EarthLink Holdings Corp.
EARTHLINK INC (Form: 10-K/A, Received: 03/30/2007 14:48:24)

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K/A

 

x                                  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

                                                For the fiscal year ended December 31, 2006

OR

o                TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934

                              For the transition period from          to          

Commission File Number: 001-15605

EARTHLINK, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

 

58-2511877

(State of incorporation)

 

(I.R.S. Employer Identification No.)

 

 

 

1375 Peachtree St., Atlanta, Georgia 30309

(Address of principal executive offices, including zip code)

 

(404) 815-0770

(Registrant’s telephone number, including area code)

 

Securities registered pursuant to Section 12(b) of the Act:  None

 

Securities registered pursuant to Section 12(g) of the Act: Common Stock, $.01 par value

 


 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.     Yes x   No o

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.     Yes o   No x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes x   No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation of S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.     o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act):

Large accelerated filer   x       Accelerated filer   o        Non-accelerated filer   o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes o   No x

The aggregate market value of the registrant’s outstanding common stock held by non-affiliates of the registrant on June 30, 2006 was $1,107.9 million.

 As of February 28, 2007, 123,214,658 shares of common stock were outstanding.

                Portions of the Proxy Statement to be filed with the Securities and Exchange Commission and to be used in connection with the Annual Meeting of Stockholders to be held on May 1, 2007 are incorporated by reference in Part III of this Form 10-K.

 




EXPLANATORY NOTE

EarthLink, Inc. (the “Company”) is filing this Amendment No. 1 on Form 10-K/A (“Amendment No. 1”) to its Annual Report on Form 10-K for the year ended December 31, 2006, which was originally filed on March 1, 2007 (the “Original Filing”), to amend Item 15, Exhibits and Financial Statement Schedules, in order to file Exhibit 99.1, Consolidated Financial Statements of HELIO, Inc. and HELIO LLC. Pursuant to Rule 3-09 of Regulation S-X, the Company must file separate financial statements of HELIO, Inc. and HELIO LLC. In accordance with Rule 3-09, the separate financial statements are being filed as an amendment to the Company’s Annual Report on Form 10-K within 90 days after the end of the Company’s fiscal year. The Company is also filing this Amendment No. 1 to amend Item 8, Financial Statements and Supplementary Data, in order to conform the summarized balance sheet information of HELIO in Footnote 4, “Investments,” to the financial statements filed in Exhibit 99.1. No other changes to Item 8 have been made.

Pursuant to Rule 12b-15 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), this Amendment No. 1 amends Items 8 and Item 15 in their entirety and contains new certifications pursuant to Rules 13a-14 and 15d-14 under the Exchange Act and Section 302 of the Sarbanes-Oxley Act of 2002.  Other than the inclusion of Exhibit 99.1, the conformity of summarized balance sheet information of HELIO in Footnote 4 to Exhibit 99.1 and the inclusion of new certifications pursuant to Rules 13a-14 and 15d-14 under the Exchange Act and Section 302 of the Sarbanes-Oxley Act of 2002, no other changes or amendments to the Original Filing are being made.

This Amendment No. 1 contains only the sections and exhibits to the Original Filing that are being amended, and those unaffected parts or exhibits are not included herein.  This Amendment No. 1 continues to speak as of the date of the Original Filing and the Company has not updated the disclosure contained herein to reflect events that have occurred since the date of the Original Filing.  Accordingly, this Amendment No. 1 should be read in conjunction with the Company’s other filings, if any, made with the Securities and Exchange Commission.

2




Item 8.                         Financial Statements And Supplementary Data.

EARTHLINK, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

Page

Reports of Independent Registered Public Accounting Firm

 

64

 

Consolidated Balance Sheets as of December 31, 2005 and 2006

 

66

 

Consolidated Statements of Operations for the years ended December 31, 2004, 2005 and 2006

 

67

 

Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss) for the years ended December 31, 2004, 2005 and 2006

 

68

 

Consolidated Statements of Cash Flows for the years ended December 31, 2004, 2005 and 2006

 

69

 

Notes to Consolidated Financial Statements

 

70

 

 

63




REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and
Stockholders of EarthLink, Inc.

We have audited the accompanying consolidated balance sheets of EarthLink, Inc. as of December 31, 2005 and 2006, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of EarthLink, Inc. at December 31, 2005 and 2006, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.

As discussed in Note 2 of the Notes to the Consolidated Financial Statements, in 2006 the Company adopted Statement of Financial Accounting Standards No. 123 (revised), Share-Based Payment .

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of EarthLink, Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 28, 2007 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Atlanta, Georgia

February 28, 2007

 

64




REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON
INTERNAL CONTROL OVER FINANCIAL REPORTING

The Board of Directors and
Stockholders of EarthLink, Inc.

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that EarthLink, Inc. maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). EarthLink, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that EarthLink, Inc. maintained effective internal control over financial reporting as of December 31, 2006 is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, EarthLink, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006 based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets as of December 31, 2005 and 2006, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the three years in the period ended December 31, 2006 of EarthLink, Inc. and our report dated February 28, 2007 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Atlanta, Georgia

February 28, 2007

 

65




EARTHLINK, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)

 

 

December 31,

 

 

 

2005

 

2006

 

ASSETS

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

173,294

 

$

158,369

 

Investments in marketable securities

 

207,845

 

214,947

 

Accounts receivable, net of allowance of $8,054 and $8,062 as of December 31, 2005 and 2006, respectively

 

36,033

 

51,054

 

Prepaid expenses

 

14,225

 

14,831

 

Other current assets

 

13,121

 

17,549

 

Total current assets

 

444,518

 

456,750

 

Long-term investments in marketable securities

 

40,980

 

21,460

 

Property and equipment, net

 

73,177

 

96,620

 

Investment in equity affiliate

 

67,143

 

61,743

 

Investments in other companies

 

1,417

 

59,325

 

Purchased intangible assets, net

 

16,278

 

59,798

 

Goodwill

 

101,125

 

202,277

 

Other long-term assets

 

4,511

 

10,066

 

Total assets

 

$

749,149

 

$

968,039

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

Current liabilities:

 

 

 

 

 

Trade accounts payable

 

$

31,578

 

$

41,298

 

Accrued payroll and related expenses

 

37,741

 

41,079

 

Other accounts payable and accrued liabilities

 

84,139

 

94,882

 

Deferred revenue

 

58,359

 

53,511

 

Total current liabilities

 

211,817

 

230,770

 

Long-term debt

 

 

258,750

 

Other long-term liabilities

 

15,468

 

19,855

 

Total liabilities

 

227,285

 

509,375

 

Commitments and contingencies (See Note 14)

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Convertible preferred stock, $0.01 par value, 100,000 shares authorized, 0 shares issued and outstanding as of December 31, 2005 and 2006

 

 

 

Common stock, $0.01 par value, 300,000 shares authorized, 181,962 and 184,545 shares issued as of December 31, 2005 and 2006, respectively, and 131,390 and 122,634 shares outstanding as of December 31, 2005 and 2006, respectively

 

1,820

 

1,845

 

Additional paid-in capital

 

1,997,906

 

2,016,578

 

Warrants to purchase common stock

 

259

 

259

 

Accumulated deficit

 

(1,049,982

)

(1,044,995

)

Treasury stock, at cost, 50,572 and 61,911 shares, respectively, as of December 31, 2005 and 2006

 

(422,619

)

(508,232

)

Unrealized losses on investments

 

(653

)

(6,791

)

Deferred compensation

 

(4,867

)

 

Total stockholders’ equity

 

521,864

 

458,664

 

Total liabilities and stockholders’ equity

 

$

749,149

 

$

968,039

 

 

The accompanying notes are an integral part of these consolidated financial statements.

66




EARTHLINK, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

 

 

Year Ended December 31,

 

 

 

2004

 

2005

 

2006

 

 

 

(in thousands, except per share data)

 

Revenues

 

$

1,382,202

 

$

1,290,072

 

$

1,301,267

 

Operating costs and expenses:

 

 

 

 

 

 

 

Telecommunications service and equipment costs

 

431,162

 

366,654

 

424,425

 

Sales incentives

 

10,040

 

8,973

 

10,916

 

Total cost of revenues

 

441,202

 

375,627

 

435,341

 

Sales and marketing

 

417,250

 

389,522

 

389,079

 

Operations and customer support

 

255,192

 

233,907

 

260,941

 

General and administrative

 

105,043

 

112,173

 

128,479

 

Amortization of intangible assets

 

24,363

 

12,267

 

11,902

 

Facility exit and restructuring costs

 

28,394

 

2,080

 

(117

)

Total operating costs and expenses

 

1,271,444

 

1,125,576

 

1,225,625

 

Income from operations

 

110,758

 

164,496

 

75,642

 

Net losses of equity affiliate

 

 

(15,608

)

(84,782

)

Gain (loss) on investments in other companies, net

 

(1,420

)

2,877

 

377

 

Interest income and other, net

 

6,131

 

13,491

 

14,636

 

Income before income taxes

 

115,469

 

165,256

 

5,873

 

Provision for income taxes

 

4,460

 

22,476

 

886

 

Net income

 

$

111,009

 

$

142,780

 

$

4,987

 

Basic net income per share

 

$

0.72

 

$

1.04

 

$

0.04

 

Diluted net income per share

 

$

0.70

 

$

1.02

 

$

0.04

 

Basic weighted average common shares outstanding

 

154,233

 

137,080

 

128,790

 

Diluted weighted average common shares outstanding

 

157,815

 

139,950

 

130,583

 

 

The accompanying notes are an integral part of these consolidated financial statements.

67




EARTHLINK, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (LOSS)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Unrealized

 

 

 

Total

 

Total

 

 

 

 

 

 

 

Additional

 

 

 

Accumu-

 

 

 

 

 

Gains (Losses)

 

Deferred

 

Stock-

 

Compre-

 

 

 

Common Stock

 

Paid-in

 

 

 

lated

 

Treasury Stock

 

on Invest-

 

Compen-

 

holders’

 

hensive

 

 

 

Shares

 

Amount

 

Capital

 

Warrants

 

Deficit

 

Shares

 

Amount

 

ments

 

sation

 

Equity

 

Income (Loss)

 

 

 

(in thousands)

 

 

Balance as of December 31, 2003

 

176,410

 

 

$

1,764

 

 

 

$

1,949,105

 

 

 

$

1,223

 

 

$

(1,303,771

)

(17,368

)

$

(104,344

)

 

$

(117

)

 

 

$

(197

)

 

$

543,663

 

 

 

 

 

Issuance of common stock pursuant to exercise of stock options and vesting of restricted stock units

 

2,132

 

 

22

 

 

 

15,845

 

 

 

 

 

 

 

 

 

 

 

 

 

 

15,867

 

 

 

 

 

Issuance of common stock pursuant to employee stock purchase plan

 

223

 

 

2

 

 

 

1,694

 

 

 

 

 

 

 

 

 

 

 

 

 

 

1,696

 

 

 

 

 

Issuance of restricted stock units and phantom share units

 

 

 

 

 

 

4,564

 

 

 

 

 

 

 

 

 

 

 

 

(4,431

)

 

133

 

 

 

 

 

Amortization of deferred compensation

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

633

 

 

633

 

 

 

 

 

Repurchase of common stock

 

 

 

 

 

 

 

 

 

 

 

 

(12,677

)

(125,712

)

 

 

 

 

 

 

(125,712

)

 

 

 

 

Unrealized holding gains on certain investments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

318

 

 

 

 

 

318

 

 

$

318

 

 

Net income

 

 

 

 

 

 

 

 

 

 

 

111,009

 

 

 

 

 

 

 

 

 

111,009

 

 

111,009

 

 

Total comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

111,327

 

 

Balance as of December 31, 2004

 

178,765

 

 

1,788

 

 

 

1,971,208

 

 

 

1,223

 

 

(1,192,762

)

(30,045

)

(230,056

)

 

201

 

 

 

(3,995

)

 

547,607

 

 

 

 

 

Issuance of common stock pursuant to exercise of stock options and vesting of restricted stock units

 

3,150

 

 

32

 

 

 

22,876

 

 

 

 

 

 

 

 

 

 

 

 

 

 

22,908

 

 

 

 

 

Issuance of common stock pursuant to employee stock purchase plan

 

47

 

 

 

 

 

444

 

 

 

 

 

 

 

 

 

 

 

 

 

 

444

 

 

 

 

 

Issuance of restricted stock units and phantom share units

 

 

 

 

 

 

2,048

 

 

 

 

 

 

 

 

 

 

 

 

(2,001

)

 

47

 

 

 

 

 

Amortization of deferred compensation

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

1,129

 

 

1,129

 

 

 

 

 

Stock-based compensation expense

 

 

 

 

 

 

366

 

 

 

 

 

 

 

 

 

 

 

 

 

 

366

 

 

 

 

 

Repurchase of common stock

 

 

 

 

 

 

 

 

 

 

 

 

(20,527

)

(192,563

)

 

 

 

 

 

 

(192,563

)

 

 

 

 

Expiration of warrants

 

 

 

 

 

 

964

 

 

 

(964

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Unrealized holding losses on certain investments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(854

)

 

 

 

 

(854

)

 

$

(854

)

 

Net income

 

 

 

 

 

 

 

 

 

 

 

142,780

 

 

 

 

 

 

 

 

 

142,780

 

 

142,780

 

 

Total comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

141,926

 

 

Balance as of December 31, 2005

 

181,962

 

 

1,820

 

 

 

1,997,906

 

 

 

259

 

 

(1,049,982

)

(50,572

)

(422,619

)

 

(653

)

 

 

(4,867

)

 

521,864

 

 

 

 

 

Issuance of common stock pursuant to exercise of stock options and vesting of restricted stock units

 

844

 

 

8

 

 

 

4,023

 

 

 

 

 

 

 

 

 

 

 

 

 

 

4,031

 

 

 

 

 

Issuance of common stock for acquisition of New Edge

 

1,739

 

 

17

 

 

 

20,177

 

 

 

 

 

 

 

 

 

 

 

 

 

 

20,194

 

 

 

 

 

Issuance of phantom share units

 

 

 

 

 

 

43

 

 

 

 

 

 

 

 

 

 

 

 

 

 

43

 

 

 

 

 

Reclass of deferred compensation

 

 

 

 

 

 

(4,867

)

 

 

 

 

 

 

 

 

 

 

 

4,867

 

 

 

 

 

 

 

Stock-based compensation expense

 

 

 

 

 

 

14,242

 

 

 

 

 

 

 

 

 

 

 

 

 

 

14,242

 

 

 

 

 

Tax provision from stock options

 

 

 

 

 

 

117

 

 

 

 

 

 

 

 

 

 

 

 

 

 

117

 

 

 

 

 

Purchase of call options

 

 

 

 

 

 

(47,162

)

 

 

 

 

 

 

 

 

 

 

 

 

 

(47,162

)

 

 

 

 

Issuance of warrants

 

 

 

 

 

 

32,099

 

 

 

 

 

 

 

 

 

 

 

 

 

 

32,099

 

 

 

 

 

Repurchase of common stock

 

 

 

 

 

 

 

 

 

 

 

 

(11,339

)

(85,613

)

 

 

 

 

 

 

(85,613

)

 

 

 

 

Unrealized holding losses on certain investments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(6,138

)

 

 

 

 

(6,138

)

 

$

(6,138

)

 

Net income

 

 

 

 

 

 

 

 

 

 

 

4,987

 

 

 

 

 

 

 

 

 

4,987

 

 

4,987

 

 

Total comprehensive loss

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

(1,151

)

 

Balance as of December 31, 2006

 

184,545

 

 

$

1,845

 

 

 

$

2,016,578

 

 

 

$

259

 

 

$

(1,044,995

)

(61,911

)

$

(508,232

)

 

$

(6,791

)

 

 

$

 

 

$

458,664

 

 

 

 

 

 

The accompanying notes are an integral part of these consolidated financial statements.

68




EARTHLINK, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 

Year Ended December 31,

 

 

 

2004

 

2005

 

2006

 

 

 

(in thousands)

 

Cash flows from operating activities:

 

 

 

 

 

 

 

Net income

 

$

111,009

 

$

142,780

 

$

4,987

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

 

 

Depreciation and amortization

 

79,219

 

47,138

 

46,287

 

Bad debt expense

 

26,253

 

22,622

 

23,033

 

Loss (gain) on disposals and impairments of fixed assets

 

10,103

 

(73

)

1,351

 

Loss (gain) on investments in other companies, net

 

1,420

 

(2,877

)

(377

)

Net losses of equity affiliate

 

 

15,608

 

84,782

 

Stock-based compensation

 

633

 

1,542

 

14,285

 

Deferred income taxes

 

1,969

 

17,139

 

588

 

Other adjustments

 

 

(255

)

(375

)

Increase in accounts receivable

 

(21,401

)

(28,876

)

(26,131

)

Decrease (increase) in prepaid expenses and other assets

 

74

 

4,630

 

(3,968

)

Decrease in accounts payable and accrued and other liabilities

 

(11,746

)

(22,306

)

(24,060

)

Decrease in deferred revenue

 

(9,381

)

(8,368

)

(5,153

)

Net cash provided by operating activities

 

188,152

 

188,704

 

115,249

 

Cash flows from investing activities:

 

 

 

 

 

 

 

Purchases of property and equipment

 

(29,890

)

(33,879

)

(38,852

)

Purchases of subscriber bases

 

(2,419

)

(6,690

)

(8,879

)

Proceeds from sales of fixed assets

 

733

 

124

 

8

 

Investments in marketable securities

 

 

 

 

 

 

 

Purchases

 

(540,881

)

(411,006

)

(179,165

)

Sales and maturities

 

507,222

 

474,512

 

191,882

 

Investments in and net advances to equity affiliate

 

 

(82,301

)

(79,020

)

Purchase of business, net of cash acquired

 

 

(9,352

)

(108,663

)

Investments in other companies

 

(3,835

)

 

(60,000

)

Distributions received from investments in other companies

 

 

4,440

 

377

 

Other

 

 

(929

)

(752

)

Net cash used in investing activities

 

(69,070

)

(65,081

)

(283,064

)

Cash flows from financing activities:

 

 

 

 

 

 

 

Principal payments under capital lease obligations

 

(896

)

(28

)

(31

)

Repayment of note payable

 

 

 

(2,000

)

Proceeds from issuance of convertible senior notes, net

 

 

 

251,568

 

Purchase of call options

 

 

 

(47,162

)

Proceeds from issuance of warrants

 

 

 

32,099

 

Proceeds from exercises of stock options and other

 

17,696

 

23,352

 

4,029

 

Repurchases of common stock

 

(125,712

)

(192,563

)

(85,613

)

Net cash (used in) provided by financing activities

 

(108,912

)

(169,239

)

152,890

 

Net increase (decrease) in cash and cash equivalents

 

10,170

 

(45,616

)

(14,925

)

Cash and cash equivalents, beginning of year

 

208,740

 

218,910

 

173,294

 

Cash and cash equivalents, end of year

 

$

218,910

 

$

173,294

 

$

158,369

 

 

The accompanying notes are an integral part of these consolidated financial statements.

69




EARTHLINK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.    Organization

EarthLink, Inc. (“EarthLink” or the “Company”) is a total communications provider, providing integrated communication services and related value-added services to individual consumers and business customers utilizing Internet Protocol, or IP, based technologies. EarthLink’s core service offerings are dial-up and wireline broadband Internet access services and value-added services. EarthLink’s growth initiatives include IP-based voice services, municipal wireless broadband services and services for business customers.

2.    Summary of Significant Accounting Policies

Basis of Consolidation

The consolidated financial statements include the accounts of EarthLink and all wholly-owned subsidiaries. All intercompany transactions and balances have been eliminated.

Use of Estimates in Preparation of Financial Statements

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities in the consolidated financial statement and accompanying footnotes. On an ongoing basis, the Company evaluates its estimates, including, but not limited to, those related to the allowance for doubtful accounts; the use, recoverability, and/or realizability of certain assets, including deferred tax assets; useful lives of intangible assets and property and equipment; the fair values of assets acquired and liabilities assumed in acquisitions of businesses, including acquired intangible assets; facility exit and restructuring liabilities; fair values of investments; stock-based compensation; contingent liabilities and long-lived asset impairments. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable. Actual results could differ from those estimates.

Revenues

General.    EarthLink recognizes revenue in accordance with Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition.” Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectibility is probable. Generally, these criteria are met monthly as EarthLink’s service is provided on a month-to-month basis and collection for the service is generally made within 30 days of the service being provided. Revenues are recorded as earned. Deferred revenue is recorded when payments are received in advance of EarthLink performing its service obligations and recognized ratably over the service period.

Narrowband access revenues consist of monthly fees charged to customers for dial-up Internet access. Broadband access revenues consist of retail and wholesale fees charged for high-speed, high-capacity access services including DSL, cable, satellite, wireless and dedicated circuit services; fees charged for high-speed data networks to businesses and communications carriers; fees charged for IP-based voice services; installation fees; fees for equipment; early termination fees; and regulatory surcharges billed to customers. Web hosting revenues consist of fees charged for leasing server space and providing web services to companies and individuals wishing to present a web or e-commerce presence. Advertising and other value-added services revenues consist of revenues earned from promotional arrangements with advertisers,

70




EARTHLINK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

retailers, service providers and content providers. Advertising and other value-added services revenues also include revenues from certain ancillary services sold as add-on features to the Company’s Internet services, such as email storage and security products.

Advertising and other value-added services revenues include amounts derived from selling other companies’ products and services to EarthLink subscribers, subscribers using and buying other vendors’ products and services, and other companies purchasing advertising on EarthLink’s online properties, among other activities. Advertising revenues are recorded when earned based on the per unit contractual rate and the number of units sold, number of subscriber impressions, or number of subscriber purchases or actions.

Gross versus net revenue recognition.    EarthLink maintains relationships with certain telecommunications partners (including cable companies) in which it provides services to customers using the “last mile” element of the telecommunication providers’ networks. The term “last mile” generally refers to the element of telecommunications networks that is directly connected to homes and businesses. In these instances, EarthLink evaluates the criteria outlined in Emerging Issues Task Force (“EITF”) Issue No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent,” in determining whether it is appropriate to record the gross amount of revenue and related costs or the net amount due it from the telecommunications partner. Generally, when EarthLink is the primary obligor in the transaction with the subscriber, has latitude in establishing prices, is the party determining the service specifications or has several but not all of these indicators, EarthLink records the revenue at the amount billed the subscriber. If EarthLink is not the primary obligor and/or the telecommunications partner has latitude in establishing prices, EarthLink records revenue associated with the related subscribers on a net basis, netting the cost of revenue associated with the service against the gross amount billed the customer and recording the net amount as revenue.

Cost of Revenues

Cost of revenues include telecommunications service and equipment costs and sales incentives. Telecommunications service and equipment costs include telecommunications fees and network operations costs incurred to provide the Company’s Internet access services; fees paid to content providers for information provided on the Company’s online properties, including the Company’s Personal Start Page TM ; the costs of equipment sold to customers for use with the Company’s services; activation and deactivation fees paid to the Company’s network providers for the provisioning and disconnection of services; depreciation of network equipment; and surcharges due to regulatory agencies.

Sales incentives include the cost of promotional products and services provided to potential and new subscribers, including free Internet access on a trial basis and free modems and other hardware. EarthLink accounts for sales incentives in accordance with EITF Issue No. 01-09, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products),” which requires the costs of sales incentives to be classified as cost of revenues.

The Company also pays fees to retailers, manufacturers or other marketing partners for marketing EarthLink’s products and services. Depending on the nature of the arrangement, the marketing partners may purchase EarthLink’s products and services in addition to providing marketing services. If the retailer or manufacturer does not purchase EarthLink’s products or services, the Company classifies the fees as sales and marketing expenses when incurred. In this scenario, the retailer or manufacturer is not a reseller and the accounting in EITF Issue No. 01-09 does not apply. If the retailer or manufacturer purchases and

71




EARTHLINK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

then resells EarthLink’s products or services, the Company accounts for the fees as a reduction in revenue in accordance with EITF Issue No. 01-09 because the consideration is presumed to be a reduction of the selling price of EarthLink’s products or services; however, if the Company receives an identifiable benefit whose fair value can be reasonably estimated in exchange for the fees, the Company classifies the fees as operating expenses.

Sales and Marketing

Sales and marketing expenses include advertising and promotion expenses, fees paid to distribution partners to acquire new paying subscribers, personnel-related expenses for sales and marketing personnel and telemarketing costs incurred to acquire and retain subscribers. The Company’s marketing strategies include national branding campaigns comprised of television, radio, Internet, print and outdoor advertising. Marketing and advertising costs to promote the Company’s products and services are expensed in the period incurred. The Company also uses direct mail advertising, and the Company incurs production, printing, mailing and postage related to its direct mail advertising activities. Media and direct mail production costs are expensed the first time the advertisement is run. Media and agency costs are expensed over the period the advertising runs. Advertising expenses were $224.4 million, $245.7 million and $242.0 million during the years ended December 31, 2004, 2005 and 2006, respectively. Prepaid advertising expenses were $2.0 million and $3.6 million as of December 31, 2005 and 2006, respectively.

During the years ended December 31, 2004, 2005 and 2006, EarthLink incurred various shipping charges in connection with providing welcome kits to new customers and shipping equipment. The Company classifies shipping and handling charges associated with welcome kits as sales and marketing expenses, which were $1.8 million, $1.2 million and $1.0 million during the years ended December 31, 2004, 2005 and 2006, respectively, because the Company does not invoice the customer for the welcome kits or the associated shipping. All other shipping and handling costs are included in cost of revenues.

Software Development Costs

EarthLink accounts for research and development costs in accordance with several accounting pronouncements, including Statement of Financial Accounting Standards (“SFAS”) No. 2, “Accounting for Research and Development Costs,” and SFAS No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed.” SFAS No. 86 specifies that costs incurred internally in creating a computer software product should be charged to expense when incurred as research and development until technological feasibility has been established for the product. Once technological feasibility is established, all software costs should be capitalized until the product is available for general release to customers. Judgment is required in determining when the technological feasibility of a product is established. The Company has determined that technological feasibility for its products is reached very shortly before the products are released. Costs incurred after technological feasibility is established are not material, and, accordingly, the Company expenses research and development costs when incurred.

EarthLink accounts for costs incurred to develop software for internal use in accordance with Statement of Position 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use,” which requires such costs be capitalized and amortized over the estimated useful life of the software. Costs related to design or maintenance of internal-use software are expensed as incurred.

72




EARTHLINK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Income Taxes

The Company recognizes deferred tax assets and liabilities for operating loss carryforwards, tax credit carryforwards and the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which the temporary differences are expected to be recovered or settled. A valuation allowance is recorded to reduce the carrying amounts of net deferred tax assets if there is uncertainty regarding their realization. EarthLink considers many factors when assessing the likelihood of future realization including the Company’s recent cumulative earnings experience by taxing jurisdiction, expectations of future taxable income, the carryforward periods available to the Company for tax reporting purposes and other relevant factors.

Net Income per Share

Net income per share has been computed according to SFAS No. 128, “Earnings per Share,” which requires a dual presentation of basic and diluted earnings per share (“EPS”). Basic EPS represents net income divided by the weighted average number of common shares outstanding during a reported period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock, including stock options, warrants, restricted stock units, phantom share units and contingently issuable shares (collectively “Common Stock Equivalents”), were exercised or converted into common stock. The dilutive effect of outstanding stock options, warrants and restricted stock units is reflected in diluted earnings per share by application of the treasury stock method. Phantom share units and contingently issuable shares are reflected on an if-converted basis. EarthLink’s convertible debt instruments were excluded from the calculation of diluted earnings per share as their effect was antidilutive. In applying the treasury stock method for stock-based compensation arrangements during the year ended December 31, 2006, the assumed proceeds were computed as the sum of the amount the employee must pay upon exercise and the amounts of compensation cost attributed to future services and not yet recognized.

The following table sets forth the computation for basic and diluted net income per share for the years ended December 31, 2004, 2005 and 2006:

 

 

Year Ended December 31,

 

 

 

2004

 

2005

 

2006

 

 

 

(in thousands, except per share data)

 

Net income (A)

 

$

111,009

 

$

142,780

 

$

4,987

 

Basic weighted average common shares outstanding (B)

 

154,233

 

137,080

 

128,790

 

Dilutive effect of Common Stock Equivalents

 

3,582

 

2,870

 

1,793

 

Diluted weighted average common shares outstanding (C)

 

157,815

 

139,950

 

130,583

 

Basic net income per share (A/B)

 

$

0.72

 

$

1.04

 

$

0.04

 

Diluted net income per share (A/C)

 

$

0.70

 

$

1.02

 

$

0.04

 

 

During the years ended December 31, 2004, 2005 and 2006, approximately 8.7 million, 9.9 million and 21.2 million, respectively, options and warrants were excluded from the calculation of diluted EPS because the exercise prices exceeded the Company’s average stock price during the respective years. These options and warrants could be dilutive in future periods. In addition, approximately 28.4 million shares underlie the Company’s convertible debt instruments, which could be dilutive in future periods.

73




EARTHLINK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Stock-Based Compensation

As of December 31, 2006, EarthLink had various stock-based compensation plans, which are more fully described in Note 11, “Stock-Based Compensation.” Prior to January 1, 2006, the Company accounted for stock-based compensation using the intrinsic value method, which follows the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and Financial Accounting Standards Board (“FASB”) Interpretation (“FIN”) No. 44, “Accounting for Certain Transactions Involving Stock Compensation.” Generally, no stock-based employee compensation cost related to stock options was reflected in net income (loss) prior to January 1, 2006, as all options granted under stock-based compensation plans had an exercise price equal to the market value of the underlying common stock on the grant date. However, to the extent that the Company modified stock options subsequent to the grant date, the Company recorded compensation expense based on the modification, as required by SFAS No. 123, “Accounting for Stock-Based Compensation,” and APB Opinion No. 25. Compensation cost related to restricted stock units granted to non-employee directors and certain key employees was reflected in net income as services were rendered.

On January 1, 2006, the Company adopted SFAS No. 123(R), “Share-Based Payment,” using the modified prospective method, which requires measurement of compensation cost for all stock awards at fair value on the date of grant and recognition of compensation over the requisite service period for awards expected to vest. In accordance with the modified prospective method, the Company’s financial statements for periods prior to implementation have not been restated to reflect, and do not include, the impact of SFAS No. 123(R). The Company estimates the fair value of stock options using the Black-Scholes valuation model, and determines the fair value of restricted stock units based on the number of shares granted and the quoted price of EarthLink’s common stock on the date of grant . Such value is recognized as expense over the requisite service period, net of estimated forfeitures, using the straight-line attribution method. The estimate of awards that will ultimately vest requires significant judgment, and to the extent actual results or updated estimates differ from the Company’s current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. The Company considers many factors when estimating expected forfeitures, including types of awards, employee class and historical employee attrition rates. Actual results, and future changes in estimates, may differ substantially from the Company’s current estimates.

In March 2005, the SEC published SAB No. 107, which provides the Staff’s views on a variety of matters relating to stock-based payments. SAB No. 107 requires stock-based compensation to be classified in the same expense line items as cash compensation. The Company has classified stock-based compensation expense during the year ended December 31, 2006 within the same operating expense line items as cash compensation paid to employees.

In November 2005, the FASB issued FASB Staff Position (“FSP”) No. FAS 123(R)-3, “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards,” which provides an elective transition method for calculating the initial pool of excess tax benefits available to absorb tax deficiencies recognized subsequent to the adoption of SFAS No. 123(R). Companies were permitted to take up to one year from the effective date of this FASB Staff Position to evaluate the available transition alternatives and make a one-time election as to which method to adopt. The Company elected to use the alternative method provided in FSP No. FAS 123(R)-3.

The cumulative effect of adoption of SFAS No. 123(R) using the modified prospective transition method, which resulted from estimating forfeitures on nonvested shares of restricted stock rather than

74




EARTHLINK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

accounting for forfeitures as they occurred, was not material. Prior to the adoption of SFAS No. 123(R), deferred compensation relating to restricted stock units was presented as a separate component of stockholders’ equity. Upon adoption of SFAS No. 123(R) on January 1, 2006, the deferred compensation balance of $4.9 million was reclassified to additional paid-in capital.

Stock-based compensation expense under SFAS No. 123(R) was $14.2 million during the year ended December 31, 2006, of which $12.2 million related to stock options and $2.0 million related to restricted stock units. Stock-based compensation expense during the year ended December 31, 2005 was $1.5 million, of which $1.1 million related to restricted stock units and $0.4 million was stock-based compensation expense arising from modifications to extend the exercise periods of certain vested stock options for EarthLink employees transferring to HELIO. As a result of adopting SFAS No. 123(R) on January 1, 2006, the Company’s income from operations and net income for the year ended December 31, 2006 were $12.3 million lower than if it had continued to account for share-based compensation using the intrinsic method of accounting under APB Opinion No. 25. Basic and diluted net income per share for the year ended December 31, 2006 were $0.10 per share and $0.09 per share lower, respectively, than if the Company had continued to account for share-based compensation using the intrinsic method of accounting under APB Opinion No. 25. The incremental impact of SFAS No. 123(R) during the year ended December 31, 2006 represents stock-based compensation expense related to stock options and the impact of estimating forfeitures related to nonvested shares of restricted stock.

If the Company had elected to adopt the optional recognition provisions of SFAS No. 123, which uses the fair value based method for stock-based compensation, and amortized the grant date fair value of stock options to compensation expense on a straight-line basis over the vesting period of the options, net income and basic and diluted net income per share for the years ended December 31, 2004 and 2005 would have been changed to the pro forma amounts indicated below:

 

 

Year Ended December 31,

 

 

 

2004

 

2005

 

 

 

(in thousands, except
per share data)

 

Net income, as reported

 

$

111,009

 

$

142,780

 

Add: Stock-based compensation expense associated with stock options included in reported net income

 

 

366

 

Deduct: Stock-based compensation expense determined using a fair value based method for all stock options

 

(23,311

)

(15,900

)

Pro forma net income

 

$

87,698

 

$

127,246

 

Basic net income per share:

 

 

 

 

 

As reported

 

$

0.72

 

$

1.04

 

Pro forma

 

$

0.57

 

$

0.93

 

Diluted net income per share:

 

 

 

 

 

As reported

 

$

0.70

 

$

1.02

 

Pro forma

 

$

0.57

 

$

0.92

 

 

75




EARTHLINK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Cash and Cash Equivalents

All highly liquid investments with original maturities of three months or less at the date of acquisition are considered cash equivalents. These investments primarily consist of money market funds and commercial paper.

Investments in Marketable Securities

Investments in marketable securities are accounted for in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” All investments with original maturities greater than 90 days are classified as investments in marketable securities. Investments in marketable securities with maturities less than one year from the balance sheet date are considered short-term investments. Short-term investments also include investments in asset-backed, auction rate debt securities with interest rate reset periods of 90 days or less but whose underlying agreements have original maturities of more than 90 days, based on the provisions of Accounting Research Bulletin No. 43, Chapter 3A, Working Capital-Current Assets and Liabilities, which allows classification of investments based on management’s view. Investments in marketable securities with maturities greater than one year from the balance sheet date, excluding investments in asset-backed, auction rate debt securities with interest reset periods of 90 days or less, are considered long-term investments. The Company has invested in government agency notes, asset-backed debt securities (including auction rate debt securities), corporate notes and commercial paper, all of which bear a minimum short-term rating of A1/P1 or a minimum long-term rating of A/A2.

The Company has classified all short- and long-term investments in marketable securities as available-for-sale. The Company may or may not hold its investments in marketable securities until maturity. In response to changes in the availability of and the yield on alternative investments as well as liquidity requirements, the Company occasionally sells its investments in marketable securities prior to their stated maturities. Available for sale securities are carried at fair value, with any unrealized gains and losses, net of tax, included in unrealized gains (losses) on investments as a separate component of stockholders’ equity and in total comprehensive income (loss). Realized gains and losses are included in interest income and other, net, in the Consolidated Statements of Operations and are determined on a specific identification basis.

The Company periodically evaluates whether declines in fair values of its investments below their cost are potentially other than temporary. This evaluation consists of several qualitative and quantitative factors regarding the severity and duration of the unrealized loss as well as the Company’s ability and intent to hold the investment for a period of time which may be sufficient for an anticipated recovery in market value.

Allowance for Doubtful Accounts

EarthLink maintains an allowance for doubtful accounts for estimated losses resulting from the inability of EarthLink’s customers to make payments. In assessing the adequacy of the allowance for doubtful accounts, management considers multiple factors including the aging of its receivables, historical write-offs, the credit quality of its customers, the general economic environment and other factors that may affect customers’ ability to pay. If the financial condition of EarthLink’s customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. The Company’s allowance for doubtful accounts was $8.1 million as of December 31, 2005 and 2006. The Company recorded bad debt expense of $26.3 million, $22.6 million and $23.0 million during the years

76




EARTHLINK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

ended December 31, 2004, 2005 and 2006, respectively. The Company’s write-offs of uncollectible accounts were $24.3 million, $22.4 million and $25.2 million during the years ended December 31, 2004, 2005 and 2006, respectively. The Company acquired a $2.2 million allowance for doubtful accounts in its acquisition of New Edge Holding Company (“New Edge”).

Property and Equipment

Property and equipment are stated at cost less accumulated depreciation. Depreciation expense is determined using the straight-line method over the estimated useful lives of the various asset classes, which are generally three to five years for computers, telecommunications equipment and furniture and other office equipment and 15 years for buildings. Leasehold improvements are depreciated using the straight-line method over the shorter of their estimated useful lives or the remaining term of the lease. When leases are extended, the remaining useful lives of leasehold improvements are increased as appropriate, but not for a period in excess of the remaining lease term. Expenditures for maintenance and repairs are charged to operating expense as incurred. Upon retirements or sales, the original cost and related accumulated depreciation are removed from the respective accounts, and the gains and losses are included in interest income and other, net, or as facility exit and restructuring costs, as appropriate. Upon impairment, the Company accelerates depreciation of the asset and such cost is included in operating expenses.

Investments in Other Companies

Minority investments in other companies are classified as investments in other companies in the Consolidated Balance Sheets and are accounted for under the cost method of accounting because the Company does not have the ability to exercise significant influence over the companies’ operations. Under the cost method of accounting, investments in private companies are carried at cost and are only adjusted for other-than-temporary declines in fair value and distributions of earnings. For cost method investments in public companies that have readily determinable fair values, the Company classifies its investments as available-for-sale in accordance with SFAS No. 115 and, accordingly, records these investments at their fair values with unrealized gains and losses included as a separate component of stockholders’ equity and in total comprehensive income (loss). Upon sale or liquidation, realized gains and losses are included in the Consolidated Statement of Operations.

Management regularly evaluates the recoverability of its investments in other companies based on the performance and the financial position of those companies as well as other evidence of market value. Such evaluation includes, but is not limited to, reviewing the investee’s cash position, recent financings, projected and historical financial performance, cash flow forecasts and financing needs. During the years ended December 31, 2004 and 2005, the Company recognized losses due to other-than-temporary declines of the value of investments of $1.4 million and $0.9 million, respectively. These losses are included in gain (loss) on investments in other companies, net, in the Consolidated Statements of Operations. During the year ended December 31, 2006, the Company did not recognize any losses due to other-than-temporary declines of the value of investments.

Variable Interest Entities

The Company applies the guidance prescribed in FIN No. 46, “Consolidation of Variable Interest Entities,” to determine if the Company must consolidate the results of companies in which the Company has invested. Variable interest entities (“VIEs”) are entities that either do not have equity investors with proportionate economic and voting rights or have equity investors that do not provide sufficient financial

77




EARTHLINK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

resources for the entity to support its activities. Consolidation is required if it is determined that the Company absorbs a majority of the expected losses and/or receives a majority of the expected returns. In determining if an investee is a VIE and whether EarthLink must consolidate its results, management evaluates whether the equity of the entity is sufficient to absorb its expected losses and whether EarthLink is the primary beneficiary. Management generally performs this assessment at the date EarthLink becomes involved with the entity and upon changes in the capital structure or related governing documents of the entity. Management has concluded that the Company does not have any arrangements with entities that would require consolidation pursuant to FIN No. 46.

Investment in Equity Affiliate

The Company has a joint venture with SK Telecom Co., Ltd. (“SK Telecom”), HELIO. HELIO is a non-facilities-based mobile virtual network operator (“MVNO”) offering mobile communications services and handsets to U.S. consumers. EarthLink and SK Telecom each have an equal voting and economic ownership interest in HELIO. EarthLink and SK Telecom, as partners, invested an aggregate of $166.0 million of cash and non-cash assets upon completing the formation of HELIO in March 2005, invested an aggregate of $78.0 million of cash in August 2005, invested an aggregate $157.0 million in 2006 and have committed to invest additional cash of $39.0 million in 2007, including $27.0 million that was invested in February 2007.

The Company accounts for its investment in HELIO under the equity method of accounting because the Company can exert significant influence over HELIO’s operating and financial policies. The Company determined that HELIO does not qualify as a VIE under FIN No. 46, so consolidation pursuant to FIN No. 46 is not required. In accordance with the equity method of accounting, EarthLink’s investment in HELIO was recorded at original cost and is adjusted to recognize EarthLink’s proportionate share of HELIO’s net income (loss), amortization of basis differences and additional contributions made.

Goodwill and Purchased Intangible Assets

Goodwill is the excess of the purchase price over the fair value of identifiable net assets acquired in business combinations accounted for under the purchase method of accounting pursuant to SFAS No. 141, “Business Combinations.” Purchased intangible assets consist primarily of subscriber bases and customer relationships, acquired software and technology and other assets acquired in conjunction with the purchases of businesses and subscriber bases from other companies. Subscriber bases acquired directly are valued at cost plus assumed service liabilities, which approximates fair value at the time of purchase. When management determines material intangible assets are acquired in conjunction with the purchase of a company, EarthLink engages an independent third party to determine the allocation of the purchase price to the intangible assets acquired. Intangible assets determined to have definite lives are amortized on a straight-line basis over their estimated useful lives.

The Company accounts for goodwill and intangible assets in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” which prohibits the amortization of goodwill and certain intangible assets deemed to have indefinite lives. SFAS No. 142 requires the Company to test its goodwill for impairment at least annually. The Company performs an impairment test of its goodwill annually during the fourth quarter of its fiscal year or when events and circumstances indicate that goodwill might be permanently impaired. Impairment testing of goodwill is tested at the reporting unit level by comparing the reporting unit’s carrying amount, including goodwill, to the estimated fair value of the reporting unit. The fair values of the reporting unit are estimated using discounted expected future cash flows. If the

78




EARTHLINK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

carrying amount of the reporting unit exceeds its fair value, goodwill is considered impaired and a second step is performed to measure the amount of the impairment loss, if any. The Company conducted its annual impairment test as of October 1, 2006 and determined that the estimated fair value exceeded the carrying value. There have not been any events or circumstances from the date of the Company’s assessment through December 31, 2006 that would cause the Company to retest its goodwill.

Long-Lived Assets

The Company accounts for long-lived assets in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which addresses financial accounting and reporting for the impairment and disposition of long-lived assets, including property and equipment and purchased intangible assets. The Company evaluates the recoverability of long-lived assets for impairment when events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Conditions that would necessitate an impairment assessment include a significant decline in the observable market value of an asset, a significant change in the extent or manner in which an asset is used, or a significant adverse change that would indicate the carrying amount of an asset or group of assets is not recoverable. For long-lived assets to be held and used, EarthLink recognizes an impairment loss only if its carrying amount is not recoverable through its undiscounted cash flows and measures the impairment loss, if any, based on the difference between the carrying amount and fair value. Long-lived assets held for sale are reported at the lower of cost or fair value less costs to sell.

Leases

The Company accounts for lease agreements in accordance with SFAS No. 13, “Accounting for Leases,” which requires categorization of leases at their inception as either operating or capital leases depending on certain criteria. The Company recognizes rent expense for operating leases on a straight-line basis without regard to deferred payment terms, such as rent holidays or fixed escalations. Incentives are treated as a reduction of the Company’s rent costs over the term of the lease agreement. The Company records leasehold improvements funded by landlords under operating leases as leasehold improvements and deferred rent.

Facility Exit and Restructuring Costs

The Company accounts for facility exit and restructuring costs in accordance with SFAS No. 144 and SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Facility exit and restructuring liabilities include estimates for, among other things, severance payments and amounts due under lease obligations, net of estimated sublease income, if any. Key variables in determining such estimates include operating expenses due under lease arrangements, the timing and amounts of sublease rental payments, tenant improvement costs and brokerage and other related costs. The Company periodically evaluates and, if necessary, adjusts its estimates based on currently-available information. Such adjustments are classified as facility exit and restructuring costs in the Consolidated Statements of Operations.

Comprehensive Income (Loss)

Comprehensive income (loss) as presented in the Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss) includes unrealized gains and losses which are excluded from the

79




EARTHLINK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Consolidated Statements of Operations in accordance with SFAS No. 130, “Reporting Comprehensive Income.” For the years ended December 31, 2004, 2005 and 2006, these amounts included changes in unrealized gains and losses on certain investments classified as available-for-sale. The amounts are presented net of tax-related effects, which management estimated to be approximately zero.

Certain Risks and Concentrations

Credit Risk.    By their nature, all financial instruments involve risk, including credit risk for non-performance by counterparties. Financial instruments that potentially subject the Company to credit risk consist principally of cash, cash equivalents, investments in marketable securities, trade receivables and investments in other companies. The Company’s cash investment policy limits investments to investment grade instruments. Accounts receivable are typically unsecured and are derived from revenues earned from customers primarily located in the U.S. Credit risk with respect to trade receivables is limited due to the large number of customers comprising the Company’s customer base. Additionally, the Company performs ongoing credit evaluations of its customers and maintains allowances for potential credit losses. As of December 31, 2005 and 2006, two companies each accounted for more than 10% of gross accounts receivable. Management regularly evaluates the recoverability of its investments in other companies based on the performance and the financial position of those companies as well as other evidence of market value.

Regulatory Risk.    EarthLink purchases broadband access from incumbent local exchange carriers, competitive local exchange carriers and cable providers. Please refer to “Regulatory Environment” in the Business section of this Annual Report on 10-K for a discussion of the regulatory environment as well as a discussion regarding the Company’s contracts with broadband access providers.

Supply Risk.    The Company’s business substantially depends on the capacity, affordability, reliability and security of third-party telecommunications and data service providers. Only a small number of providers offer the network services the Company requires, and the majority of its telecommunications services are currently purchased from a limited number of telecommunications service providers. Telecommunications service providers have recently merged and may continue to merge, which would reduce the number of suppliers from which the Company could purchase telecommunications services. Although management believes that alternate telecommunications providers could be found in a timely manner, any disruption of these services could have a material adverse effect on the Company’s financial position, results of operations and cash flows.

The Company also relies on the reliability, capacity and effectiveness of its outsourced contact center service providers. The Company purchases contact center services from several geographically dispersed service providers. The contact center service providers may become subject to financial, economic and political risks beyond the Company’s or the providers’ control which could jeopardize their ability to deliver services. Although management believes that alternate contact center service providers could be found in a timely manner, any disruption of these services could have a material adverse effect on the Company’s financial position, results of operations and cash flows.

Fair Value of Financial Instruments

The carrying amounts of the Company’s cash, cash equivalents, trade receivables and trade payables approximate their fair values because of their nature and respective durations. The Company’s short- and long-term investments in marketable securities consist of available-for-sale securities and are carried at market value, which is based on quoted market prices, with unrealized gains and losses included in

80




EARTHLINK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

stockholders’ equity. The Company’s equity investments in publicly-held companies are stated at fair value, which is based on quoted market prices, with unrealized gains and losses included in stockholders’ equity. The Company’s investments in privately-held companies are stated at cost, net of other-than-temporary impairments. The Company’s long-term debt is carried at cost, and the estimated fair value of the Company’s long-term debt is based on the quoted market price.

Segments

The Company operates in one principal business segment, IP-based access and communications services. Substantially all of the Company’s operating results and identifiable assets are in the U.S.

Reclassifications

Certain amounts in the prior year financial statements have been reclassified to conform to the current year presentation.

Recently Issued Accounting Pronouncements

In June 2006, the FASB ratified the consensus reached in EITF Issue No. 06-2, “Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43.” EITF Issue No. 06-2 provides recognition guidance on the accrual of employees’ rights to compensated absences under a sabbatical or other similar benefit arrangement. EITF Issue No. 06-2 is effective for the Company for all financial statements after December 31, 2006. The Company is currently assessing the impact of the adoption of EITF Issue No. 06-2 on its financial statements.

In July 2006, the FASB issued FIN No. 48, “Accounting for Uncertainty in Income Taxes,” which prescribes a comprehensive model for how a company should recognize, measure, present and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return (including a decision whether to file or not to file a return in a particular jurisdiction). The accounting provisions of FIN No. 48 are effective for fiscal years beginning after December 15, 2006. The Company is currently assessing the impact that the adoption of FIN No. 48 will have, if any, on its consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which establishes a framework for reporting fair value and expands disclosures about fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. The Company is currently assessing the impact of the adoption of this standard on its financial statements.

3.                  Acquisitions and Asset Purchases

Aluria Software LLC

In September 2005, the Company acquired the assets of Aluria Software LLC (“Aluria”), a privately held developer and provider of protection and security products for consumers, small businesses and enterprise customers, for $13.4 million, which consisted of $9.3 million in cash and notes payable of $4.1 million. The Company repaid $2.0 million of the notes payable during the year ended December 31, 2006. The acquisition of Aluria enabled EarthLink to enhance and improve its suite of protection applications.

The acquisition was accounted for pursuant to SFAS No. 141, “Business Combinations.” The Company assumed net liabilities of approximately $0.1 million and allocated $3.1 million to identifiable

81




EARTHLINK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

definite lived intangible assets, primarily acquired software and technology, resulting in $10.4 million of goodwill. The amounts of identifiable intangible assets acquired were based on a third-party appraisal. The purchase price was allocated to the assets acquired and liabilities assumed based on their estimated fair values, including identifiable intangible assets. The acquired software and technology is being amortized on a straight-line basis over the estimated useful lives of the assets, which range from one to six years, from the date of the acquisition. The pro forma effect of the transaction was not material.

New Edge

In April 2006, EarthLink acquired New Edge, a single-source national provider of secure multi-site managed data networks and dedicated Internet access for businesses and communications carriers. Through this acquisition, EarthLink expanded its business in the small and medium-sized business market. New Edge is a wholly-owned subsidiary of EarthLink and continues to operate under its current name. The results of operations of New Edge are included in the consolidated financial statements from the date of the acquisition.

The acquisition was accounted for pursuant to SFAS No. 141. The total purchase price of $144.8 million consisted of $108.7 million net cash paid, including direct transaction costs of $3.7 million; $20.2 million in EarthLink, Inc. common stock, representing approximately 1.7 million shares; and estimated net liabilities assumed of $15.9 million. In addition, approximately 0.9 million shares of EarthLink, Inc. common stock are being held in escrow and will be used to cover liabilities that may arise under EarthLink’s indemnification rights under the merger agreement. The fair value of EarthLink, Inc. common stock was determined based on the average market price per share the three days before and the three days after the announcement of the execution of the merger agreement.

EarthLink allocated $37.0 million of the total purchase price to identifiable definite lived intangible assets, consisting of acquired customer relationships and software, and $7.8 million of the total purchase price to identifiable indefinite lived intangible assets, consisting of trade names. The fair values of identifiable intangible assets acquired were based on a third-party appraisal. The purchase price allocation resulted in $100.0 million of goodwill. The purchase price was allocated to the assets acquired and liabilities assumed based on their estimated fair values, including identifiable intangible assets. The acquired customer relationships and software are being amortized on a straight-line basis from the date of the acquisition over the estimated useful lives of the assets, which range from three to nine years. The weighted average amortizable life of the acquired intangible assets is 5.9 years. The acquired trade names were deemed to have indefinite useful lives. The amounts of liabilities assumed and identifiable assets acquired are subject to adjustment for up to one year from the date of acquisition. Any change will change the amount of purchase price allocable to goodwill. The pro forma effect of the transaction was not material.

82




EARTHLINK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

4.   Investments

Investments in Marketable Securities

The following table summarizes unrealized gains and losses on the Company’s investments in marketable securities based on quoted market prices as of December 31, 2005 and 2006:

 

As of December 31, 2005

 

As of December 31, 2006

 

 

 

 

 

Gross

 

Gross

 

Estimated

 

 

 

Gross

 

Gross

 

Estimated

 

 

 

Amortized

 

Unrealized

 

Unrealized

 

Fair

 

Amortized

 

Unrealized

 

Unrealized

 

Fair

 

 

 

Cost

 

Losses

 

Gains

 

Value

 

Cost

 

Losses

 

Gains

 

Value

 

 

 

(in thousands)

 

Short-term

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Government agency notes

 

 

$ 101,226

 

 

 

$ (376

)

 

 

$ —

 

 

 

$ 100,850

 

 

 

$ 46,666

 

 

 

$ (154

)

 

 

$ —

 

 

 

$ 46,512

 

 

Asset-backed (including auction rate) securities

 

 

85,107

 

 

 

 

 

 

 

 

 

85,107

 

 

 

85,050

 

 

 

 

 

 

 

 

 

85,050

 

 

Corporate notes

 

 

12,445

 

 

 

(24

)

 

 

3

 

 

 

12,424

 

 

 

8,498

 

 

 

(6

)

 

 

3

 

 

 

8,495

 

 

Commercial paper

 

 

9,487

 

 

 

(23

)

 

 

 

 

 

9,464

 

 

 

74,967

 

 

 

(77

)

 

 

 

 

 

74,890

 

 

 

 

 

$ 208,265

 

 

 

$ (423

)

 

 

$ 3

 

 

 

$ 207,845

 

 

 

$ 215,181

 

 

 

$ (237

)

 

 

$ 3

 

 

 

$ 214,947

 

 

Long-term

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Government agency notes

 

 

$ 20,110

 

 

 

$ (133

)

 

 

$ —

 

 

 

$ 19,977

 

 

 

$ 20,997

 

 

 

$ (39

)

 

 

$ 1

 

 

 

$ 20,959

 

 

Asset-backed securities

 

 

4,951

 

 

 

(13

)

 

 

 

 

 

4,938

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Corporate notes

 

 

16,069

 

 

 

(15

)

 

 

11

 

 

 

16,065

 

 

 

500

 

 

 

 

 

 

1

 

 

 

501

 

 

 

 

$ 41,130

 

 

 

$ (161

)

 

 

$ 11

 

 

 

$ 40,980

 

 

 

$ 21,497

 

 

 

$ (39

)

 

 

$ 2

 

 

 

$ 21,460

 

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Government agency notes

 

 

$ 121,336

 

 

 

$ (509

)

 

 

$ —

 

 

 

$ 120,827

 

 

 

$ 67,663

 

 

 

$ (193

)

 

 

$ 1

 

 

 

$ 67,471

 

 

Asset-backed (including auction rate) securities

 

 

90,058

 

 

 

(13

)

 

 

 

 

 

90,045

 

 

 

85,050

 

 

 

 

 

 

 

 

 

85,050

 

 

Corporate notes

 

 

28,514

 

 

 

(39

)

 

 

14

 

 

 

28,489

 

 

 

8,998

 

 

 

(6

)

 

 

4

 

 

 

8,996

 

 

Commercial paper

 

 

9,487

 

 

 

(23

)

 

 

 

 

 

9,464

 

 

 

74,967

 

 

 

(77

)

 

 

 

 

 

74,890

 

 

 

 

$ 249,395

 

 

 

$ (584

)

 

 

$ 14

 

 

 

$ 248,825

 

 

 

$ 236,678

 

 

 

$ (276

)

 

 

$ 5

 

 

 

$ 236,407

 

 

 

The unrealized losses on the Company’s investments in marketable securities were caused primarily by changes in interest rates. The Company’s investment portfolio consists of government and high-quality corporate securities. Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. The longer the term of the securities, the more susceptible they are to changes in market rates of interest and yields on bonds. Investments are reviewed periodically to identify possible other-than-temporary impairment. When evaluating the investments, the Company reviews factors such as the length of time and extent to which fair value has been below cost basis, the financial condition of the issuer and the Company’s ability and intent to hold the investment for a period of time which may be sufficient for anticipated recovery in market value. The Company believes its gross unrealized losses are temporary because management has the intent and ability to hold these investments until maturity, at which time the Company would expect to receive the amortized cost basis of the investment based on the underlying contractual arrangement. The Company has not experienced any significant realized gains or losses on its investments in marketable securities during the years presented.

83




EARTHLINK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The following table summarizes the estimated fair value of the Company’s investments in marketable securities designated as available-for-sale classified by the maturity of the security:

 

 

As of December 31,

 

 

 

2005

 

2006

 

 

 

(in thousands)

 

Due within one year

 

$ 207,845

 

$ 214,947

 

Due after one year through two years

 

32,934

 

19,466

 

Due after two years through five years

 

8,046

 

1,994

 

 

 

$ 248,825

 

$ 236,407

 

 

Investments in Other Companies

As of December 31, 2005 and 2006, minority investments in other companies were $1.4 million and $59.3 million, respectively, and are classified as investments in other companies in the Consolidated Balance Sheets. Minority investments in other companies as of December 31, 2005 and 2006 included $1.0 million and $11.0 million, respectively, of investments carried at cost, and $0.4 million and $48.3 million, respectively, of investments recorded at fair value. As of December 31, 2005, gross unrealized losses were $0.1 million and there were no gross unrealized gains. As of December 31, 2006, gross unrealized losses were $6.5 million and there were no gross unrealized gains.

In March 2006, the Company invested $50.0 million in Covad Communications Group, LLC (“Covad”), which consisted of 6.1 million shares of Covad common stock for an aggregate purchase price of $10.0 million and $40.0 million aggregate principal amount of 12% Senior Secured Convertible Notes due 2011 (the “Covad Notes”). The Company cannot exert significant influence over Covad’s operating and financial policies and, as such, accounts for its investment in Covad under the cost method of accounting and classifies the investment as available-for-sale. The Company deferred $0.8 million of direct loan origination costs that are being recognized as a reduction in the effective yield over the term of the Covad Notes.

In April 2006, the Company invested $10.0 million in Current Communications Group, LLC (“Current”), a privately-held broadband-over-powerline provider. The Company accounts for its investment in Current under the cost method of accounting because the Company cannot exert significant influence over Current’s operating and financial policies.

During the year ended December 31, 2005, the Company received $4.4 million in cash distributions from eCompanies Venture Group, L.P. (“EVG”), a limited partnership that invested in domestic emerging Internet-related companies. In applying the cost method, EarthLink recorded $0.6 million as a return of EarthLink’s investment based on the carrying value of the investment, and the gain of $3.8 million was included in gain (loss) on investments in other companies, net, in the Consolidated Statement of Operations for the year ended December 31, 2005. During the year ended December 31, 2006, the Company recorded a $0.4 million gain on investments in other companies resulting from an additional EVG dividend.

Investment in Equity Affiliate

In March 2005, the Company completed the formation of a joint venture with SK Telecom, HELIO, to market and sell wireless voice and data services in the U.S. EarthLink and SK Telecom each have an equal voting and economic ownership interest in HELIO. Upon formation, the Company invested

84




EARTHLINK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

$43.0 million of cash and contributed non-cash assets valued at $40.0 million, including 27,000 wireless customers, contractual arrangements and agreements to prospectively market HELIO’s services. The non-cash assets contributed were recorded by the Company as an additional investment of $0.5 million based on the Company’s carrying value of the assets. The Company recorded its initial investment at $43.5 million, reflecting the cash invested plus the carrying value of assets contributed. In addition, the Company paid HELIO to assume $0.9 million of net liabilities associated with wireless customers and related operations. The Company recorded no gain or loss in March 2005 associated with the contribution of non-cash assets, the transfer of net liabilities, or the associated payment to HELIO to assume the net liabilities upon completing the formation of HELIO.

Pursuant to the HELIO Contribution and Formation Agreement, the Company contributed $122.0 million of cash and noncash assets during 2005, $78.5 million during 2006 and is committed to invest an additional $19.5 million of cash in HELIO during 2007, which includes $13.5 million that was contributed in February 2007. During 2006, HELIO received minority investments, which reduced EarthLink’s and SK Telecom’s economic ownership interest in HELIO from 50 percent at formation to approximately 48 percent as of December 31, 2006. However, EarthLink’s and SK Telecom’s voting interest remains the same.

The Company accounts for its investment in HELIO under the equity method of accounting because the Company can exert significant influence over HELIO’s operating and financial policies. As a result, the Company records its proportionate share of HELIO’s net loss in its Consolidated Statement of Operations. The Company is amortizing the difference between the book value and fair value of non-cash assets contributed to HELIO over their estimated useful lives. The amortization increases the carrying value of the Company’s investment and decreases the net losses of equity affiliate included in the Consolidated Statement of Operations. During the years ended December 31, 2005 and 2006, the Company recorded $15.6 million and $84.8 million, respectively, of net losses of equity affiliate related to its HELIO investment, which is net of amortization of basis differences and certain other equity method accounting adjustments.

The following is summarized statement of operations information of HELIO for the years ended December 31, 2005 and 2006:

 

 

Year Ended December 31,

 

 

 

2005

 

2006

 

 

 

(in thousands)

 

Revenues

 

$ 16,365

 

$  46,580

 

Operating loss

 

(45,658

)

(201,266

)

Net loss

 

(42,023

)

(191,755

)

 

The following is summarized balance sheet information of HELIO as of December 31, 2005 and 2006:

 

 

As of December 31,

 

 

 

2005

 

2006

 

 

 

(in thousands)

 

Current assets

 

$ 159,067

 

$ 184,014

 

Long-term assets

 

64,880

 

80,956

 

Current liabilities

 

17,912

 

78,889

 

Long-term liabilities

 

2,394

 

4,853

 

 

85




EARTHLINK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

5.   Property and Equipment

Property and equipment is recorded at cost and consisted of the following as of December 31, 2005 and 2006:

 

 

As of December 31,

 

 

 

2005

 

2006

 

 

 

(in thousands)

 

Data center and network equipment

 

$ 247,677

 

$ 286,805

 

Office and other equipment

 

185,734

 

193,692

 

Land and buildings

 

14,777

 

15,113

 

Leasehold improvements

 

58,332

 

65,333

 

Construction in progress

 

11,266

 

13,848

 

 

 

517,786

 

574,791

 

Less accumulated depreciation

 

(444,609

)

(478,171

)

 

 

$  73,177

 

$  96,620

 

 

During the year ended December 31, 2005, the Company wrote-down and retired abandoned and disposed property and equipment that had a cost basis and accumulated depreciation of $6.8 million.

Depreciation expense charged to operations, which includes depreciation expense associated with property under capital leases, was $54.9 million, $34.9 million and $34.4 million for the years ended December 31, 2004, 2005 and 2006, respectively.

6.   Goodwill and Purchased Intangible Assets

Goodwill

Pursuant to SFAS No. 142, the Company performs an impairment test annually during the fourth quarter of its fiscal year or when events and circumstances indicate goodwill might be permanently impaired. During the years ended December 31, 2004, 2005 and 2006, the Company’s tests indicated its goodwill was not impaired.

During the year ended December 31, 2005, the carrying amount of goodwill decreased $6.7 million. This consisted of a $17.1 million decrease in goodwill due to the realization of tax benefits associated with net operating loss carryforwards which were acquired in connection with acquisitions, offset by a $10.4 million increase in goodwill resulting from the acquisition of Aluria. During the year ended December 31, 2006, the carrying amount of goodwill increased $101.2 million, which consisted of a $100.0 million increase in goodwill resulting from the acquisition of New Edge and $1.2 million of purchase accounting adjustments.

86




EARTHLINK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Purchased Intangible Assets

The following table presents the components of the Company’s acquired identifiable intangible assets included in the accompanying Consolidated Balance Sheets as of December 31, 2005 and 2006:

 

 

As of December 31, 2005

 

As of December 31, 2006

 

 

 

Gross

 

 

 

Net

 

Gross

 

 

 

Net

 

 

 

Carrying

 

Accumulated

 

Carrying

 

Carrying

 

Accumulated

 

Carrying

 

 

 

Value

 

Amortization

 

Value

 

Value

 

Amortization

 

Value

 

 

 

(in thousands)

 

Subscriber bases and customer relationships

 

$

337,511

 

 

$

(327,020

)

 

$

10,491

 

$

384,336

 

 

$

(337,708

)

 

$

46,628

 

Software, technology and other

 

3,125

 

 

(338

)

 

2,787

 

3,864

 

 

(1,551

)

 

2,313

 

Trade names

 

3,000

 

 

 

 

3,000

 

10,857

 

 

 

 

10,857

 

Total

 

$

343,636

 

 

$

(327,358

)

 

$

16,278

 

$

399,057

 

 

$

(339,259

)

 

$

59,798

 

 

Amortization of intangible assets in the Consolidated Statements of Operations for the years ended December 31, 2004, 2005 and 2006 represents the amortization of definite lived intangible assets. The Company’s definite lived intangible assets primarily consist of subscriber bases and customer relationships, acquired software and technology and other assets acquired in conjunction with the purchases of businesses and subscriber bases from other ISPs that are not deemed to have indefinite lives. Definite lived intangible assets are amortized on a straight-line basis over their estimated useful lives, which are generally three to six years for subscriber bases and customer relationships and one to six years for acquired software and technology. As of December 31, 2006, the weighted average amortization periods were 3.3 years for subscriber bases and customer relationships and 4.1 years for software and technology. Based on the current amount of definite lived intangible assets, the Company expects to record amortization expense of approximately $13.8 million, $11.8 million, $9.0 million, $6.4 million, $6.0 million and $1.9 million during the years ending December 31, 2007, 2008, 2009, 2010, 2011 and thereafter, respectively. Actual amortization expense to be reported in future periods could differ materially from these estimates as a result of asset acquisitions, changes in useful lives and other relevant factors. The Company’s indefinite lived intangible assets consist of trade names.

In connection with the formation of HELIO and the transfer of 27,000 wireless subscribers to HELIO, EarthLink reclassified a subscriber base asset with a net book value of $0.4 million associated with certain wireless subscribers to its investment in HELIO during the year ended December 31, 2005. The subscriber base asset had a cost basis of $1.9 million and accumulated amortization of $1.5 million.

7.   Facility Exit and Restructuring Costs

During the year ended December 31, 2003, EarthLink executed a plan to streamline its contact center facilities (the “2003 Plan”). In connection with the 2003 Plan, EarthLink closed contact center facilities in Dallas, Texas; Sacramento, California; Pasadena, California; and Seattle, Washington. The closure of the four contact center facilities resulted in the termination of 1,220 employees and the net reduction of 920 employees, primarily customer support personnel. In connection with the 2003 Plan, EarthLink recorded facility exit costs of $36.6 million, including $10.7 million for employee, personnel and related costs; $18.2 million for real estate and telecommunications costs; and $7.7 million in asset disposals. As of December 31, 2006, the Company had a $1.2 million liability remaining for real estate commitments. All other costs have been paid.

87




EARTHLINK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

During the year ended December 31, 2004, EarthLink executed a plan to restructure and further streamline its contact center operations (the “2004 Plan”). Under the 2004 Plan, EarthLink closed contact center operations in Harrisburg, Pennsylvania; Roseville, California; San Jose, California; and Pasadena, California; and reduced its contact center operations in Atlanta, Georgia. Approximately 1,140 employees were directly impacted, primarily customer support personnel. As a result of the 2004 Plan, EarthLink recorded facility exit costs of $30.2 million, including $10.5 million for employee, personnel and related costs; $11.3 million for real estate and telecommunications costs; and $8.4 million in asset disposals. As of December 31, 2006, the Company had a $2.6 million liability remaining for real estate commitments. All other costs have been paid.

During the year ended December 31, 2005, EarthLink executed plans to further streamline operations by outsourcing certain contact center and credit and collections activities (the “2005 Plans”). Approximately 227 employees were directly impacted. As a result of the 2005 Plans, EarthLink recorded $1.4 million of restructuring costs for severance and personnel-related costs. As of December 31, 2006, all severance and personnel-related costs related to the 2005 Plans were paid and there was no remaining liability.

EarthLink periodically evaluates and adjusts its estimates for facility exit and restructuring costs based on currently-available information. Such adjustments are included as facility exit and restructuring costs in the Consolidated Statements of Operations. During the years ended December 31, 2004 and 2006, EarthLink reduced its estimates for facility exit costs by $1.8 million and $0.1 million, respectively, based on events occurring during the periods. During the year ended December 31, 2005, EarthLink increased its estimates for facility exit costs by $0.7 million based on events occurring during the period.

Facility exit and restructuring liabilities due within one year of the balance sheet date are classified as other accounts payable and accrued liabilities and liabilities due after one year are classified as other long-term liabilities in the Consolidated Balance Sheets. Of the unpaid balance as of December 31, 2006, approximately $2.1 million associated with the 2003 Plan and 2004 Plan was classified as long-term.

8.   Other Accounts Payable and Accrued Liabilities

Other accounts payable and accrued liabilities consisted of the following as of December 31, 2005 and 2006:

 

 

As of December 31,

 

 

 

2005

 

2006

 

 

 

(in thousands)

 

Accrued communications costs

 

$

7,952

 

$

14,052

 

Accrued advertising

 

19,026

 

17,299

 

Accrued taxes

 

7,923

 

11,874

 

Accrued bounties

 

9,760

 

1,442

 

Accrued professional fees and settlements

 

3,755

 

5,475

 

Liabilities associated with non-cancelable operating leases

 

3,473

 

2,704

 

Accrued outsourced customer support

 

10,088

 

8,021

 

Subscriber base and fixed asset purchases

 

3,858

 

6,457

 

Deposits and due to customers

 

4,088

 

5,654

 

Other

 

14,216

 

21,904

 

 

 

$

84,139

 

$

94,882

 

 

88




EARTHLINK, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

9.   Long-Term Debt

In November 2006, the Company issued $258.8 million aggregate principal amount of Convertible Senior Notes due November 15, 2026 (the “Notes”) in a registered offering, which reflects the exercise by the underwriters of their option to purchase an additional $33.8 million of principal to cover over-allotments. The Company received net proceeds of $251.6 million after transaction fees of $7.2 million. The Notes bear interest at 3.25% per year on the principal amount of the Notes until November 15, 2011, and 3.50% interest per year on the principal amount of the Notes thereafter, payable semi-annually in May and November of each year. The Notes rank as senior unsecured obligations of the Company.

The Notes are payable with cash and, if applicable, convertible into shares of the Company’s common stock based on an initial conversion rate, subject to adjustment, of 109.6491 shares per $1,000 principal amount of Notes (which represents an initial conversion price of approximately $9.12 per share). Upon conversion, a holder will receive cash up to the principal amount of the Notes and, at the Company’s option, cash, or shares of the Company’s common stock or a combination of cash and shares of common stock for the remainder, if any, of the conversion obligation. The conversion obligation is based on the sum of the “daily settlement amounts” for the 20 consecutive trading days that begin on, and include, the second trading day after the day the notes are surrendered for conversion. The Notes will be convertible only in the following circumstances: (1) during any calendar quarter after the calendar quarter ending December 31, 2006 (and only during such calendar quarter), if the closing sale price of the Company’s common stock for each of 20 or more trading days in a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter exceeds 130% of the conversion price in effect on the last trading day of the immediately preceding calendar quarter; (2) during the five consecutive business days immediately after any five consecutive trading day period in which the average trading price per $1,000 principal amount of Notes was equal to or less than 98% of the average conversion value of the Notes during the note measurement period; (3) upon the occurrence of specified corp