease in average consumer access subscribers, which were 1.5 million, 1.2 million and 1.1 million during the years ended December 31, 2011, 2012 and 2013, respectively. The decrease in average consumer access subscribers resulted from limited sales and marketing activities, the continued maturation of and competition in the market for Internet access and competitive pressures in the industry. However, we continue to focus on the retention of customers and on marketing channels that we believe will produce an acceptable rate of


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return. Our monthly consumer subscriber churn rates were 2.6%, 2.4% and 2.1% during the years ended December 31, 2011, 2012 and 2013, respectively, which moderated the decline in average consumer subscribers. Churn rates decreased due to the increased tenure of our consumer subscriber base. Slightly offsetting the decreases in revenues during the years ended December 31, 2012 and 2013 compared to the prior years was an increase in average revenue per subscriber due to targeted price increases implemented over the past year and a change in mix of subscribers.

Value-added services revenues. Value-added services revenues consist of revenues . . .

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