Wall Street’s all about mixed messages – even companies with seemingly stellar investment prospects can turn out to be bad bets upon closer inspection. That’s the case with the small-cap internet stock I’m writing to you about today. Here’s everything you need to know to avoid this tiny vestige of the dot-com bubble…

EarthLink (NASDAQ: ELNK) is a large Internet service provider in the U.S., servicing over 2 million consumer and small business customers. The company provides about 44% of those customers with broadband access, and the rest through premium dial-up, which EarthLink looks to be a leader in. You read that right. EarthLink’s strategy is to be the leader in servicing the premium dial-up Internet access market.

Obviously, with that strategy revenue growth is not a priority here. Subscriber count was down 22% in the most recent quarter. Revenues for 2009 were down over 24% from 2008 levels. Broadband is a lower margin business, so as more and more dial-up customers convert over, operating margins may take a hit. Growing the dial-up subscriber base will have to be achieved by buying existing customers from legacy providers, most likely MSN (NASDAQ: MSFT). Clearly, growth here isn’t going to come from the top line. This is a business that will likely see declining sales for the foreseeable future.

Despite this fact, I still give EarthLink a B+ management grade, because the strategy that is being employed makes the best of a difficult situation. New management in 2007 drastically changed EarthLink’s direction: Instead of desperately burning capital trying to enter new businesses like municipal wi-fi and youth branded mobile services (a joint venture to form HELIO), new CEO Rolla Huff is getting back to basics…

EarthLink will focus on the business where it can succeed: premium dial-up. The wi-fi business has been divested, and HELIO was sold to Virgin Mobile — since acquired by Sprint (NYSE: S). Thousands of jobs have been cut, several facilities were closed, and marketing costs have been cut by 80%. The priority now is on retaining long-time dial-up customers, who are less likely to switch to broadband and require fewer support resources. Examples of these are primarily in rural areas where broadband is still not available. The changes have had a dramatically positive effect on profitability. Operating margins have jumped from about 10% to near 30%. Returns on capital and cash flows improved dramatically. EarthLink is a lean, cash-generating machine under the current structure.

Management last year decided to take that cash flow and provide value to their shareholders the proper way for a declining business: pay a dividend. And currently, it’s a whopper – a 7.3% yield. Despite the yield, EarthLink’s cash flow is plenty strong enough to support it over the next few years. Free cash flow payout is just 26%, and the board hiked the dividend last quarter by 14%.

Given this huge yield, the question is: will the stock price hold up? Obviously, EarthLink appears to be very cheap. Trailing earnings yield is 29%.

However, we have to remember the declining state of the company. Ultimately, I believe that EarthLink is going to have to stem its annual revenue decline from the current 20% down into the 7-8% range to be worth the current price of $8.80. There was some hope for this — last quarter net subscriber loss declined from a year ago, and a large percentage (86%) of current customers have been with the firm for 2 or more years.

Still, the company will need better, so despite its positive attributes, this stock gets nowhere near my “buy” list.

In addition to the bleak growth picture, EarthLink has other risks. Without a dedicated network, EarthLink is dependent on providers like Level 3 (NASDAQ: LVLT) or Time Warner Cable (NYSE: TWC) to renew service contracts. With this relationship, the network providers have the bargaining power, and if they decide to provide their own Internet services, EarthLink is out of luck.

The company is not losing only dial-up customers, but also broadband customers, illustrating their significant competitive disadvantages.

Truth be told, EarthLink can probably hold on for several years. Its financial health is good, with $708 million in cash vs. just $232 million in debt, and very strong free cash flow with margins at 25%. But the fact remains that this is just a business caught in a fast declining market with very poor prospects. The best hope for long-term EarthLink investors is for the company to be acquired for its subscriber base, perhaps by one of the cable providers who contract with it.

Outside of that, it’s difficult to see EarthLink around in 10 years. If you own this small-cap internet play, I’d recommend getting out while its valuation remains high…

Sincerely,
Steve Alexander
MagicDiligence.com
Penny Sleuth

May 24, 2010

Steve Alexander

Steve Alexander is the founder and editor of MagicDiligence, an Internet-based research and recommendation service focused on finding the best opportunities from Joel Greenblatt's Magic Formula Investing screens.  By fundamental research of growth potential, competitive position, and financial health, his picks have vastly outperformed the market at a success rate far exceeding that of most mutual funds.  Prior to this, he was a successful independent stock investor for over 10 years.

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