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EARTHLINK HOLDINGS CORP. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.(Edgar Glimpses Via Acquire Media NewsEdge) Certain statements in this Quarterly Report on 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 we believe that our expectations are based on reasonable assumptions, we can give no assurance that our 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 "Cautionary Note Concerning Factors That May Affect Future Results" in this Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations is intended to provide a reader of our financial statements with a narrative from the perspective of management. The following Management's Discussion and Analysis 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, 2013. Management's Discussion and Analysis of Financial Condition and Results of Operations is presented in the following sections: • Overview • Consolidated Results of Operations • Segment Results of Operations • Liquidity and Capital Resources • Non-GAAP Financial Measures • Cautionary Note Regarding Factors That May Affect Future Results Overview EarthLink Holdings Corp. ("EarthLink" or the "Company"), together with our consolidated subsidiaries, is a leading managed network, security and cloud services provider to business and residential customers in the United States. We operate two reportable segments, Business Services and Consumer Services. Our Business Services segment provides a broad range of data, voice and IT services to retail and wholesale business customers. Our Consumer Services segment provides nationwide Internet access and related value-added services to residential customers. We operate an extensive network including more than 28,000 route miles of fiber, 90 metro fiber rings and secure enterprise-class data centers that provide data and voice IP service coverage across more than 90 percent of the United States. General Developments in our Business Key developments in our business during the nine months ended September 30, 2014 are described below: • Generated revenues of $892.4 million, a 5% decrease compared to the nine months ended September 30, 2013, consisting of a $23.2 million decrease in Business Services revenue and a $23.1 million decrease in Consumer Services revenue. The decreases were primarily driven by declines in traditional voice and data products. However, partially offsetting these declines were several favorable items, including sales of growth products for our Business Services, the inclusion of revenues from CenterBeam, Inc. ("CenterBeam") which we acquired in July 2013, favorable dispute settlements related to our billings to other carriers for access to our network, targeted rate increases and new fees for modem equipment rental on certain Consumer Services subscribers. • Generated a net loss of $50.3 million, which reflects a decrease in Adjusted EBITDA, as described below. • Generated Adjusted EBITDA (a non-GAAP measure, see "Non-GAAP Financial Measures" in this Item 2) of $159.8 million, a decrease from $177.0 million in the prior year period primarily due to the decrease in revenues from traditional voice and data products, offset by reduced costs. • Generated cash flows from operating activities of $101.3 million, an increase from $83.4 million during the nine months ended September 30, 2013. • Generated Unlevered Free Cash Flow (a Non-GAAP measure, see "Non-GAAP Financial Measures" in this Item 2) of 20-------------------------------------------------------------------------------- Table of Contents $85.6 million, an increase from $67.3 million in prior year period primarily due to reduced capital expenditures, offset by the decrease in Adjusted EBITDA noted above. • Declared dividends of $0.15 per share, resulting in $10.9 million of dividend payment to shareholders during the nine months ended September 30, 2014 and $5.1 million of dividend payments to shareholders in October 2014. • Repurchased 0.7 million shares of our common stock pursuant to our share repurchase program for $2.2 million. Developments in our Business Strategy Our business strategy has been to be the premier communications and IT services provider for mid-market and enterprise customers. After our new Chief Executive Officer joined us in the first quarter of 2014, we conducted a thorough review of our strategy. We currently have a broad portfolio of products and services. In our Business Services segment, these include: managed network services, traditional voice and data services for small business customers, carrier and transport services, and cloud and IT services. We also operate a Consumer Services business. In connection with our review of our strategy, we analyzed these products and services to establish a more focused direction for our company and to align our organization, operations and investments accordingly. The primary result of this analysis is that we believe we should leverage our core strengths and focus our business strategy on growing our managed network services to distributed multi-location customers, as we have successfully been doing in the retail industry. We will support our managed network services with a relevant set of cloud and IT services. Other features of our developing business strategy include the following: • Increasing cash flow in our traditional voice and data services through a lower and more variable cost structure, as we have successfully done in our consumer business. • Managing our investment in cloud and IT services and in data centers to invest in services that are most relevant to our managed network services business. • Simplifying and rationalizing our product portfolio in our Business Services segment in order to be better able to invest in core products such as Multiprotocol Label Switching ("MPLS") and hosted voice. • Reviewing our addressable market in order to align our business around customer segments and to focus on the highest growth segments. • Increasing our emphasis on selling transport services. • Evaluating product portfolio alternatives that could further simplify our business and accelerate our development, which could lead us to discontinue or divest non-strategic products, assets or customers. We believe that these and other features of our operating plan will enable us to optimize our go-to-market model and the experience of our customers in our core products and services. This will include a refined customer segmentation and coverage model, a simpler pricing structure and shortened customer installation times. Challenges and Risks The primary challenge we face in executing on our business strategy is to continue to grow revenues from our growth products and services in order to offset revenue declines in our other products and services. Contributing to this challenge are the following: responding to competitive and economic pressures, reducing churn in our existing customer base, reducing the cycle time for customer installations, providing products and services that meet changing customer needs on a timely and cost-effective basis, and adapting to regulatory changes and initiatives. Another primary challenge is managing the rate of decline in revenues for our traditional products. To address these challenges, we are targeting larger customers who have lower churn profiles, focusing efforts on customer retention, re-terming contracts with our existing customers, upselling additional growth products and services to existing customers, implementing cost efficiencies in order to maximize cash flows and seeking to make costs more variable. Our future success for growth depends on the timing and market acceptance of our new products and services, our ability to market our services to new customers, our ability to differentiate our services from those of our competitors, our ability to maintain and expand our sales to existing customers, our ability to strengthen awareness of our brand, our ability to provide quality implementation and customer support for these products and the reliability and quality of our services. 21 -------------------------------------------------------------------------------- Table of Contents Revenue Sources Business Services. Our Business Services segment earns revenue by providing a broad range of data, voice and IT services to retail and wholesale business customers. We present our Business Services revenue in the following three categories: (1) retail services, which includes data, voice and IT services provided to business customers; (2) wholesale services, which includes the sale of transmission capacity to other telecommunications carriers and businesses; and (3) other services, which primarily consists of web hosting. Our IT services, which are included within our retail services, include data centers, virtualization, security, applications, premises-based solutions, managed solutions and support services. Revenues generally consist of recurring monthly charges for such services; usage fees; installation fees; termination fees; and administrative fees. Consumer Services. Our Consumer Services segment earns revenue by providing nationwide Internet access and related value-added services to residential customers. We present our Consumer Services in two categories: (1) access services, which includes narrowband access services and broadband access services; and (2) value-added services, which includes revenues from ancillary services sold as add-on features to EarthLink's Internet access services, such as security products, premium email only, home networking and email storage; search revenues; and advertising revenues. Revenues generally consist of recurring monthly charges for such services. Trends in our Business Our financial results are impacted by several significant trends, which are described below. Industry factors. We operate in the communications and IT services industry, which is characterized by intense competition, industry consolidation resulting in larger competitors, an evolving regulatory environment, changing technology and changes in customer needs. We expect these trends to continue. In addition, merger and acquisition transactions and other factors have reduced the number of vendors from which we may purchase network elements that we leverage to operate our business. Traditional Business Services revenues. Our traditional voice and data business service revenues, specifically traditional voice and lower-end, single site broadband services, have been declining due to competitive pressures and changes in the industry, and we expect this trend to continue. We have also experienced an increase in churn for these retail products, especially as customers come out of contract term and as we implement targeted price increases. To counteract trends in our Business Services revenues, we are focused on building long-term customer relationships, offering customers a bundle that includes our growth services and focusing on larger, more complex customers who have a lower churn profile. We are focused on providing managed network services and relevant cloud and IT services. As a result, sales in our growth products have increased and the mix of new sales is shifting towards our growth products. We are also taking steps to lower the cost structure of our Business Services operations. Economic conditions. Many of our customers are small and medium-sized businesses, and more specifically retail businesses. We believe these businesses are more likely to be affected by economic downturns than larger, more established businesses. We believe that the financial and economic pressures faced by our customers in this environment of diminished consumer spending, corporate downsizing and tightened credit have had, and may continue to have, an adverse effect on our results of operations, including longer sales cycles and increased customer demands for price reductions in connection with contract renewals. Additionally, our consumer access services are discretionary and dependent upon levels of consumer spending. Unfavorable economic conditions could cause customers to slow spending in the future, which could adversely affect our revenues and churn. Consumer access declines. Our consumer access subscriber base and revenues have been declining and are expected to continue to decline due to the continued maturation of the market for Internet access and competitive pressures in the industry. In addition, we have implemented, and expect to continue to implement, targeted price increases, which could negatively impact our churn rates. To counteract trends in our consumer revenues, we are focused on customer retention, operational efficiency and adding customers through marketing channels that we believe will produce an acceptable rate of return. Business Outlook We expect continued declines in Business Services revenues from traditional voice and data products. Revenues may also be adversely impacted by churn, competition, regulatory changes, timing and market acceptance of our newer products and services, shifting patterns of use, convergence of technology and general economic conditions. However, to counteract these pressures, we are focusing on growing our managed network products and services and improving operating efficiency. We are also focused on growing our wholesale services as we capitalize on new and unique fiber routes within our footprint. As a result, we expect the mix of our retail Business Service revenues to change over time, from traditional products to growth products and services. As our product mix shifts towards growth products, revenues may be impacted in the near term by longer sales cycles 22 -------------------------------------------------------------------------------- Table of Contents and installations and higher costs to deliver these services. We expect our consumer access subscriber base and revenues to continue to decrease due to limited sales and marketing activities, competition from cable, DSL and wireless providers, declines in gross broadband subscriber additions and the continued maturation of the market for narrowband Internet access. However, we expect the rate of churn and revenue decline to continue to decline as our customer base becomes longer tenured. Consolidated Results of Operations The following table sets forth statement of operations data for the three and nine months ended September 30, 2013 and 2014: |