EarthLink is a telecom provider that has expanded from a concentration on consumer Internet access to a focus on Internet protocol (IP)-based communications services largely to small and midsize businesses (SMBs). The consumer business has experienced ongoing customer losses and we expect high customer churn and declining revenues to continue. EarthLink’s acquisitions of ITC DeltaCom and One Communications provide it with a wider geographic reach that now includes expanded network capabilities in the Southeast and Northeast.
These acquisitions also expand the company’s IP product set and provide it with a business customer base to which it can sell additional data-centric communications services. The acquired companies have reduced EarthLink’s dependence on the consumer Internet business to about 25% of revenues. However, the acquisitions have also reduced its overall profitability, since the consumer businesses’ 30% EBITDA margin is significantly higher than that of the acquired companies. As a result, EarthLink’s consolidated reported EBITDA margin was about 23% for the first quarter of 2012.
The company’s financial risk profile is less of a rating constraint than the business risk profile, in our view. We consider the financial risk profile “significant,” in light of the company’s 2.4x leverage and 31.5% funds from operations (FFO) to total debt for the last 12 months ended Dec. 31, 2011. The profit characteristics of the consumer business, and very limited capital requirements, contribute to our expectation that the company will continue to generate positive free operating cash flow (FOCF) over the next few years, despite near-term integration expenses and the heightened capital expenditures associated with the servicing of the business communications market.
The company’s liquidity is “adequate” under our criteria. Sources of liquidity are likely to be at least 1.2x uses of liquidity over the next 12 months. At March 31, 2012, sources included a cash balance of $271 million and an undrawn $150 million revolving credit facility. We also expect the company to continue to generate positive FOCF despite heightened capital expenditures of about $120 million to support the expansion of the business services segment. Uses of liquidity also include an ongoing common dividend of about $23 million, and we expect that the company’s financial maintenance covenants under its revolving credit will provide at least 15% of ongoing EBITDA cushion.
We rate the company’s $300 million of unsecured notes and subsidiary ITC DeltaCom’s $325 million of secured notes ‘B-’ with a ‘5’ recovery rating. The ‘5’ recovery rating indicates expectations for modest (10%-30%) recovery in the event of a payment default.
The outlook is stable. The company faces possible integration risks, which, in our view, could prompt customer service issues and accelerated churn, the latter being an ongoing challenge for all companies in this space. An increase in customer churn could compress margins and constrain the company’s ability to achieve operational synergies. Therefore, if churn or other operational missteps from the integration process result in our assessment that the company will be unable to generate FOCF a sustained basis, we could lower the ratings. This would be especially problematic if it also resulted in leverage increasing above 4x. Given the current vulnerable business risk assessment, an upgrade is not likely in the next year unless the company can reduce leverage significantly below 2x, including our adjustments, with no expectation for re-leveraging.
Related Criteria And Research
-- Issuer Ranking: U.S. Telecommunications And Cable Companies, Strongest To Weakest, April 26, 2012
-- Industry Report Card: U.S. Telecommunications And Cable: Some Islands Of Weakness In A Relatively Stable Sea, April 25, 2012
-- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
-- Criteria Methodology: Business Risk/Financial Risk Matrix Expanded, May 27, 2009
-- Key Credit Factors: Business And Financial Risks In the Global Telecommunication, Cable, And Satellite Broadcast Industry, Jan. 27, 2009