EarthLink Holdings Corp.
EARTHLINK INC (Form: 10-Q, Received: 10/31/2008 13:59:12)

Table of Contents

 

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

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

 

For the quarterly period ended September 30, 2008

 

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 or other jurisdiction of incorporation or organization)

 

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

 

1375 Peachtree St., Atlanta, Georgia

 

30309

(Address of principal executive offices)

 

(Zip Code)

 

(404) 815-0770

(Registrant’s telephone number, including area code)

 

 

(Former name, former address and former fiscal year, if changed since last report date)

 


 

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 whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company (as defined in Rule 12b-2 of the Exchange Act):

 

See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer x

 

Accelerated filer o

 

Non-accelerated filer o

 

Smaller reporting company 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

 

As of October 29, 2008, 108,362,551 shares of common stock, $.01 par value per share, were outstanding.

 

 

 



Table of Contents

 

EARTHLINK, INC.

Quarterly Report on Form 10-Q

For the Quarterly Period Ended September 30, 2008

 

TABLE OF CONTENTS

 

Part I

 

 

 

Item 1. Financial Statements

 

1

 

 

 

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

 

24

 

 

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

 

45

 

 

 

Item 4. Controls and Procedures

 

45

 

 

 

Part II

 

 

 

Item 1. Legal Proceedings

 

46

 

 

 

Item 1A. Risk Factors

 

46

 

 

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

46

 

 

 

Item 5. Other Information

 

47

 

 

 

Item 6. Exhibits

 

47

 

 

 

Signatures

 

48

 



Table of Contents

 

PART I

 

Item 1.  Financial Statements.

 

EARTHLINK, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

 

 

 

December 31,

 

September 30,

 

 

 

2007

 

2008

 

 

 

 

 

(unaudited)

 

ASSETS

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

173,827

 

$

432,539

 

Investments in marketable securities

 

93,204

 

 

Accounts receivable, net of allowance of $6,422 and $4,486 as of December 31, 2007 and September 30, 2008, respectively

 

41,483

 

28,198

 

Prepaid expenses

 

7,747

 

7,603

 

Current assets of discontinued operations

 

6,744

 

1,076

 

Other current assets

 

12,999

 

14,800

 

Total current assets

 

336,004

 

484,216

 

Long-term investments in marketable securities

 

21,564

 

52,428

 

Property and equipment, net

 

57,300

 

42,911

 

Investments in other companies

 

62,923

 

14,129

 

Purchased intangible assets, net

 

46,276

 

36,581

 

Goodwill

 

202,277

 

186,066

 

Other long-term assets

 

8,149

 

6,391

 

Total assets

 

$

734,493

 

$

822,722

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

Current liabilities:

 

 

 

 

 

Trade accounts payable

 

$

28,808

 

$

14,875

 

Accrued payroll and related expenses

 

32,055

 

29,810

 

Other accounts payable and accrued liabilities

 

66,930

 

51,141

 

Current liabilities of discontinued operations

 

15,930

 

372

 

Deferred revenue

 

44,626

 

36,097

 

Total current liabilities

 

188,349

 

132,295

 

 

 

 

 

 

 

Long-term debt

 

258,750

 

258,750

 

Other long-term liabilities

 

25,921

 

19,896

 

Total liabilities

 

473,020

 

410,941

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Convertible preferred stock, $0.01 par value, 100,000 shares authorized, 0 shares issued and outstanding as of December 31, 2007 and September 30, 2008

 

 

 

Common stock, $0.01 par value, 300,000 shares authorized, 186,490 and 188,104 shares issued as of December 31, 2007 and September 30, 2008, respectively, and 110,547 and 108,356 shares outstanding as of December 31, 2007 and September 30, 2008, respectively

 

1,865

 

1,881

 

Additional paid-in capital

 

2,047,268

 

2,071,033

 

Accumulated deficit

 

(1,184,119

)

(1,021,743

)

Treasury stock, at cost, 75,943 and 79,748 shares as of December 31, 2007 and September 30, 2008, respectively

 

(602,564

)

(634,420

)

Unrealized losses on investments

 

(977

)

(4,970

)

Total stockholders’ equity

 

261,473

 

411,781

 

Total liabilities and stockholders’ equity

 

$

734,493

 

$

822,722

 

 

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

 

1



Table of Contents

 

EARTHLINK, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2007

 

2008

 

2007

 

2008

 

 

 

(in thousands, except per share data)

 

 

 

(unaudited)

 

 

 

 

 

 

 

 

 

 

 

Revenues

 

$

297,992

 

$

230,831

 

$

934,005

 

$

739,508

 

 

 

 

 

 

 

 

 

 

 

Operating costs and expenses:

 

 

 

 

 

 

 

 

 

Service and equipment costs

 

105,954

 

86,917

 

324,344

 

275,626

 

Sales incentives

 

3,801

 

699

 

13,515

 

2,029

 

Total cost of revenues

 

109,755

 

87,616

 

337,859

 

277,655

 

 

 

 

 

 

 

 

 

 

 

Sales and marketing

 

71,584

 

22,191

 

246,653

 

78,913

 

Operations and customer support

 

54,561

 

34,048

 

174,525

 

106,914

 

General and administrative

 

28,652

 

23,316

 

101,344

 

72,010

 

Amortization of intangible assets

 

3,836

 

3,153

 

10,874

 

11,153

 

Facility exit, restructuring and other costs

 

34,162

 

1,078

 

34,162

 

4,169

 

Total operating costs and expenses

 

302,550

 

171,402

 

905,417

 

550,814

 

 

 

 

 

 

 

 

 

 

 

Income (loss) from operations

 

(4,558

)

59,429

 

28,588

 

188,694

 

Net losses of equity affiliate

 

(41,895

)

 

(111,295

)

 

Gain (loss) on investments in other companies, net

 

(5,810

)

4,352

 

(5,600

)

5,677

 

Interest income (expense) and other, net

 

4,182

 

(490

)

11,282

 

366

 

Income (loss) from continuing operations before income taxes

 

(48,081

)

63,291

 

(77,025

)

194,737

 

Income tax benefit (provision)

 

30

 

(7,924

)

(365

)

(23,923

)

Income (loss) from continuing operations

 

(48,051

)

55,367

 

(77,390

)

170,814

 

Loss from discontinued operations, net of tax

 

(31,330

)

(681

)

(48,243

)

(8,438

)

Net income (loss)

 

$

(79,381

)

$

54,686

 

$

(125,633

)

$

162,376

 

 

 

 

 

 

 

 

 

 

 

Basic net income (loss) per share

 

 

 

 

 

 

 

 

 

Continuing operations

 

$

(0.39

)

$

0.50

 

$

(0.63

)

$

1.55

 

Discontinued operations

 

(0.26

)

(0.01

)

(0.39

)

(0.08

)

Basic net income (loss) per share

 

$

(0.65

)

$

0.50

 

$

(1.02

)

$

1.48

 

Basic weighted average common shares outstanding

 

121,864

 

110,153

 

122,772

 

109,895

 

 

 

 

 

 

 

 

 

 

 

Diluted net income (loss) per share

 

 

 

 

 

 

 

 

 

Continuing operations

 

$

(0.39

)

$

0.49

 

$

(0.63

)

$

1.53

 

Discontinued operations

 

(0.26

)

(0.01

)

(0.39

)

(0.08

)

Diluted net income (loss) per share

 

$

(0.65

)

$

0.49

 

$

(1.02

)

$

1.46

 

Diluted weighted average common shares outstanding

 

121,864

 

112,039

 

122,772

 

111,534

 

 

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

 

2



Table of Contents

 

EARTHLINK, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 

 

Nine Months Ended

 

 

 

September 30,

 

 

 

2007

 

2008

 

 

 

(in thousands)

 

 

 

(unaudited)

 

Cash flows from operating activities:

 

 

 

 

 

Net income (loss)

 

$

(125,633

)

$

162,376

 

Adjustments to reconcile net income (loss) to net cash

 

 

 

 

 

provided by operating activities:

 

 

 

 

 

Depreciation and amortization

 

40,803

 

29,388

 

Loss on disposals and impairments of fixed assets

 

15,054

 

6,255

 

Net losses of equity affiliate

 

111,295

 

 

Loss (gain) on investments in other companies, net

 

5,600

 

(5,677

)

Stock-based compensation

 

15,138

 

14,319

 

Income taxes

 

206

 

15,968

 

Other adjustments

 

(51

)

 

(Increase) decrease in accounts receivable, net

 

(1,588

)

13,269

 

Decrease (increase) in prepaid expenses and other assets

 

442

 

(6,466

)

Decrease in accounts payable and accrued and other liabilities

 

(976

)

(45,491

)

Decrease in deferred revenue

 

(5,797

)

(9,364

)

Net cash provided by operating activities

 

54,493

 

174,577

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Purchases of property and equipment

 

(42,317

)

(3,877

)

Purchases of subscriber bases

 

(6,501

)

(880

)

Proceeds from sales of fixed assets

 

36

 

 

Investments in marketable securities:

 

 

 

 

 

Purchases

 

(337,835

)

(53,027

)

Sales and maturities

 

335,701

 

109,929

 

Investments in and net advances to/from equity affiliate

 

(48,913

)

65

 

Proceeds received from investments in other companies

 

1,417

 

57,070

 

Net cash (used in) provided by investing activities

 

(98,412

)

109,280

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Principal payments under capital lease obligations

 

(149

)

(2,698

)

Proceeds from exercises of stock options and other

 

5,676

 

7,985

 

Repurchases of common stock

 

(24,972

)

(31,857

)

Other financing activities

 

 

1,425

 

Net cash used in financing activities

 

(19,445

)

(25,145

)

 

 

 

 

 

 

Net (decrease) increase in cash and cash equivalents

 

(63,364

)

258,712

 

Cash and cash equivalents, beginning of period

 

158,369

 

173,827

 

Cash and cash equivalents, end of period

 

$

95,005

 

$

432,539

 

 

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

 

3



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED

 

1.  Organization

 

EarthLink, Inc. (“EarthLink” or the “Company”) is an Internet service provider (“ISP”), providing nationwide Internet access and related value-added services to individual and business customers. The Company’s primary service offerings include dial-up Internet access, high-speed Internet access and web hosting services. The Company also provides value-added services, such as search, advertising and ancillary services sold as add-on features to the Company’s Internet access services. In addition, through the Company’s wholly-owned subsidiary, New Edge Networks, the Company provides secure multi-site managed data networks and dedicated Internet access for businesses and communications carriers.

 

The Company operates two reportable segments, Consumer Services and Business Services. The Company’s Consumer Services segment provides Internet access and related value-added services to individual customers. These services include dial-up and high-speed Internet access and voice services, among others. The Company’s Business Services segment provides Internet access and related value-added services to businesses and communications carriers. These services include managed data networks, dedicated Internet access and web hosting, among others. For further information concerning the Company’s business segments, see Note 14, “Segment Information.”

 

2.  Basis of Presentation

 

Basis of Presentation

 

The condensed consolidated financial statements of EarthLink, which include the accounts of its wholly-owned subsidiaries, for the three and nine months ended September 30, 2007 and 2008 and the related footnote information are unaudited and have been prepared on a basis consistent with the Company’s audited consolidated financial statements as of December 31, 2007 contained in the Company’s Annual Report on Form 10-K as filed with the Securities and Exchange Commission (the “Annual Report”).  All significant intercompany transactions have been eliminated.

 

These financial statements should be read in conjunction with the audited consolidated financial statements and the related notes thereto contained in the Company’s Annual Report.  In the opinion of management, the accompanying unaudited financial statements contain all adjustments (consisting of normal recurring adjustments), which management considers necessary to present fairly the Company’s financial position, results of operations and cash flows for the interim periods presented.  The results of operations for the three and nine months ended September 30, 2008 are not necessarily indicative of the results anticipated for the entire year ending December 31, 2008.

 

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements.  Actual results may differ from those estimates.

 

Discontinued Operations

 

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company has reflected its municipal wireless broadband results of operations as discontinued operations for all periods presented.  See Note 5, “Discontinued Operations,” for further discussion.

 

Reclassifications

 

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

 

4



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

Recently Issued Accounting Pronouncements

 

In May 2008, Financial Accounting Standards Board (“FASB”) issued Staff Position No. APB 14-1, “Accounting for Convertible Debt Instruments that May be Settled in Cash Upon Conversion” (“FSP APB 14-1”). FSP APB 14-1 requires that the liability and equity components of convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement) be separately accounted for in a manner that reflects an issuer’s non-convertible debt borrowing rate. The resulting debt discount is amortized over the period the convertible debt is expected to be outstanding as additional non-cash interest expense. FSP APB 14-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Retrospective application to all periods presented is required except for instruments that were not outstanding during any of the periods that will be presented in the annual financial statements for the period of adoption but were outstanding during an earlier period. The adoption of FSP APB 14-1 will affect the accounting for the Company’s Convertible Senior Notes due November 15, 2026, which were issued in November 2006, and will result in increased non-cash interest expense. The Company is currently assessing the impact of the adoption of this standard on its financial statements.

 

Also in May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles.” SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (GAAP) in the United States (the GAAP hierarchy). SFAS No. 162 is effective 60 days following the Securities and Exchange Commission’s approval of the Public Company Accounting Oversight Board amendments to AU Section 411, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles.” The Company does not expect the adoption of SFAS No. 162 to have a material impact on its financial statements.

 

3.  Earnings per Share

 

Net income (loss) 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 (loss) 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 convertible debt (collectively “Common Stock Equivalents”), were exercised or converted into common stock. The dilutive effect of outstanding stock options, warrants, restricted stock units and convertible debt is reflected in diluted earnings per share by application of the treasury stock method. Phantom share units are reflected on an if-converted basis. In applying the treasury stock method for stock-based compensation arrangements, the assumed proceeds are computed as the sum of the amount the employee must pay upon exercise and the amounts of average unrecognized compensation cost attributed to future services.

 

5



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

The following table sets forth the computation for basic and diluted net income per share for the three and nine months ended September 30, 2008:

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30, 2008

 

September 30, 2008

 

 

 

(in thousands, except per share data)

 

 

 

 

 

 

 

Numerator

 

 

 

 

 

Income from continuing operations

 

$

55,367

 

$

170,814

 

Loss from discontinued operations

 

(681

)

(8,438

)

Net income

 

$

54,686

 

$

162,376

 

 

 

 

 

 

 

Denominator

 

 

 

 

 

Basic weighted average common shares outstanding

 

110,153

 

109,895

 

Dilutive effect of Common Stock Equivalents

 

1,886

 

1,639

 

Diluted weighted average common shares outstanding

 

112,039

 

111,534

 

 

 

 

 

 

 

Basic net income per share

 

 

 

 

 

Continuing operations

 

$

0.50

 

$

1.55

 

Discontinued operations

 

(0.01

)

(0.08

)

Basic net income per share

 

$

0.50

 

$

1.48

 

 

 

 

 

 

 

Diluted net income per share

 

 

 

 

 

Continuing operations

 

$

0.49

 

$

1.53

 

Discontinued operations

 

(0.01

)

(0.08

)

Diluted net income per share

 

$

0.49

 

$

1.46

 

 

During the three and nine months ended September 30, 2008, approximately 8.0 million and 8.7 million, respectively, options and restricted stock units were excluded from the calculation of diluted EPS because the exercise prices plus the amount of unrecognized compensation cost attributed to future services exceeded the Company’s average stock price during the period. Approximately 28.4 million shares that underlie the Company’s convertible debt instruments were also excluded from the calculation of diluted EPS because the exercise price exceeded the Company’s average stock price during the period. These securities could be dilutive in future periods.

 

The Company has not included the effect of Common Stock Equivalents in the calculation of diluted EPS for the three and nine months ended September 30, 2007 because such inclusion would have an anti-dilutive effect due to the Company’s net loss. As of September 30, 2007, the Company had 19.9 million options outstanding, 2.4 million restricted stock units outstanding and 28.5 million warrants outstanding.

 

6



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

4.  Facility Exit, Restructuring and Other Costs

 

Facility exit, restructuring and other costs consisted of the following during the three and nine months ended September 30, 2007 and 2008:

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2007

 

2008

 

2007

 

2008

 

 

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

2007 Restructuring Plan

 

$

34,162

 

$

1,159

 

$

34,162

 

$

4,421

 

Legacy Restructuring Plans

 

 

(81

)

 

(252

)

 

 

$

34,162

 

$

1,078

 

$

34,162

 

$

4,169

 

 

2007 Restructuring Plan

 

In August 2007, EarthLink adopted a restructuring plan (the “2007 Plan”) to reduce costs and improve the efficiency of the Company’s operations. The 2007 Plan was the result of a comprehensive review of operations within and across the Company’s functions and businesses. Under the 2007 Plan, the Company reduced its workforce by approximately 900 employees, closed office facilities in Orlando, Florida; Knoxville, Tennessee; Harrisburg, Pennsylvania and San Francisco, California and is consolidating its office facilities in Atlanta, Georgia and Pasadena, California. The 2007 Plan was primarily implemented during the latter half of 2007 and is expected to be completed during 2008. In connection with the 2007 Plan, the Company expects to record total costs of approximately $76.0 to $83.0 million, including $31.0 million for severance and personnel-related costs, $17.0 to $22.0 million for lease termination and facilities-related costs, $26.0 to $28.0 million for non-cash asset impairments and $2.0 million for other associated costs.

 

The following table summarizes facility exit and restructuring costs during the three and nine months ended September 30, 2008 and the cumulative costs incurred to date as a result of the 2007 Plan. Such costs have been classified as facility exit, restructuring and other costs in the Condensed Consolidated Statement of Operations.

 

 

 

 

 

 

 

Cumulative

 

 

 

Three Months

 

Nine Months

 

Costs

 

 

 

Ended

 

Ended

 

Incurred

 

 

 

September 30, 2008

 

September 30, 2008

 

To Date

 

 

 

(in thousands)

 

 

 

 

 

 

 

 

 

Severance and personnel-related costs

 

$

 

$

474

 

$

30,777

 

Lease termination and facilities-related costs

 

1,347

 

3,352

 

15,568

 

Non-cash asset impairments

 

201

 

514

 

21,135

 

Other associated costs

 

(389

)

81

 

1,212

 

 

 

$

1,159

 

$

4,421

 

$

68,692

 

 

Management continues to evaluate EarthLink’s business and, therefore, may have supplemental provisions for new plan initiatives as well as changes in estimates to amounts previously recorded, as payments are made or actions are completed.

 

7



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

The following table summarizes activity for the liability balances associated with the 2007 Plan for the nine months ended September 30, 2008, including changes during the period attributable to costs incurred and charged to expense and costs paid or otherwise settled:

 

 

 

Severance

 

 

 

Asset

 

Other

 

 

 

 

 

and Benefits

 

Facilities

 

Impairments

 

Costs

 

Total

 

 

 

(in thousands)

 

Balance as of December 31, 2007

 

$

12,041

 

$

16,124

 

$

 

$

 

$

28,165

 

Accruals

 

474

 

3,352

 

514

 

81

 

4,421

 

Payments

 

(12,502

)

(4,638

)

 

(81

)

(17,221

)

Non-cash charges

 

 

1,062

 

(514

)

 

548

 

Balance as of September 30, 2008

 

$

13

 

$

15,900

 

$

 

$

 

$

15,913

 

 

Facility exit and restructuring liabilities due within one year of the balance sheet date are classified as other accounts payable and accrued liabilities and facility exit and restructuring liabilities due after one year are classified as other long-term liabilities in the Condensed Consolidated Balance Sheets. Of the unpaid balance as of September 30, 2008, approximately $5.2 million associated with the 2007 Plan was classified as other accounts payable and accrued liabilities and $10.7 million was classified as other long-term liabilities.

 

Legacy Restructuring Plans

 

EarthLink periodically evaluates and adjusts its estimates for facility exit and restructuring costs for legacy restructuring plans based on currently-available information. Such adjustments are included as facility exit, restructuring and other costs in the Condensed Consolidated Statements of Operations. During the three and nine months ended September 30, 2008, EarthLink recorded $0.1 million and $0.3 million, respectively, in reductions to facility exit, restructuring and other costs as a result of changes in estimates for legacy restructuring plans.

 

5.  Discontinued Operations

 

In November 2007, management concluded that its municipal wireless broadband operations were no longer consistent with the Company’s strategic direction and the Company’s Board of Directors authorized management to pursue the divestiture of the Company’s municipal wireless broadband assets. During the nine months ended September 30, 2008, the Company transferred its municipal wireless broadband networks to the cities of Corpus Christi, TX and Milpitas, CA in exchange for releasing the Company from its existing network agreements. The Company also transferred its municipal wireless broadband networks in the city of Philadelphia, PA to a local Philadelphia company. Additionally, the Company terminated its municipal wireless broadband service in New Orleans, LA and Anaheim, CA and removed its network equipment from those cities. As of September 30, 2008, the divestiture of the Company’s municipal wireless broadband assets was substantially complete.

 

The Company classified its municipal wireless broadband assets as held for sale in the Condensed Consolidated Balance Sheets and presented the municipal wireless broadband results of operations as discontinued operations for all periods presented. The municipal wireless broadband results of operations were previously included in the Consumer Services segment.

 

The Company recorded impairment and other costs of $6.1 million during the nine months ended September 30, 2008 related to the municipal wireless broadband operations, including $2.6 million for non-cash asset impairments and other non-cash charges; $0.3 million for severance and personnel-related costs; and $3.2 million for other associated costs. These charges are reflected within discontinued operations in the Condensed Consolidated Statements of Operations.

 

8



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

The following table presents summarized results of operations related to the Company’s discontinued operations for the three and nine months ended September 30, 2007 and 2008:

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2007

 

2008

 

2007

 

2008

 

 

 

(in thousands)

 

Revenues

 

$

771

 

$

18

 

$

1,368

 

$

1,306

 

Operating costs and expenses

 

(11,443

)

(842

)

(28,953

)

(4,534

)

Impairment and other costs

 

(20,658

)

(128

)

(20,658

)

(6,081

)

Income tax benefit

 

 

271

 

 

871

 

Loss from discontinued operations, net of tax

 

$

(31,330

)

$

(681

)

$

(48,243

)

$

(8,438

)

 

The assets of discontinued operations as of December 31, 2007 consisted primarily of property and equipment and the liabilities of discontinued operations as of December 31, 2007 consisted primarily of accruals for purchases of property and equipment. As of September 30, 2008, the divestiture of the Company’s municipal wireless broadband assets was substantially complete and only a minimal amount of assets and liabilities of discontinued operations remained. Pursuant to SFAS No. 144, the assets as of December 31, 2007 and September 30, 2008 were reported at their estimated fair value less costs to sell and were no longer being depreciated.

 

6.  Investments

 

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.” The Company has invested in government agency notes, asset-backed debt securities (including auction rate 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. 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 in marketable securities. Investments in marketable securities with maturities greater than one year from the balance sheet date are considered long-term investments in marketable securities. Long-term investments in marketable securities as of September 30, 2008 also include investments in asset-backed, auction rate securities with interest rate reset periods of 90 days or less but whose underlying agreements have original maturities of more than 90 days. These investments were included in short-term investments in marketable securities as of December 31, 2007.

 

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). As of December 31, 2007, gross unrealized gains were $0.1 million and gross unrealized losses were nominal. As of September 30, 2008, gross unrealized losses were $5.3 million and there were no gross unrealized gains. The Company believes its gross unrealized losses are temporary impairments as management has the intent and ability to hold these investments until maturity or until the market price fully recovers, at which time the Company would expect to receive the amortized cost basis of the investments based on the underlying contractual arrangement.

 

As of September 30, 2008, the Company’s long-term investments in marketable securities included auction rate securities with a par value of $57.8 million and a fair value of $52.4 million. Beginning in February 2008, auctions for these securities failed to attract sufficient buyers, resulting in the Company continuing to hold

 

9



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

such securities. Accordingly, the Company began classifying these securities as long-term investments in marketable securities in the Condensed Consolidated Balance Sheet due to uncertainty surrounding the timing of a market recovery. These securities are variable-rate debt instruments whose underlying agreements have contractual maturities of up to 40 years, but have interest rate reset periods at pre-determined intervals, usually every 28 days. These securities are predominantly secured by student loans guaranteed by state related higher education agencies and reinsured by the United States Department of Education. As a result of temporary declines in the fair value of the Company’s auction rate securities, which the Company attributes to liquidity issues rather than credit issues, it has recorded an unrealized loss of $5.3 million as of September 30, 2008. The Company will continue to evaluate the fair value of its investments in auction rate securities each reporting period for a potential other-than-temporary impairment.

 

In October 2008, EarthLink entered into an agreement with the broker that sold the Company its auction rate securities that gives the Company the right to sell its existing auction rate securities back to the broker at par plus accrued interest, beginning on June 30, 2010 until July 2, 2012. The agreement also grants the broker the right to buy the Company’s auction rate securities at par plus accrued interest, until July 2, 2012.

 

Investments in other companies

 

Investments in other companies consisted of the following as of December 31, 2007 and September 30, 2008:

 

 

 

As of

 

As of

 

 

 

December 31,

 

September 30,

 

 

 

2007

 

2008

 

 

 

(in thousands)

 

Investments stated at fair value

 

$

52,923

 

$

4,829

 

Investments stated at cost

 

10,000

 

9,300

 

Total investments in other companies

 

$

62,923

 

$

14,129

 

 

The Company accounts for minority investments in other companies under the cost method of accounting and classifies investments in other companies which are publicly traded as available-for-sale securities. Accordingly, the Company adjusts the carrying values of those investments to market value through unrealized gains (losses) included in stockholders’ equity and accumulated other comprehensive income (loss). As of December 31, 2007, gross unrealized losses were $1.1 million and there were no gross unrealized gains. As of September 30, 2008, gross unrealized gains were $0.4 million and there were no gross unrealized losses.

 

The Company’s investments in other companies as of December 31, 2007 included $5.3 million for 6.1 million shares of Covad Communications Group, LLC (“Covad”) common stock and $47.5 million aggregate principal amount of 12% Senior Secured Convertible Notes due 2011 (the “Covad Notes”), including accrued and unpaid interest. In April 2008, Platinum Equity, LLC acquired all outstanding shares of Covad. Upon closing of the transaction, a change of control of Covad occurred, resulting in Covad’s repurchase of all Covad Notes held by EarthLink at a purchase price equal to 100% of the principal amount thereof plus accrued and unpaid interest. As a result, the Company received cash of $50.8 million for the aggregate principal amount of the Covad Notes plus accrued interest and received cash of $6.3 million for the 6.1 million shares of common stock. The Company recognized a gain of $2.0 million based on its cost basis of the Covad common stock, which was classified as gain (loss) on investments in other companies, net, in the Condensed Consolidated Statements of Operations.

 

During the three and nine months ended September 30, 2007, the Company received $1.2 million and $1.4 million in cash distributions, respectively, from eCompanies Venture Group, L.P. (“EVG”), a limited partnership that has invested in domestic emerging Internet-related companies, which was classified as gain (loss) on investments in other companies, net, in the Condensed Consolidated Statements of Operations.

 

10



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

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 three and nine months ended September 30, 2007, the Company recognized an impairment loss of $7.0 million and during the nine months ended September 30, 2008 the Company recognized an impairment loss of $0.7 million due to other-than-temporary declines of the value of its investments in other companies. These losses were classified within gain (loss) on investments in other companies, net, in the Condensed Consolidated Statements of Operations.

 

Investment in equity affiliate

 

The Company had a joint venture with SK Telecom Co., Ltd. (“SK Telecom”), HELIO. HELIO was a non-facilities-based mobile virtual network operator (“MVNO”) offering mobile communications services and handsets to U.S. consumers.  HELIO was formed in March 2005 and began offering its products and services in April 2006. As of December 31, 2007, EarthLink had an approximate 31% economic ownership interest and 33% voting interest in HELIO, while SK Telecom had an approximate 65% economic ownership interest and 67% voting interest in HELIO.

 

In August 2008, Virgin Mobile USA, Inc. (“Virgin Mobile”) acquired HELIO in exchange for limited partnership units equivalent to 13 million shares of Virgin Mobile common stock. EarthLink’s equity and debt investments in HELIO were exchanged for limited partnership units equivalent to approximately 1.8 million shares of Virgin Mobile common stock. As a result of the transaction, EarthLink recorded a gain of $4.4 million, which is included in gain (loss) on investments in other companies, net, in the Condensed Consolidated Statements of Operations.  EarthLink has an approximate 2% ownership interest in Virgin Mobile. The Company cannot exert significant influence over Virgin Mobile’s operating and financial policies and, as such, accounts for its investment in Virgin Mobile under the cost method of accounting and classifies the investment as available-for-sale.

 

Prior to the transaction with Virgin Mobile, the Company accounted for its investment in HELIO under the equity method of accounting because the Company was able to exert significant influence over HELIO’s operating and financial policies.  The Company had been recording its proportionate share of HELIO’s net loss in its Condensed Consolidated Statements of Operations and amortizing the difference between the book value and fair value of non-cash assets contributed to HELIO over their estimated useful lives. The amortization increased the carrying value of the Company’s investment and decreased the net losses of equity affiliate included in the Condensed Consolidated Statements of Operations. During the three and nine months ended September 30, 2007, the Company recorded $41.9 million and $111.3 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. During 2007, EarthLink discontinued recording additional net losses of equity affiliate because the carrying value of its investment in HELIO was reduced to zero.

 

11



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

7.  Purchased Intangible Assets and Goodwill

 

Goodwill

 

During the nine months ended September 30, 2008, the carrying amount of goodwill decreased $16.2 million due to the utilization of net operating loss carryforwards acquired from OneMain.com, Inc., Cidco Incorporated, PeoplePC Inc. and New Edge Networks.

 

Purchased Intangible Assets

 

The following table presents the components of the Company’s acquired identifiable intangible assets included in the accompanying Condensed Consolidated Balance Sheets as of December 31, 2007 and September 30, 2008:

 

 

 

As of December 31, 2007

 

As of September 30, 2008

 

 

 

Gross

 

 

 

Net

 

Gross

 

 

 

Net

 

 

 

Carrying

 

Accumulated

 

Carrying

 

Carrying

 

Accumulated

 

Carrying

 

 

 

Value

 

Amortization

 

Value

 

Value

 

Amortization

 

Value

 

 

 

(in thousands)

 

Intangible assets subject to amortization:

 

 

 

 

 

 

 

 

 

 

 

 

 

Subscriber bases and customer relationships

 

$

118,702

 

$

(79,763

)

$

38,939

 

$

120,160

 

$

(90,107

)

$

30,053

 

Software, technology and other

 

3,892

 

(3,161

)

731

 

739

 

(589

)

150

 

Trade names

 

 

 

 

1,521

 

(228

)

1,293

 

 

 

122,594

 

(82,924

)

39,670

 

122,420

 

(90,924

)

31,496

 

Intangible assets not subject to amortization:

 

 

 

 

 

 

 

 

 

 

 

 

 

Trade names

 

6,606

 

 

6,606

 

5,085

 

 

5,085

 

 

 

$

129,200

 

$

(82,924

)

$

46,276

 

$

127,505

 

$

(90,924

)

$

36,581

 

 

Amortization of intangible assets in the Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2007 and 2008 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, certain trade names and other assets acquired in conjunction with the purchases of businesses and subscriber bases from other companies that are not deemed to have indefinite lives. The Company’s identifiable indefinite lived intangible assets consist of certain trade names. 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 three years for acquired software and technology.  As of September 30, 2008, the weighted average amortization periods were 3.9 years for subscriber base assets and customer relationships, 3.3 years for software and technology and 5.0 years for trade names. Based on the current amount of definite lived intangible assets, the Company expects to record amortization expense of approximately $3.2 million during the remaining three months in the year ending December 31, 2008 and $11.5 million, $8.0 million, $6.7 million and $2.1 million during the years ending December 31, 2009, 2010, 2011 and 2012, 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.

 

During the nine months ended September 30, 2008, the Company wrote-off fully amortized definite lived intangible assets, consisting of software and technology, with a gross carrying value and accumulated amortization of $3.2 million.

 

12



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

8.  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. 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 corporate transactions; (4) if the Company has called the Notes for redemption; and (5) at any time from, and including, October 15, 2011 to, and including, November 15, 2011 and at any time on or after November 15, 2024.  The Company has the option to redeem the Notes, in whole or in part, for cash, on or after November 15, 2011, provided that the Company had made at least ten semi-annual interest payments. In addition, the holders may require the Company to purchase all or a portion of their notes on each of November 15, 2011, November 15, 2016 and November 15, 2021.

 

As of December 31, 2007 and September 30, 2008, the fair value of the Notes was approximately $262.0 million and $274.1 million, respectively, based on the quoted market prices.

 

In connection with the issuance of the Notes, the Company entered into separate convertible note hedge transactions and separate warrant transactions with respect to the Company’s common stock to reduce the potential dilution upon conversion of the Notes (collectively referred to as the “Call Spread Transactions”). In September 2008, the Company terminated the convertible note hedge and warrant agreements. See Note 9, “Stockholders’ Equity,” for more information on the Call Spread Transactions.

 

13



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

9.  Stockholders’ Equity

 

Comprehensive Income (Loss)

 

Comprehensive income (loss) includes unrealized gains and losses on certain investments classified as available-for-sale, net of tax, which are excluded from the Condensed Consolidated Statements of Operations in accordance with SFAS No. 130, “Reporting Comprehensive Income.” Comprehensive income (loss) for the three and nine months ended September 30, 2007 and 2008 was as follows:

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2007

 

2008

 

2007

 

2008

 

 

 

(in thousands)

 

Net income (loss)

 

$

(79,381

)

$

54,686

 

$

(125,633

)

$

162,376

 

Net unrealized holding gains (losses) on investments

 

452

 

(1,190

)

(3,235

)

(2,214

)

Reclassification adjustment for realized gains on certain investments

 

 

 

 

(1,779

)

Total comprehensive income (loss)

 

$

(78,929

)

$

53,496

 

$

(128,868

)

$

158,383

 

 

Share Repurchases

 

Since the inception of the Company’s share repurchase program, the Board of Directors has authorized a total of $750.0 million for the repurchase of EarthLink’s common stock. As of September 30, 2008, the Company had $169.1 million available under the current authorizations. The Company may repurchase its common stock from time to time in compliance with Securities and Exchange Commission regulations and other legal requirements, including through the use of derivative transactions, and subject to market conditions and other factors. The share repurchase program does not require the Company to acquire any specific number of shares and may be terminated by the Board of Directors at any time.

 

The Company repurchased 3.9 million of its common stock for $25.0 million during the nine months ended September 30, 2007 pursuant to its share repurchase program. The Company repurchased 3.8 million shares of its common stock for $31.9 million during the nine months ended September 30, 2008 pursuant to its share repurchase program, of which 2.5 million shares were repurchased upon termination of the convertible note hedge and warrant agreements, as more fully described below under “Call Spread Transactions.”

 

Call Spread Transactions

 

In connection with the issuance of the Notes (see Note 8, “Long-Term Debt”), the Company entered into separate convertible note hedge transactions and separate warrant transactions with respect to the Company’s common stock to minimize the impact of the potential dilution upon conversion of the Notes.  The Company purchased call options in private transactions to cover approximately 28.4 million shares of the Company’s common stock at a strike price of $9.12 per share, subject to adjustment in certain circumstances, for $47.2 million. The Company also sold warrants permitting the purchasers to acquire up to approximately 28.4 million shares of the Company’s common stock at an exercise price of $11.20 per share, subject to adjustments in certain circumstances, in private transactions for total proceeds of approximately $32.1 million. The Company recorded the purchase of the call options as a reduction in additional paid-in capital and the proceeds of the warrants as an addition to paid-in capital. As of December 31, 2007, the estimated fair value of the call options was $43.8 million and the estimated fair value of the warrants was $28.0 million.

 

In September 2008, the Company terminated its convertible note hedge and warrant agreements.  The Company received an aggregate payment from the counterparties to the agreements, which was recorded as additional paid-in capital. Upon termination of the agreements, the Company purchased approximately 2.5

 

14



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

million shares of common stock the counterparties held in hedge positions for approximately $22.7 million, based on the closing price of the EarthLink common stock on the purchase date.

 

10.  Stock-Based Compensation

 

The Company accounts for stock-based compensation pursuant to SFAS No. 123(R), “Share-Based Payment,” which requires measurement of compensation cost for all stock awards at fair value on the date of grant and recognition of compensation expense over the requisite service period for awards expected to vest. 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.

 

Stock-based compensation expense under SFAS No. 123(R) was $4.3 million and $4.6 million during the three months ended September 30, 2007 and 2008, respectively, and $15.1 million and $14.3 million during the nine months ended September 30, 2007 and 2008, respectively.  In accordance with Staff Accounting Bulletin No. 107, the Company has classified stock-based compensation expense during the three and nine months ended September 30, 2007 and 2008 within the same operating expense line items as cash compensation paid to employees.

 

Stock Incentive Plans

 

The Company has granted stock options and restricted stock units to employees and non-employee directors to purchase the Company’s common stock under various stock incentive plans. Under the plans, employees and non-employee directors are eligible to receive awards of various forms of equity-based incentive compensation, including stock options, restricted stock, restricted stock units, phantom share units and performance awards, among others. The plans are administered by the Board of Directors or the Leadership and Compensation Committee of the Board of Directors, which determine the terms of the awards granted. Stock options are generally granted with an exercise price equal to the market value of EarthLink, Inc. common stock on the date of grant, have a term of ten years or less and vest over terms of four to six years from the date of grant. Restricted stock units are granted with various vesting terms that range from one to six years from the date of grant.

 

Deferred Compensation Plan

 

The Company’s Second Deferred Compensation Plan for Directors and Certain Key Employees permits members of the Board of Directors and eligible employees to elect to defer receipt of shares of common stock pursuant to vested restricted stock units and various cash consideration, such as directors’ fees and bonuses. The cash consideration is converted into phantom share units at the closing price on the date the consideration would otherwise be paid, and vested restricted stock units are converted into phantom share units on a one-for-one basis. Phantom share units are fully vested at the date of grant and are converted to common stock upon the occurrence of various events. As of December 31, 2007 and September 30, 2008, approximately 43,000 and 24,000 phantom share units were outstanding, respectively.

 

15



Table of Contents

 

Options Outstanding

 

The following table summarizes information concerning stock option activity as of and for the nine months ended September 30, 2008:

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

 

 

 

 

 

 

Weighted

 

 

 

 

 

 

 

Weighted

 

Average

 

 

 

 

 

 

 

Average

 

Remaining

 

Aggregate

 

 

 

 

 

Exercise

 

Contractual

 

Intrinsic

 

 

 

Stock Options

 

Price

 

Term (Years)

 

Value

 

 

 

(shares and dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

Outstanding as of December 31, 2007

 

13,427

 

$

10.69

 

 

 

 

 

Granted

 

164

 

7.73

 

 

 

 

 

Exercised

 

(1,162

)

6.88

 

 

 

 

 

Forfeited and expired

 

(3,159

)

13.05

 

 

 

 

 

Outstanding as of September 30, 2008

 

9,270

 

$

10.31

 

5.9

 

$

5,687

 

Vested and expected to vest as of September 30, 2008

 

8,606

 

$

9.77

 

5.3

 

$

4,945

 

Exercisable as of September 30, 2008

 

6,625

 

$

11.32

 

5.0

 

$

2,897

 

 

The aggregate intrinsic value amounts in the table above represent the closing price of the Company’s common stock on September 30, 2008 in excess of the exercise price, multiplied by the number of stock options outstanding or exercisable, when the closing price is greater than the exercise price. This represents the amount that would have been received by the stock option holders if they had all exercised their stock options on September 30, 2008. The total intrinsic value of options exercised during the three and nine months ended September 30, 2007 was $0.5 million and $1.7 million, respectively. The total intrinsic value of options exercised during the three and nine months ended September 30, 2008 was $0.7 million and $2.2 million, respectively. The intrinsic value of stock options exercised represents the difference between the price of the Company’s common stock at the time of exercise and the exercise price, multiplied by the number of stock options exercised. To the extent the forfeiture rate is different than what the Company has anticipated, stock-based compensation related to these awards will be different from the Company’s expectations.

 

16



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

The following table summarizes the status of the Company’s stock options as of September 30, 2008:

 

 

 

 

 

 

 

 

 

 

 

Stock Options

 

Stock Options Outstanding

 

Exercisable

 

 

 

 

 

 

 

Weighted

 

 

 

 

 

 

 

 

 

 

 

 

 

Average

 

Weighted

 

 

 

Weighted

 

 

 

 

 

 

 

Remaining

 

Average

 

 

 

Average

 

Range of

 

Number

 

Contractual

 

Exercise

 

Number

 

Exercise

 

Exercise Prices

 

Outstanding

 

Life (Years)

 

Price

 

Exercisable

 

Price

 

 

 

 

 

(in thousands)

 

 

 

 

 

(in thousands)

 

 

 

$

5.10

 

$

6.86

 

853

 

5.4

 

$

5.97

 

562

 

$

5.84

 

6.90

 

7.25

 

917

 

8.3

 

6.97

 

282

 

6.96

 

7.31

 

7.31

 

1,500

 

8.7

 

7.31

 

700

 

7.31

 

7.32

 

9.01

 

1,281

 

6.4

 

8.54

 

974

 

8.74

 

9.23

 

9.64

 

961

 

5.5

 

9.51

 

588

 

9.54

 

10.06

 

10.06

 

853

 

2.0

 

10.06

 

853

 

10.06

 

10.36

 

11.38

 

1,590

 

6.5

 

10.57

 

1,366

 

10.57

 

11.45

 

48.61

 

1,315

 

2.7

 

21.03

 

1,300

 

21.14

 

$

5.10

to

$

48.61

 

9,270

 

5.9

 

$

10.31

 

6,625

 

$

11.32

 

 

Valuation Assumptions for Stock Options

 

The fair value of stock options granted during the nine months ended September 30, 2007 and 2008 was estimated using the Black-Scholes option-pricing model with the following assumptions:

 

 

 

Nine Months Ended September 30,

 

 

 

2007

 

2008

 

 

 

 

 

 

 

Dividend yield

 

0

%

0

%

Expected volatility

 

39

%

39

%

Risk-free interest rate

 

4.81

%

3.00

%

Expected life

 

4.3 years

 

4.2 years

 

 

The weighted average grant date fair value of options granted during the nine months ended September 30, 2007 and 2008 was $2.79 and $2.71, respectively.

 

The dividend yield assumption is based on the Company’s history and expectation of future dividend payouts. The expected volatility is based on a combination of the Company’s historical stock price and implied volatility. The selection of implied volatility data to estimate expected volatility is based upon the availability of prices for actively traded options on the Company’s stock. The risk-free interest rate assumption is based upon the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected life of the option. The expected life of employee stock options represents the weighted-average period the stock options are expected to remain outstanding.

 

17



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

Restricted Stock Units

 

The following table summarizes the Company’s restricted stock units as of and for the nine months ended September 30, 2008:

 

 

 

 

 

Weighted

 

 

 

 

 

Average

 

 

 

Restricted

 

Grant Date

 

 

 

Stock Units

 

Fair Value

 

 

 

 

 

 

 

Nonvested as of December 31, 2007

 

2,061,000

 

$

7.17

 

Granted

 

3,564,000

 

7.20

 

Vested

 

(631,000

)

7.27

 

Forfeited

 

(623,000

)

7.16

 

Nonvested as of September 30, 2008

 

4,371,000

 

7.19

 

 

The fair value of restricted stock units is determined based on the closing trading price of EarthLink’s common stock on the grant date. The weighted-average grant date fair value of restricted stock units granted during the nine months ended September 30, 2007 and 2008 was $6.92 and $7.20, respectively. As September 30, 2008, there was $21.0 million of total unrecognized compensation cost related to nonvested restricted stock units. That cost is expected to be recognized over a weighted-average period of 2.3 years. The total fair value of shares vested during the nine months ended September 30, 2007 and 2008 was $2.5 million and $5.7 million, respectively, which represents the closing price of the Company’s common stock on the vesting date multiplied by the number of restricted stock units that vested.

 

11. Income Taxes

 

EarthLink recorded an income tax provision from continuing operations of $7.9 million and $23.9 million during the three and nine months ended September 30, 2008, respectively. The income tax provision is based on management’s current expectations for the results of operations for the year ending December 31, 2008 in accordance with the interim reporting requirements of SFAS No. 109, “Accounting for Income Taxes,” Accounting Principles Board (“APB”) Opinion No. 28, “Interim Financial Reporting,” and FASB Interpretation No. 18 “Accounting for Income Taxes in Interim Periods — an interpretation of APB Opinion No. 28.”

 

The major components of the income tax provision for the three and nine months ended September 30, 2007 and 2008 are as follows:

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2007

 

2008

 

2007

 

2008

 

 

 

(in millions)

 

 

 

 

 

 

 

 

 

 

 

Federal alternative minumum tax

 

$

 

$

1.0

 

$

 

$

3.4

 

State income tax

 

 

2.9

 

0.3

 

4.2

 

Other

 

 

 

 

(0.5

)

Current provision

 

 

3.9

 

0.3

 

7.1

 

 

 

 

 

 

 

 

 

 

 

Deferred provision

 

 

4.0

 

0.1

 

16.8

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

 

$

7.9

 

$

0.4

 

$

23.9

 

 

18



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

A discrete item has been recorded during the nine months ended September 30, 2008 for a change in valuation allowance resulting from a change in classification of an indefinite lived intangible asset to a definite lived intangible asset, corresponding to a decrease in the valuation allowance which resulted in a tax benefit of $0.5 million. The non-cash deferred tax provision has been recorded for estimated utilization of federal and state net operating loss carryforwards acquired from OneMain.com, Inc., Cidco Incorporated, PeoplePC Inc., and New Edge Networks.  The associated reduction in the valuation allowance due to the expected utilization of these acquired federal and state net operating losses has been recorded as a reduction to goodwill and not as a benefit to income taxes.  The current alternative minimum tax (“AMT”) liability is payable as a result of net operating loss carryforward limitations associated with the AMT calculation.

 

EarthLink continues to maintain a full valuation allowance against its unrealized deferred tax assets, which include net operating loss carryforwards.  EarthLink may recognize deferred tax assets in future periods when they are determined to be more likely than not realizable.  To the extent EarthLink reports income in future periods, EarthLink intends to use its net operating loss carryforwards to the extent available to offset taxable income and reduce cash outflows for income taxes.  The Company’s ability to use its federal and state net operating loss carryforwards and federal and state tax credit carryforwards may be subject to restrictions attributable to equity transactions in the future resulting from changes in ownership as defined under the Internal Revenue Code.

 

On January 1, 2007, EarthLink adopted Financial Interpretation (“FIN”) No. 48.  The Company has identified its federal tax return and its state tax returns in California, Florida, Georgia and Illinois as “major” tax jurisdictions, as defined in FIN No. 48.  Periods extending back to 1994 are still subject to examination for all “major” jurisdictions. The adoption of FIN No. 48 on January 1, 2007 did not result in a material cumulative-effect adjustment. The Company believes that its income tax filing positions and deductions will be sustained on audit and does not anticipate any adjustments that will result in material adverse effect on the Company’s financial condition, results of operations or cash flows.  The Company’s policy for recording interest and penalties associated with audits is to record such items as a component of income taxes.  No adjustments were made to the FIN No. 48 liability during the quarter.

 

12.  Related Party Transactions

 

As a result of EarthLink’s ownership interest in HELIO, HELIO was considered a related party. In August 2008, Virgin Mobile acquired HELIO and EarthLink’s equity and debt investments in HELIO were exchanged for limited partnership units of Virgin Mobile. EarthLink and HELIO have a services agreement pursuant to which EarthLink provides HELIO billing and other support services in exchange for management fees. The service agreement will remain in effect through the remainder of 2008. The management fees were determined based on EarthLink’s costs to provide the services, and management believes such fees are reasonable.  The total amount of fees that HELIO pays to EarthLink depends on the extent to which HELIO utilizes EarthLink’s services.  Fees for services provided to HELIO are reflected as reductions to the associated expenses incurred by EarthLink to provide such services. During the three months ended September 30, 2007 and 2008, fees received for services provided to HELIO were $0.4 million and $0.3 million, respectively. During the nine months ended September 30, 2007 and 2008, fees received for services provided to HELIO were $1.3 million and $1.0 million, respectively.

 

As of December 31, 2007, the Company had accounts receivable from HELIO of approximately $0.2 million.

 

19



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

13.  Fair Value Measurements

 

On January 1, 2008, the Company adopted SFAS No. 157, “Fair Value Measurements,” which establishes a framework for reporting fair value and expands disclosures required for fair value measurements. Although the adoption of SFAS No. 157 did not materially impact its financial condition, results of operations or cash flow, the Company is now required to provide additional disclosures as part of its financial statements.

 

SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (an exit price). SFAS No. 157 establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value.  These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.

 

As of September 30, 2008, the Company held certain assets that are required to be measured at fair value on a recurring basis.  These included the Company’s cash equivalents, investments in marketable securities, including auction rate securities, and investments in other companies.

 

The following table presents the Company’s assets measured at fair value on a recurring basis subject to the disclosure requirements of SFAS No. 157 as of September 30, 2008:

 

 

 

 

 

Fair Value Measurements as of September 30, 2008 Using

 

 

 

 

 

Quoted Prices in

 

Significant Other

 

Significant

 

 

 

 

 

Active Markets for

 

Observable

 

Unobservable

 

 

 

Balance as of

 

Identical Assets

 

Inputs

 

Inputs

 

Description

 

September 30, 2008

 

(Level 1)

 

(Level 2)

 

(Level 3)

 

 

 

(in thousands)

 

Cash equivalents

 

$

427,594

 

$

427,594

 

$

 

$

 

Auction rate securities

 

52,428

 

 

 

52,428

 

Investments in other companies

 

4,829

 

125

 

 

4,704

 

Total

 

$

484,851

 

$

427,719

 

$

 

$

57,132

 

 

Cash equivalents, auction rate securities and equity investments in other companies are measured at fair value.  Cash equivalents and equity investments in other companies that are valued using quoted market prices are classified within Level 1. Equity investments in other companies that are valued using unobservable inputs are classified as Level 3. These inputs reflect the Company’s assumptions about the assumptions market participants would use in pricing the assets and were developed based on the best information available. Investments in auction rate securities are classified within Level 3 because they are valued using a discounted cash flow model. Some of the inputs to this model are unobservable in the market and are significant. The Company has consistently applied these valuation techniques in all periods presented.

 

The Company has invested in auction rate securities, which are more fully described in Note 6, “Investments.”  Beginning in February 2008, these instruments held by the Company failed to attract sufficient buyers.  As a result, these securities do not have a readily determinable market value and are not liquid. The fair values of the Company’s auction rate securities as of September 30, 2008 were estimated utilizing a discounted cash flow analysis.  These analyses consider, among other items, the collateralization underlying the security investments, the creditworthiness of the counterparty, and the timing and value of expected future cash flows.  These securities were also compared, when possible, to other observable market data with similar characteristics to the securities held by the Company.

 

Based on market conditions, the Company changed its valuation methodology for auction rate securities to a discounted cash flow analysis during the nine months ended September 30, 2008.  Accordingly, these

 

20



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

securities changed from Level 1 to Level 3 within SFAS No. 157’s hierarchy since the Company’s initial adoption of SFAS No. 157 on January 1, 2008.

 

The following table presents the Company’s assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as defined in SFAS No. 157 as of September 30, 2008:

 

 

 

Auction

 

 

 

Rate

 

 

 

Securities

 

 

 

(in thousands)

 

Balance as of December 31, 2007

 

$

 

Transfers to Level 3

 

38,900

 

Total unrealized losses

 

(5,322

)

Purchases and settlements (net)

 

18,850

 

Balance as of September 30, 2008

 

$

52,428

 

 

The $5.3 million of unrealized losses are included in unrealized losses on investments as a separate component of stockholders’ equity and in total comprehensive income (loss) and relate to assets held as of September 30, 2008.

 

14.  Segment Information

 

In accordance with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” the Company reports segment information along the same lines that its chief executive officer reviews its operating results in assessing performance and allocating resources. The Company operates two reportable segments, Consumer Services and Business Services, which are described below in more detail.

 

The Company’s segments are strategic business units that are managed based upon differences in customers, services and marketing channels. The Company’s Consumer Services segment provides Internet access services and related value-added services to individual customers. These services include dial-up and high-speed Internet access and voice services, among others. The Company’s Business Services segment provides Internet access services and related value-added services to businesses and communications carriers. These services include managed data networks, dedicated Internet access and web hosting, among others.

 

The Company evaluates performance of its segments based on segment income from operations. Segment income from operations includes revenues from external customers, related cost of revenues and operating expenses directly attributable to the segment, which include costs over which segment managers have direct discretionary control, such as advertising and marketing programs, customer support expenses, site operations expenses, product development expenses, certain technology and facilities expenses, billing operations and provisions for doubtful accounts. Segment income from operations excludes other income and expense items and certain expenses over which segment managers do not have discretionary control. Costs excluded from segment income from operations include various corporate expenses (consisting of certain costs such as corporate management, human resources, finance and legal), amortization of intangible assets, facility exit and restructuring costs, and stock-based compensation expense under SFAS No. 123(R), as they are not considered in the measurement of segment performance.

 

21



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

Information on reportable segments and a reconciliation to consolidated income from operations for the three and nine months ended September 30, 2007 and 2008 is as follows:

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

 

 

2007

 

2008

 

2007

 

2008

 

 

 

(in thousands)

 

Consumer Services

 

 

 

 

 

 

 

 

 

Revenues

 

$

250,521

 

$

187,799

 

$

790,692

 

$

605,340

 

Cost of revenues

 

80,395

 

62,550

 

249,024

 

201,053

 

Gross margin

 

170,126

 

125,249

 

541,668

 

404,287

 

Direct segment operating expenses

 

126,631

 

49,803

 

417,914

 

164,496

 

Segment operating income

 

$

43,495

 

$

75,446

 

$

123,754

 

$

239,791

 

 

 

 

 

 

 

 

 

 

 

Business Services

 

 

 

 

 

 

 

 

 

Revenues

 

$

47,471

 

$

43,032

 

$

143,313

 

$

134,168

 

Cost of revenues

 

29,360

 

25,066

 

88,835

 

76,602

 

Gross margin

 

18,111

 

17,966

 

54,478

 

57,566

 

Direct segment operating expenses

 

12,253

 

12,481

 

45,040

 

39,308

 

Segment operating income

 

$

5,858

 

$

5,485

 

$

9,438

 

$

18,258

 

 

 

 

 

 

 

 

 

 

 

Consolidated

 

 

 

 

 

 

 

 

 

Revenues

 

$

297,992

 

$

230,831

 

$

934,005

 

$

739,508

 

Cost of revenues

 

109,755

 

87,616

 

337,859

 

277,655

 

Gross margin

 

188,237

 

143,215

 

596,146

 

461,853

 

Direct segment operating expenses

 

138,884

 

62,284

 

462,954

 

203,804

 

Segment operating income

 

49,353

 

80,931

 

133,192

 

258,049

 

Stock-based compensation expense

 

4,303

 

4,597

 

15,081

 

14,319

 

Amortization of intangible assets

 

3,836

 

3,153

 

10,874

 

11,153

 

Facility exit, restructuring and other costs

 

34,162

 

1,078

 

34,162

 

4,169

 

Other operating expenses

 

11,610

 

12,674

 

44,487

 

39,714

 

Income from operations

 

$

(4,558

)

$

59,429

 

$

28,588

 

$

188,694

 

 

The primary component of the Company’s revenues is access and service revenues, which consist of narrowband access services (including traditional, fully-featured narrowband access and value-priced narrowband access); broadband access services (including high-speed access via DSL, cable and satellite technologies, IP-based voice and fees charged for high-speed data networks to small and medium-sized businesses); and web hosting services. The Company also earns revenues from value-added services, which include ancillary services sold as add-on features to the Company’s access services, search and advertising revenues.

 

Consumer access and service revenues consist of narrowband access, broadband access and voice services. These revenues are derived from monthly fees charged to customers for dial-up Internet access; monthly retail and wholesale fees charged for high-speed, high-capacity access services including DSL, cable and satellite; fees charged for IP-based voice services; usage fees; installation fees; termination fees; and fees for equipment. Consumer value-added services revenues consist of search revenues; advertising revenues; revenues from ancillary services sold as add-on features to the Company’s Internet services, such as security products, email by phone, Internet call waiting and email storage; and revenues from home networking products and services.

 

Business access and service revenues consist of retail and wholesale fees charged for high-speed, high-capacity access services including DSL, cable, satellite and dedicated circuit services; fees charged for high-speed

 

22



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

data networks for small and medium-sized businesses; installation fees; termination fees; fees for equipment; regulatory surcharges billed to customers; and web hosting.

 

Information on revenues by groups of similar services and by segment for the three and nine months ended September 30, 2007 and 2008 is as follows:

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2007

 

2008

 

2007

 

2008

 

 

 

(in thousands)

 

Consumer Services

 

 

 

 

 

 

 

 

 

Access and service

 

$

218,609

 

$

164,306

 

$

692,801

 

$

529,557

 

Value-added services

 

31,912

 

23,493

 

97,891

 

75,783

 

Total revenues

 

$

250,521

 

$

187,799

 

$

790,692

 

$

605,340

 

 

 

 

 

 

 

 

 

 

 

Business Services

 

 

 

 

 

 

 

 

 

Access and service

 

$

46,833

 

$

42,387

 

$

141,115

 

$

132,026

 

Value-added services

 

638

 

645

 

2,198

 

2,142

 

Total revenues

 

$

47,471

 

$

43,032

 

$

143,313

 

$

134,168

 

 

 

 

 

 

 

 

 

 

 

Consolidated

 

 

 

 

 

 

 

 

 

Access and service

 

$

265,442

 

$

206,693

 

$

833,916

 

$

661,583

 

Value-added services

 

32,550

 

24,138

 

100,089

 

77,925

 

Total revenues

 

$

297,992

 

$

230,831

 

$

934,005

 

$

739,508

 

 

The Company manages its working capital on a consolidated basis and does not allocate long-lived assets to segments. In addition, segment assets are not reported to, or used by, the chief operating decision maker and therefore, pursuant to SFAS No. 131, total segment assets have not been disclosed.

 

The Company has not provided information about geographic segments because substantially all of the Company’s revenues, results of operations and identifiable assets are in the United States.

 

23



Table of Contents

 

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

 

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