Why EarthLink needs Wi-Fi to work
With dial-up dying and broadband subscriptions stagnant, EarthLink must build its own networks to survive.
By Owen Thomas, Business 2.0 Magazine online editor

SAN FRANCISCO (Business 2.0 Magazine) - The first-quarter earnings that EarthLink announced today illustrate its plight. While the Internet service provider is still profitable, dial-up revenues dropped 18 percent from the same period last year, broadband revenues increased a mere 6 percent, and earnings-per-share dropped nearly 50 percent to 12 cents per share.

Most ominously, free cash flow, which is mostly generated by EarthLink's declining Internet access business, dropped 38 percent to $21.5 million. That's a particularly troubling sign, since it is that dwindling cash flow that CEO Garry Betty says he plans to invest in the company's new wired and wireless networks, which may be the key to its survival.

To get out of its slump, EarthLink (Research) is making moves to build and operate its own telecom networks, rather than renting them from wholesale providers. But Wall Street analysts are mixed on how likely that gambit is to succeed.

Last week, the company completed the $144 million acquisition of New Edge Networks, a Vancouver, Wash.-based telecom provider that mostly serves retailers and other small businesses, and owns its own switching facilities across the U.S.

And yesterday, EarthLink quietly launched the first of several citywide Wi-Fi networks it's building in Anaheim, Calif., charging $21.95 a month for Internet access. In the past few weeks, EarthLink has also teamed up with Google (Research) to win a bid to build a Wi-Fi network in San Francisco, and won a contract for a high-speed wireless broadband network in Milpitas, Calif. EarthLink also won a bid last year to build a network in Philadelphia.

It has also invested $50 million in Covad, a telecom company which provides DSL and phone service using a combination of its own network equipment and lines rented from local phone companies.

Avoiding infrastructure

When it was founded a dozen years ago, EarthLink made a then-radical decision: It was going to provide Internet service by renting out other companies' network facilities instead of building its own. Before EarthLink came along, ISPs built their own networks, and were even valued on how many network points of presence - also called hubs of connectivity - they had.

At the time, EarthLink's infrastructure-free strategy gave it a big advantage over rivals which spent heavily to build their own networks.

"EarthLink has been a great marketing services company," says CEO Garry Betty. "We've tried to pick our battles about how to allocate capital. We were the first non-facilities-based ISP."

By concentrating on marketing, customer service, and easy-to-use installation software, EarthLink snapped up smaller competitors and rose to the top of the dial-up Internet business, with only Time Warner's (Research) AOL and Microsoft's (Research) MSN counting more subscribers.

As broadband grew more widely available, EarthLink rented DSL and cable lines from the likes of BellSouth (Research), Time Warner Cable, and Verizon (Research), serving customers over those companies' networks. But many broadband providers refused to play ball.

And EarthLink could only charge customers a small markup over those companies' wholesale fees, making broadband less profitable than dial-up, where many providers competed to offer wholesale access lines.

Betty notes that limited DSL coverage and a refusal by most cable providers to rent out their lines has also made it hard for the ISP to market broadband. "In 75% of the U.S., I can't provision an EarthLink connection on cable systems, and it's not for lack of trying," he says.

The price of rolling your own networks

That's why EarthLink is now shifting gears and building out its own infrastructure.

Through New Edge's networking facilities, EarthLink could offer broadband Internet and telephone service directly to customers over its own network. Betty says the company is considering trials of such a service, even as it continues to work with Covad, the telecom in which EarthLink invested $50 million, and Level 3, another telecom partner.

As for its Wi-Fi investment, says Betty, "if there were third parties that were stepping up to build these networks, EarthLink would be glad to buy access wholesale from them." But with most Wi-Fi networks limited to isolated hotspots, a wholesale market for networks that cover entire cities has yet to develop.

But building Wi-Fi networks won't break EarthLink's bank, says Keith Dalrymple, an analyst at investment bank New York Global Securities. Dalrymple estimates that citywide Wi-Fi networks will cost about $100,000 a square mile to build, which means EarthLink could blanket a city like San Francisco for about $5 million. "Wi-Fi is a very cheap way to get into network ownership," he said.

A matter of experience

Betty says EarthLink can cut the cost of Wi-Fi deployment nearly in half over time as it gains experience in building networks and negotiates larger orders with suppliers.

CIBC Worlds Markets analyst Tim Horan is less optimistic. In a recent report in which he downgraded EarthLink to "sector underperformer," he observed that "the company does not have a lot of experience in managing these different facilities-based services. The history of many of these facilities-based networks is that they cost more and take longer to develop than managements expect."

"I disagree," says Betty. "Managing networks is something we can do."

Betty points out that EarthLink already manages the network infrastructure that it rents, and could apply the same expertise to networks it builds. EarthLink has also added more network-management expertise with its New Edge Networks acquisition.

Still, Betty is placing a large bet on his team's ability to run networks. Jefferies & Co. analyst Youssef Squali estimates that investment in Wi-Fi and New Edge Networks will add $75 million to $100 million in operating expenses in the 2006 fiscal year. In recent years, EarthLink has put its cash flow to use buying back stock; now it's using virtually all of that cash to expand its networks.

In its favor, EarthLink has a strong brand and loyal customers; more than a third of its new broadband signups come from current dial-up Internet customers.

EarthLink's new moves will take time to prove their success: Betty doesn't expect to see substantial revenues from Wi-Fi subscribers until 2007. In the meantime, its cash-cow dial-up revenues, which were $743 million in 2005, keep dropping 17 to 18 percent a year.

As the cash that flows from dial-up shrinks, for EarthLink, building its own broadband network isn't an experiment - it's a matter of life or death. Top of page

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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer.

Morningstar: © 2014 Morningstar, Inc. All Rights Reserved.

Factset: FactSet Research Systems Inc. 2014. All rights reserved.

Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved.

Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor’s Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2014 and/or its affiliates.