EarthLink (Nasdaq: ELNK) is in the midst of some serious climate change -- it's trying to continue to transition from its dial-up Internet-access roots to a better-rounded communications provider. But some investors may be in the mood to send their ISP off to Mars after its most recent quarterly earnings.
The company's sales did inch up 2% to $332 million, but its second-quarter profit was cut by more than half to $17 million, or $0.12 per share, on a year-over-year basis. Gross margins decreased and expenses increased, and that's hardly music to investors' ears at this point. Although much has been made about the cash flow that EarthLink generates from its ISP offerings, its aggressive plans mean that it's throwing the greenbacks around at a pretty good clip. As a result, free cash flow generation dropped 43% to $32 million. Meanwhile, on a year-over-year basis, the company's cash reserve dropped 45% to $236 million.
Last quarter, I remarked on what seemed mystifying to me -- investors pumped up EarthLink shares despite a drop in profitability and a continued challenging competitive landscape. Of course, judging by this chart, it seems that investors rapidly lost faith in the months to follow.
It's not just about the challenges EarthLink faces in repositioning itself as a broadband Internet provider from its long history in dial-up, along the lines of United Online (Nasdaq: UNTD) and Time Warner's (NYSE: TWX) AOL. Obviously, it also has to fight the powerful forces in high-speed Internet from large providers such as Verizon (NYSE: VZ) and Comcast (Nasdaq: CMCSA), which can easily offer bundled deals at competitive prices to their subscribers.
Of course, EarthLink has some plans to differentiate itself -- and they're aggressive and pricey. Agreements to provide Wi-Fi to municipalities and a plan to offer high-speed Internet over power lines by 2007 may prove to be bright spots. In other attempts to bolster earnings, EarthLink's trying to get into other areas such as Internet calling, Helio wireless service with SK Telecom (NYSE: SKM) (one Foolish colleague thinks Helio could help EarthLink become relevant again), and the launch of some bricks-and-mortar retail stores to help evangelize its array of services. Of course, these plans all require capital expenditures to carry out, and many risks remain. With AOL angling to offer at least some of its own services for free because subscribers keep dwindling, it just goes to show the major challenges that related companies face.
EarthLink trades at just 8 times earnings, and granted, that's unusual in a tech company. And to give some credit where it's due, EarthLink's got guts. It has to, considering how its premium dial-up service continues to leak subscribers and competition intensifies, as everyone knew it would. Regardless, EarthLink faces a long, hard road to keep itself relevant. It's not the kind of risk I would be willing to take, and I'm not surprised investors have been giving EarthLink shares the cold shoulder now and in recent months.
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Alyce Lomax
does not own shares of any of the companies mentioned.
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