EarthLink Holdings Corp.
EARTHLINK INC (Form: 10-Q, Received: 05/01/2009 15:10:04)

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 March 31, 2009

 

 

 

 

 

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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o  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. 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 April 30, 2009, 105,694,831 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 March 31, 2009

 

TABLE OF CONTENTS

 

Part I

 

 

 

Item 1. Financial Statements

1

 

 

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

21

 

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

40

 

 

Item 4. Controls and Procedures

41

 

 

Part II

 

 

 

Item 1. Legal Proceedings

41

 

 

Item 1A. Risk Factors

41

 

 

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

41

 

 

Item 5. Other Information

42

 

 

Item 6. Exhibits

42

 

 

Signatures

43

 



Table of Contents

 

PART I

 

Item 1.  Financial Statements.

 

EARTHLINK, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

 

 

 

December 31,

 

March 31,

 

 

 

2008

 

2009

 

 

 

 

 

(unaudited)

 

ASSETS

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

486,564

 

$

471,510

 

Accounts receivable, net of allowance of $4,048 and $3,275 as of December 31, 2008 and March 31, 2009, respectively

 

30,569

 

24,952

 

Marketable securities

 

 

40,575

 

Prepaid expenses

 

6,445

 

6,802

 

Deferred income taxes, net

 

20,254

 

15,858

 

Other current assets

 

15,452

 

11,652

 

Total current assets

 

559,284

 

571,349

 

Long-term marketable securities

 

47,809

 

53,756

 

Long-term investments

 

20,708

 

19,473

 

Property and equipment, net

 

37,246

 

35,293

 

Deferred income taxes, net

 

43,757

 

29,596

 

Purchased intangible assets, net

 

19,552

 

17,405

 

Goodwill

 

112,812

 

112,812

 

Other long-term assets

 

4,698

 

4,147

 

Total assets

 

$

845,866

 

$

843,831

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

13,109

 

$

17,732

 

Accrued payroll and related expenses

 

37,470

 

17,083

 

Other accrued liabilities

 

39,415

 

41,192

 

Deferred revenue

 

33,649

 

31,189

 

Total current liabilities

 

123,643

 

107,196

 

 

 

 

 

 

 

Long-term debt, net of discount of $39,017 and $35,999 as of December 31, 2008 and March 31, 2009, respectively

 

219,733

 

222,751

 

Other long-term liabilities

 

16,015

 

13,787

 

Total liabilities

 

359,391

 

343,734

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Convertible preferred stock, $0.01 par value, 100,000 shares authorized, 0 shares issued and outstanding as of December 31, 2008 and March 31, 2009

 

 

 

Common stock, $0.01 par value, 300,000 shares authorized, 188,264 and 188,969 shares issued as of December 31, 2008 and March 31, 2009, respectively, and 108,516 and 105,629 shares outstanding as of December 31, 2008 and March 31, 2009, respectively

 

1,883

 

1,890

 

Additional paid-in capital

 

2,135,887

 

2,138,114

 

Accumulated deficit

 

(1,016,833

)

(984,336

)

Treasury stock, at cost, 79,748 and 83,340 shares as of December 31, 2008 and March 31, 2009, respectively

 

(634,420

)

(656,760

)

Unrealized (losses) gains on investments

 

(42

)

1,189

 

Total stockholders’ equity

 

486,475

 

500,097

 

Total liabilities and stockholders’ equity

 

$

845,866

 

$

843,831

 

 

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 March 31,

 

 

 

2008

 

2009

 

 

 

(in thousands, except per share data)

 

 

 

(unaudited)

 

 

 

 

 

 

 

Revenues

 

$

263,074

 

$

199,063

 

 

 

 

 

 

 

Operating costs and expenses:

 

 

 

 

 

Cost of revenues

 

97,551

 

75,565

 

Sales and marketing

 

30,916

 

17,022

 

Operations and customer support

 

39,224

 

27,746

 

General and administrative

 

24,926

 

18,622

 

Amortization of intangible assets

 

4,013

 

2,147

 

Facility exit and restructuring costs

 

1,030

 

488

 

Total operating costs and expenses

 

197,660

 

141,590

 

 

 

 

 

 

 

Income from operations

 

65,414

 

57,473

 

Gain on investments, net

 

 

259

 

Interest expense and other, net

 

(1,041

)

(4,291

)

Income from continuing operations before income taxes

 

64,373

 

53,441

 

Income tax provision

 

(9,274

)

(20,944

)

Income from continuing operations

 

55,099

 

32,497

 

Loss from discontinued operations

 

(3,392

)

 

Net income

 

$

51,707

 

$

32,497

 

 

 

 

 

 

 

Basic net income per share

 

 

 

 

 

Continuing operations

 

$

0.50

 

$

0.30

 

Discontinued operations

 

(0.03

)

 

Basic net income per share

 

$

0.47

 

$

0.30

 

Basic weighted average common shares outstanding

 

109,493

 

108,071

 

 

 

 

 

 

 

Diluted net income per share

 

 

 

 

 

Continuing operations

 

$

0.50

 

$

0.30

 

Discontinued operations

 

(0.03

)

 

Diluted net income per share

 

$

0.47

 

$

0.30

 

Diluted weighted average common shares outstanding

 

110,300

 

109,168

 

 

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

 

2



Table of Contents

 

EARTHLINK, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2008

 

2009

 

 

 

(in thousands)

 

 

 

(unaudited)

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

51,707

 

$

32,497

 

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

 

 

 

 

 

Depreciation and amortization

 

10,519

 

6,509

 

Loss on disposals and impairments of fixed assets

 

2,370

 

61

 

Stock-based compensation

 

5,152

 

4,390

 

Deferred income taxes

 

7,219

 

18,512

 

Accretion of debt discount and amortization of debt issuance costs

 

3,028

 

3,301

 

Gain on investments, net

 

 

(259

)

Decrease in accounts receivable, net

 

1,223

 

5,617

 

(Increase) decrease in prepaid expenses and other assets

 

(6,674

)

3,789

 

Decrease in accounts payable and accrued and other liabilities

 

(29,852

)

(17,884

)

Decrease in deferred revenue

 

(2,959

)

(2,609

)

Net cash provided by operating activities

 

41,733

 

53,924

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Purchases of property and equipment

 

(278

)

(3,133

)

Purchases of subscriber bases

 

(117

)

 

Purchases of marketable securities

 

(53,027

)

(44,075

)

Sales and maturities of marketable securities

 

86,059

 

 

Other investing activities

 

87

 

200

 

Net cash provided by (used in) investing activities

 

32,724

 

(47,008

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Principal payments under capital lease obligations

 

(145

)

(8

)

Proceeds from exercises of stock options

 

1,943

 

378

 

Repurchases of common stock

 

(9,125

)

(22,340

)

Net cash used in financing activities

 

(7,327

)

(21,970

)

 

 

 

 

 

 

Net increase (decrease) in cash and cash equivalents

 

67,130

 

(15,054

)

Cash and cash equivalents, beginning of period

 

173,827

 

486,564

 

Cash and cash equivalents, end of period

 

$

240,957

 

$

471,510

 

 

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 are dial-up and high-speed Internet access services and related value-added services, such as ancillary services sold as add-on features to the Company’s Internet access services, search and advertising. In addition, through the Company’s wholly-owned subsidiary, New Edge Networks (“New Edge”), the Company builds and manages private IP-based wide area networks 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-over-Internet protocol (“VoIP”) services, among others. The Company’s Business Services segment provides integrated communications services and related value-added services to businesses and communications carriers. These services include managed private IP-based wide area networks, dedicated Internet access and web hosting, among others. For further information concerning the Company’s business segments, see Note 14, “Segment Information.”

 

2.  Summary of Significant Accounting Policies

 

Basis of Presentation

 

The condensed consolidated financial statements of EarthLink, which include the accounts of its wholly-owned subsidiaries, for the three months ended March 31, 2008 and 2009 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, 2008 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 months ended March 31, 2009 are not necessarily indicative of the results anticipated for the entire year ending December 31, 2009.

 

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 reflected its municipal wireless broadband results of operations as discontinued operations for the three months ended March 31, 2008. 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)

 

Adoption of Recent Accounting Pronouncement

 

On January 1, 2009, the Company adopted Financial Accounting Standards Board (“FASB”) 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 accreted over the period the convertible debt is expected to be outstanding as additional non-cash interest expense. Retrospective application to all periods presented is required. The adoption of FSP APB 14-1 on January 1, 2009 affected the accounting for the Company’s Convertible Senior Notes due November 15, 2026 (the “Notes”), which were issued in November 2006. Upon adoption, the Company recorded an adjustment to increase additional paid-in capital as of the November 2006 issuance date by approximately $62.1 million. The Company is accreting the resulting debt discount to interest expense over the estimated five-year life of the Notes, which represents the first redemption date of November 2011. The Company recorded a pre-tax adjustment of approximately $22.3 million to retained earnings that represents the debt discount accretion during the years ended December 31, 2006, 2007 and 2008 and will recognize additional non-cash interest expense of $12.2 million, $13.4 million and $12.4 million during the years ending December 31, 2009, 2010 and 2011, respectively, for accretion of the debt discount. As a result of the adoption of FSP APB 14-1, the Company reduced income from continuing operations and net income for the three months ended March 31, 2009 by $2.9 million and reduced basic and diluted earnings per share by $0.03 per share. The Company also recorded a deferred tax liability for temporary differences resulting from the application of FASB Statement No. 109, “Accounting for Income Taxes.” However, this was offset by a corresponding decrease in the valuation allowance for deferred tax assets.

 

The following tables present the effect of the adoption of FSP APB 14-1 on the Company’s affected financial statement line items for the three months ended March 31, 2008 and as of December 31, 2008:

 

 

 

Three Months Ended March 31, 2008

 

 

 

As Originally

 

As

 

Effect of

 

 

 

Reported

 

Adjusted

 

Change

 

 

 

(in thousands, except per share data)

 

Statement of Operations:

 

 

 

 

 

 

 

Interest income (expense) and other, net

 

$

1,616

 

$

(1,041

)

$

(2,657

)

Income from continuing operations

 

57,756

 

55,099

 

(2,657

)

Net income

 

54,364

 

51,707

 

(2,657

)

 

 

 

 

 

 

 

 

Basic net income per share

 

 

 

 

 

 

 

Continuing operations

 

$

0.53

 

$

0.50

 

$

(0.02

)

Basic net income per share

 

0.50

 

0.47

 

(0.02

)

 

 

 

 

 

 

 

 

Diluted net income per share

 

 

 

 

 

 

 

Continuing operations

 

$

0.52

 

$

0.50

 

$

(0.02

)

Diluted net income per share

 

0.49

 

0.47

 

(0.02

)

 

5



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

 

 

As of December 31, 2008

 

 

 

As Originally

 

As

 

Effect of

 

 

 

Reported

 

Adjusted

 

Change

 

 

 

(in thousands)

 

Balance Sheet:

 

 

 

 

 

 

 

Other long-term assets

 

$

5,725

 

$

4,698

 

$

(1,027

)

Long-term debt

 

258,750

 

219,733

 

(39,017

)

Additional paid-in capital

 

2,075,571

 

2,135,887

 

60,316

 

Accumulated deficit

 

(994,507

)

(1,016,833

)

(22,326

)

 

3.  Earnings 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 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.

 

The following table sets forth the computation for basic and diluted net income per share for the three months ended March 31, 2008 and 2009:

 

 

 

Three Months Ended March 31,

 

 

 

2008

 

2009

 

 

 

(in thousands,

 

 

 

except per share data)

 

Numerator

 

 

 

 

 

Income from continuing operations

 

$

55,099

 

$

32,497

 

Loss from discontinued operations

 

(3,392

)

 

Net income

 

$

51,707

 

$

32,497

 

 

 

 

 

 

 

Denominator

 

 

 

 

 

Basic weighted average common shares outstanding

 

109,493

 

108,071

 

Dilutive effect of Common Stock Equivalents

 

807

 

1,097

 

Diluted weighted average common shares outstanding

 

110,300

 

109,168

 

 

 

 

 

 

 

Basic net income per share

 

 

 

 

 

Continuing operations

 

$

0.50

 

$

0.30

 

Discontinued operations

 

(0.03

)

 

Basic net income per share

 

$

0.47

 

$

0.30

 

 

 

 

 

 

 

Diluted net income per share

 

 

 

 

 

Continuing operations

 

$

0.50

 

$

0.30

 

Discontinued operations

 

(0.03

)

 

Diluted net income per share

 

$

0.47

 

$

0.30

 

 

6



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

During the three months ended March 31, 2008 and 2009, approximately 10.1 million and 6.7 million, respectively, stock 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 respective periods. 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 periods. These securities could be dilutive in future periods.

 

4.  Facility Exit and Restructuring Costs

 

Facility exit and restructuring costs consisted of the following during the three months ended March 31, 2008 and 2009:

 

 

 

Three Months Ended March 31,

 

 

 

2008

 

2009

 

 

 

(in thousands)

 

 

 

 

 

 

 

2007 Restructuring Plan

 

$

1,093

 

$

488

 

Legacy Restructuring Plans

 

(63

)

 

 

 

$

1,030

 

$

488

 

 

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 consolidated its office facilities in Atlanta, Georgia and Pasadena, California. The 2007 Plan was implemented during the latter half of 2007 and completed during the year ended December 31, 2008. Management continues to evaluate EarthLink’s businesses and, therefore, there may be supplemental provisions for new plan initiatives as well as changes in estimates to amounts previously recorded.

 

The following table summarizes facility exit and restructuring costs during the three months ended March 31, 2008 and 2009 and the cumulative costs incurred to date as a result of the 2007 Plan. Such costs have been classified as facility exit and restructuring costs in the Condensed Consolidated Statements of Operations.

 

 

 

 

 

 

 

Cumulative

 

 

 

 

 

 

 

Costs

 

 

 

Three Months Ended March 31,

 

Incurred

 

 

 

2008

 

2009

 

To Date

 

 

 

(in thousands)

 

 

 

 

 

 

 

 

 

Severance and personnel-related costs

 

$

367

 

$

 

$

30,764

 

Lease termination and facilities-related costs

 

 

488

 

17,512

 

Non-cash asset impairments

 

286

 

 

24,753

 

Other associated costs

 

440

 

 

1,124

 

 

 

$

1,093

 

$

488

 

$

74,153

 

 

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 years ended December 31, 2007 and 2008 and for the three months ended March 31, 2009, including changes during the years 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, 2006

 

$

 

$

 

$

 

$

 

$

 

Accruals

 

30,303

 

12,216

 

20,621

 

1,131

 

64,271

 

Payments

 

(18,262

)

(480

)

 

(760

)

(19,502

)

Non-cash charges

 

 

4,388

 

(20,621

)

(371

)

(16,604

)

Balance as of December 31, 2007

 

12,041

 

16,124

 

 

 

28,165

 

Accruals

 

461

 

4,808

 

4,125

 

 

9,394

 

Payments

 

(12,502

)

(6,174

)

 

 

(18,676

)

Non-cash charges

 

 

1,936

 

(4,125

)

 

(2,189

)

Balance as of December 31, 2008

 

$

 

$

16,694

 

$

 

$

 

$

16,694

 

Accruals

 

 

488

 

 

 

488

 

Payments

 

 

(1,359

)

 

 

(1,359

)

Non-cash charges

 

 

 

 

 

 

Balance as of March 31, 2009

 

$

 

$

15,823

 

$

 

$

 

$

15,823

 

 

Facility exit and restructuring liabilities due within one year of the balance sheet date are classified as other 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 December 31, 2008 and March 31, 2009, approximately $5.9 million and $6.6 million, respectively, was classified as other accrued liabilities and approximately $10.8 million and $9.2 million, respectively, was classified as other long-term liabilities.

 

Legacy Restructuring Plans

 

During the years ended December 31, 2003, 2004 and 2005, the Company executed a series of plans to restructure and streamline our contact center operations and outsource certain internal functions (collectively referred to as “Legacy Plans”). The Legacy Plans included facility exit costs, personnel-related costs and asset disposals. 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 Condensed Consolidated Statements of Operations. During the three months ended March 31, 2008, EarthLink recorded a $0.1 million reduction to facility exit and restructuring costs as a result of changes in estimates for legacy restructuring plans. As of March 31, 2009, the Company had a $1.3 million liability remaining for real estate commitments related to Legacy Plans, of which $0.8 million was classified as other accrued liabilities and $0.5 million was classified as other long-term liabilities in the Condensed Consolidated Balance Sheet. All other costs have been paid.

 

8



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

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. As a result of that decision, the Company classified the municipal wireless broadband assets as held for sale and presented the municipal wireless broadband results of operations as discontinued operations. The results of operations for municipal wireless broadband were previously included in the Consumer Services segment.  As of December 31, 2008, the Company had completed the divestiture of its municipal wireless broadband assets.

 

The following table presents summarized results of operations related to the Company’s discontinued operations for the three months ended March 31, 2008:

 

 

 

Three Months Ended

 

 

 

March 31, 2008

 

 

 

(in thousands)

 

 

 

 

 

Revenues

 

$

737

 

Operating costs and expenses

 

(2,180

)

Impairment and restructuring costs

 

(1,949

)

Loss from discontinued operations

 

(3,392

)

 

6.  Investments

 

Marketable Securities

 

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 marketable securities. Marketable securities with maturities less than one year from the balance sheet date are classified as short-term marketable securities. Marketable securities with maturities greater than one year from the balance sheet date are classified as long-term marketable securities. Long-term investments in marketable securities as of December 31, 2008 and March 31, 2009 also included 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.

 

As of March 31, 2009, $40.6 million of the Company’s short-term marketable securities and $3.5 million of the Company’s long-term marketable securities consisted of government agency notes and were classified as available-for-sale. Gross unrealized gains on these securities as of March 31, 2009 were $0.1 million and there were no gross unrealized losses. As of March 31, 2009, $50.3 million of the Company’s long-term marketable securities consisted of auction rate securities and were classified as trading. 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 U.S. Department of Education. Beginning in February 2008, auctions for these securities failed to attract sufficient buyers, resulting in the Company continuing to hold such securities. Accordingly, the Company began classifying these securities as long-term marketable securities in the Condensed Consolidated Balance Sheet due to uncertainty surrounding the timing of a market recovery.

 

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 (herein referred to as “put right”). 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. The Company records the auction rate securities at fair value, with changes in fair

 

9



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

value included in earnings, as the Company no longer intends to hold the securities until maturity. The Company also elected a one-time transfer of its auction rate securities from the available-for-sale category to the trading category. The Company also records the value of the put right at fair value, with changes in fair value included in earnings, as the Company elected the fair value option under SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” for the put right to offset the fair value changes of the auction rate securities. The fair value of the put right is estimated using a discounted cash flow analysis. During the three months ended March 31, 2009, the Company recorded a $2.4 million gain on investments to record the auction rate securities at their fair value and recorded a $2.4 million loss on investments to record the put right at its fair value. The net gain of $0.1 million during the three months ended March 31, 2009 is included in gain on investments, net, in the Condensed Consolidated Statement of Operations.

 

Investments

 

Long-term investments consisted of the following as of December 31, 2008 and March 31, 2009:

 

 

 

As of

 

As of

 

 

 

December 31,

 

March 31,

 

 

 

2008

 

2009

 

 

 

(in thousands)

 

Investments stated at fair value

 

$

11,408

 

$

10,173

 

Investments stated at cost

 

9,300

 

9,300

 

Total long-term investments

 

$

20,708

 

$

19,473

 

 

Long-term investments in the Condensed Consolidated Balance Sheets consist of investments in other companies and the Company’s put right. Investments in other companies 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. As of March 31, 2009, gross unrealized gains on available-for-sale investments were $1.1 million and there were no gross unrealized losses.  As of December 31, 2008, gross unrealized losses on available-for-sale investments were nominal and there were no gross unrealized gains.

 

The Company has a right to sell its existing auction rate securities back to the broker, which is classified as a long-term investment in the Condensed Consolidated Balance Sheets. The Company elected the fair value option under SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” for the put right and records the put right at fair value, with changes in fair value recognized in the Condensed Consolidated Statement of Operations. The fair value of the put right is estimated using a discounted cash flow analysis.

 

Management regularly evaluates the recoverability of its investments 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. Management also regularly 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 to recover the cost basis of the investment.

 

10



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

During the three months ended March 31, 2009, the Company recognized a gain on investments of $0.3 million. This consisted of $0.2 million in cash distributions from eCompanies Venture Group, L.P., a limited partnership that invested in domestic emerging Internet-related companies, and a net gain of $0.1 million related to the Company’s auction rate securities and put right.

 

7.  Purchased Intangible Assets and Goodwill

 

Goodwill

 

There were no changes in the carrying amount of goodwill during the three months ended March 31, 2009.

 

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, 2008 and March 31, 2009:

 

 

 

As of December 31, 2008

 

As of March 31, 2009

 

 

 

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

 

$

94,039

 

$

(77,758

)

$

16,281

 

$

94,039

 

$

(79,769

)

$

14,270

 

Software, technology and other

 

739

 

(649

)

90

 

739

 

(709

)

30

 

Trade names

 

1,521

 

(304

)

1,217

 

1,521

 

(380

)

1,141

 

 

 

96,299

 

(78,711

)

17,588

 

96,299

 

(80,858

)

15,441

 

Intangible assets not subject to amortization:

 

 

 

 

 

 

 

 

 

 

 

 

 

Trade names

 

1,964

 

 

1,964

 

1,964

 

 

1,964

 

 

 

$

98,263

 

$

(78,711

)

$

19,552

 

$

98,263

 

$

(80,858

)

$

17,405

 

 

Amortization of intangible assets in the Condensed Consolidated Statements of Operations for the three months ended March 31, 2008 and 2009 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, 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 March 31, 2009, the weighted average amortization periods were 4.2 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 $5.6 million during the remaining nine months in the year ending December 31, 2009 and $4.1 million, $2.9 million, $1.5 million, $0.8 million and $0.5 million during the years ending December 31, 2010, 2011, 2012, 2013 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.

 

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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 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, are 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 has 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.

 

On January 1, 2009, the Company adopted FSP APB 14-1, which 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 accreted over the period the convertible debt is expected to be outstanding as additional non-cash interest expense. The adoption of FSP APB 14-1 on January 1, 2009 affected the accounting for the Company’s Notes. Upon adoption, the Company recorded an adjustment to increase additional paid-in capital as of the November 2006 issuance date by approximately $62.1 million. The Company is accreting the resulting debt discount to interest expense over the estimated five-year life of the Notes, which represents the first redemption date of November 2011. The Company recorded a pre-tax adjustment of approximately $22.3 million to retained earnings that represents the debt discount accretion during the years ended December 31, 2006, 2007 and 2008 and will recognize additional non-cash interest expense of $12.2 million, $13.4 million and $12.4 million during the years ending December 31, 2009, 2010 and 2011, respectively, for accretion of the debt discount.

 

As of December 31, 2008, the principal amount of the Notes, the unamortized discount and the net carrying value was $258.8 million, $39.1 million and $219.7 million, respectively. As of March 31, 2009, the principal amount of the Notes, the unamortized discount and the net carrying value was $258.8 million, $36.0 million and $222.8 million, respectively. As of December 31, 2008 and March 31, 2009, the fair value of the Notes was approximately $236.6 million and $252.1 million, respectively, based on the quoted market prices.

 

12



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

9.  Stockholders’ Equity

 

Comprehensive Income

 

Comprehensive income 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 for the three months ended March 31, 2008 and 2009 was as follows:

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2008

 

2009

 

 

 

(in thousands)

 

 

 

Net income

 

$

51,707

 

$

32,497

 

Unrealized holding (losses) gains on certain investments

 

(257

)

1,231

 

Total comprehensive income

 

$

51,450

 

$

33,728

 

 

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 March 31, 2009, the Company had $146.8 million available under the current authorization. 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 1.3 million and 3.6 million shares, respectively, of its common stock for $9.1 million and $22.3 million, respectively, during the three months ended March 31, 2008 and 2009.

 

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. For performance-based awards, the Company recognizes expense over the requisite service period, net of estimated forfeitures, using the accelerated attribution method when it is probable that the performance measure will be achieved. 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 $5.2 million and $4.4 million during the three months ended March 31, 2008 and 2009, respectively.  In accordance with Staff Accounting Bulletin No. 107, “Share-Based Payment,” the Company has classified stock-based compensation expense during the three months ended March 31, 2008 and 2009 within the same operating expense line items as cash compensation paid to employees.

 

13



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

Stock Incentive Plans

 

The Company has granted options to employees and directors to purchase the Company’s common stock under various stock incentive plans. The Company has also granted restricted stock units to employees and directors 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 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.

 

Options Outstanding

 

The following table summarizes information concerning stock option activity as of and for the three months ended March 31, 2009:

 

 

 

 

 

 

 

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, 2008

 

7,159

 

$

9.58

 

 

 

 

 

Granted

 

 

 

 

 

 

 

Exercised

 

(63

)

5.80

 

 

 

 

 

Forfeited and expired

 

(366

)

13.36

 

 

 

 

 

Outstanding as of March 31, 2009

 

6,730

 

9.41

 

5.9

 

$

476

 

Vested and expected to vest as of March 31, 2009

 

6,395

 

$

9.51

 

5.8

 

$

476

 

Exercisable as of March 31, 2009

 

5,136

 

$

9.90

 

5.3

 

$

476

 

 

The aggregate intrinsic value amounts in the table above represent the closing price of the Company’s common stock on March 31, 2009 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 March 31, 2009. The total intrinsic value of options exercised during the three months ended March 31, 2008 and 2009 was $0.5 million and $0.1 million, respectively. The intrinsic value of stock options exercised represents the difference between 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.

 

14



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 March 31, 2009:

 

Stock Options Outstanding

 

Stock Options
Exercisable

 

 

 

 

 

 

 

 

 

Weighted

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Average

 

Weighted

 

 

 

Weighted

 

 

 

 

 

 

 

 

 

Remaining

 

Average

 

 

 

Average

 

Range of

 

Number

 

Contractual

 

Exercise

 

Number

 

Exercise

 

Exercise Prices

 

Outstanding

 

Life

 

Price

 

Exercisable

 

Price

 

 

 

 

 

 

 

(in thousands)

 

 

 

 

 

(in thousands)

 

 

 

$

5.10

 

to

 

$

6.86

 

760

 

5.1

 

$

6.04

 

603

 

$

5.83

 

6.90

 

to

 

7.25

 

771

 

7.8

 

6.97

 

368

 

6.96

 

7.31

 

to

 

7.31

 

1,500

 

8.2

 

7.31

 

1,050

 

7.31

 

7.32

 

to

 

8.96

 

606

 

6.5

 

8.15

 

404

 

8.27

 

9.01

 

to

 

9.24

 

574

 

5.6

 

9.05

 

540

 

9.03

 

9.48

 

to

 

9.89

 

738

 

5.0

 

9.56

 

480

 

9.60

 

10.06

 

to

 

10.06

 

411

 

1.4

 

10.06

 

411

 

10.06

 

10.36

 

to

 

48.61

 

1,370

 

4.3

 

15.37

 

1,280

 

15.71

 

$

5.10

 

to

 

$

48.61

 

6,730

 

5.9

 

$

9.41

 

5,136

 

$

9.90

 

 

Restricted Stock Units

 

The following table summarizes the Company’s restricted stock units as of and for the three months ended March 31, 2009:

 

 

 

 

 

Weighted

 

 

 

 

 

Average

 

 

 

Restricted

 

Grant Date

 

 

 

Stock Units

 

Fair Value

 

 

 

(in thousands)

 

 

 

Nonvested as of December 31, 2008

 

4,123

 

$

7.20

 

Granted

 

190

 

6.74

 

Vested

 

(962

)

7.04

 

Forfeited

 

(215

)

7.18

 

Nonvested as of March 31, 2009

 

3,136

 

7.22

 

 

The fair value of restricted stock units is determined based on the closing price of EarthLink’s common stock on the grant date. The weighted-average grant date fair value of restricted stock units granted during the three months ended March 31, 2008 and 2009 was $7.16 and $6.74, respectively. As of March 31, 2009, there was $12.2 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 1.9 years. The total fair value of shares vested during the three months ended March 31, 2008 and 2009 was $0.4 million and $7.0 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.

 

15



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

11. Income Taxes

 

EarthLink recorded an income tax provision of $9.3 million and $20.9 million during the three months ended March 31, 2008 and 2009, respectively. The income tax provision for the three months ended March 31, 2008 and 2009 was based on management’s current expectations 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 months ended March 31, 2008 and 2009 are as follows:

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2008

 

2009

 

 

 

(in thousands)

 

 

 

 

 

 

 

Federal alternative minumum tax

 

$

1,204

 

$

1,033

 

State income tax

 

786

 

1,354

 

Other

 

(520

)

 

Current provision

 

1,470

 

2,387

 

 

 

 

 

 

 

Deferred provision

 

7,804

 

18,557

 

 

 

 

 

 

 

Total

 

$

9,274

 

$

20,944

 

 

During the year ended December 31, 2008, the Company released $65.6 million of its valuation allowance related to its deferred tax assets. These deferred tax assets primarily related to net operating loss carryforwards which the Company determined, in accordance with SFAS No. 109, it would more likely than not be able to utilize due to the generation of sufficient taxable income in 2009. For the three months ended March 31, 2009, the non-cash deferred tax provision recorded was primarily a result of the utilization of these federal and state net operating loss tax assets.  The current tax federal and state liabilities are payable as a result of limitations on net operating loss utilization associated with the alternative minimum tax calculation and state laws.

 

EarthLink continues to maintain a partial valuation allowance against its unrealized deferred tax assets, which include net operating loss carryforwards.  EarthLink may recognize additional 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 a material adverse effect on the Company’s financial condition, results of operations or cash flows.  The Company’s policy for recording interest and

 

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EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

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.

 

13.  Fair Value Measurements

 

SFAS No. 157, “Fair Value Measurements,” 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 March 31, 2009, 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, marketable securities, auction rate securities, equity investments in other companies, and put right.

 

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 March 31, 2009:

 

 

 

 

 

Fair Value Measurements as of March 31, 2009 Using

 

 

 

 

 

Quoted Prices in

 

Significant Other

 

Significant

 

 

 

 

 

Active Markets for

 

Observable

 

Unobservable

 

 

 

Balance as of

 

Identical Assets

 

Inputs

 

Inputs

 

Description

 

March 31, 2009

 

(Level 1)

 

(Level 2)

 

(Level 3)

 

 

 

(in thousands)

 

Cash equivalents

 

$

448,331

 

$

448,331

 

$

 

$

 

Marketable securities

 

44,075

 

44,075

 

 

 

Auction rate securities

 

50,256

 

 

 

50,256

 

Equity investments in other companies

 

2,732

 

417

 

2,315

 

 

Put right

 

7,441

 

 

 

7,441

 

Total

 

$

552,835

 

$

492,823

 

$

2,315

 

$

57,697

 

 

Cash equivalents, marketable securities, auction rate securities, equity investments in other companies and the Company’s put right are measured at fair value.  Cash equivalents, marketable securities and equity investments in other companies that are valued using quoted market prices are classified within Level 1. The Company’s investment in Virgin Mobile partnership units is valued using quoted prices for similar assets and is classified within Level 2. 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’s put right is estimated using a discounted cash flow analysis and is classified within Level 3. 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 March 31, 2009 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.

 

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

 

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EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

plus accrued interest, beginning on June 30, 2010 until July 2, 2012. The Company recorded the value of the put right to long-term investments in its Condensed Consolidated Balance Sheet and elected the fair value option under SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” for the put right to offset the fair value changes of the auction rate securities. The fair value of the put right is estimated using a discounted cash flow analysis and is classified within Level 3.

 

The following table presents a reconciliation of the beginning and ending balances of 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 March 31, 2009:

 

 

 

Auction

 

 

 

 

 

 

 

Rate

 

Put

 

 

 

 

 

Securities

 

Right

 

Total

 

 

 

(in thousands)

 

Balance as of December 31, 2008

 

$

47,809

 

$

9,828

 

$

57,637

 

Total realized gains

 

2,447

 

 

2,447

 

Total realized losses

 

 

(2,387

)

(2,387

)

Balance as of March 31, 2009

 

$

50,256

 

$

7,441

 

$

57,697

 

 

During the three months ended March 31, 2009, the Company recorded a realized gain of $2.4 million to record its auction rate securities at their fair value and recorded a realized loss of $2.4 million to record its put right at its fair value, which are included in gain on investments, net, in the Condensed Consolidated Statement of Operations.  The entire amount of realized gains and losses relate to assets still held as of March 31, 2009.

 

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. 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 integrated communications services and related value-added services to businesses and communications carriers. These services include managed private IP-based wide area 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, impairment of goodwill and 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.

 

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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 months ended March 31, 2008 and 2009 is as follows:

 

 

 

Three Months Ended March 31,

 

 

 

2008

 

2009

 

 

 

(in thousands)

 

Consumer Services

 

 

 

 

 

Revenues

 

$

216,344

 

$

159,562

 

Cost of revenues

 

71,173

 

52,334

 

Gross margin

 

145,171

 

107,228

 

Direct segment operating expenses

 

61,001

 

37,206

 

Segment operating income

 

$

84,170

 

$

70,022

 

 

 

 

 

 

 

Business Services

 

 

 

 

 

Revenues

 

$

46,730

 

$

39,501

 

Cost of revenues

 

26,378

 

23,231

 

Gross margin

 

20,352

 

16,270

 

Direct segment operating expenses

 

14,871

 

11,259

 

Segment operating income

 

$

5,481

 

$

5,011

 

 

 

 

 

 

 

Consolidated

 

 

 

 

 

Revenues

 

$

263,074

 

$

199,063

 

Cost of revenues

 

97,551

 

75,565

 

Gross margin

 

165,523

 

123,498

 

Direct segment operating expenses

 

75,872

 

48,465

 

Segment operating income

 

89,651

 

75,033

 

Stock-based compensation expense

 

5,152

 

4,390

 

Amortization of intangible assets

 

4,013

 

2,147

 

Facility exit and restructuring costs

 

1,030

 

488

 

Other operating expenses

 

14,042

 

10,535

 

Income from operations

 

$

65,414

 

$

57,473

 

 

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 and cable technologies, VoIP and managed private IP-based networks); 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 fees charged for high-speed access services; fees charged for VoIP services; usage fees; installation fees; termination fees; and fees for equipment. Consumer value-added services revenues consist of 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, email storage and home networking; search revenues; and advertising revenues.

 

Business access and service revenues consist of fees charged for managing private IP-based networks; fees charged for business Internet access and dedicated circuit services; installation fees; termination fees; fees for equipment; regulatory surcharges billed to customers; and fees charged for leasing server space and providing web services to customers wishing to have a web or e-commerce presence.

 

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EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

Information on revenues by groups of similar services and by segment for the three months ended March 31, 2008 and 2009 is as follows:

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2008

 

2009

 

 

 

(in thousands)

 

Consumer Services

 

 

 

 

 

Access and service

 

$

188,971

 

$

139,790

 

Value-added services

 

27,373

 

19,772

 

Total revenues

 

$

216,344

 

$

159,562

 

 

 

 

 

 

 

Business Services

 

 

 

 

 

Access and service

 

$

45,878

 

$

38,908

 

Value-added services

 

852

 

593

 

Total revenues

 

$

46,730

 

$

39,501

 

 

 

 

 

 

 

Consolidated

 

 

 

 

 

Access and service

 

$

234,849

 

$

178,698

 

Value-added services

 

28,225

 

20,365

 

Total revenues

 

$

263,074

 

$

199,063

 

 

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.

 

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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 from estimates or projections contained in the forward-looking statements are described under “Safe Harbor Statement” in this Item 2.

 

The following discussion should be read in conjunction with the accompanying unaudited Condensed Consolidated Financial Statements and related Notes thereto and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the audited Consolidated Financial Statements and the Notes thereto contained in the Annual Report on Form 10-K for the year ended December 31, 2008.

 

Overview

 

EarthLink, Inc. is an Internet service provider (“ISP”), providing nationwide Internet access and related value-added services to individual and business customers. Our primary service offerings are dial-up and high-speed Internet access services and related value-added services, such as ancillary services sold as add-on features to our Internet access services, search and advertising. In addition, through our wholly-owned subsidiary, New Edge Networks (“New Edge”), we build and manage private IP-based wide area networks for businesses and communications carriers.

 

We operate two reportable segments, Consumer Services and Business Services. Our 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-over-Internet Protocol (“VoIP”) services, among others. Our Business Services segment provides integrated communications services, dedicated Internet access and related value-added services to businesses and communications carriers. These services include managed private IP-based wide area networks, dedicated Internet access and web hosting, among others.

 

Business Strategy

 

Our business strategy is to focus on customer retention, operational efficiency and opportunities for growth.

 

·                   Customer Retention . We are focused on retaining our existing tenured customers. We believe focusing on the customer relationship increases loyalty and reduces churn.  We also believe that these tenured customers provide cost benefits, including reduced call center support costs and reduced bad debt expense. We continue to focus on offering our access services with high-quality customer service and technical support.

 

·                   Operational Efficiency . We are focused on improving the cost structure of our business and aligning our cost structure with trends in our revenue, without impacting the quality of services we provide. We are focused on delivering our services more cost effectively by reducing and more efficiently handling the number of calls to contact centers, managing cost-effective outsourcing opportunities, managing our network costs and streamlining our internal processes and operations.

 

·                   Opportunities for Growth .  In response to changes in our business, we have significantly reduced our sales and marketing spending. However, we continue to seek to add customers that generate an acceptable rate of return and increase the number of subscribers we add through alliances, partnerships

 

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and acquisitions from other ISPs.  We also continue to evaluate potential strategic transactions that could complement our business.

 

In response to declining revenues, changes in our industry and changes in consumer behavior, we implemented a restructuring plan (“the 2007 Plan”) to reduce operating costs and improve the efficiency of our organization. Under the 2007 Plan, we significantly reduced employees, closed or consolidated certain facilities, discontinued certain projects and reduced sales and marketing efforts. The 2007 Plan was implemented during 2007 and completed during 2008. The strategies noted above represent the future plans for our business. The primary challenges we face in executing our business strategy are managing the rate of decline in our revenues, responding to competition, reducing churn, implementing cost reduction initiatives, purchasing cost-effective wholesale broadband access and adding customers that generate an acceptable rate of return. The factors we believe are instrumental to the achievement of our business strategy may be subject to competitive, regulatory and other events and circumstances that are beyond our control. Further, we can provide no assurance that we will be successful in achieving any or all of the strategies identified above, that the achievement or existence of such strategies will favorably impact profitability, or that other factors will not arise that would adversely affect future profitability.

 

Revenue Sources

 

The primary component of our 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 and cable; VoIP; and managed private IP-based networks); and web hosting services. We also earn revenues from value-added services, which include revenues from ancillary services sold as add-on features to our Internet access services, such as security products, email by phone, Internet call waiting, email storage and home networking; search revenues; and advertising revenues.

 

Narrowband access revenues consist of monthly fees charged to customers for dial-up Internet access. Broadband access revenues consist of fees charged for high-speed access services; fees charged for managing private IP-based networks; fees charged for VoIP services; usage fees; activation fees; termination fees; fees for equipment; and regulatory surcharges billed to customers. Web hosting revenues consist of fees charged for leasing server space and providing web services to customers wishing to have a web or e-commerce presence. Value-added services revenues consist of monthly fees charged for ancillary services; fees charged for paid placements for searches; delivering traffic to EarthLink’s partners in the form of subscribers, page views or e-commerce transactions; advertising EarthLink partners’ products and services in EarthLink’s various online properties and electronic publications; and referring EarthLink customers to partners’ products and services.

 

Trends in our Business

 

Consumer services . We operate in the Internet access market, which is characterized by intense competition, changing technology, changes in customer needs and new service and product introductions. Consumers continue to migrate from dial-up to broadband access service due to the faster connection and download speeds provided by broadband access, the ability to free up their phone lines and the more reliable and “always on” connection. The pricing for broadband services has been declining, making it a more viable option for consumers that continue to rely on dial-up connections for Internet access. In addition, advanced applications such as online gaming, music downloads, videos and social networking require greater bandwidth for optimal performance, which adds to the demand for broadband access. Our narrowband subscriber base and revenues have been declining and are expected to continue to decline due to the continued maturation of the market for narrowband access.

 

In light of this continued maturation of the market for narrowband access, we refocused our business strategy to significantly reduce our sales and marketing efforts and focus instead on retaining tenured customers and adding customers that have similar characteristics of our tenured customer base and are more likely to produce an acceptable rate of return. This change has resulted in a decrease in gross subscriber additions, which we expect will continue. However, we expect the rate of revenue decline to decrease as our subscriber base becomes more tenured. We experienced an improvement in consumer subscriber churn rates during the three

 

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months ended March 31, 2009 compared to the prior year period. However, our consumer access services are discretionary and dependent upon levels of consumer spending. Unfavorable economic conditions could cause customers to slow spending in the future, which could adversely affect our revenues and churn, and we may not be able to align our cost structure with a decline in our revenue.

 

Consistent with trends in the Internet access industry, the mix of our consumer access subscriber base has been shifting from narrowband access to broadband access customers. Consumer broadband access revenues have lower gross margins than narrowband revenues due to the costs associated with delivering broadband services. This change in mix has negatively affected our profitability and we expect this trend to continue as broadband subscribers continue to become a greater proportion of our consumer access subscriber base. However, our consumer broadband access customers also have lower churn rates than our consumer narrowband access customers. Accordingly, we expect to realize benefits from a more tenured subscriber base, such as reduced support costs and lower bad debt expense.

 

Business services. The markets in which we operate our business services are characterized by industry consolidation, the emergence of new technologies and intense competition. We sell our services to end user business customers and to wholesale customers. Our end users range from large enterprises with many locations, to small and medium-sized multi-site businesses to business customers with one site, often a home-based location. Many of our end user customers are retail businesses. Our wholesale customers consist primarily of telecommunications carriers. Our business has become more focused on end users as a result of mergers in the telecommunications industry. In addition, our small and medium-sized business customers, including retail businesses, are particularly exposed to an economic downturn. We may experience pressure on revenue and churn rates for our business services, especially given the state of the economy. However, we will seek to align our cost structure with trends in our revenue.

 

We recognized an impairment charge of $78.7 million during the fourth quarter of 2008 related to our Business Services segment in conjunction with our annual test of goodwill and intangible assets. The primary factor contributing to the impairment charge was the recent significant economic downturn, which resulted in management updating its long-range financial outlook. As the ongoing expected cash flows and carrying amounts of our remaining goodwill and other intangible assets are assessed, changes in economic conditions, changes to our business strategy, changes in operating performance or other indicators of impairment, could cause us to realize an additional impairment charge.

 

First Quarter 2009 Highlights

 

Total revenues decreased $64.0 million, or 24%, from the three months ended March 31, 2008 to the three months ended March 31, 2009, as our subscriber base decreased from approximately 3.6 million paying subscribers as of March 31, 2008 to approximately 2.6 million paying subscribers as of March 31, 2009. The decrease in subscribers was attributable to the change in our business strategy to reduce sales and marketing activities, as well as the continuing maturation of the narrowband Internet access market. Operating expenses decreased during the three months ended March 31, 2009 compared to the prior year period primarily due to a reduction in costs to acquire new subscribers and a decrease in support costs due to fewer customers and a more tenured subscriber base. We recognized net income of $51.7 million during the three months ended March 31, 2008 compared to net income of $32.5 million during the three months ended March 31, 2009. The decrease in net income was due to the decrease in revenues and an increase in our income tax provision, offset by the decrease in total operating costs and expenses.

 

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Table of Contents

 

Key Operating Metrics

 

We utilize certain non-financial and operating measures to assess our financial performance. Terms such as churn and average revenue per user (“ARPU”) are terms commonly used in our industry. The following table sets forth subscriber and operating data for the periods indicated:

 

 

 

March 31,

 

December 31,

 

March 31,

 

 

 

2008

 

2008

 

2009

 

Subscriber Data (a)

 

 

 

 

 

 

 

Consumer Services

 

 

 

 

 

 

 

Narrowband access subscribers

 

2,368,000

 

1,747,000

 

1,587,000

 

Broadband access subscribers (b)

 

1,026,000

 

896,000

 

856,000

 

Total consumer services

 

3,394,000

 

2,643,000

 

2,443,000

 

Business Services

 

 

 

 

 

 

 

Narrowband access subscribers

 

25,000

 

17,000

 

14,000

 

Broadband access subscribers

 

65,000

 

59,000

 

57,000

 

Web hosting accounts

 

97,000

 

87,000

 

84,000

 

Total business services

 

187,000

 

163,000

 

155,000

 

Total subscriber count at end of period

 

3,581,000

 

2,806,000

 

2,598,000

 

 

 

 

 

 

 

 

 

Three Months Ended

 

 

 

 

 

March 31,

 

 

 

 

 

2008

 

2009

 

 

 

Subscriber Activity

 

 

 

 

 

 

 

Subscribers at beginning of period

 

3,876,000

 

2,806,000

 

 

 

Gross organic subscriber additions

 

253,000

 

116,000

 

 

 

Adjustment (c)

 

 

(7,000

)

 

 

Churn

 

(548,000

)

(317,000

)

 

 

Subscribers at end of period

 

3,581,000

 

2,598,000

 

 

 

 

 

 

 

 

 

 

 

Churn rate (d)

 

4.9

%

3.9

%

 

 

 

 

 

 

 

 

 

 

Consumer Services Data

 

 

 

 

 

 

 

Average subscribers (e)

 

3,538,000

 

2,539,000

 

 

 

ARPU (f)

 

$

20.38