EarthLink takes giant leap

As outlined to the investment community in February, EarthLink is launching a series of initiatives that collectively could establish the company as a dominant force in all phases of telecom, with the exception of the enterprise market. Through major partnerships and acquisitions, the ISP plans to become a force in small and medium-sized business (SMB) services, quadruple-play bundles for consumers and broadband wireless infrastructure.

In the process, the company could become “an alternative last-mile connection for many consumers,” EarthLink CEO Garry Betty told an investment analyst conference Feb. 23.

“This year will be transformational,” Betty said. “We plan to become a total communications company. Our mission is for EarthLink to connect people to the power and possibilities of the Internet, anytime and anywhere.”

The riskiest part of the strategy is that it pits EarthLink directly against the companies with whom it has partnered, including major telecom players such as AT&T, BellSouth, Qwest, Sprint and Verizon and cable companies that include BrightHouse, Comcast and Time Warner Cable. Unlike other ISPs, EarthLink has sold its broadband service through commercial agreements with these operators, instead of using a “bring your own broadband” strategy.

If successful in its new initiatives, however, EarthLink would become a competitor in wireless communications, through its Helio mobile virtual network operatory (MVNO) partnership with SK Telecom of Korea, and its partnerships with major municipalities nationwide to offer public mesh wireless networks that could ultimately carry voice and data traffic. It would also offer high-speed data and line-powered voice through a partnership with Covad Communications, bundling in resold satellite service under deals with EchoStar and DirecTV and delivering IP/VPN and other IP-based services including voice to SMBs using its New Edge Networks acquisition.

It is the fact that EarthLink is directly challenging the telecom and cable giants that has financial analysts concerned that the company this year will invest $75 million to $100 million of the free cash flow generated by its ISP business into these new ventures. Although EarthLink executives expect their dial-up and broadband ISP business to continue to generate significant profits, the company is dramatically changing how it uses that money. After spending three years using its free cash flow to buy back shares — a total of $422 million worth since August 2002 — EarthLink is suspending that effort to focus on its new initiatives and expects to lose up to $45 million in 2006 as a result.

“We agree that the company needs to focus on new growth initiatives and diversify its revenue mix,” said Tim Horan of CIBC World Markets. “However, we believe that EarthLink's growth initiatives are very risky with uncertain long-term paybacks and will probably be more expensive and take longer to develop than management is estimating.”

Betty said at the February investment conference that the projected losses for the year take into account investments on all fronts, and the expectation is that there won't be any significant revenue uptick until the fourth quarter of 2006. EarthLink executives think they then will start seeing growth of 10% to 15% through 2009.

One other major question is whether one company can handle major initiatives on so many fronts at a single time. In addition to investing in the $440 million Helio joint venture, expected to launch by mid-year, EarthLink is spending $144 million to buy data CLEC New Edge Networks and will invest further to enable the company to market its services on a more widespread basis.

In addition, EarthLink has rolled out line-powered voice-over-IP service, called Home Phone Service, with Covad in four markets with plans to expand that further. Betty has admitted that EarthLink may need to help Covad pay for the network buildout required to extend Home Phone.

At the same time, EarthLink has emerged as the predominant partner for municipalities building out their own wireless networks, landing deals to build networks in Philadelphia and Anaheim, Calif., and becoming one of two finalists for the Minneapolis buildout. It also is a major bidder — with Google as its partner — in San Francisco. The Philadelphia and Anaheim networks are expected to be in operation by fourth quarter 2006.

“They are trying to do a lot at once,” said Bruce McGregor, senior analyst with Current Analysis. “And there are a lot of services they are looking to juggle. I have a kind of ‘wait and see’ attitude.”

EarthLink's ability to challenge the telephone and cable companies may be hampered by its dependence on commercial contracts with major players to provide its broadband services — the higher-value portion of the ISP business it is using to fund the rest of the business expansion, McGregor said.

“They are going against a lot of providers and trying to be a one-stop solution,” he said. “But consumers already have a lot of choices in these areas. And EarthLink won't own a lot of this — it will be reselling.”

For example, EarthLink will resell DirecTV in franchise territories where AT&T is selling EchoStar's Dish Network and, conversely, sell Dish where Verizon and BellSouth offer DirecTV as part of their bundle.

But as cable and telcos move to integrate their bundled services by offering cross-platform applications such as caller ID on a TV screen or digital video recorder programming via cell phone, EarthLink could be at a disadvantage, McGregor said.

However, as Betty insisted to his analyst audience, it is hard to count out a company that has so far delivered on its promises, both to customers and investors.

In fact, Current Analysis has taken a “slightly positive” stance on EarthLink because, McGregor said, the company has built a solid “marketing, customer acquisition and customer service machine,” which has been in the forefront of offering new services and features.

Betty acknowledges the major risks — particularly with Helio, which will compete as an MVNO in an already-cutthroat wireless market. The company is banking on the fact that the advanced applications its partner, SK Telecom, has successfully launched in South Korea will catch on here with younger wireless users. These include video, gaming and community services that already include a partnership with MySpace, the wildly popular Web site/blog with 57 million users.

And by deploying dual-mode Wi-Fi phones, the company hopes to not only offer its customers single-number service but also cut the costs of being an MVNO by moving voice traffic onto a home Wi-Fi network — perhaps even one it provides.

“Helio is very disruptive. It has the highest risk, but it also has the potential to, by itself, create significantly greater enterprise value than what's currently existing in our entire business today,” Betty said. “Voice is going to become part of our core, so you won't believe in three years that it has never been part of our business. It will be significant revenue value for us, with the promise of better margins and characteristics of retention than our existing areas of business.”