EarthLink has fought to get out of America Online's shadow, but it keeps getting left farther behind. Its strategy to buy up smaller ISPs and move into broadband may not improve the situation.
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EarthLink released its second-quarter results today. The company's net loss before merger and acquisition expenses was $35.2 million, or $0.29 per share, beating analysts' estimates. Unfortunately, revenue for the quarter, though 41% ahead of the year-ago quarter, was slightly below expectations ($231 million vs. $233 million). Subscriber rolls, too, came in a little low, gaining 180,000 to 3.69 million. Analysts wanted to see 3.7 million.
As a result, the stock received a downgrade from Jefferies & Co., one of EarthLink's biggest proponents (and, coincidentally, co-manager of its secondary equity offerings and a convertible security offering for MindSpring, which merged with EarthLink in February). The stock dropped closer to its 52-week low, hitting $13.50 a stub during the day. That puts the company's market cap at $1.6 billion. As of June 30, EarthLink was sitting on $1.1 billion in cash and had almost no debt.
Why is the nation's second-biggest ISP getting assigned such a low enterprise value? It consistently garners praise for its service. It has been making big strides in broadband, increasing its subs 78% sequentially this quarter to 80,000. It has also continued to diversify its revenue streams to include more content, commerce, and advertising revenues and less reliance on narrowband. So what's the problem?
The problem is that, when you look at EarthLink, you can see a hoary beard growing on its business. It still derives 85% of its revenue from narrowband, and narrowband will make money for no one but America Online (NYSE: AOL). EarthLink is already finding it difficult to grow organically in narrowband. Netting out broadband subs and subs acquired from the recent acquisition of InfiNet, EarthLink added 75,000 subs this quarter through its own marketing. That's only a 2.2% sequential increase.
According to the company, AOL and Microsoft (Nasdaq: MSFT) have locked up a significant portion of the market through long-term contracts offered with computer purchases. A typical deal might offer a $400 rebate on a computer purchase if the buyer commits to AOL as her ISP for the next three years. That blocks new customer acquisition and keeps people from switching ISPs. The result is that AOL drew about 980,000 new members last quarter compared to Earthlink's 75,000.
EarthLink has devoted itself to broadband as a result. It is slated to offer cable access on AT&T (NYSE: T) cable networks after 2002, and may be able to access Time Warner (NYSE: TWX) cable sooner. EarthLink has begun offering self-installation digital subscriber line (DSL) kits in order to speed up adoption of the technology. Furthermore, by buying up small, struggling narrowband ISPs for a song, the company can market its broadband services directly to a broader user base.
But what happens when the broadband business becomes commoditized, like the narrowband business has? EarthLink is nowhere near the king of that hill, and won't be anytime soon. If it can't be the top dog in that industry either, where will the revenue come from when access prices fall and cash for acquisition dries up? That, I think, is what the market is worried about today.
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