Summary
- We believe that EarthLink could be worth $6/share, potentially nearly double its current share price, based on fundamental cash flow analysis alone.
- In a value recognition scenario, which we view as potentially likely, we believe EarthLink might be worth $8/share.
- Downside case of $3 based on valuation in line with the assumption that growth rates on its key legacy businesses materially worsen with no valuation credit for its sizeable NOL.
- The risk/reward is uniquely asymmetric with potential downside of 10% relative to potential 80-250% upside.
- Upcoming catalysts over the next 6 months include quarterly earnings (potential guidance revisions upward) and potential value enhancement via a potential sale of all or parts of the company.
EarthLink (NASDAQ:ELNK) is a provider of IT services, network and communications with a market cap of ~$360 million and an enterprise value of ~$880 million. Underfollowed by sell-side analysts and dissuaded by its legacy business, investor apathy has artificially depressed EarthLink's market value far below its fundamental value. The few investors and limited sell side analysts who do cover ELNK focus too much on the negativity surrounding its already well-known issues in the CLEC and traditional ISP world and overlook ELNK's fast growing IT service business, strong balance sheet, NOLs and underlying asset value. Despite analysts continuing to value the company as a dying CLEC and ISP business, a sum of parts examination of EarthLink shows that it holds several extremely valuable assets. We believe the valuation is so disconnected that investors have limited fundamental downside with upside catalysts including the CEO's new standalone turnaround plan and a potential takeout at a substantial premium. Collect a 6.1% dividend yield while you wait. Among the positives:
- Several of EarthLink's operating segments are underappreciated by the Street. The stock is heavily discounted vs. a sum of parts valuation. At current share price levels, the Street is pricing in a worst case scenario from a sum of the parts perspective (basically, complete value destruction and 0 credit for its NOL)
- 20% YoY growth in the overlooked IT service business that will bundle attractively with legacy CLEC services. Stemming the declines of the legacy CLEC will help re-rate the multiple to more appropriate levels.
- Significant cash flow generation from legacy businesses, reinvested into growth initiatives and dividends.
- New management team has an undying focus on ROIC and FCF generation (will continue to cut low-ROIC capex to maximize FCF generation).
- Attractive acquisition target for any strategic acquirers looking to grow fiber base in the southeast US or strategic acquirer looking to create synergy value with its own legacy CLEC. Private equity could be a very significant opportunity given high capex that could likely be cut in order to significantly increase free cash flow.
- Hidden Gem: Fiber Optics network that has a book value of 200 million and a market value of $300 million.
- Strong balance sheet at less than 2.5x net leverage - the lowest amongst its peers.
- Tax Assets worth $200mm on an NPV basis
Future Projections Show Improving Core EBITDA Performance:
Consolidated
|
2012
|
2013
|
2014E
|
2015E
|
2016E
|
Revenue
|
$1,335
|
$1,241
|
$1,174
|
$1,143
|
$1,147
|
% YoY Growth
|
-7.0%
|
-5.4%
|
-2.6%
|
0.3%
| |
EBITDA
|
$284
|
$227
|
$199
|
$195
|
$195
|
% YoY Growth
|
-20.1%
|
-12.1%
|
-2.3%
|
-0.1%
| |
% Margin
|
21.3%
|
18.3%
|
17.0%
|
17.0%
|
17.0%
|
Run-Off Value Analysis Generates Significant Margin of Safety:
The most important element of the story to analyze here is: what is the downside case? We believe there is a significant margin of safety given the NPV of the cash flows associated with its legacy CLEC business, consumer ISP business, asset value from its fiber business and NOL value (which we could argue should be included but in a conservative case might not be). Thus, we believe a potential downside case is $5 / share (almost 40% higher than the current market value). Assuming a worst case scenario with no valuation credit for the NOL, we believe a potential worst case downside scenario is $3.11.
On each of the cash flow generating segments, we assume a 15% discount rate and revenue growth / EBITDA growth rates in accordance with our downside case. We also assume maintenance capex levels stay consistent.
The fiber asset value is corroborated by the value on the balance sheet of ELNK's filings; we believe in a sale, this fiber could be worth materially more than book value but we recognize that in a downside case, ELNK's bargaining position from an asset sale perspective might not be as strong.
Run-Off Value Analysis
| |
Run-Off NPV of Consumer ISP
|
$382
|
Run-Off NPV of CLEC
|
$200
|
Fiber Asset Value (Book)
|
$200
|
NOL Value
|
$200
|
Total Enterprise Value
|
$983
|
Net Debt
|
($466)
|
Equity Value
|
$517
|
Share Price
|
$5.07
|
Share Price (ex NOL)
|
$3.11
|
Sum of the Parts Also Presents Intriguing Valuation:
EBITDA
|
EV
| ||||||
(2014E)
|
Low
|
Avg
|
High
|
Low
|
Average
|
High
| |
Business Segment
|
83
|
4.0x
|
6.0x
|
8.0x
|
$333
|
$499
|
$666
|
Consumer Segment
|
116
|
2.5x
|
3.0x
|
3.5x
|
290
|
348
|
406
|
EV
|
623
|
848
|
1,072
| ||||
NOL
|
200
|
200
|
200
| ||||
Total EV
|
823
|
1,048
|
1,272
| ||||
Debt
|
466
|
466
|
466
| ||||
Equity Value
|
357
|
582
|
806
| ||||
Share Price
|
$3.50
|
$5.70
|
$7.90
|
Catalyst 1: Fundamental Turnaround
EarthLink has undertaken a fundamental turnaround strategy in its business operations. From a business operations standpoint, EarthLink is valued as a legacy CLEC/IPS business with limited cash flow generation potential. We expect EarthLink to approach revenue stability in the next 2-3 years which will cause a significant re-rating in the multiple as this phenomenon will occur. In addition, management's outlook towards key financial drivers has changed. Management has taken a keen interest in driving lower capex and higher ROIC. As a result, management expects to drive down capital expenditures by 20% from 2013. New 2014 management compensation plans also include an increased emphasis on cash flows.
Significant Improvement in Management Team
The EarthLink board significantly upgraded the management team's focus on execution when they hired Joe Eazor, who previously was a key EMC sales executive. He remains hyper-focused on free cash flow growth and value creation and will look at any option to enhance shareholder value.
On December 23, 2013, EarthLink named Eazor the new president and chief executive officer. Previously, Eazor was EVP and COO of Global Sales and Customer operations for EMC and held a variety of senior leadership positions at HP and EDS. Eazor's executive compensation includes a 100% of his base salary bonus if bonus criteria are met, 300,000 stock options which will vest 25% a year and 125,000 restricted stock units, 62,500 of which would vest upon the third anniversary of the grant date, 62,500 of which would vest if the average closing price of the Company's common stock for 20 consecutive trading days is at least 125% of the closing price on the last trading day prior to the employment date. In addition, Eazor acquired 64,600 shares personally at a price of $3.88 after taking the helm of the company. With over two decades of IT industry and consulting experience, the new CEO has been adamant about pushing ROIC and Cash flows as well as articulating EarthLink's willingness to sell parts or all of its business.
On a recent earnings call he said:
Over the last few months, I've undertaken a thorough strategic, operational and financial review of the company. To me it's clear that we have tremendous opportunity to create significant value and we have a lot of work to do to get there, to be the great company that we can be …We initiated an intense focus on managing CapEx and cash flow and are pleased with our results in the quarter … We are continuing to look at strategic alternatives and we will do what is best in the interest - the best interest of value creation. And we'll take a look at whether it's best - creates more value in our hands or we get the appropriate value by looking at strategic alternatives for another buyer. So it's one of those things that's an ongoing, how do you - I think you used the word option value, optionality, I think that's a good word for it. And we will constantly look at that optionality and see which way it makes the most value for us.
EBITDA estimates for 2014E are too low: We believe that EarthLink is likely to beat 2014E EBITDA guidance to the upside based on Q4 2013 and Q1/Q2 2014 performance. Business stability has been quite good at EarthLink over the last 2 years and that has only increased with the new CEO in place. They have a focused cost reduction effort and, for the first time, have incentivized the sales force in the right way to actually generate PROFITABLE, growth sales such that churn should begin to decline at the legacy CLEC. At the same time, overall revenue should accelerate at the IT services business. The Street is at $185mm for 2014E EBITDA, while we believe they will generate closer to $200mm of EBITDA in 2014E.
Capex Reductions to continue: One of the biggest issues EarthLink has had over the course of time has been an elevated capex budget with very questionable returns on that investment. The new CEO has heard this complaint loud and clear and has spent months focused on this issue. On the Q1 call, management reduced capex expectations for 2014 by $10mm and we believe they are likely to step it down further throughout the year as the management team pares away at lower return growth capex. They took down capex expectations further on the Q2 call as well.
Revenue declines should turn into revenue stability in the next 2-3 years: The chart below exemplifies how companies within this space trade in relation to their revenue growth rate. As EarthLink increases top-line growth through their Next Gen IT business and normalizing legacy CLEC business EarthLink will be near a 0% growth rate top line and rerate to a much higher multiple around 7x. Even on what we believe is a likely scenario for 2015, we believe EarthLink should improve its 5% decline from 2014 to much closer to a 2-3% decline, which should create opportunity for a re-rating to 5.5-6x EBITDA. As this transition becomes more understood, throughout the rest of the year, we expect investors to buy EarthLink in anticipation of that improvement given the relatively low multiple today vs. peers.
Catalyst 2: EarthLink (Part or Whole) as a potential acquisition target
EarthLink holds a number of attractive qualities as an acquisition target, these include:
1. Cost Synergies w Strategic Buyers
2. Tax Assets
3. An extensive fiber optics infrastructure
4. Legacy CLEC business w high customer count
5. Highly cash flow generative ISP business that can be moved to discontinued operations so as to not optically reduce revenue/EBITDA growth for a potential buyer.
Cost synergies: With over $100 million in cost synergies (based on 12.5% of Business Segment Opex, a comp lower than traditional deals at 20%) for potential acquirers, an acquisition of EarthLink would be extremely attractive in cutting expenses by utilizing the easily transferable business infrastructure that EarthLink has already built out rather than the network duplication or network leasing that exists within EarthLink's footprint today by other potential strategic players.
NOL: EarthLink's significant tax assets include a $500 million federal NOL from the legacy ELNK and Deltacom business, $700 million in State NOLs and deductions from depreciation and amortization as a result of the OneComm purchase. EarthLink is currently only paying single digit millions of dollars in taxes and have tax assets that save approximately $200 million of cash taxes on an NPV basis. Most importantly, we believe that because of built in gain regulations, a buyer could avoid the usual section 382 limitations in an acquisition of this sort and generally use a substantial majority of these taxes for their own corporate purposes.
Fiber Value: EarthLink has extremely valuable fiber assets in the Southeast that has a book value of approximately $200 million. With a market value of closer to $300 million based on 30 thousand fiber route miles, this asset would be extremely valuable for companies that need quick and large amounts of data as EarthLink currently does not use the fiber network for personal use. With several companies looking to acquire a broader fiber optics network as evidenced by the recent acquisitions in the telecom space, EarthLink could be in a position to monetize the fiber network far beyond what it is currently being carried on its book at.
Value of Legacy CLEC: While most analysts assign very little value to the declining CLEC business that is being consumed by the larger players (e.g. Cable) in the industry the CLEC could have a significant impact in a potential acquisition. Along with cost synergies, EarthLink has a significant number of customers from their legacy CLEC business that would be of significant interest to a potential acquirer. With several players in this space struggling to find scale in their operations in the SMB, ELNK's CLEC would provide increased scale and revenues for a potential acquirer in a highly synergistic fashion.
Comparable precedent transactions: Recently we saw Cbeyond (NASDAQ:CBEY) acquired by Birch Communications. Birch paid a 41% premium on the stock as on Cbeyond's closing price on April 17th. CBEY sold for 6.5X EBITDA and it is likely that if EarthLink is acquired that it would sell for materially more as a much more fundamentally sound business with real fiber in the ground and a significant NOL (Cbeyond on the other hand had basically no NOL and was, in effect, a complete single location CLEC).
Company Overview:
- Four main operating segments: Next Gen IT, Legacy CLEC, Wholesale and Consumer.
- Next Gen IT provides cloud, security and IT services for mid-sized retail customers.
- Legacy CLEC business provides voice and data services to retail clients.
- Wholesale consists of the sale of their fiber cables as well as data centers mostly to telecommunications companies.
- Consumer provides internet services to individual consumers.
- In 2013, EarthLink acquired CenterBeam which was a provider of remote managed IT services.
- On the Q2 2014 earnings call, the CEO of EarthLink spoke about his strategic plan which included an opportunistic sale of certain valuable assets inside EarthLink to potential buyers which investors appear to have missed completely.
Segment Breakdown:
Next Gen IT:
Retail: Next Gen IT
|
2012
|
2013
|
2014E
|
2015E
|
2016E
|
Revenue
|
$133
|
$168
|
$211
|
$263
|
$329
|
YoY Growth %
|
26.3%
|
25.4%
|
25.0%
|
25.0%
| |
% of Total Revenue
|
10.0%
|
13.5%
|
18.0%
|
23.0%
|
28.7%
|
EBITDA
|
$6
|
$8
|
$12
|
$17
|
$25
|
% YoY Growth
|
26.3%
|
53.3%
|
47.7%
|
44.2%
| |
% Margin
|
4.5%
|
4.5%
|
5.5%
|
6.5%
|
7.5%
|
% of Total EBITDA
|
2.1%
|
3.3%
|
5.8%
|
8.8%
|
12.7%
|
Description:
- Next Gen IT approximately earns 17% of total consolidated revenue a year and I estimate it grows at a base case 20-30% year over year.
- Next Gen IT is composed of cloud, security and IT services for customers.
- Next Gen IT was bolstered by EarthLink's 2013 acquisition of CenterBeam which serves to increase EarthLink's service portfolio nationwide.
- Decreasing churn rates amongst businesses, around 2% and declining.
Opportunities:
- Acceleration of growth from low to mid 20s to 30s and beyond
- Churn reducer for traditional telecom products have a myriad of positive effects across the consumer base
- Very high ROIC given relatively capital light growth
Risks:
- Competition is the most serious risk - either eliminating rather significant pricing power today or causing increased churn in the next gen business or the legacy business.
- Certain products remain non-core but would not necessarily generate significant asset sale value given the size of the base.
Legacy CLEC:
Retail: Legacy CLEC
|
2012
|
2013
|
2014E
|
2015E
|
2016E
|
Revenue
|
$732
|
$645
|
$571
|
$514
|
$473
|
YoY Growth %
|
-11.8%
|
-11.6%
|
-10.0%
|
-8.0%
| |
% of Total Revenue
|
54.8%
|
52.0%
|
48.6%
|
44.9%
|
41.2%
|
EBITDA
|
$110
|
$74
|
$66
|
$69
|
$73
|
% YoY Growth
|
-32.4%
|
-11.6%
|
5.7%
|
5.6%
| |
% Margin
|
15.0%
|
11.5%
|
11.5%
|
13.5%
|
15.5%
|
% of Total EBITDA
|
38.7%
|
32.7%
|
32.9%
|
35.6%
|
37.6%
|
Description:
- Legacy CLEC approximately declines at 10% year over year and should normalize at around 5-6% declines year over year over time.
- EarthLink's legacy CLEC services include data services, IP-based network services, broadband Internet access services and voice services.
- EarthLink has already begun to bundle services for customers in order to push the Next Gen IT business as well as stabilize the CLEC business.
- Legacy CLEC; holds many strategic synergies with other telecom companies which leads us to believe that this segment may be an attractive acquisition target.
Opportunities:
- Reduction in churn will increase customer lifetime value across the base
- Pricing increases over the course of the base (the first ones were just taken in early 2014), will help preserve margin flexibility
- Continued use of on-net fiber reduces incremental opex/capex required for growth
- Significant synergy value with a potential acquirer
Risks:
Continued elevated churn or pricing degradation from competition is by far the most serious and important risk to watch for.
Wholesale / Fiber Network Asset:
Wholesale
|
2012
|
2013
|
2014E
|
2015E
|
2016E
|
Revenue
|
$152
|
$151
|
$150
|
$153
|
$157
|
YoY Growth %
|
-0.6%
|
-0.4%
|
2.0%
|
2.0%
| |
% of Total Revenue
|
11.4%
|
12.2%
|
12.8%
|
13.4%
|
13.7%
|
EBITDA
|
$9
|
$7
|
$6
|
$6
|
$6
|
% YoY Growth
|
-25.5%
|
-11.5%
|
2.0%
|
2.0%
| |
% Margin
|
6.0%
|
4.5%
|
4.0%
|
4.0%
|
4.0%
|
% of Total EBITDA
|
3.2%
|
3.0%
|
3.0%
|
3.2%
|
3.2%
|
Description:
- Wholesale services are estimated to grow at around 2% YoY.
- Wholesale services provide voice and data services to communication carriers and large scale providers of network capacity.
- Wholesale services include EarthLink's vast fiber optics network that has been built out and it's currently being leased to large telecom providers.
- With more than 30,000 route fiber miles, 90 metro fiber rings and eight secure enterprise-class data centers, most of which is currently being leased out and not used within the company, EarthLink should be able to monetize the asset for much more than the 200 million for which it is currently being held on its books.
Consumer:
Consumer
|
2012
|
2013
|
2014E
|
2015E
|
2016E
|
Revenue
|
$318
|
$276
|
$242
|
$213
|
$188
|
YoY Growth %
|
-13.1%
|
-12.5%
|
-12.0%
|
-11.5%
| |
% of Total Revenue
|
23.8%
|
22.3%
|
20.6%
|
18.6%
|
16.4%
|
EBITDA
|
$159
|
$138
|
$116
|
$102
|
$90
|
% YoY Growth
|
-13.1%
|
-16.0%
|
-12.0%
|
-11.5%
| |
% Margin
|
50.0%
|
50.0%
|
48.0%
|
48.0%
|
48.0%
|
% of Total EBITDA
|
56.0%
|
60.9%
|
58.2%
|
52.4%
|
46.5%
|
Description:
- The decline in the Consumer segment which has a negative outlook by analysts has largely been overblown.
- With record low churn rates, the consumer segment has been a steady provider of cash flows and has shown consistent improvements year over year in terms of growth.
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