Summary
Earthlink (ELNK; the “Company”) is in the process of a corporate turnaround in which it has slowed the decline of its traditional consumer-oriented Internet access business, cut corporate costs, and diversified into IT business services. It trades at a depressed valuation (i.e. 3.5x-4.0x TEV/EBITDA; 5x-7x TEV/(EBITDA-CAPEX); excluding deferred tax assets) reflecting declining headline revenues, but we expect revenue and EBITDA to grow again on an organic basis by the end of the year based on improvements in both the core business and business services. We believe that this change is the primary catalyst for a revaluation of the Company. FCF yield in the high teens offers a healthy margin of safety against permanent capital loss or failure of the market to re-rate its valuation.
Background
Earthlink has its roots in consumer-oriented Internet access (both narrowband and broadband). This service is offered as a repackaged service whereby it provides access under its own brand but using the infrastructure of local third-party cable and telco operators. This business has eroded over time as more competitive and robust offerings have come to market, but it has been very cash generative in the meantime (i.e. c $1bn of cumulative CFO in the last 6 years). It used the cash to repurchase shares (c $400m), pay dividends (c $100m), and build its balance sheet (i.e. c $500m of cash as of MRQ). The remaining cash was used to fund its expansion into business services in which it packages various telco products to business customers (i.e. voice and data services, hosted VoIP, enterprise class data center, IT security, etc).
The Company made a series of acquisitions to develop this offering, most significantly ITC^Deltacom in December 2010 ($524m TEV; 4.7x EBITDA (mgmt presentation April 2011)) and One Communications in April 2011 ($370m TEV; 3.7x EBITDA(ibid)). Each business had extensive fiber networks, but in different geographic regions of the country. The Company's strategy was to combine these networks and offer dedicated and secure connectivity for mid-sized business customers operating multiple locations. Its key point of differentiation is its nationwide fiber footprint that make it cheaper and more reliable than competitors that focus in discrete local markets (ELNK has the 4th largest fiber footprint in the US behind Level 3, Cogent, and Windstream). Its brand is also well recognized and well-perceived by IT decision makers in mid-sized companies relative to competitors.
While the two acquisitions were made at low valuations, each company had declining revenues at transaction. The thesis was that the companies were under-managed and that integration of these companies into a nationwide platform with more resources would make them more competitive. Thus far this has proved correct. The Deltacom business was shrinking at 6% per year when acquired and is now flat and expected to grow topline. The One Communications business was shrinking at 16% when acquired in April of last year and that decline is projected to be cut roughly in half by 1Q12. Management expected $40m of run-rate synergies between these two acquisitions and thus far has delivered faster than originally projected.
The profile of the Company overall has changed dramatically following these acquisitions. The two acquisitions have materially increased EBITDA and cash generation at Earthlink as well as shifted its dependency away from the declining consumer ISP business. The business segment is expected to increase from c 10% of EBITDA in 2010 to c 50% in 2011. Yet the improved profile and trend toward growth does not appear to be reflected in the Company valuation.
Valuation
Relative. The Company is currently valued at c 3.5x-4x TEV/EBITDA versus a comparable universe of c 7x-8x. On an EBITDA less Capex basis it trades at c 5-7x versus a comparable universe of c 14x-16x.
Historical. Over the last few years it has traded in the 2-3x TEV/EBITDA range. We believe that the historic low valuation was reflective of the fact that its core consumer ISP business was in rapid decline; however, the c 1x turn re-rating of the Company valuation does not seem commensurate with the turnaround results that have been delivered by management or the transformative nature of the recent acquisitions.
SOTP. On a sum-of the parts basis we estimate fair value in the $11-13 per share context. We use a 4x EBITDA multiple on the legacy consumer business and a 5-6x EBITDA multiple on the business services segment (i.e. 12x-14x EBITDA less CAPEX). We give zero credit here to the deferred tax assets but note that the Company pays limited cash tax and has over $500m of NOLs. Including the deferred tax assets would imply perhaps an additional $1 or $2 per share in fair value.
Replacement Cost. Earthlink's fiber footprint is the 4th largest in the country. The two companies it acquired spent c $3.2bn to install this infrastructure and Earthlink spent c $900m to acquire those businesses. In the context of the current c $1.3bn enterprise value for Earthlink we believe that the value of the underlying assets offers substantial downside protection to any investment.
Risk Reward
In our base case we believe that Earthlink is worth c $11-13/share represent c 50% upside from current trading (see SOTP in valuation above). In a downside case, we believe the Company could be worth c $6.50/share or c 20% below current trading. In this scenario, we would value the business segment at a 30% discount to the consideration paid for the last two acquisitions (i.e. $630m), the legacy access business at 3x cash flow (i.e. $450m), give no credit to the deferred tax assets, and would assume the Company destroys all cash it generates in the meantime.
Key Risks
(1) Execution. Integrating the acquired businesses of ITC and One Communications is inherently difficult and is further complicated by the fact that the standalone revenues of both of the acquired companies are in decline. Management will seek to arrest these trends in addition to the revenue declines of its own legacy businesses, as well as to continue to cut costs and develop a coherent and unified product offering to customers.
Mitigant. Underwriting cases assume none or only modest and incremental improvements over the next several years.
Mitigant. Current management has shown track-record executing turnaround plan of Earthlink since 2007.
(2) No Re-Rating of the Stock. The management delivers on its strategy; however, the market does not give credit to the improved financial profile of company in its valuation.
Mitigant. The Company is cheaply valued in absolute terms. The downside is limited even without multiple expansion given FCF yield in the high teens. The value of the underlying network infrastructure offers additional asset protection in a downside case.
(3) Significant Industry Headwinds. The Company operates in highly competitive markets. In its consumer segment, the Company faces significant competition from Incumbent Local Exchange Carriers (ILECs), cable companies, and others. In its business segment, the Company also faces significant competition as well as challenging economic conditions, which have place particular pressure on corporate spending on IT services and consequently on prices and customer acquisition costs. There has also been consolidation in the industry, which has created larger, more formidable, companies with whom Earthlink must compete.
Mitigant. Earthlink has a strong and recognized brand among corporate IT decision makers.
Mitigant. Have incorporated the challenging market conditions into underwriting cases.
Mitigant. Notwithstanding industry difficulties, the Company is cheaply valued in absolute and relative terms.