EarthLink's New Day

The Internet provider is at a crossroads as it juggles its old and new businesses.
Author:
Publish date:

Investors who like the thrill of betting on a dark horse might take a look at

EarthLink

(ELNK)

. It's been dark indeed for the Internet service provider's stock lately, but it could just end up posting big winnings.

In fact, EarthLink shares have largely done just that since bottoming out in the summer of 2002, thanks mainly to management's ability to push margins higher. Revenue has dipped 8% over the past two years to $1.29 billion, but operating costs have fallen 23%, moving the company from an operating loss of $67 million in 2003 to an operating profit of $164 million last year. That's a 12.7% margin -- a healthy one for ISPs.

That fiscal performance has bought the company a lot of good faith among investors as EarthLink has pushed into new, potentially lucrative areas -- voice over Internet protocol phone services, for one.

More notably, EarthLink has emerged as the biggest winner of contracts to transform U.S. cities into wireless zones. EarthLink not only won the first plum wireless contract, in Philadelphia, but it's also snagged projects in the California cities of Milpitas and Anaheim and is among the two finalists for bids in Milwaukee and Portland, Ore.

Last week, EarthLink's joint bid with

Google

(GOOG) - Get Report

to provide wireless coverage in San Francisco won the city's high-profile nod. On Friday, Dow Jones Newswires reported that EarthLink and Google were taking their wireless act on the road, partnering up for a second joint bid.

And as even larger cities like Los Angeles, Chicago and Atlanta prepare to send out requests for proposals, EarthLink has earned a reputation as the company best positioned to be the wireless service provider for millions of urban residents and businesses.

As that image was gradually built, EarthLink's stock began its climb. A year ago, it was trading as low as $8.32, but continuing efforts to cut costs and lay the groundwork for new sources of revenue pushed it up to $12.21 by mid-January.

But since then, evidence has suggested its core business continues to slow while investments for the new lines of business keep growing. As a result, EarthLink closed trading last Friday at $9.36, a 23% slide in less than three months.

The company's trail of bad news was disappointing: EarthLink said net income for all of 2005 rose 29%, but for the fourth quarter it fell 18%, to $29.2 million. Revenue in the quarter fell 7.5% as dial-up subscribers canceled their service for broadband accounts, and often switched providers in the process. CFO Kevin Dotts said EarthLink's margins would "continue to go sideways" -- that is, they weren't as likely to rise anymore.

A week later, at a February investor meeting, EarthLink forecast 2006 revenue to be roughly flat at $1.3 billion. And as a result of technology and marketing investments in the wireless projects and other initiatives, EarthLink said it "expects net income to be between breakeven and a net loss of $45 million." That's an awfully wide range, but there isn't a single number inside it that would make investors happy.

And that puts EarthLink investors at a crossroads. Their faith in the company's management will be tested as it hasn't been since the stock bottomed out four years ago. If investors believe that the company will make good on its new initiatives, now is the time to buy. The bad news is out there: Everybody knows that dial-up is an ailing business model. The question now is, will the new lines of business pay off?

With the wireless contracts, it's too early to tell. Building the Philadelphia network will cost at least $20 million to cover 135 square miles, and the work in San Francisco is estimated to cost $15 million. EarthLink will need to rent space on 4,000 Philadelphia lightposts at $74 a lamp, or a total of $296,000 a year.

In return, it will charge low-income residents $9.95 a month and wholesale wireless access to other ISPs at $12 a month; they would in turn charge customers $20 a month. So, 50,000 wholesale accounts at $12 a month would bring in $600,000 a year. Taking out rent and the 5% revenue it shares with Philadelphia, as well as the amortized costs of building the network, EarthLink could pull in a decent profit. Much also will depend on whether big ISPs like

Verizon

(VZ) - Get Report

try to undercut EarthLink on monthly DSL fees.

EarthLink is also investing heavily in Helio, a $440 million joint venture with

SK Telecom

(SKM) - Get Report

of Korea to provide a mobile-phone service targeted to young consumers. Scheduled to launch in the current quarter, Helio is a mobile virtual-network operator, or MVNO, which leases spectrum access from another company in hope of creating a brand with greater value than, say, Verizon Wireless or T-Mobile.

A lot is riding on Helio. Not only will it need to woo hip, young mobile customers from their current cell plans, it will be competing with other MVNOs bearing powerful brands such as

Disney

(DIS) - Get Report

and ESPN.

At the moment, Wall Street seems split on whether EarthLink can pull all of this off. CIBC downgraded EarthLink on Feb. 28 to sector underperformer, citing "concerns surrounding short-term dilution from new growth initiatives." Analyst Timothy Horan wrote, "EarthLink is expanding into three to four different businesses at the same time that its core business is under pressure." (CIBC says it expects investment-banking compensation from EarthLink.)

More recently, Jefferies & Co. analyst Youssef Squali boosted his rating on EarthLink to buy from hold, after dropping it in the wake of the company's 2006 forecasts. "Success in one or more of the company's four new initiatives could reignite growth and cause valuation multiples to expand from their current rock-bottom level over the next 12-18 months."

Squali, whose firm has no underwriting relationship with EarthLink, said, "While we may be early in predicting success for EarthLink's new initiatives, we believe that the stock's recent pullback has discounted much of the risk associated with the new strategy, but fails to recognize the prospects of one or more of these initiatives."

Given the level of disagreement and uncertainty about the company's future, the time for investors to place their bets on this dark horse is now.