UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

ý  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2004

 

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)

 

 

 

(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 ý  No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý  No o

 

As of October 31, 2004, 149,448,918 shares of common stock, $.01 par value per share, were outstanding.

 

 

EARTHLINK, INC.

Quarterly Report on Form 10-Q

For the Quarterly Period Ended September 30, 2004

 

TABLE OF CONTENTS

 

Part I
Item 1.  Financial Statements
Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.  Quantitative and Qualitative Disclosures About Market Risk
Item 4.  Controls and Procedures
Part II
Item 1.  Legal Proceedings
Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds
Item 6.  Exhibits
Signatures

 

 

PART I

Item 1.  Financial Statements.

 

EARTHLINK, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

 

ASSETS

 

		December 31, 2003				September 30, 2004
		(audited)				(unaudited)
Current assets:
Cash and cash equivalents		$		349,740		$		270,007
Investments in marketable securities		89,088				169,593
Accounts receivable, net of allowance of $5,885 and $8,127 at December 31, 2003 and September 30, 2004, respectively		35,585				30,454
Prepaid expenses		12,934				14,851
Other current assets		13,230				10,568
Total current assets		500,577				495,473
Long-term investments in marketable securities		49,037				68,698
Other long-term assets		12,101				15,731
Property and equipment, net		108,810				76,952
Subscriber bases, net		38,264				17,699
Goodwill and other indefinite life intangible assets		118,231				118,231
Total assets		$	827,020			$			792,784
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Trade accounts payable		$	49,882			$			44,009
Accrued payroll and related expenses		31,965				32,224
Other accounts payable and accrued liabilities		115,484				115,936
Capital lease obligations		884				723
Deferred revenue		69,002				64,511
Total current liabilities		267,217				257,403
Deferred revenue, net of current portion		6,375				4,046
Other long-term liabilities		9,765				8,620
Total liabilities		283,357				270,069
Stockholders’ equity:
Common stock, $0.01 par value, 300,000 shares authorized, 176,410 and 178,227 shares issued as of December 31, 2003 and September 30, 2004, respectively, and 159,042 and 149,623 shares outstanding as of December 31, 2003 and September 30, 2004, respectively		1,764				1,782
Additional paid-in capital		1,949,105				1,966,925
Warrants to purchase common stock		1,223				1,223
Accumulated deficit		(1,303,771			)	(1,228,351				)
Treasury stock, at cost, 17,368 and 28,604 shares as of December 31, 2003 and September 30, 2004, respectively		(104,344			)	(214,276				)
Unrealized losses on investments		(117			)	(335				)
Deferred compensation		(197			)	(4,253				)
Total stockholders’ equity		543,663				522,715
Total liabilities and stockholders’ equity		$	827,020			$	792,784

 

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

 

1

 

EARTHLINK, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2003			2004			2003			2004
					(unaudited)
		(in thousands, except per share data)
Revenues:
Narrowband access		$	235,713		$	217,232		$	734,594		$	665,451
Broadband access		93,045			104,863			262,934			313,234
Web hosting		12,363			11,682			37,583			36,321
Advertising and other value-added services		6,231			10,197			18,243			29,118
Total revenues		347,352			343,974			1,053,354			1,044,124
Operating costs and expenses:
Telecommunications service and equipment costs		130,631			103,660			398,695			329,364
Sales incentives		6,312			2,148			16,826			7,709
Total cost of revenues		136,943			105,808			415,521			337,073
Sales and marketing		86,314			110,790			282,728			311,971
Operations and customer support		69,271			60,340			223,714			194,716
General and administrative		29,666			24,054			96,814			78,374
Acquisition-related amortization		22,867			4,883			75,619			19,417
Facility exit costs		—			269			36,596			28,991
Total operating costs and expenses		345,061			306,144			1,130,992			970,542
Income (loss) from operations		2,291			37,830			(77,638		)	73,582
Loss on investments in other companies		—			(726		)	—			(726		)
Interest income and other, net		1,209			1,584			4,726			4,330
Income (loss) before income taxes		3,500			38,688			(72,912		)	77,186
Provision for income taxes		—			1,136			—			1,766
Net income (loss)		3,500			37,552			(72,912		)	75,420
Deductions for accretion dividends		—			—			(4,586		)	—
Net income (loss) attributable to common stockholders		$	3,500		$	37,552		$	(77,498	)	$	75,420
Basic net income (loss) per share		$	0.02		$	0.25		$	(0.49	)	$	0.48
Diluted net income (loss) per share		$	0.02		$	0.24		$	(0.49	)	$	0.47
Basic weighted average common shares outstanding		159,998			152,970			156,617			155,917
Diluted weighted average common shares outstanding		162,747			156,056			156,617			159,186

 

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

 

2

 

 

EARTHLINK, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

 

		Nine Months Ended September 30,
		2003				2004
		(unaudited)
		(in thousands)
Cash flows from operating activities:
Net income (loss)		$		(72,912	)	$	75,420
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization		138,429				62,005
Disposals and impairments of fixed assets		7,798				9,436
Loss on investments in other companies		—				726
Deferred compensation		—				377
Decrease in accounts receivable, net		13,394				5,131
Decrease in prepaid expenses and other assets		4,168				513
Decrease in accounts payable and accrued and other liabilities		(15,098			)	(2,488			)
Decrease in deferred revenue		(12,696			)	(6,882			)
Net cash provided by operating activities		63,083				144,238
Cash flows from investing activities:
Purchases of property and equipment		(22,006			)	(21,465			)
Proceeds from sales of fixed assets		542				705
Investments in marketable securities:
Purchases		(131,284			)	(247,697			)
Sales and maturities		100,237				147,021
Purchases of subscriber bases		(7,804			)	(1,984			)
Investments in other companies		—				(3,835			)
Net cash used in investing activities		(60,315			)	(127,255			)
Cash flows from financing activities:
Principal payments under capital lease obligations		(3,000			)	(191			)
Proceeds from stock options exercised and employee stock purchase plan purchases		1,792				13,407
Purchases of treasury stock		(80,982			)	(109,932			)
Net cash used in financing activities		(82,190			)	(96,716			)
Net decrease in cash and cash equivalents		(79,422			)	(79,733			)
Cash and cash equivalents, beginning of period		382,065				349,740
Cash and cash equivalents, end of period		$	302,643			$		270,007
Supplemental non-cash disclosure:
Non-cash adjustments related to accretion dividends		$	4,586			$		—

 

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

 

3

 

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED

 

1.  Organization

 

EarthLink, Inc. (“EarthLink” or the “Company”) is a leading Internet service provider (“ISP”), providing nationwide Internet access and related value-added services to its individual and business customers.  EarthLink’s primary service offerings are narrowband, broadband or high-speed, and wireless Internet access services; web hosting services; and advertising and related marketing services. The Company provides a broad range of products and services to more than five million paying customers through a nationwide network of dial-up points of presence (“POPs”), a nationwide broadband footprint and wireless technologies.

 

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 and nine months ended September 30, 2003 and 2004 and the related footnote information are unaudited and have been prepared on a basis substantially consistent with the Company’s audited consolidated financial statements as of December 31, 2003 contained in the Company’s Annual Report on Form 10-K, as filed with the Securities and Exchange Commission (“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 and nine months ended September 30, 2004 are not necessarily indicative of the results anticipated for the entire year ending December 31, 2004.

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements.  Actual results may differ from those estimates.

 

Stock-Based Compensation

 

The Company accounts for stock-based compensation issued to employees using the intrinsic value method as prescribed by Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” Accordingly, the Company discloses pro forma information required under Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” and SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” Stock and other equity instruments issued to non-employees are accounted for in accordance with SFAS No. 123 and Emerging Issues Task Force (“EITF”) Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” and valued using the Black-Scholes model.

 

4

 

During the three and nine months ended September 30, 2003 and 2004, the Company recognized no amounts of compensation expense for stock options based on the intrinsic value method prescribed by APB Opinion No. 25 and related interpretations. If the Company had elected to adopt the optional recognition provisions of SFAS No. 123, which uses the fair value based method for stock-based compensation, and amortized the fair value of the options to compensation expense on a straight-line basis over the vesting period of the options, the net income (loss) attributable to common stockholders and basic and diluted net income (loss) per share would have been changed to the pro forma amounts indicated below:

 

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2003			2004			2003			2004
		(in thousands, except per share data)
Net income (loss) attributable to common stockholders, as reported		$	3,500		$	37,552		$	(77,498	)	$	75,420
Stock-based compensation expense determined using a fair value based method for all awards		(9,812		)	(5,593		)	(32,471		)	(17,414		)
Pro forma net income (loss) attributable to common stockholders		$	(6,312	)	$	31,959		$	(109,969	)	$	58,006
Basic net income (loss) per share:
As reported		$	0.02		$	0.25		$	(0.49	)	$	0.48
Pro forma		$	(0.04	)	$	0.21		$	(0.70	)	$	0.37
Diluted net income (loss) per share:
As reported		$	0.02		$	0.24		$	(0.49	)	$	0.47
Pro forma		$	(0.04	)	$	0.21		$	(0.70	)	$	0.37

 

3.  Recent Accounting Pronouncements

 

In January 2003, the Financial Accounting Standards Board (“FASB”) issued Financial Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities.” In December 2003, the FASB published revised guidance on FIN 46. FIN 46 addresses the consolidation of certain variable interest entities (“VIEs”). As modified, FIN 46 was effective immediately for financial interests in special purpose entities and is effective for all other types of VIEs for periods ending after March 15, 2004.  The adoption of FIN 46 did not have a material effect on EarthLink’s results of operations or financial position.

 

In July 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 02-14, “Whether an Investor Should Apply the Equity Method of Accounting to Investments Other Than Common Stock.”  The consensus was that when an investor has the ability to exercise significant influence over the operating and financial policies of an investee, the investor should apply the equity method of accounting only when it has an investment in common stock and/or an investment that is in-substance common stock. EITF Issue No.  02-14 is effective for periods beginning after September 15, 2004.  The adoption of EITF Issue No.  02-14 is not expected to have a material effect on EarthLink’s results of operations or financial position.

 

5

 

4.  Earnings per Share

 

SFAS No. 128, “Earnings per Share,” requires a dual presentation of basic and diluted earnings (loss) per share (“EPS”).  Basic EPS represents the weighted average number of common shares outstanding divided into net income (loss) attributable to common stockholders during a reported period.  Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock, including convertible preferred stock and stock options and warrants (commonly and hereinafter referred to as “Common Stock Equivalents”), were exercised or converted into common stock.  The following table reconciles the denominator for the basic and diluted per share computations for the three months ended September 30, 2003 and 2004 and for the nine months ended September 30, 2004:

 

		Three Months Ended						Nine Months Ended September 30, 2004
		September 30, 2003			September 30, 2004
		(in thousands, except per share data)
Net income attributable to common stockholders (A)		$	3,500		$	37,552		$	75,420
Basic weighted average common shares outstanding (B)		159,998			152,970			155,917
Dilutive effect of Common Stock Equivalents:
Stock options and warrants		2,749			3,086			3,269
Diluted weighted average common shares outstanding (C)		162,747			156,056			159,186
Basic net income per share (A/B)		$	0.02		$	0.25		$	0.48
Diluted net income per share (A/C)		$	0.02		$	0.24		$	0.47

 

The Company has not included the effect of Common Stock Equivalents in the calculation of diluted EPS for the nine months ended September 30, 2003 because such inclusion would have an anti-dilutive effect.  The Common Stock Equivalents for the nine months ended September 30, 2003 would have included outstanding options and warrants with exercise prices less than the average closing price of the Company’s common stock during the respective period and outstanding shares of Series A and Series B convertible preferred stock on an as converted basis. The following table summarizes the Common Stock Equivalents that would have been included if such securities had a dilutive effect:

 

		Nine Months Ended September 30, 2003
		(in thousands)
Weighted average common shares outstanding used to calculate basic and diluted EPS		156,617
Common Stock Equivalents:
Convertible preferred stock		7,401
Stock options and warrants		1,877
Diluted weighted average common shares outstanding		165,895

 

During the three months ended June 30, 2003, the holder of Series A and Series B convertible preferred stock converted all remaining shares of Series A and Series B convertible preferred stock into shares of common stock.

 

6

 

5.  Comprehensive Income (Loss)

 

Comprehensive income (loss) includes unrealized gains and losses which are excluded from the Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2003 and 2004 as follows:

 

		Three Months Ended September 30,							Nine Months Ended September 30,
		2003			2004				2003				2004
		(in thousands)
Net income (loss)		$	3,500		$	37,552			$		(72,912	)	$	75,420
Net change in unrealized gain (loss) on investments		(171		)	742				(448			)	(218			)
Total comprehensive income (loss)		$	3,329		$		38,294		$	(73,360		)	$		75,202

 

6.  Facility Exit Costs

 

During the three months ended March 31, 2003, EarthLink executed a plan to streamline its contact center facilities (the “2003 Plan”).  In connection with the 2003 Plan, EarthLink closed contact center facilities in Dallas, Texas; Sacramento, California; Pasadena, California; and Seattle, Washington during the months of February and March 2003.  The closure of the four contact center facilities resulted in the termination of 1,220 employees and the net reduction of 920 employees, primarily customer support personnel.  In connection with the 2003 Plan, EarthLink recorded facility exit costs of approximately $36.6 million during the three months ended March 31, 2003.  These costs included approximately $10.7 million for employee, personnel and related costs; $18.2 million for real estate and telecommunications costs; and $7.7 million in asset disposals.

 

During the three months ended March 31, 2004, EarthLink executed a plan to restructure and further streamline its contact center operations (the “2004 Plan”). Under the 2004 Plan, EarthLink closed contact center operations in Harrisburg, Pennsylvania; Roseville, California; San Jose, California; and Pasadena, California; and reduced its contact center operations in Atlanta, Georgia.  Approximately 1,140 employees were directly impacted, primarily customer support personnel.  As a result of the 2004 Plan, EarthLink recorded facility exit costs of $30.2 million during the three months ended March 31, 2004. These costs included approximately $10.5 million for employee, personnel and related costs; $11.3 million for real estate and telecommunications costs; and $8.4 million in asset disposals.

 

During the nine months ended September 30, 2004, EarthLink reduced its estimates for real estate commitments associated with the 2003 Plan and 2004 Plan by $1.5 million based on events occurring during the period. In addition, EarthLink recorded additional severance of $0.1 million and realized additional expense of $0.2 million associated with the disposal and write-down of fixed assets, net of proceeds received.  As a result, EarthLink reduced its facility exit costs by $1.2 million during the nine months ended September 30, 2004.

 

7

 

The following table summarizes the status of the accrued costs associated with the 2003 Plan and 2004 Plan as of and for the nine months ended September 30, 2004:

 

2003 Plan		Balance December 31, 2003			Facility Exit Costs			Adjustments			Non-Cash Items			Deferred Rent Reclassification			Payments			Balance September 30, 2004
		(in thousands)
Real estate and telecommunications costs, including non-cancelable leases		$	9,892		$	—		$	(479	)	$	—		$	—		$	(6,085	)	$	3,328

 

2004 Plan		Balance December 31, 2003			Facility Exit Costs			Adjustments			Non-Cash Items			Deferred Rent Reclassification			Payments			Balance September 30, 2004
		(in thousands)
Severance and personnel related costs		$	—		$	10,580		$	87		$	—		$	—		$	(10,600	)	$	67
Real estate and telecommunications  costs, including non-cancelable leases		—			11,292			(1,054		)	—			1,359			(4,589		)	7,008
Abandoned and disposed assets		—			8,360			205			(8,565		)	—			—			—
		$	—		$	30,232		$	(762	)	$	(8,565	)	$	1,359		$	(15,189	)	$	7,075
Total		$	9,892		$	30,232		$	(1,241	)	$	(8,565	)	$	1,359		$	(21,274	)	$	10,403

 

7.  Investments

 

Investments in marketable securities

 

Short and long-term investments in marketable securities consist of investments in debt securities classified as available-for-sale and have maturities greater than 90 days from the date of acquisition.  Short-term investments in marketable securities consist of investments that have maturity dates of up to one year from the balance sheet date, and long-term investments in marketable securities consist of investments that have maturity dates of more than one year from the balance sheet date.  The Company has invested primarily in U.S. corporate notes and asset-backed securities, all of which have a minimum investment rating of A, and government agency notes.  Realized gains and losses are included in interest income and other, net in the Condensed Consolidated Statements of Operations and are determined on a specific identification basis. The following table summarizes proceeds received from the sale of available-for-sale securities and realized gains and losses from the sale of available-for-sale securities for the three and nine months ended September 30, 2003 and 2004:

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2003			2004			2003			2004
		(in thousands)
Proceeds from the sale of investments		$	8,926		$	33,728		$	42,508		$	51,814
Realized gains from the sale of investments		40			46			306			77
Realized losses from the sale of investments		(3		)	(40		)	(7		)	(105		)

 

8

 

Investments in other companies

 

During the three and nine months ended September 30, 2004, the Company recognized a loss of $0.7 million on certain of its investments in other companies as a result of a decline in fair value that was considered other than temporary. This loss is included in loss on investments in other companies in the Condensed Consolidated Statements of Operations. Management regularly evaluates the recoverability of its investments in other companies based on the performance and the financial position of those companies as well as other evidence of market value.

 

In addition, certain of EarthLink’s investments in other companies are classified as available-for-sale securities. Accordingly, unrealized gains and losses resulting from changes in the fair value of available-for-sale securities between measurement dates are included in unrealized gains (losses) on investments as a separate component of stockholders’ equity. As of September 30, 2004, EarthLink increased the carrying value of its investments in other companies and adjusted unrealized losses on investments by $0.3 million based on quoted market prices.

 

8.  Goodwill and Intangible Assets

 

The following table presents the components of the Company’s acquired definite life intangible assets and goodwill and other indefinite life intangible assets included in the accompanying Condensed Consolidated Balance Sheets as of December 31, 2003 and September 30, 2004:

 

		As of December 31, 2003									As of September 30, 2004
		Gross Carrying Value			Accumulated Amortization			Net Carrying Value			Gross Carrying Value			Accumulated Amortization			Net Carrying Value
		(in thousands)
Acquired subscriber bases		$	330,510		$	(292,246	)	$	38,264		$	329,362		$	(311,663	)	$	17,699
Goodwill and other indefinite life intangible assets								$	118,231								$	118,231

 

Acquisition-related amortization in the Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2003 and 2004 represents the amortization of definite life intangible assets.  The Company’s definite life intangible assets primarily consist of subscriber bases and other assets that are not deemed to have indefinite lives acquired in conjunction with the purchases of businesses and subscriber bases from other ISPs, but exclude any acquired software. Generally, definite life intangible assets are amortized on a straight-line basis over three years from the date of their respective acquisitions. Based on the current amount of definite life intangible assets, the Company expects to record amortization expense of approximately $4.9 million for the remaining three months in the year ending December 31, 2004 and $10.7 million, $2.0 million and $0.1 million for the years ending December 31, 2005, 2006 and 2007, 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.

 

9.  Income Taxes

 

The Company has historically reported net losses and, in accordance with accounting principles generally accepted in the United States, has not recorded any income tax benefits from those losses. The Company reported net income for the three and nine months ended September 30, 2004 and anticipates net income for the year ending December 31, 2004.  Although the Company intends to utilize net operating loss carryforwards to offset taxable income in 2004, the Company expects alternative minimum tax amounts to be payable primarily due to the net operating loss carryforward limitations associated with the alternative minimum tax calculation.

 

9

 

The Company continues to maintain a valuation allowance against its deferred tax assets, consisting primarily of net operating loss carryforwards, and the Company may recognize deferred tax assets in future periods when they are estimated to be realizable.

 

10.  Share Repurchases

 

In August 2002, the Board of Directors approved a share repurchase program.  During the three months ended September 30, 2004, the Board of Directors increased the amount authorized to repurchase the Company’s common stock under the share repurchase program by $100.0 million to a total of $250.0 million and approved repurchasing common stock pursuant to a plan under Rule 10b5-1 of the Securities Exchange Act of 1934. During the three and nine months ended September 30, 2004, the Company repurchased 5.9 million and 11.2 million shares, respectively, of its common stock for $58.6 million and $109.5 million, respectively, pursuant to authorizations by the Board of Directors. As of September 30, 2004, the Company had $89.3 million available under the current authorization. The Company may repurchase its common stock from time to time in compliance with the Securities and Exchange Commission’s regulations and other legal requirements, 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 at any time.

 

During the three months ended June 30, 2004, EarthLink completed its rescission offer for shares of EarthLink common stock in the EarthLink, Inc. 401(k) Plan that were not registered under the Securities Act of 1933. EarthLink repurchased approximately 48,000 shares of common stock for approximately $1.0 million. Approximately $0.4 million of the amounts paid pursuant to the rescission offer was recorded as treasury stock based on the fair value of common stock acquired on the date the rescission offer expired and the remainder was recorded as expense.

 

11.  Deductions for Accretion Dividends

 

Increases in the liquidation value per share of the outstanding convertible preferred stock resulting from the payment “in kind” of dividends on the Series A and Series B convertible preferred stock are included in deductions for accretion dividends and reduce the amount of earnings attributable to common stockholders. Deductions for accretion dividends includes approximately $3.0 million for the nine months ended September 30, 2003 related to increases in the liquidation value per share pursuant to the provisions of the convertible preferred stock. Deductions for accretion dividends also includes amounts related to the beneficial conversion features of the Series A and Series B convertible preferred stock recognized in accordance with EITF Issue No. 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios,” based upon the rate at which the preferred stock becomes convertible.  In effect, the Series A and Series B convertible preferred stock were issued at a discount to fair value, and the discount for each series was accreted through deductions for accretion dividends over the period from the date of issuance to the date the conversion ratio was equal to one to one in June 2003. Deductions for accretion dividends includes approximately $1.6 million for the nine months ended September 30, 2003 related to amounts recognized pursuant to EITF Issue No. 98-5.

 

Because Sprint Corporation converted all outstanding shares of Series A and Series B convertible preferred stock into common stock during 2003, there are no dividends associated with the Series A and Series B convertible preferred stock in 2004.

 

12.  Subsequent Event

 

In October 2004, the Board of Directors increased the amount authorized to repurchase the Company’s common stock under the Company’s share repurchase program by $100.0 million to a total of $350.0 million. As of October 31, 2004, the Company had $184.1 million available under the current authorization.

 

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

 

Certain statements in this 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, 2003.

 

Overview

 

EarthLink, Inc. (“EarthLink,” “we,” “us” or “our”) is a leading Internet service provider (“ISP”), providing nationwide Internet access and related value-added services to its individual and business customers.  Our primary service offerings are narrowband, broadband or high-speed, and wireless Internet access services; web hosting services; and advertising and related marketing services.  We provide our broad range of services to more than five million paying customers through a nationwide network of dial-up points of presence (“POPs”), a nationwide broadband footprint and wireless technologies.  We derive substantially all revenues from services, primarily Internet access services and related fees, and such revenues represented 97% or more of total revenues for all periods presented. The remaining revenues relate to sales of equipment and devices used by our subscribers to access our services.

 

The Internet access market in the U.S. grew dramatically from the mid-1990’s through 2000 but has experienced slower growth since, as the market has reached a mature stage of growth. Approximately 70 million households were estimated to have had Internet access services at December 31, 2003, and approximately three to four million new households are estimated to be currently adding Internet access each year. Within the total Internet access market, the market for traditional, fully-featured, unlimited narrowband dial-up access services, which are typically priced at $17.95 to $23.95 per subscriber per month, is shrinking but is the most common service. Focused, value-priced narrowband access providers offer services with a limited set of features priced typically at $9.95 to $14.95 per month and are currently demonstrating an ability to grow by attracting households new to the Internet or current Internet users interested in reducing their cost of Internet access. Broadband or high-speed access is typically priced at $27 to $50 per month and is growing rapidly, having added an estimated six million households in 2003, totaling an estimated 22 million households at the end of 2003. The largest competitors in the broadband access market are the cable companies and regional bell operating companies offering broadband access over their own cable or telephone lines.

 

EarthLink provides all three types of access described above (traditional, fully-featured narrowband access; value-priced narrowband access; and broadband access). Our subscriber base grew from approximately 5.0 million paying subscribers at September 30, 2003 to approximately 5.4 million paying subscribers at September 30, 2004.  Total revenues decreased from $347.4 million during the three months ended September 30, 2003 to $344.0 million during the three months ended September 30, 2004, reflecting a decrease of $2.8 million in equipment and related revenues and a decrease of $3.1 million in revenues associated with acquired prepaid PeoplePC Inc. (“PeoplePC”) subscribers, partially offset by a $2.5 million increase in service and advertising

 

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revenues. While our overall subscriber base grew over the last year, the mix of customers has shifted toward broadband services, reflecting the growth of this component of the Internet access market and our expanding broadband footprint and offerings, and toward value-priced Internet access services, reflecting the growth of our PeoplePC services. Our traditional, premium-priced narrowband subscriber base has been declining reflecting the increasing maturity of this service.  EarthLink continues to explore new initiatives and has launched voice over Internet Protocol (VoIP), converged voice/data and alternative broadband services, which may generate incremental sources of revenue and income.

 

Our goal is to sustain and build upon our strong position in the U.S. Internet access market by focusing on high-growth opportunities such as broadband and value-priced narrowband access to generate organic subscriber growth; providing a high-quality customer experience, including a full range of Internet access services and innovative applications; improving operating margins to fund growth; and emphasizing customer service.

 

Strategic Alliances

 

We have a marketing relationship with Sprint Corporation (“Sprint”).  During the three and nine months ended September 30, 2003 and 2004, our relationship with Sprint generated more than 10% of EarthLink’s total gross organic subscriber additions.  In April 2004, we entered into a new three-year marketing and sales agreement with Sprint which provides that EarthLink will be the preferred high-speed ISP for Sprint’s local residential and small business customers. Sprint may pursue relationships with other ISPs, and a significant decrease in the number of gross subscriber additions generated through our relationship with Sprint could adversely affect our results of operations.

 

We have a marketing relationship with Dell Inc. (“Dell”).  During the three and nine months ended September 30, 2004, our relationship with Dell generated more than 5% of EarthLink’s total gross organic subscriber additions.  Our marketing relationship is not exclusive, and a significant decrease in the number of gross subscriber additions generated through our relationship with Dell could adversely affect our results of operations.

 

We have an agreement with Time Warner Cable and Bright House Networks, companies whose networks pass more than 22 million homes, to offer our broadband Internet services over their systems.  In connection with the agreement, Time Warner Cable and Bright House Networks receive consideration from EarthLink for carrying the EarthLink service and related Internet traffic. As of September 30, 2004, more than 25% of our broadband subscribers were serviced via either the Time Warner Cable or Bright House Networks network.

 

We have a strategic alliance with Apple Computer, Inc. (“Apple”).  In connection with this alliance, we serve as the default ISP in Apple’s setup software on its Macintosh branded line of computers through January 4, 2005.  We are the exclusive default ISP for dial-up, ISDN and digital subscriber line (“DSL”) services on Macintosh computers sold in the U.S., and we pay Apple for each gross organic subscriber addition generated as a result of our alliance.  Apple may terminate the agreement at any time with 90 days advance notice.  There can be no assurance that Apple will not terminate the agreement or that we will be able to extend our arrangement with Apple beyond January 4, 2005, and a significant decrease in the number of gross subscriber additions generated through our relationship with Apple could adversely affect our results of operations.

 

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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 EarthLink’s industry. The following table sets forth subscriber and operating data for the periods indicated:

 

		September 30, 2003		December 31, 2003		September 30, 2004
Subscriber Data (a)
Narrowband subscribers		3,841,000		3,984,000		3,973,000
Broadband subscribers		953,000		1,061,000		1,280,000
Web hosting accounts		164,000		161,000		149,000
Total subscriber count at end of period		4,958,000		5,206,000		5,402,000

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2003			2004			2003			2004
Subscriber Activity
Subscribers at beginning of period		5,039,000			5,335,000			4,987,000			5,206,000
Gross organic subscriber additions		658,000			823,000			1,879,000			2,387,000
Acquired subscribers		5,000			3,000			25,000			7,000
Adjustment (b)		(152,000		)	—			(152,000		)	—
Churn		(592,000		)	(759,000		)	(1,781,000		)	(2,198,000		)
Subscribers at end of period		4,958,000			5,402,000			4,958,000			5,402,000
Churn rate (c)		4.0		%	4.7		%	4.0		%	4.5		%
Narrowband Data
Average subscribers		3,854,000			3,975,000			3,926,000			3,980,000
ARPU
Service ARPU (d)		$	19.73		$	18.08		$	19.97		$	18.40
Total ARPU (e)		20.39			18.22			20.79			18.58
Churn rate (c)		4.6		%	5.5		%	4.5		%	5.2		%
Broadband Data
Average subscribers		921,000			1,241,000			895,000			1,178,000
ARPU (e)		$	33.68		$	28.16		$	32.63		$	29.53
Web Hosting Data
Average accounts		165,000			151,000			168,000			156,000
ARPU (e)		$	25.04		$	25.72		$	24.93		$	25.94

 

(a)  Subscriber amounts include paying customers only. Subscriber amounts do not include nonpaying customers. Customers receiving service under promotional programs that include periods of free service at inception are not included in subscriber counts until they become paying customers.  The subscriber amounts in the table above and in subsequent tables do not include nonpaying customers.

 

(b) Due to the reduction in revenue per subscriber during the transition period under our arrangement with Charter Communications (“Charter”), EarthLink excluded approximately 152,000 Charter wholesale broadband subscribers from its total paying subscriber count beginning in the three months ended September 30, 2003. See discussion below under “Broadband access revenues” for more information.

 

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(c) Churn rate is used to measure the rate at which subscribers discontinue service on a voluntary or involuntary basis.  Churn is computed by dividing the average monthly number of subscribers that discontinued service during the period by the average subscribers for the period.

 

(d) Narrowband service ARPU represents average monthly service revenue per user (subscriber). Narrowband service ARPU is computed by dividing average monthly service revenue for the period by the average number of subscribers for the period. Service revenue includes monthly fees charged to customers for dial-up and wireless Internet access and excludes equipment and related revenues and revenues associated with acquired Membership Customers (as described below).

 

(e) ARPU represents the average monthly revenue per user (subscriber). ARPU is computed by dividing average monthly revenue for the period by the average number of subscribers for the period.

 

The subscriber amounts above and in subsequent tables do not include prepaid, bundled subscribers (“Membership Customers”) that purchased a bundled package (which included a computer, Internet access, customer support and an in-home warranty) from PeoplePC prior to the date of our acquisition of PeoplePC in July 2002 that continue to receive service for their prepaid terms.  As of September 30, 2003 and 2004, there were 294,000 and 26,000 such Membership Customers, respectively, receiving services, a decline from 518,000 at the date of the acquisition. These amounts include 99,000 and 11,000 international Membership Customers as of September 30, 2003 and 2004, respectively, which EarthLink does not intend to target in our efforts to convert these Membership Customers to paying subscribers. We have excluded these Membership Customers from our subscriber counts because they prepaid for service for periods of up to four years prior to the date of our acquisition of PeoplePC. At the acquisition date, EarthLink established a liability for its estimated cost to deliver services to these Membership Customers pursuant to their contract terms, and EarthLink reduces the liability and records non-cash revenues as it delivers services to these Membership Customers.   Such reduction is intended to offset the cost of delivering the services.  The reduction in the deferred service liability and the amount of associated revenues recorded were $3.4 million and $12.1 million during the three and nine months ended September 30, 2003, respectively, and $0.3 million and $1.6 million during the three and nine months ended September 30, 2004, respectively.

 

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Results of Operations

 

The following table sets forth statement of operations data for the periods indicated:

 

		Three Months Ended September 30,											Nine Months Ended September 30,
		2003			2004			$ Change			% Change		2003			2004			$ Change			% Change
		(dollars in millions)
Revenues:
Narrowband access		$	235.7		$	217.2		$	(18.5	)	-8%		$	734.6		$	665.5		$	(69.1	)	-9	%
Broadband access		93.1			104.9			11.8			13%		262.9			313.2			50.3			19	%
Web hosting		12.4			11.7			(0.7		)	-6%		37.6			36.3			(1.3		)	-3	%
Advertising and other value-added services		6.2			10.2			4.0			65%		18.3			29.1			10.8			59	%
Total revenues		347.4			344.0			(3.4		)	-1%		1,053.4			1,044.1			(9.3		)	-1	%
Operating costs and expenses:
Telecommunications service and equipment costs		130.6			103.7			(26.9		)	-21%		398.7			329.4			(69.3		)	-17	%
Sales incentives		6.3			2.1			(4.2		)	-67%		16.8			7.7			(9.1		)	-54	%
Total cost of revenues		136.9			105.8			(31.1		)	-23%		415.5			337.1			(78.4		)	-19	%
Sales and marketing		86.3			110.8			24.5			28%		282.8			312.0			29.2			10	%
Operations and customer support		69.3			60.3			(9.0		)	-13%		223.7			194.7			(29.0		)	-13	%
General and administrative		29.7			24.1			(5.6		)	-19%		96.8			78.3			(18.5		)	-19	%
Acquisition-related amortization		22.9			4.9			(18.0		)	-79%		75.6			19.4			(56.2		)	-74	%
Facility exit costs		—			0.3			0.3			*		36.6			29.0			(7.6		)	-21	%
Total operating costs and expenses		345.1			306.2			(38.9		)	-11%		1,131.0			970.5			(160.5		)	-14	%
Income (loss) from operations		2.3			37.8			35.5			*		(77.6		)	73.6			151.2				*
Loss on investments in other companies		—			(0.7		)	(0.7		)	*		—			(0.7		)	(0.7		)		*
Interest income and other, net		1.2			1.6			0.4			33%		4.7			4.3			(0.4		)	-9	%
Income (loss) before income taxes		3.5			38.7			35.2			*		(72.9		)	77.2			150.1				*
Provision for income taxes		—			1.1			1.1			*		—			1.8			1.8				*
Net income (loss)		3.5			37.6			34.1			*		(72.9		)	75.4			148.3				*
Deductions for accretion dividends		—			—			—			*		(4.6		)	—			4.6				*
Net income (loss) attributable to common stockholders		$	3.5		$	37.6		$	34.1		*		$	(77.5	)	$	75.4		$	152.9			*

 

* denotes percentage is not meaningful or not calculable

 

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