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EarthLink: Despite Poor Stock Performance, Analysts Bullish

Financial analysts who cover EarthLink Inc. seem to agree that the telecommunications provider is worth investing in.

Five financial services firms rate the stock either a “strong buy” or a “buy,” according to Zacks Investment Research data. The downside for investors is that EarthLink’s stock price has been steadily declining over the last year and is trading near a 52-week low that was reached on Nov. 25 ($5.97). EarthLink’s stock performance is only better than 20 percent of the companies covered by TheStreet, a financial media company.

Scott Kessler, an equities analyst with S&P Capital IQ, thinks the company is undervalued and has rated the stock a “strong buy.”

“We view the company as well positioned and notably undervalued based on a variety of more traditional and less traditional metrics,” Kessler said in a statement Nov. 28. “While we see a number of investment risks, we think EarthLink is a compelling value and note its recent indicated dividend yield of 3.4 percent.”

An Old Image

Atlanta-based EarthLink may be best known as a dial-up Internet service provider for Americans. That’s the old EarthLink: The company has transformed into a business-oriented telecommunications provider by acquiring such companies as ITC^DeltaCom and One Communications Corp. Business revenues were responsible for 74 percent of third-quarter sales, according to D.A. Davidson & Co.

EarthLink has gone through significant changes over the last four years under its chairman and CEO Rolla Huff. Since Huff took the helm in 2007, the company has streamlined operations, slashed its workforce by more than 70 percent, cut customer acquisition costs and reduced investments and expenses connected to various ventures.

The stock price doesn’t necessarily reflect the new business-focused EarthLink.

“ELNK is making progress on its transformation, yet continues to trade like a dying consumer ISP,” D.A. Davidson & Co. analyst Donna Jaegers wrote in a note Oct. 28 following EarthLink’s third-quarter earnings. “We think the stock could move up to the low teens as they continue to execute.”

Jaegers has a 12- to 18-month price target of $14 on the stock, although it’s currently worth less than half of that; EarthLink’s stock price closed at $6.03 on Thursday.

Organic Growth Coming?

Investors are waiting for EarthLink to grow its operations organically. Consumer revenues have been falling, with residential subscriber churn increasing to 2.7 percent in the third quarter from 2.6 percent in the previous quarter, according to Jeffries equity analyst Youssef Squali. However, EarthLink said revenue declines in its legacy business are slowing down. Consumer churn, a measure of the percentage of customers leaving EarthLink, has been steadily falling for the last four years, according to a third-quarter investor presentation.

EarthLink anticipates growing its business service revenues sequentially sometime near the end of 2012, and the entire company should grow shortly thereafter, Louis Alterman, EarthLink’s vice president of finance, said in an interview with Channel Partners.

“As investors begin to appreciate that we should get a higher multiple on our earnings,” he said. “In other words, the stock should go up.”

About a year ago, EarthLink announced that it would lower its dividend payment from 16 cents per share to five cents per share. EarthLink didn’t do so because the companies it acquired were losing money; they were actually producing free cash flow, according to Alterman.

“We felt there were opportunities to invest that cash flow in other acquisitions” that would produce a better return for the investors, he said.

EarthLink has paid out about $18 million in dividends over the first three quarters of the year. The reduction in dividends, though, may have alienated the type of investors who rely on a steady return on their investment in the form of quarterly dividend payments.

“Who you want to attract now” are investors that are interested in a company that is growing, said Dougherty & Co. senior research analyst Mark Kelleher in an interview.

EarthLink hasn’t “demonstrated they can knit this collection of companies together into a national platform and achieve that growth,” Kelleher said. “Growth investors haven’t quite discovered EarthLink. They still think it’s this sleepy company.”

Kelleher, however, has faith in EarthLink; he initiated coverage on the stock in September with a buy rating.

The stock is trading at three-and-a-half times earnings before interest, taxes, depreciation and amortization, and that matters because most comparable stocks are trading between six and 10 times EBITDA, the analyst said.

“It means they are undervalued,” Kelleher said. “They should be valued considerably higher than where they are.”

Risks and More M&A?

Still, EarthLink must prove itself and doesn’t have an easy road ahead. Some potential risks include problems integrating ITC^DeltaCom and One Communications as well as facing escalating competition from phone and cable companies for high-speed data customers, Jaegers wrote.

“One of the main risks that potential investors worry about is the fact that ELNK has built most of its business operations through acquisitions and management admits that they will continue to look at other local and regional fiber assets,” Jaegers wrote. “There is risk in ELNK’s strategy, but management has done a good job so far on integration.”

EarthLink has revealed it expected to incur about $30 million integrating ITC^DeltaCom and One Communications, and the company has recognized more than half of those expenses this year, Alterman said. The good news: The company already has achieved more than half of the forecasted $40 million in “synergies” or savings from the deals, and it revealed earlier this fall it’s likely it will yield even greater savings. The bulk of the remaining synergies relate to consolidating things like billing and customer provisioning systems and don’t predominantly concern reductions in staff, he said.

In spite of the recent acquisitions, EarthLink doesn’t have to worry about paying off a mountain of debt anytime soon. The company has total debt of $625 million yet the principal debt doesn’t have to be paid back over the next few years, Alterman said. Still, EarthLink is scheduled to pay a little more than $61 million in interest next year. The company, which brought home a third-quarter profit of $7.5 million or $0.07 per share on revenues of $357.3 million, is currently sitting on roughly $259 million in cash and equivalents.

EarthLink may well use cash or some other financing instrument to get even bigger. Asked what Huff has said about future M&A activity, Alterman responded: “They are not required for us to execute on our strategy but they are on the table.”

Wrote S&P Capital IQ analyst Kessler: “We expect the company to pursue further acquisitions to expand and fortify its networks and presence west of the Mississippi River.”


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