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EarthLink is the third largest Internet service provider in the U.S., servicing over 3.6 million consumer and small business customers. The company provides about a third 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 27% in 2006. Revenues so far for 2008 have been down over 21% from 2007 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, such as AOL or MSN. Clearly, growth here isn't going to come from the top line. This is a business that will likely see declining sales for the forseeable future.

Despite this fact, MagicDiligence still gives EarthLink a B+ management grade, because the strategy that is being employed makes the best of a difficult situation. New management last year drastically changed EarthLink's direction. Instead of desparately 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 EarthLink will not make additional investments towards HELIO. 900 jobs were cut, several facilities were closed, and marketing costs were cut by two-thirds. The focus now is on retaining long-time dial-up customers, which are less likely to switch to broadband and require fewer support resources. The changes have had a dramatically positive effect on profitability. Operating margins have jumped from about 10% to the mid-20's. MFI return on capital has skyrocketed to a figure over 180%. EarthLink is a lean, cash generating machine under the current structure.

Still, obviously, this stock gets nowhere near the Top Buys list. Clearly, EarthLink will face continuously declining prospects, and you can't cost cut your way to sustained prosperity. There's no moat here, in fact the opposite is true. Without a dedicated network, EarthLink is dependent on providers like Level 3 (LVLT) or Time Warner Cable (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 (like, for example, Comcast (CMCSA)), EarthLink is out of luck. Traditional landline phone service companies are getting into the Internet service game with services like DSL. The company is not losing only dial-up customers, but also broadband customers, illustrating their significant competitive disadvantages.

The company can probably hold on for several years. Financial health is good, with $379 million in cash vs. just $258 million in debt, and very strong free cash flow with margins here approaching 20%. The current share buyback authorization still has $190 million left on it, a whopping 21% of market capitalization. But the fact remains that this is just a business caught in a fast declining market with very poor prospects. The best hope for EarthLink investors is for the company to be acquired for it's 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. Avoid this one.

Steve owns no position in any stocks discussed in this article.

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