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How Earthbound Is EarthLink?

By Jane Black On May 21, the Senate Commerce Committee served notice on spammers everywhere that their days of clogging the information superhighway may be numbered. The congressional panel held a hearing to determine how best to reduce the billions of unwanted e-mails, hawking everything from Viagra to the latest get-rich-quick scheme, that clog innocent surfers' in-boxes. The House of Representatives is in on the act too -- a handful of bills aimed at helping reduce spam have been introduced on the other side of the U.S. Capitol.

Lawmakers aren't the only ones who have noticed the growing backlash against spam, however. On May 28, EarthLink (ELNK), the largest independent Internet service provider, introduced its new and improved Spam Blocker. Instead of filtering incoming e-mails and blocking what appears to be junk, EarthLink will only allow e-mail from approved contacts to enter a user's in-box. "We call it dethorning the rose of the Internet. [Our focus is to provide tools] that give the user control of their Internet experience," EarthLink CEO Garry Betty told the Goldman Sachs Internet conference in Las Vegas on May 21.

EarthLink hopes services such as Spam Blocker will help differentiate it from the gaggle of ISPs -- including giant telecom and cable providers -- squabbling over the $17 billion U.S. market. It already has a respected reputation for its privacy-protection policies, as well as for providing other useful tools, such as its pop-up blocker, which puts an end to those ads that automatically pop up while you're navigating your favorite Web site (including BusinessWeek Online). And EarthLink says about 60% of Americans are familiar with its brand, according to its own survey.

A QUESTION OF TIMING. That popularity -- and a fat balance sheet -- have kept EarthLink afloat in rough economic times, especially for ISPs. Earthlink has 4 million subscribers, with 82% of them still using dial-up. But it's only a matter of time before growth flattens or, as analysts have speculated for years, EarthLink is acquired by a DSL provider, cable operator, or portal player, such as AOL or MSN.

In that sense, investors with an appetite for risk might view EarthLink as an opportunity -- at $6.66 a share, as of the closing bell on May 28, its stock appears cheap, and the outfit seems to be doing all the right things. If it were bought, there would most likely be a healthy run-up in the shares first. But timing is key, and an acquisition is hardly guaranteed. For most investors, the uncertainty is good reason to think carefully before investing in EarthLink.

Unlike DSL and cable providers, EarthLink doesn't own its own network. In the dial-up world, that hasn't mattered since subscribers connected via their phone lines. But in the emerging broadband era, EarthLink's independent status leaves it at the mercy of the telcos and cable operators, who historically have been hostile to opening up their pipes to resellers.

ADDICTED TO DIAL-UP? "EarthLink can only play with the cards it has been dealt," says Tim Horan, an analyst at CIBC World Markets. "Considering what they've got, they're executing as well as you can expect." That's part of the reason why a consensus of analysts expect only modest growth in the stock price by year end, to around $7.50 a share.

Even as broadband spreads, EarthLink is still banking on dial-up for much of its growth. In the first quarter, it reported revenues of $354 million, up 6.1% over the same period a year ago, and earnings before interest, taxes, depreciation, and amortization of $22 million. But the profit comes entirely from its traditional, premium-priced dial-up business, which it sells for $21.95 per month.

To compete in the future, EarthLink has expanded into two new arenas: limited or value dial-up, where subscribers get fewer bells and whistles, which costs about $9.95 a month, and an unlimited, high-speed broadband service at $29.95 for the first six months and $49.95 for the remaining six. "We're paying to keep our options open," says Mike Lunsford, EarthLink's executive vice-president of customer experience. "We think there's a lot of value in that as the market continues to develop."

AGGRESSIVE COMPETITION. In all three areas, however, a tough road lies ahead. First, broadband: EarthLink added 112,000 new high-speed subscribers in the first quarter of 2003 -- bringing its total to 891,000 broadband users. But thanks to high acquisition and customer-service costs, the company is still at least a year away from breaking even on broadband service, according to its own estimates. Gross margins on broadband are about 25%, vs. 74% for premium dial-up service.

With competitors slashing prices, breaking even in 2004 may be a stretch. For example, on May 13, Verizon (VZ), the largest U.S. phone company, announced that it would increase connection speeds, cut prices from $49.95 to $34.95 a month, and offer free high-speed wireless access to subscribers in select areas (see BW Online, 5/14/03, "Verizon's Equalizer vs. the Cable Guys").

That handily tops EarthLink's $29.95 a month front end, $49.95 back end offer -- a promotion that already costs EarthLink $120 per customer per year. "Verizon's aggressive pricing on retail is how they plan on gaining share from the cable companies. They're not looking to resale partners to help drive market share," says Mark May, Internet analyst at New York-based investment firm Kaufman Bros.

BORROWED TIME? Then there's value dial-up, and again, EarthLink hasn't quite been able to keep up with its competitors. It entered the arena in July, 2002, with its $63 million acquisition of PeoplePC, an ISP that catered to low-end subscribers. At the end of 2002, EarthLink had added 68,000 value subscribers -- a number that analysts expect to grow 156%, to 242,000, in 2003.

By 2006, Kaufman's May estimates that the value business will produce gross margins of 54%. Not bad -- until you look at value leader United Online (UNTD) (see BW Online, 5/4/03, "United Online: Value ISP, Pricey Stock"). It already has 2.4 million subscribers and is expected to lure 470,000 more this year alone. According to May, United Online already generates 62% gross margins.

As for EarthLink's premium dial-up business, most analysts believe that market will ultimately disappear over the next decade. But not before EarthLink is able to put the division's free cash flow -- an estimated $62 million in 2003 -- to good use. And with $500 million in cash on its balance sheet, EarthLink has some time to try to plot an alternative strategy -- or, as many hope, to be acquired by a cable or telecom operator.

STRONGEST INDY. Just like the battle against spam, the path to a broadband world is likely to be a slow and bumpy. Whether EarthLink and other independent ISPs will find a profitable niche remains unclear. For now, EarthLink will continue to appeal to high-end Internet users who value its anti-spam and privacy tools. And of all the independent ISPs, EarthLink is best positioned -- financially and philosophically -- to weather the transition. It could ultimately be a tempting acquisition.

Still, investors may want to be cautious until the horizon is clearer. No matter how well EarthLink is doing now, it's fighting a dial-up clock that's running out. Black covers technology for BusinessWeek Online in New York

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