A lot of the VIC community probably has at least a passing familiarity with Earthlink (ELNK).  I have been following ELNK off and on since current CEO Rolla Huff joined the company, and each time I looked at investing (including the previous VIC write-ups) my conclusion was that while ELNK holders would probably enjoy a mid-teens IRR as the ISP business was run off, the prospective returns were not quite high enough to justify an investment. However, over the past in six months there have been significant developments that combined with the recent declines in the share price have created what is in my opinion is a compelling investment opportunity with the chance to earn 100%+ appreciation in the next three years with little chance of

a significant loss.

 

ELNK was a classic dot com story, achieving a multi billion dollar market capitalization in 1999 followed by the crash in 2000-2001 and an essentially a flat stock price since then. Throughout the 2000s ELNK's management team attempted to diversify away from the declining core ISP business through initiatives such as establishing mobile service provider Helios and constructing municipal Wi-Fi networks. None of these new business lines were particularly successful, and in retrospect simply amounted to wasting the free cash flow generated by the ISP. EarthLink's CEO Garry Betty tragically died in early 2007, leading the board to search for a new candidate and reconsider the direction of the company.

 

The board eventually settled on Rolla Huff, a veteran telecom executive who was brought on in June 2007. He was previously Chairman and CEO of Mpower Holding Corporation, a business telecommunications company that was sold to U.S. TelePacific Holdings Corp. after emerging from bankruptcy in 2002. He also served in operating, M&A and financial roles at Frontier Corporation and AT&T. Since joining EarthLink, Mr. Huff has done the right thing for investors. He cancelled or sold EarthLink's money losing projects and rebuilt the company into a free cash flow generating machine by rationalizing the cost structure and refocusing the company on intelligently managing its declining ISP business. In 2006, the last full year before Mr. Huff' arrival, EarthLink generated $115M of operating cash flow but spent $187M on capital expenditures, subscriber base purchases, investments, joint ventures and other initiatives. By 2008, operating cash flow had doubled to $231M despite a reduction in revenue while capital and other spending declined to a mere $7M. Through the third quarter of 2010, ELNK's free cash flow built up, the rate of revenue decline attenuated and the company's core ISP customer base became increasingly concentrated in long-tenured broadband subscribers.

 

In the fourth quarter of 2010, EarthLink announced the acquisitions of two competitive local exchange carriers ("CLECs" in telecom parlance), ITC^Deltacom ("Deltacom") and One Communications ("OneComm"). Both were struggling to some extent, and OneComm in particular was overly levered. Including expected merger-related cost reductions, ELNK bought Deltacom at 4.7x EBITDA and OneComm at 3.7x, near the very low end of historical telecom industry acquisition multiples. In both cases it later surfaced that EarthLink was not the highest bidder at either auction, rather that its bids were selected because the company's cash offered a high certainty of closing. The total combined purchase price of around $900M compared to the total network build-out and customer acquisition spend for Deltacom and OneComm of over $4B. Earthlink is also now the owner of about 7,000 metro fiber route miles, putting it in the top 10 independent owners of these increasingly valuable assets. As the rumored transaction for ABVT and other recent buyouts of metro fiber-based telcos show, private equity is currently willing to pay in excess of 8x EBITDA for metro fiber assets.

 

So what do we have now with ELNK? Pro forma for the two acquisitions, the company is basically an under-levered CLEC with a wildly profitable but declining ISP business (about 1/3 of pro forma revenue) attached. I estimate this company will be doing about $325M in annualized EBITDA as of the third quarter of this year and the company guided to $175M to $200M in free cash flow. All of this on a $1.2B enterprise value and net debt of around 1.2x EBITDA. The legacy CLEC business of providing voice and T-1 data lines to small businesses is shrinking. EarthLink management plans on applying the same discipline it used upon arriving at EarthLink to optimize profitability in the declining CLEC revenue streams and is confident the acquisitions can more than pay for themselves with free cash flow. More importantly, EarthLink management thinks it has a plan to grow the companies in combination with some assets it already owns. More on this below, and you can also reference their recent Cowen presentation at http://bit.ly/kTOu5G  to get a sense for what the combined company looks like and ELNK's strategy.

 

I believe ELNK offers the prospect of attractive returns with potential appreciation of 100% (with the simple accretion of cash flow and revaluation as a CLEC) to 200% (if some of its new business initiatives pan out and the company buys back stock aggressively) over the next three years and little risk of significant loss. EarthLink should generate returns for investors in four ways:

 

First and most simply, investors will benefit from the substantial free cash flow of the core ISP business. Although it has been declining, I estimate that the core ISP business will generate about $170M in free cash flow in 2011, an attenuated decline of about 13% from 2010. Pro forma for the transactions, ELNK's enterprise value is approximately $1.2B, resulting in a FCF yield of 14% from the ISP business alone. Keep in mind that Earthlink's enterprise value is now primarily composed of the $900M paid for ITC Deltacom and OneComm. While these cash flows are diminishing, they are doing so at a slower rate, while the enterprise value is shrinking as the cash builds up on the balance sheet.

 

Second, ELNK is now a radically transformed company and its valuation should benefit as Wall Street research coverage and investor perception changes from looking at ELNK as a dying ISP to a telecom company with a stable future. By the third quarter of this year, 2/3 of ELNK's revenue will be from its CLEC acquisitions and other telecom services. Simply applying 5x EBITDA (the low end of the current telecom services valuation range) to ELNK's 2012 EBITDA and accounting for the cash generated over the next six quarters gets you to over $13.00 per share. I believe that ELNK may get multiple positive research initiations by telecom analysts now that the CLEC acquisitions have closed. Currently, ELNK is generally covered by Internet analysts who care far more about Amazon and Google and only cover ELNK because it used to be considered an Internet company.

 

Third, while my investment case does not depend on this, there is a clear opportunity to engage in financial engineering. Across the telecom space, companies are generally levered at least two times EBITDA and in some cases as much as eight times EBITDA. Although some telecom businesses have gotten into trouble over-levering, given the recurring revenue and fixed asset profile some leverage makes sense. I estimate that ELNK is trading at an enterprise value of less than 4x 2012 (the first full year the telecom acquisitions will be consolidated) EBITDA with around 1x net leverage. Considering that many telecom companies have more than 4x EBITDA in debt alone, it is not hard to imagine how ELNK could enhance returns for shareholders by adding moderate leverage. At one end of the scale ELNK could simply use its free cash flow to buy back shares over time, and at the other extreme the company could potentially issue $500-$1B in debt to buy back shares or issue a one-time special dividend. The company could also use its cash and debt assumption capacity to buy other network assets and expand its telecom business. On this front, the company recently priced $300M of 8-7/8% senior notes that will enable it to retire its $260M convertible debt (more on this below) and some higher-priced debt inherited from its acquisitions while leaving roughly $240M on the balance sheet for share repurchases or acquisitions. I was initially surprised that the debt carried such a high rate given the credit profile of ELNK but from my conversations with the company I think they accepted a higher interest rate in returns for very loose covenants that enable them to pay a healthy dividend, buy back a substantial amount of stock or lever up further with senior secured notes.

 

Fourth, my conversations with the company indicate their purchases of ITC Deltacom and OneComm were not simple trades of cash for assets. EarthLink already owns New Edge Networks, a provider of multi-location communications services to enterprises. New Edge is currently not a great business for EarthLink due to its low gross margins as it depends on leasing other carriers' networks for fulfillment. However, with the addition of the owned Deltacom and OneComm networks, New Edge will be able to fulfill many of its customers internally, opening up new sales opportunities and improving gross margins while increasing capacity utilization at Deltacomm and OneComm. Both companies previously had to concentrate on serving small single location customers. EarthLink is working on several new cloud-based network services to offer multi-location customers. While my investment case is also not dependent on success with these initiatives, if effective they will revitalize growth and potentially result in an even higher valuation multiple.

 

Obviously, integrating two telecom companies carries some risks. About the only way I can see investors experiencing substantial losses with EarthLink is if the integration goes poorly enough to affect the ongoing operations and value of the CLEC businesses. While I can never totally discount the risks, Mr. Huff's background in telecom M&A gives me some comfort that the proper procedures are being followed. Conversations with the company reveal that they have retained and re-hired key IT architects from both acquired companies and have a conservative timeline for integrating key functions such as customer billing and provisioning.

 

Overall, I like investing in businesses that should make me money as long as they don't screw up horribly. In the current speculative environment, investing with a margin of safety is more important than ever, and I think ELNK has an exceptionally attractive risk/reward profile. ELNK can redeem its $260M in convertible bonds for cash November 15th of this year. The conversion price is around $8.00, so the company would probably prefer its stock to stay around this level until then although I suspect they are already buying back shares. After that, I think a significant value-enhancing step such as a large buyback, special dividend or leveraged recap could take place within a year.

 

Disclosure: Long ELNK

• Sell-side initiations by telecom analysts
• Significant financing event (special dividend, large buyback, levered recap) after the convert repurchase in November
• Accretion of free cash flow