Possible Marriage Proposals Are Lifting Earthlink
By David Shook
While most CEOs shun comment on merger rumors involving their own companies, Earthlink's affable chief, Garry Betty, has no such qualms. Microsoft? Sure. Disney? Why not. "I could speculate all day about who would buy a company like Earthlink," he says. "Our story is that we've been successful providing the basics better than the competition."
Alas, profitability continues to elude Earthlink (ELNK ), No. 2 among Internet service providers next to America Online. But it controls that first Web page the vast majority of its 4.7 million paying subscribers view every time they log on to the Net. That's valuable real estate that Earthlink could use to promote movies or software or TV shows for a larger media parent -- just as America Online now does so successfully for AOL Time Warner's media divisions. "If subscribers are forced to see that home page every time they log on to the Internet, advertisers are going to want to be there," says Yankee Group ISP expert Rob Lancaster, explaining the value of Earthlink to a profitable media company.
That welcome screen makes Earthlink intriguing to investors while merger speculation continues to swirl. The Atlanta-based ISP's stock is rising at a time when most dot-coms are still in the tank. Earthlink shares got pummeled in 2000, falling from a high of $22 to $5 in late December. But shareholders seem to believe a deal is in the works. On Feb. 9, Sprint (FON ), which owns 27% of Earthlink, announced an end to an agreement that gave it the right of first refusal on any merger proposal Earthlink receives. Result: The ISP's stock has shot up 130%, to $11.50. And it could rise a lot further if in fact an acquirer emerges over the next few months.
The most logical candidate is deep-pocketed Microsoft (MSFT ) and its MSN portal/ISP. But Disney (DIS ), an Earthlink partner with an Internet division in disarray, and Yahoo! (YHOO ), the world's largest free Web portal struggling to increase revenue, also might be suitors.
If Earthlink were bought, the deal most likely would come from a company that can offer Web content in the form of software or entertainment, broadband capacity -- from a telephone company or cable provider -- or cold, hard cash. While Earthlink's market value is just under $2 billion, Microsoft has $27 billion in cash, so money is no object there. A deal would double MSN's ISP subscriber base while hardly putting a dent in Microsoft's bank account.
"We think Microsoft is by far the most likely buyer," says Fred Moran, analyst for Jefferies & Co. "Microsoft could buy Earthlink for cash or stock, take full control, and then spin off all the Internet operations [MSN and Earthlink] into [a separate] stock or a tracking stock." Yankee Group's Lancaster says he hears Microsoft thrown around as a possible buyer almost daily because it so badly wants to challenge AOL -- with its 28 million users -- as the leading consumer Net company.
Of course, even combined, Earthlink and MSN would have just under 9 million subscribers -- still short of what's needed to give AOL a run for its money. According to Yankee Group, MSN trails Earthlink by 600,000 subscribers. Microsoft has just over 4 million, but its growth may decline now that the company has ended a $400 rebate program offered with many new computers that's designed to sign up Web surfers for MSN.
The benefits of an Earthlink combination go beyond adding subscribers, however. True, the company lost $370 million in 2000 on revenues of more than $1 billion. But that largely was due to Earthlink's heavy push into high-speed, broadband Web access. One form of broadband is digital subscriber lines, or DSL. And Earthlink has picked up more DSL customers than AOL or Microsoft.
What would other buyers bring to the table? Disney, which not so long ago shuttered its Go.com portal, might make sense as a buyer. It has the cinema (Disney Studios, Miramax) and television (ABC, ESPN, Disney Channel) to blend with Earthlink's Net users. In fact, Earthlink already receives sports news from ESPN, just as AOL gets content from its new sister companies CNN and Sports Illustrated. "We've had a long relationship with Disney," says Earthlink spokesman Kurt Rahn.
Even troubled Yahoo! (YHOO ) gets mentioned as a plausible buyer. As the world's most popular Web portal, it has heavy traffic and appealing content. But Earthlink's Betty points out that Yahoo! looks more like a takeover target now than an acquirer. As a result of the online advertising slowdown, Yahoo!'s stock has tumbled to $13 a share from $200 a year ago.
Still, the combination might make sense. Yahoo! derives about 90% of its sales from advertising and doesn't have subscription revenue to lessen its advertising exposure. Earthlink is just the opposite. It grabs 97% of its revenues from $22-a-month subscription fees, so it has a steady cash flow and almost no advertising exposure.
Betty won't acknowledge any negotiations -- or deny they've taken place. Nor would Microsoft, Disney, Yahoo!, or Sprint. But all the speculation continues to bump Earthlink's stock higher. "A deal would certainly make sense for those companies," says David Smith, a Gartner Group consultant and an expert on Microsoft and AOL.
Challenges? Earthlink faces a bundle. Getting enough broadband lines at affordable wholesale prices from the Baby Bells and cable companies remains the company's biggest hurdle. "We'd be significantly larger" if the company could buy more capacity from telephone companies such as SBC and any capacity at all from cable providers AT&T (T ) and Comcast (CCZ ), Betty says.
Earthlink has met fierce resistance from cable as broadband has emerged. It hasn't signed any major deals with four of the five biggest cable operators. Only AOL Time Warner has agreed to let Earthlink sell broadband service over its cable systems. But that's a result of government pressure applied when AOL and Time Warner were asking for permission to merge. No other cable company is legally bound to partner with Earthlink. Even so, while cable or telecom companies don't top the list of potential Earthlink buyers, a player in these industries might possibly want the ISP as the retail face of its broadband operations.
Of course, it's always possibile that no buyer emerges. Yes, investors might get burned, but it wouldn't be the end of the world for the company. Earthlink wants to keep building its brand name and has proven in the past six months that it can rapidly add subscribers, without any outside help -- something that can't be said of most other ISPs.
Betty continues to assert that Earthlink could reach operating profitability by the fourth quarter of 2001. But when asked if it would risk compromising its independence for the sake of a merger that benefits shareholders, Betty implied he might be willing if the right deal comes along. With the rest of the sector's outlook remaining in doubt, this could be a chance for Earthlink to give investors a nice surprise.
Shook covers financial markets for BW Online in New York
Edited by Beth Belton