10-Q 1 a11-25644_110q.htm 10-Q

Table of Contents

 

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

x      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2011

 

OR

 

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from           to           .

 

Commission File Number: 001-15605

 

EARTHLINK, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

 

58-2511877

(State or other jurisdiction of incorporation or organization)

 

(I.R.S. Employer Identification No.)

 

 

1375 Peachtree St., Atlanta, Georgia      30309

(Address of principal executive offices)     (Zip Code)

 

(404) 815-0770

(Registrant’s telephone number, including area code)

 


 

 

(Former name, former address and former fiscal year, if changed since last report date)

 


 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x  No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer x

 

Accelerated filer o

 

 

 

Non-accelerated filer o

 

Smaller reporting company o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No x

 

As of October 31, 2011, 106,683,532 shares of common stock, $0.01 par value per share, were outstanding.

 

 

 




Table of Contents

 

PART I

 

Item 1.  Financial Statements.

 

EARTHLINK, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

 

(in thousands, except per share data)

 

 

 

December 31,

 

September 30,

 

 

 

2010

 

2011

 

 

 

 

 

(unaudited)

 

 

 

 

 

 

 

ASSETS

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

242,952

 

$

515,310

 

Marketable securities

 

307,814

 

 

Restricted cash

 

2,270

 

1,781

 

Accounts receivable, net of allowance of $1,182 and $6,417 as of December 31, 2010 and September 30, 2011, respectively

 

60,216

 

103,795

 

Prepaid expenses

 

12,161

 

15,960

 

Deferred income taxes, net

 

45,661

 

65,435

 

Other current assets

 

14,802

 

18,087

 

Total current assets

 

685,876

 

720,368

 

Long-term marketable securities

 

12,304

 

 

Property and equipment, net

 

241,111

 

384,620

 

Deferred income taxes, net

 

189,037

 

94,976

 

Purchased intangible assets, net

 

135,364

 

297,999

 

Goodwill

 

259,046

 

428,346

 

Other long-term assets

 

1,240

 

22,280

 

Total assets

 

$

1,523,978

 

$

1,948,589

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

17,272

 

$

20,881

 

Accrued payroll and related expenses

 

18,402

 

30,978

 

Accrued interest

 

8,622

 

32,712

 

Other accrued liabilities

 

67,007

 

102,571

 

Deferred revenue

 

40,921

 

56,024

 

Current portion of long-term debt and capital lease obligations

 

243,069

 

255,888

 

Total current liabilities

 

395,293

 

499,054

 

 

 

 

 

 

 

Long-term debt and capital lease obligations

 

351,251

 

655,064

 

Other long-term liabilities

 

19,566

 

31,950

 

Total liabilities

 

766,110

 

1,186,068

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Convertible preferred stock, $0.01 par value, 100,000 shares authorized, 0 shares issued and outstanding as of December 31, 2010 and September 30, 2011

 

 

 

Common stock, $0.01 par value, 300,000 shares authorized, 191,825 and 195,936 shares issued as of December 31, 2010 and September 30, 2011, respectively, and 108,382 and 107,366 shares outstanding as of December 31, 2010 and September 30, 2011, respectively

 

1,918

 

1,959

 

Additional paid-in capital

 

2,061,555

 

2,075,532

 

Accumulated deficit

 

(648,235

)

(617,819

)

Treasury stock, at cost, 83,443 and 88,570 shares as of December 31, 2010 and September 30, 2011, respectively

 

(657,611

)

(697,151

)

Accumulated other comprehensive income

 

241

 

 

Total stockholders’ equity

 

757,868

 

762,521

 

Total liabilities and stockholders’ equity

 

$

1,523,978

 

$

1,948,589

 

 

The accompanying notes are an integral part of these financial statements.

 

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Table of Contents

 

EARTHLINK, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

 

 

2010

 

2011

 

2010

 

2011

 

 

 

(in thousands, except per share data)

 

 

 

(unaudited)

 

 

 

 

 

 

 

 

 

 

 

Revenues

 

$

145,158

 

$

357,290

 

$

455,423

 

$

963,867

 

 

 

 

 

 

 

 

 

 

 

Operating costs and expenses:

 

 

 

 

 

 

 

 

 

Cost of revenues (exclusive of depreciation and amortization shown separately below)

 

55,024

 

161,327

 

170,033

 

429,407

 

Selling, general and administrative (exclusive of depreciation and amortization shown separately below)

 

41,896

 

108,827

 

127,517

 

295,786

 

Depreciation and amortization

 

4,327

 

46,567

 

13,652

 

113,336

 

Restructuring and acquisition-related costs

 

1,921

 

8,966

 

3,267

 

24,517

 

Total operating costs and expenses

 

103,168

 

325,687

 

314,469

 

863,046

 

 

 

 

 

 

 

 

 

 

 

Income from operations

 

41,990

 

31,603

 

140,954

 

100,821

 

Gain on investments, net

 

 

 

572

 

 

Interest expense and other, net

 

(5,466

)

(22,161

)

(16,241

)

(54,197

)

Income before income taxes

 

36,524

 

9,442

 

125,285

 

46,624

 

Income tax provision

 

(15,139

)

(1,937

)

(49,113

)

(16,208

)

Net income

 

$

21,385

 

$

7,505

 

$

76,172

 

$

30,416

 

 

 

 

 

 

 

 

 

 

 

Net income per share

 

 

 

 

 

 

 

 

 

Basic

 

$

0.20

 

$

0.07

 

$

0.71

 

$

0.28

 

Diluted

 

$

0.20

 

$

0.07

 

$

0.70

 

$

0.28

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

 

 

 

 

 

 

 

 

Basic

 

108,220

 

107,794

 

107,968

 

108,585

 

Diluted

 

109,473

 

108,523

 

108,851

 

109,535

 

 

 

 

 

 

 

 

 

 

 

Dividends declared per share

 

$

0.16

 

$

0.05

 

$

0.46

 

$

0.15

 

 

The accompanying notes are an integral part of these financial statements.

 

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Table of Contents

 

EARTHLINK, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 

 

Nine Months Ended

 

 

 

September 30,

 

 

 

2010

 

2011

 

 

 

(in thousands)

 

 

 

(unaudited)

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

76,172

 

$

30,416

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Depreciation and amortization

 

13,652

 

113,336

 

Loss on disposals and impairments of fixed assets

 

561

 

3,688

 

Stock-based compensation

 

7,078

 

10,454

 

Non-cash income taxes

 

45,530

 

11,851

 

Amortization of debt discount, premium and issuance costs

 

10,847

 

9,690

 

Gain on investments, net

 

(572

)

 

Gain on debt surrendered for conversion

 

(172

)

 

Other

 

 

(748

)

(Increase) decrease in accounts receivable, net

 

(1,043

)

9,479

 

(Increase) decrease in prepaid expenses and other assets

 

(2,447

)

(28,140

)

Decrease in accounts payable and accrued and other liabilities

 

(19,498

)

(45,797

)

(Decrease) increase in deferred revenue

 

(2,903

)

2,251

 

Net cash provided by operating activities

 

127,205

 

116,480

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Purchase of businesses, net of cash acquired

 

 

(40,097

)

Purchases of property and equipment

 

(8,748

)

(70,967

)

Purchases of marketable securities

 

(345,193

)

 

Sales and maturities of marketable securities

 

92,723

 

319,729

 

Change in restricted cash

 

 

489

 

Other investing activities

 

1,618

 

(3,765

)

Net cash (used in) provided by investing activities

 

(259,600

)

205,389

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from issuance of debt, net of issue costs

 

 

278,383

 

Proceeds from exercises of stock options

 

2,565

 

566

 

Repurchases of common stock

 

(851

)

(39,540

)

Payment of dividends

 

(50,118

)

(17,214

)

Repayment for debt and capital lease obligations

 

(2,794

)

(272,391

)

Other financing activities

 

 

685

 

Net cash used in financing activities

 

(51,198

)

(49,511

)

 

 

 

 

 

 

Net (decrease) increase in cash and cash equivalents

 

(183,593

)

272,358

 

Cash and cash equivalents, beginning of period

 

610,995

 

242,952

 

Cash and cash equivalents, end of period

 

$

427,402

 

$

515,310

 

 

The accompanying notes are an integral part of these financial statements.

 

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Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED

 

1.  Organization

 

EarthLink, Inc. (“EarthLink” or the “Company”), together with its consolidated subsidiaries, provides Internet protocol (IP) infrastructure and communications services to business and residential customers in the United States. The Company operates two reportable segments, Business Services and Consumer Services. The Company’s Business Services segment provides a comprehensive suite of communications and technology services, including voice, data, managed network services, cloud hosting and equipment services, to businesses, enterprise organizations and communications carriers. The Company provides its Business Services primarily through a nationwide network utilizing a 27-state fiber optic network, Multi-Protocol Label Switching (“MPLS”) and other technologies. The Company’s Consumer Services segment provides nationwide Internet access and related value-added services to residential customers. For further information concerning the Company’s business segments, see Note 14, “Segment Information.”

 

2.  Summary of Significant Accounting Policies

 

Basis of Presentation

 

The condensed consolidated financial statements of EarthLink for the three and nine months ended September 30, 2010 and 2011 and the related footnote information are unaudited and have been prepared on a basis consistent with the Company’s audited consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010  as filed with the Securities and Exchange Commission (the “SEC”) (the “Annual Report”).

 

These financial statements should be read in conjunction with the audited consolidated financial statements and the related notes thereto contained in the Company’s Annual Report.  In the opinion of management, the accompanying unaudited financial statements contain all adjustments (consisting of normal recurring adjustments), which management considers necessary to present fairly the Company’s financial position, results of operations and cash flows for the interim periods presented.  The results of operations for the three and nine months ended September 30, 2011 are not necessarily indicative of the results anticipated for the entire year ending December 31, 2011.

 

Basis of Consolidation

 

The accompanying condensed consolidated financial statements of EarthLink include the accounts of its wholly-owned subsidiaries. All significant intercompany transactions have been eliminated.

 

Use of Estimates

 

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements.  Actual results may differ from those estimates.

 

Reclassifications

 

Certain amounts in the prior year financial statements have been reclassified to conform to the current year presentation. The Company combined sales and marketing, operations and customer support and general and administrative expenses into selling, general and administrative expenses. In addition, the Company reclassified depreciation expense from cost of revenues and selling, general and administrative expenses to depreciation and amortization. Approximately $1.9 million of depreciation expense was reclassified from cost of revenues and $1.5 million of depreciation expense was reclassified from selling, general and administrative expenses to depreciation and amortization during the three months ended September 30, 2010, and approximately $5.8 million of depreciation expense was reclassified from cost of revenues and $4.5 million of depreciation expense was reclassified from selling, general and administrative expenses to depreciation and amortization during the nine months ended September 30, 2010.

 

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Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

Recently Issued Accounting Pronouncements

 

In May 2011, the Financial Accounting Standards Board (“FASB”) issued authoritative guidance related to fair value measurements. This guidance was issued to provide a consistent definition of fair value and ensure that the fair value measurement and disclosure requirements are similar between U.S. GAAP and International Financial Reporting Standards. This guidance also changes certain fair value measurement principles and enhances the disclosure requirements particularly for Level 3 fair value measurements. This guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The Company does not expect this guidance to have a material impact on its consolidated financial statements.

 

In June 2011, the FASB issued authoritative guidance related to comprehensive income. This guidance was issued to increase the prominence of items reported in other comprehensive income and requires that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In addition, reclassification adjustments for items that are reclassified from other comprehensive income to net income must be presented on the face of the financial statements where the components of net income and the components of other comprehensive income are presented. This guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The Company does not expect this guidance to have a material impact on its consolidated financial statements.

 

In September 2011, the FASB issued authoritative guidance related to goodwill testing. This guidance allows an entity to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. Under these amendments, an entity would not be required to calculate the fair value of a reporting unit unless the entity determines, based on a qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount.  This guidance is effective for fiscal years beginning after December 15, 2011, with early adoption permitted. The Company does not expect this guidance to have a material impact on its consolidated financial statements.

 

3.  Earnings per Share

 

The Company presents a dual presentation of basic and diluted earnings per share. Basic earnings per share represents net income divided by the weighted average number of common shares outstanding during the reported period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock, including stock options, restricted stock units and convertible debt (collectively “Common Stock Equivalents”), were exercised or converted into common stock. The dilutive effect of outstanding stock options, restricted stock units and convertible debt is reflected in diluted earnings per share by application of the treasury stock method. In applying the treasury stock method for stock-based compensation arrangements, the assumed proceeds are computed as the sum of the amount the employee must pay upon exercise, the amount of compensation cost attributed to future services and not yet recognized and the amount of excess tax benefits, if any, that would be credited to additional paid-in capital assuming exercise of the awards.

 

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Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

The following table sets forth the computation for basic and diluted net income per share for the three and nine months ended September 30, 2010 and 2011:

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2010

 

2011

 

2010

 

2011

 

 

 

(in thousands, except per share data)

 

Numerator

 

 

 

 

 

 

 

 

 

Net income

 

$

21,385

 

$

7,505

 

$

76,172

 

$

30,416

 

 

 

 

 

 

 

 

 

 

 

Denominator

 

 

 

 

 

 

 

 

 

Basic weighted average common shares outstanding

 

108,220

 

107,794

 

107,968

 

108,585

 

Dilutive effect of Common Stock Equivalents

 

1,253

 

729

 

883

 

950

 

Diluted weighted average common shares outstanding

 

109,473

 

108,523

 

108,851

 

109,535

 

 

 

 

 

 

 

 

 

 

 

Basic net income per share

 

$

0.20

 

$

0.07

 

$

0.71

 

$

0.28

 

Diluted net income per share

 

$

0.20

 

$

0.07

 

$

0.70

 

$

0.28

 

 

During the three months ended September 30, 2010 and 2011, approximately 2.2 million and 1.6 million, respectively, of stock options and restricted stock units were excluded from the calculation of diluted earnings per share because their effect would have been anti-dilutive. During the nine months ended September 30, 2010 and 2011, approximately 2.8 million and 1.8 million, respectively, of stock options and restricted stock units were excluded from the calculation of diluted earnings per share because their effect would have been anti-dilutive. The shares that underlie the Company’s convertible senior notes were also excluded from the calculation of diluted earnings per share during the three months ended September 30, 2011 because their effect would have been anti-dilutive. Anti-dilutive securities could be dilutive in future periods.

 

4.  Acquisitions

 

ITC^DeltaCom

 

On December 8, 2010, EarthLink acquired ITC^DeltaCom, Inc. (“ITC^DeltaCom”), a provider of integrated communications services to customers in the southeastern U.S., at a price of $3.00 per share. EarthLink acquired 100% of ITC^DeltaCom in a merger transaction with ITC^DeltaCom surviving as a wholly-owned subsidiary of EarthLink. The primary reason for the acquisition was to enable the Company to expand its IP infrastructure and communications services by combining its existing business services with ITC^DeltaCom’s integrated communications business. EarthLink has included the financial results of ITC^DeltaCom in its consolidated financial statements from the date of the acquisition.

 

The fair value of consideration transferred was $253.8 million, which consisted of $251.4 million in cash paid to acquire the outstanding common stock of ITC^DeltaCom and $2.3 million for the fair value of restricted stock units assumed and converted. In allocating the consideration transferred based on estimated fair values, EarthLink recorded $173.7 million of goodwill, $131.2 million of identifiable intangible assets, $199.3 million of property and equipment, $351.2 million of long-term debt and $100.8 million of other net assets. The Company allocated the consideration transferred to the tangible assets, liabilities and intangible assets acquired based on their estimated fair values. The excess of the consideration transferred over those fair values was recorded as goodwill.

 

During the nine months ended September 30, 2011, the Company finalized certain provisional amounts recognized at the acquisition date related to deferred taxes. The Company retrospectively adjusted the provisional amounts recorded at the acquisition date to reflect the finalization of provisional accounting. As a result, the carrying amount of deferred tax assets was increased by $18.8 million as of December 31, 2010, with

 

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Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

a corresponding decrease to goodwill.  The Condensed Consolidated Balance Sheet as of December 31, 2010 and the allocation of consideration transferred noted above have been reflected for this adjustment. During the nine months ended September 30, 2011, the Company recorded $3.5 million of goodwill adjustments from adjustments in the fair value of assets and liabilities assumed that were not deemed material to retrospectively adjust provisional amounts recorded at the acquisition date. The primary areas of the purchase price allocation that are not yet finalized relate to income taxes and residual goodwill.

 

One Communications

 

On April 1, 2011, EarthLink completed its acquisition of One Communications Corp. (“One Communications”), a privately-held integrated telecommunications solutions provider serving customers in the Northeast, Mid-Atlantic and Upper Midwest. EarthLink acquired 100% of One Communications in a merger transaction with One Communications surviving as a wholly-owned subsidiary of EarthLink. One Communications stockholders had the right to elect to receive the net merger consideration in the form of cash or EarthLink common stock. The primary reason for the acquisition was to further transform the Company into an IP infrastructure and communications services provider by expanding its IP network footprint. EarthLink also believes the acquisition will provide strategic benefits because One Communications has a large established customer base that generates cash. EarthLink has included the financial results of One Communications in its consolidated financial statements from the date of the acquisition. EarthLink’s Condensed Consolidated Statement of Operations for the three and nine months ended September 30, 2011 included $119.8 million and $241.3 million, respectively, of One Communications’ revenue and $4.4 million and $10.9 million, respectively, of One Communications’ net loss.

 

Pursuant to the terms of the merger agreement, the aggregate merger consideration for One Communications was $370.0 million, which included repayment of debt and other liabilities and certain working capital and other adjustments. Included in the aggregate merger consideration was $13.5 million (combination of cash and approximately 0.8 million shares of common stock) deposited into an escrow account to secure potential post-closing adjustments to the aggregate consideration relating to working capital and other similar adjustments and indemnification obligations. In addition, EarthLink deposited $7.5 million (combination of cash and approximately 0.5 million shares of common stock) into an escrow account to fund certain post-closing employment-related obligations of the Company on the terms provided in the escrow agreement. This was accounted for separately from the purchase price allocation. EarthLink issued a total of 3.0 million shares in connection with the One Communications acquisition, which consisted of the 1.3 million shares deposited in escrow and 1.7 million shares issued to One Communications shareholders. During the nine months ended September 30, 2011, $1.9 million (including 0.1 million shares) that was used to fund certain post-closing employment-related obligations was returned from escrow.

 

The resulting preliminary fair value of consideration transferred was $39.9 million, which consisted of $20.0 million in cash paid to acquire the outstanding common stock of One Communications and $19.9 million for the issuance of EarthLink common stock. The assets acquired and liabilities assumed of One Communications were recognized at their acquisition date fair values.  The purchase price allocation is subject to change as the Company obtains additional information during the measurement period about the facts and circumstances that existed as of the acquisition date. The primary areas of the preliminary purchase price allocation that are not yet finalized relate to working capital adjustments, income and non-income based taxes and residual goodwill.

 

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Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

The following is a preliminary allocation of the consideration transferred based on currently available information (in thousands):

 

Acquired Assets:

 

 

 

Cash and cash equivalents

 

$

11,304

 

Property and equipment

 

145,004

 

Goodwill

 

137,903

 

Intangible assets

 

182,800

 

Other assets

 

69,409

 

Total assets

 

546,420

 

 

 

 

 

Assumed Liabilities:

 

 

 

Debt

 

(266,275

)

Deferred revenue

 

(11,379

)

Deferred tax liability, net

 

(53,473

)

Other liabilities

 

(175,366

)

Total liabilities

 

(506,493

)

Total consideration

 

$

39,927

 

 

Goodwill arising from the acquisition is attributable to the assembled workforce and expected synergies and economies of scale from combining the operations of EarthLink and One Communications. All of the goodwill will be assigned to the Company’s Business Services segment. The goodwill is not expected to be deductible for income tax purposes.

 

Included in other assets is accounts receivable with a preliminary estimate of fair value of $51.4 million and a gross contractual value of $60.8 million. The difference represents the Company’s best estimate of the contractual cash flows that will not be collected.

 

The following table summarizes the preliminary components of intangible assets acquired in connection with the One Communications acquisition (in thousands):

 

 

 

Fair Value

 

Useful Life

 

Customer relationships

 

$

166,900

 

5 Years

 

Developed technology

 

12,000

 

3 Years

 

Trade name

 

3,900

 

3 Years

 

Total intangible assets

 

$

182,800

 

 

 

 

Saturn Telecommunication Services Inc.

 

On March 2, 2011, EarthLink acquired Saturn Telecommunication Services Inc. and affiliates (“STS Telecom”), a privately-held provider of IP communication and information technology services to small and medium-sized businesses primarily in Florida. STS Telecom operates a sophisticated Voice-over-Internet Protocal (“VoIP”) platform.

 

The total consideration transferred was $22.9 million, which consisted of cash paid to acquire the outstanding equity interests of STS Telecom. In allocating the purchase price based on estimated fair values, EarthLink recorded approximately $21.5 million of goodwill, $17.9 million of identifiable intangible assets, $2.8 million of tangible assets and $19.3 million of net liabilities assumed. The allocation of the consideration transferred was based upon a preliminary valuation and the Company’s estimates and assumptions are subject to change. The primary areas of the purchase price allocation that are not yet finalized relate to income and non-income based taxes and residual goodwill. EarthLink has included the financial results of STS Telecom in

 

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Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

its consolidated financial statements from the date of acquisition. Pro forma financial information for STS Telecom has not been presented, as the effects were not material to the Company’s consolidated financial statements.

 

Other

 

During the nine months ended September 30, 2011, EarthLink acquired certain other companies and purchased certain assets to expand its services and products offerings for $9.2 million of cash consideration and $1.3 million of debt repayment. These acquisitions were not significant individually or in the aggregate. Purchased identifiable intangible assets related to these acquisitions was $3.3 million and residual goodwill was $6.3 million. The allocation of the consideration transferred was based upon a preliminary valuation and the Company’s estimates and assumptions are subject to change. EarthLink has included the financial results of these companies in its consolidated financial statements from the date of acquisition. Pro forma financial information has not been presented, as the effects were not material to the Company’s consolidated financial statements.

 

Pro Forma Financial Information

 

The following unaudited pro forma revenue and earnings assumes the acquisitions of ITC^DeltaCom and One Communications occurred on January 1, 2010:

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2010

 

2011

 

2010

 

2011

 

 

 

(in thousands)

 

Total revenues

 

$

393,281

 

$

357,290

 

$

1,221,864

 

$

1,096,643

 

Net income

 

1,546

 

12,939

 

46,143

 

43,276

 

 

5.  Restructuring and Acquisition-Related Costs

 

Restructuring and acquisition-related costs consisted of the following during the three and nine months ended September 30, 2010 and 2011:

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2010

 

2011

 

2010

 

2011

 

 

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

2007 Restructuring Plan

 

$

(210

)

$

57

 

$

1,136

 

$

520

 

Legacy Restructuring Plans

 

131

 

 

131

 

 

Total facility exit and restructuring costs

 

(79

)

57

 

1,267

 

520

 

Acquisition-related costs

 

2,000

 

8,909

 

2,000

 

23,997

 

Restructuring and acquisition-related costs

 

$

1,921

 

$

8,966

 

$

3,267

 

$

24,517

 

 

2007 Restructuring Plan

 

In August 2007, EarthLink adopted a restructuring plan (the “2007 Plan”) to reduce costs and improve the efficiency of the Company’s operations. The 2007 Plan was the result of a comprehensive review of operations within and across the Company’s functions and businesses. Under the 2007 Plan, the Company reduced its workforce by approximately 900 employees, closed office facilities in Orlando, Florida; Knoxville, Tennessee; Harrisburg, Pennsylvania and San Francisco, California and consolidated its office facilities in

 

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EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

Atlanta, Georgia and Pasadena, California. The 2007 Plan was primarily implemented during the latter half of 2007 and during the year ended December 31, 2008. However, there have been and may continue to be changes in estimates to amounts previously recorded.

 

The following table summarizes facility exit and restructuring costs during the nine months ended September 30, 2010 and 2011 and the cumulative costs incurred to date as a result of the 2007 Plan. Facility exit and restructuring costs during the nine months ended September 30, 2010 and 2011 were primarily the result of changes to sublease estimates in the Company’s exited facilities and additional costs for lease terminations. Such costs have been classified as restructuring and acquisition-related costs in the Condensed Consolidated Statements of Operations.

 

 

 

 

 

 

 

Cumulative

 

 

 

 

 

 

 

Costs

 

 

 

Nine Months Ended September 30,

 

Incurred

 

 

 

2010

 

2011

 

To Date

 

 

 

(in thousands)

 

 

 

 

 

 

 

 

 

Severance and personnel-related costs

 

$

 

$

 

$

30,764

 

Lease termination and facilities-related costs

 

1,027

 

597

 

24,330

 

Non-cash asset impairments

 

109

 

(77

)

24,824

 

Other associated costs

 

 

 

1,131

 

 

 

$

1,136

 

$

520

 

$

81,049

 

 

The following table summarizes activity for the liability balances associated with the 2007 Plan for the nine months ended September 30, 2011, including changes during the period attributable to costs incurred and charged to expense and costs paid or otherwise settled:

 

 

 

Facilities

 

Assets

 

Total

 

 

 

(in thousands)

 

Balance as of December 31, 2010

 

$

13,613

 

 

$

13,613

 

Accruals

 

597

 

(77

)

520

 

Payments

 

(5,415

)

77

 

(5,338

)

Non-cash charges

 

66

 

 

66

 

Balance as of September 30, 2011

 

$

8,861

 

$

 

$

8,861

 

 

Facility exit and restructuring liabilities due within one year of the balance sheet date are classified as other accrued liabilities and facility exit and restructuring liabilities due after one year are classified as other long-term liabilities in the Condensed Consolidated Balance Sheets. Of the unpaid balance as of December 31, 2010 and September 30, 2011, approximately $4.7 million and $3.9 million, respectively, was classified as other accrued liabilities and approximately $8.9 million and $5.0 million, respectively, was classified as other long-term liabilities.

 

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EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

Acquisition-Related Costs

 

Acquisition-related costs consist of external costs directly related to EarthLink’s acquisitions, including transaction related costs, such as advisory, legal, accounting, valuation and other professional fees; employee severance and retention costs; facility-related costs, such as lease termination and asset impairments; and integration-related costs, such as system conversion, rebranding costs and integration related consulting and employee costs. Acquisition-related costs are expensed in the period in which the costs are incurred and the services are received and are included in restructuring and acquisition-related costs in the Condensed Consolidated Statement of Operations. Acquisition-related costs consisted of the following during the three and nine months ended September 30, 2010 and 2011:

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2010

 

2011

 

2010

 

2011

 

 

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

Transaction related costs

 

$

2,000

 

$

325

 

$

2,000

 

4,867

 

Severance and retention costs

 

 

3,783

 

 

13,608

 

Facility related costs

 

 

4,208

 

 

4,688

 

Integration related costs

 

 

593

 

 

834

 

Total acquisition-related costs

 

$

2,000

 

$

8,909

 

$

2,000

 

$

23,997

 

 

6.  Investments

 

Marketable Securities

 

The Company’s marketable securities consisted of the following as of December 31, 2010 and September 30, 2011:

 

 

 

As of

 

As of

 

 

 

December 31,

 

September 30,

 

 

 

2010

 

2011

 

 

 

(in thousands)

 

Government and agency securities

 

$

284,441

 

$

 

Commercial paper

 

14,666

 

 

Corporate debt securities

 

21,011

 

 

Total marketable securities

 

320,118

 

 

Less: classified as current

 

(307,814

)

 

Total long-term marketable securities

 

$

12,304

 

$

 

 

Marketable securities consist of investments with original maturities greater than three months at the date of acquisition. Marketable securities with maturities less than one year from the balance sheet date are classified as short-term marketable securities. Marketable securities with maturities greater than one year from the balance sheet date are classified as long-term marketable securities. These investments primarily consisted of government and agency notes, which include U.S. treasury securities and government-sponsored debt securities, commercial paper and corporate debt securities. These securities were classified as available for sale. Available-for-sale securities are carried at fair value, with any unrealized gains and losses, net of tax, included in accumulated other comprehensive income as a separate component of stockholders’ equity and in total comprehensive income. Amounts reclassified out of accumulated other comprehensive income into earnings are determined on a specific identification basis. Realized gains and losses on marketable securities are determined on a specific identification basis and included in interest expense and other, net, in the Condensed Consolidated Statement of Operations.

 

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EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

During the nine months ended September 30, 2011, the Company sold its investments in marketable securities and recognized a realized gain of $0.4 million, which was included in interest expense and other, net, in the Condensed Consolidated Statement of Operations. As a result, the Company had no short- or long-term marketable securities as of September 30, 2011.

 

The following tables summarize gross unrealized gains and losses as of December 31, 2010 on the Company’s marketable securities designated as available-for-sale:

 

 

 

As of December 31, 2010

 

 

 

 

 

Gross

 

Gross

 

Estimated

 

 

 

Amortized

 

Unrealized

 

Unrealized

 

Fair

 

 

 

Cost

 

Losses

 

Gains

 

Value

 

 

 

(in thousands)

 

Government and agency notes

 

$

284,087

 

$

(1

)

$

355

 

$

284,441

 

Commercial paper

 

14,658

 

 

8

 

14,666

 

Corporate debt securities

 

20,980

 

(7

)

38

 

21,011

 

 

 

$

319,725

 

$

(8

)

$

401

 

$

320,118

 

 

Gain on investments, net

 

During the nine months ended September 30, 2010, the Company sold certain of its investments in other companies that were classified as available for sale for proceeds of $1.6 million and recognized a realized gain on investments of $0.6 million.

 

7.  Goodwill and Other Intangible Assets

 

Goodwill

 

The changes in the carrying amount of goodwill by operating segment during the nine months ended September 30, 2011 were as follows:

 

 

 

Consumer

 

Business

 

 

 

 

 

Services

 

Services

 

 

 

 

 

Segment

 

Segment

 

Total

 

 

 

(in thousands)

 

Balance as of December 31, 2010

 

 

 

 

 

 

 

Goodwill

 

$

88,920

 

$

258,004

 

$

346,924

 

Accumulated impairment loss

 

 

(87,878

)

(87,878

)

 

 

88,920

 

170,126

 

259,046

 

 

 

 

 

 

 

 

 

Goodwill acquired during year

 

 

 

165,748

 

165,748

 

Goodwill adjustments

 

 

3,552

 

3,552

 

 

 

 

 

 

 

 

 

Balance as of September 30, 2011

 

 

 

 

 

 

 

Goodwill

 

88,920

 

427,304

 

516,224

 

Accumulated impairment loss

 

 

(87,878

)

(87,878

)

 

 

$

88,920

 

$

339,426

 

$

428,346

 

 

Goodwill acquired during the period resulted from EarthLink’s acquisitions of One Communications, STS Telecom and certain other companies, which are more fully described in Note 4, “Acquisitions.” Goodwill adjustments during the period resulted from adjustments in the fair value of assets and liabilities assumed in acquisitions that were not deemed material to retrospectively adjust provisional amounts recorded at the acquisition date.

 

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EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

Other Intangible Assets

 

The gross carrying value and accumulated amortization by major intangible asset category as of December 31, 2010 and September 30, 2011 were as follows:

 

 

 

As of December 31, 2010

 

As of September 30, 2011

 

 

 

Gross

 

 

 

Net

 

Gross

 

 

 

Net

 

 

 

Carrying

 

Accumulated

 

Carrying

 

Carrying

 

Accumulated

 

Carrying

 

 

 

Value

 

Amortization

 

Value

 

Value

 

Amortization

 

Value

 

 

 

(in thousands)

 

Subscriber bases and customer relationships

 

$

192,414

 

$

(71,067

)

$

121,347

 

$

378,332

 

$

(106,713

)

$

271,619

 

Developed technology and software

 

10,611

 

(821

)

9,790

 

24,311

 

(4,599

)

19,712

 

Trade names

 

5,221

 

(994

)

4,227

 

9,121

 

(2,798

)

6,323

 

Other

 

 

 

 

450

 

(105

)

345

 

 

 

$

208,246

 

$

(72,882

)

$

135,364

 

$

412,214

 

$

(114,215

)

$

297,999

 

 

The Company’s identifiable intangible assets consist of subscriber bases and customer relationships, developed technology and software, trade names and other assets acquired in conjunction with the purchases of businesses and subscriber bases from other companies that are not deemed to have indefinite lives. The gross carrying value of identifiable intangible assets as of September 30, 2011 includes $166.9 million of customer relationships, $12.0 million of developed technology and $3.9 million of trade name assets resulting from the One Communications acquisition and includes $15.7 million of customer relationships, $1.7 million of developed technology and $0.5 million of other intangible assets resulting from the STS Telecom acquisition.

 

Definite-lived intangible assets are amortized on a straight-line basis over their estimated useful lives. The Company’s customer relationships are being amortized using the straight-line method to match the estimated cash flow generated by such assets, and the developed technology and trade names are being amortized using the straight-line method because a pattern to which the expected benefits will be consumed or otherwise used up could not be reliably determined. As of September 30, 2011, the weighted average amortization periods were 5.2 years for subscriber base assets and customer relationships, 4.1 years for developed technology and software, 3.3 years for trade names and 2.5 years for other identifiable intangible assets.

 

Amortization of intangible assets, which is included in depreciation and amortization in the Condensed Consolidated Statements of Operations, for the three and nine months ended September 30, 2010 and 2011 was as follows:

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2010

 

2011

 

2010

 

2011

 

 

 

(in thousands)

 

Amortization expense

 

$

890

 

$

17,509

 

$

3,386

 

$

41,591

 

 

Based on the current amount of definite-lived intangible assets, the Company expects to record amortization expense of approximately $17.2 million during the remaining three months in the year ending December 31, 2011 and $67.7 million, $65.9 million, $60.5 million, $58.2 million, $27.8 million and $0.7 million during the years ending December 31, 2012, 2013, 2014, 2015, and 2016 and thereafter, respectively. Actual amortization expense to be reported in future periods could differ materially from these estimates as a result of acquisitions, changes in useful lives and other relevant factors.

 

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EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

8.  Long-Term Debt and Capital Lease Obligations

 

The Company’s long-term debt and capital lease obligations consisted of the following as of December 31, 2010 and September 30, 2011:

 

 

 

As of

 

As of

 

 

 

December 31,

 

September 30,

 

 

 

2010

 

2011

 

 

 

(in thousands)

 

ITC^DeltaCom senior secured notes due April 2016

 

$

325,000

 

$

324,800

 

Unamortized premium on ITC^DeltaCom senior secured notes due April 2016

 

26,251

 

23,143

 

EarthLink senior notes due May 2019

 

 

300,000

 

Unamortized discount on EarthLink senior notes due May 2019

 

 

(10,005

)

EarthLink convertible senior notes due November 2026

 

255,791

 

255,791

 

Unamortized discount on EarthLink convertible senior notes due November 2026

 

(12,722

)

(1,744

)

Capital lease obligations

 

 

18,967

 

Carrying value of debt and capital lease obligations

 

594,320

 

910,952

 

Less current portion of debt and capital lease obligations

 

(243,069

)

(255,888

)

Long-term debt and capital lease obligations

 

$

351,251

 

$

655,064

 

 

ITC^DeltaCom Senior Secured Notes due April 2016

 

General.  In connection with the acquisition of ITC^DeltaCom, EarthLink assumed ITC^DeltaCom’s outstanding $325.0 million aggregate principal amount of 10.5% senior secured notes due on April 1, 2016 (the “ITC^DeltaCom Notes”). The ITC^DeltaCom Notes were not repaid or guaranteed by EarthLink.  The ITC^DeltaCom Notes were recorded at acquisition date fair value, which was based on publicly-quoted market prices. The resulting debt premium of $26.3 million is being amortized over the remaining life of the ITC^DeltaCom Notes.

 

Under the indenture for the ITC^DeltaCom Notes, following the consummation of the acquisition, ITC^DeltaCom was required to offer to repurchase any or all of the ITC^DeltaCom Notes at 101% of their principal amount.  The tender window was open from December 20, 2010 through January 18, 2011. As a result, approximately $0.2 million outstanding principal amount of the ITC^DeltaCom Notes was repurchased in January 2011. The remaining ITC^DeltaCom Notes remain outstanding as obligations of ITC^DeltaCom and its subsidiaries.

 

The ITC^DeltaCom Notes accrue interest at a rate of 10.5% per year. Interest on the ITC^DeltaCom Notes is payable semi-annually in cash in arrears on April 1 and October 1 of each year. The ITC^DeltaCom Notes will mature on April 1, 2016.

 

Redemption.  ITC^DeltaCom may redeem some or all of the ITC^DeltaCom Notes, at any time before April 1, 2013, at a redemption price equal to 100% of their principal amount plus a “make-whole” premium. ITC^DeltaCom may redeem some or all of the ITC^DeltaCom Notes at any time on or after April 1, 2013, at specified redemption prices declining from 105.250% to 100% of their principal amount. In addition, before April 1, 2013, ITC^DeltaCom may redeem up to 35% of the aggregate principal amount of the ITC^DeltaCom Notes at a redemption price equal to 110.5% of their principal amount with the net proceeds of certain equity offerings. During any 12-month period before April 1, 2013, ITC^DeltaCom may redeem up to 10% of the aggregate principal amount of the ITC^DeltaCom Notes at a redemption price equal to 103% of their principal amount.

 

If (1) ITC^DeltaCom sells certain of its assets and does not either (a) apply the net sale proceeds to repay indebtedness under the ITC^DeltaCom Notes, or other indebtedness secured on a first-priority basis or (b) reinvest the net sale proceeds in its business, or (2) ITC^DeltaCom experiences a change of control,

 

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EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

ITC^DeltaCom may be required to offer to purchase ITC^DeltaCom Notes from holders at 100% of their principal amount, in the case of a sale of assets, or 101% of their principal amount, in the case of a change of control. ITC^DeltaCom would be required to pay accrued and unpaid interest, if any, on the ITC^DeltaCom Notes redeemed or purchased in each of the foregoing events of redemption or purchase.

 

Ranking and guaranty. The ITC^DeltaCom Notes are ITC^DeltaCom’s general senior obligations and rank equally in right of payment with any future senior indebtedness. The ITC^DeltaCom Notes are secured on a first-priority basis, along with any future pari passu secured obligations, subject to specified exceptions and permitted liens, by substantially all of the assets of ITC^DeltaCom and its subsidiaries that are deemed to be restricted subsidiaries under the indenture governing the ITC^DeltaCom Notes. Currently all of ITC^DeltaCom’s subsidiaries are deemed to be restricted subsidiaries under the indenture.

 

The ITC^DeltaCom Notes are guaranteed on a senior secured basis by each of ITC^DeltaCom’s restricted subsidiaries on the initial issue date of the ITC^DeltaCom Notes and will be guaranteed on a senior secured basis by each future domestic restricted subsidiary, other than certain excluded subsidiaries, and by any foreign restricted subsidiary that guarantees any indebtedness of ITC^DeltaCom or any domestic restricted subsidiary. The guarantees are the subsidiary guarantors’ general senior obligations and rank equally in right of payment with all of the subsidiary guarantors’ existing and future senior indebtedness.

 

Covenants. The indenture governing the ITC^DeltaCom Notes contains covenants that, among other things, limit ITC^DeltaCom’s ability, and the ability of ITC^DeltaCom’s restricted subsidiaries, to incur additional indebtedness, create liens, pay dividends on, redeem or repurchase ITC^DeltaCom’s capital stock, make investments or repay subordinated indebtedness, engage in sale-leaseback transactions, enter into transactions with affiliates, sell assets, create restrictions on dividends and other payments to ITC^DeltaCom from its subsidiaries, issue or sell stock of subsidiaries, and engage in mergers and consolidations. All of the covenants are subject to a number of important qualifications and exceptions under the indenture. As of December 31, 2010 and September 30, 2011, ITC^DeltaCom was in compliance with all of its financial covenants.

 

EarthLink Senior Notes due May 2019

 

General.  In May 2011, the Company completed a private placement of $300.0 million aggregate principal amount of 8-7/8% Senior Notes due 2019 (the “Senior Notes”).  The Senior Notes were issued at 96.555% of their principal amount, resulting in gross proceeds of approximately $289.7 million and net proceeds of $280.3 million after deducting transaction fees of $9.4 million. In September 2011, in accordance with the registration rights granted to the original purchasers of the Senior Notes, the Company completed an exchange offer of the privately placed Senior Notes for new 8-7/8% Senior Notes due 2019 registered with the SEC with substantially identical terms to the original Senior Notes.

 

The Senior Notes accrue interest at a rate of 8-7/8% per year, payable on May 15 and November 15 of each year, commencing on November 15, 2011. The Senior Notes will mature on May 15, 2019.

 

Redemption.  The Company may redeem the Senior Notes, in whole or in part, (i) from May 15, 2015 until May 15, 2016 at a price equal to 104.438% of the principal amount of the Senior Notes redeemed; (ii) from May 15, 2016 until May 15, 2017 at a price equal to 102.219% of the principal amount of the Senior Notes redeemed; and (iii) from May 15, 2017 at a price equal to 100% of the principal amount of the Senior Notes redeemed, in each case plus accrued and unpaid interest.  Prior to May 15, 2015, the Company may also redeem the Senior Notes, in whole or in part, at a price equal to 100% of the aggregate principal amount of the Senior Notes to be redeemed plus a make-whole premium and accrued and unpaid interest.  In addition, prior to May 15, 2014, the Company may redeem up to 35% of the aggregate principal amount of the Senior Notes with the net cash proceeds of certain equity offerings at a price equal to 108.875% of the principal amount of the Senior Notes redeemed, plus accrued and unpaid interest.

 

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Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

Ranking and guaranty. The Senior Notes and the related guarantees of certain of the Company’s wholly-owned subsidiaries (the “Guarantors”) are the Company’s and the Guarantors’ unsecured senior obligations and rank equally with all of the Company’s and the Guarantors’ other senior indebtedness.

 

Covenants. The indenture governing the Senior Notes includes covenants which, subject to certain exceptions, limit the ability of the Company and its Restricted Subsidiaries (as defined in the indenture) to, among other things, incur additional indebtedness, make certain types of restricted payments, incur liens on assets of the Company or the Restricted Subsidiaries, engage in asset sales and enter into transactions with affiliates. Upon a change of control (as defined in the indenture), the Company may be required to make an offer to repurchase the Notes at 101% of their principal amount, plus accrued and unpaid interest. The indenture governing the Senior Notes also contains customary events of default. The Company was in compliance with these covenants as of September 30, 2011.

 

EarthLink Convertible Senior Notes due November 2026

 

General.  In November 2006, EarthLink issued $258.8 million aggregate principal amount of convertible senior notes due November 15, 2026 (the “Convertible Notes”) in a registered offering. The Convertible Notes bear interest at 3.25% per year on the principal amount of the Convertible Notes until November 15, 2011, and 3.50% interest per year on the principal amount of the Convertible Notes thereafter, payable semi-annually in May and November of each year. The Convertible Notes rank as senior unsecured obligations of the Company.

 

Conversion. The Convertible Notes are payable with cash and, if applicable, are convertible into shares of the Company’s common stock. The initial conversion rate was 109.6491 shares per $1,000 principal amount of Convertible Notes (which represented an initial conversion price of approximately $9.12 per share). As a result of the Company’s cash dividend payments, the conversion rate has been adjusted and was 123.5033 shares per $1,000 principal amount of Convertible Notes as of September 30, 2011 (which represents a conversion price of approximately $8.10  per share), subject to further adjustment. Upon conversion, a holder will receive cash up to the principal amount of the Convertible Notes and, at the Company’s option, cash, shares of the Company’s common stock or a combination of cash and shares of common stock for the remainder, if any, of the conversion obligation.

 

The conversion obligation is based on the sum of the “daily settlement amounts” for the 20 consecutive trading days that begin on, and include, the second trading day after the day the Convertible Notes are surrendered for conversion. The Convertible Notes will be convertible only in the following circumstances: (1) during any calendar quarter after the calendar quarter ending December 31, 2006 (and only during such calendar quarter), if the closing sale price of the Company’s common stock for each of 20 or more trading days in a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter exceeds 130% of the conversion price in effect on the last trading day of the immediately preceding calendar quarter; (2) during the five consecutive business days immediately after any five consecutive trading day period in which the average trading price per $1,000 principal amount of Convertible Notes was equal to or less than 98% of the average conversion value of the Convertible Notes during the note measurement period; (3) upon the occurrence of specified corporate transactions, including the payment of dividends in certain circumstances; (4) if the Company has called the Convertible Notes for redemption; and (5) at any time from, and including, October 15, 2011 to, and including, November 15, 2011 and at any time on or after November 15, 2024.  In addition, the holders may require the Company to purchase all or a portion of their Convertible Notes on each of November 15, 2011, November 15, 2016 and November 15, 2021.

 

Under the terms of the indenture governing the Convertible Notes, the Company’s payment of cash dividends while the Convertible Notes are outstanding requires an adjustment to the conversion rate for the Convertible Notes. In addition, as a result of the adjustment, the Convertible Notes may be surrendered for conversion for a period of time between the declaration date and the record date, as defined in the indenture, for the consideration provided for in the indenture. During the nine months ended September 30, 2010, $3.0 million principal amount of Convertible Notes were surrendered for conversion for cash payment of $2.8 million, resulting in a gain on conversion of debt of $0.2 million. Such gain is included in interest expense and other, net, in the Condensed Consolidated Statement of Operations.

 

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Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

Redemption. The Company had the option to redeem the Convertible Notes, in whole or in part, for cash, on or after November 15, 2011, provided that the Company has made at least ten semi-annual interest payments. On October 14, 2011, the Company issued a notice of redemption to redeem all of the Company’s outstanding Convertible Notes.  The redemption date is November 15, 2011. See Note 16, “Subsequent Events,” for more information.

 

Accounting.  The Company accounts for the liability and equity components of the Convertible Notes separately. The Company is accreting the debt discount related to the equity component to non-cash interest expense over the estimated five-year life of the Convertible Notes, which represents the first redemption date of November 2011. As of September 30, 2011, the remaining amortization period for the discount was 1.5 months.

 

The principal amount, unamortized discount and net carrying amount of the debt and equity components as of December 31, 2010 and September 30, 2011 are presented below:

 

 

 

As of

 

As of

 

 

 

December 31,

 

September 30,

 

 

 

2010

 

2011

 

 

 

(in thousands)

 

Principal amount

 

$

255,791

 

$

255,791

 

Unamortized discount

 

(12,722

)

(1,744

)

Net carrying amount

 

$

243,069

 

$

254,047

 

 

 

 

 

 

 

Carrying amount of the equity component

 

$

61,847

 

$

61,847

 

 

The following table presents the associated interest cost related to the Convertible Notes during the three and nine months ended September 30, 2010 and 2011, which consists of both the contractual interest coupon and amortization of the discount on the equity component:

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2010

 

2011

 

2010

 

2011

 

 

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

Contractual interest recognized

 

$

2,221

 

$

2,221

 

$

6,647

 

$

6,662

 

Discount amortization

 

3,408

 

3,746

 

9,987

 

10,978

 

 

 

 

 

 

 

 

 

 

 

Effective interest rate

 

9.5

%

9.5

%

9.5

%

9.5

%

 

Classification. On November 15, 2011, holders of the Convertible Notes have the right under the governing indenture to require the Company to repurchase the Convertible Notes. As a result, the Company classified the Convertible Notes as a current liability in the Consolidated Balance Sheets as of December 31, 2010. On October 14, 2011, the Company issued a notice of redemption to redeem all of the Company’s outstanding Convertible Notes.  As a result, the Company classified the Convertible Notes as a current liability in the Consolidated Balance Sheets as of September 30, 2011.

 

Revolving Credit Facility

 

General.  On May 20, 2011, the Company entered into a credit agreement (the “Credit Agreement”) providing for a senior secured revolving credit facility with aggregate revolving commitments of $150.0 million. Also on May 20, 2011, EarthLink terminated its $30.0 million revolving credit facility entered into on March 18, 2011. The senior secured revolving credit facility terminates on May 20, 2015, and all amounts outstanding thereunder shall be due and payable in full.  No amounts were outstanding under the senior

 

17



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

secured revolving credit facility as of September 30, 2011. The Company paid $1.9 million of transaction fees related to the new senior secured revolving credit facility, which are being amortized to interest expense over the life of the credit facility.

 

Prepayment. The Company may prepay the senior secured revolving credit facility in whole or in part at any time without premium or penalty, subject to reimbursement of the lenders’ breakage and redeployment costs in the case of prepayment of LIBOR borrowings. The Company may irrevocably reduce or terminate the unutilized portion of the senior secured revolving credit facility at any time without penalty.

 

Covenants. The Credit Agreement contains representations and warranties, covenants, and events of default with respect to the Company and its subsidiaries that are customarily applicable to senior secured credit facilities.  However, such covenants will not apply to ITC^DeltaCom and its subsidiaries until the earlier of (i) the repayment or refinancing in full of the ITC^DeltaCom Notes or (ii) the date ITC^DeltaCom and its U.S. subsidiaries become guarantors of the senior secured revolving credit facility.  ITC^DeltaCom is not currently a guarantor under the senior secured revolving credit facility. The negative covenants contained in the Credit Agreement include restrictions on the ability of the Company and its subsidiaries to, among other things, incur additional indebtedness, incur liens on assets, engage in certain mergers, acquisitions or divestitures, pay dividends or make other distributions, voluntarily prepay certain other indebtedness (including certain prepayments of the Company’s existing notes and the ITC^DeltaCom Notes), enter into transactions with affiliates, make investments, and change the nature of their businesses, and amend the terms of certain other indebtedness (including the Company’s existing notes and the ITC^DeltaCom Notes), in each case subject to certain exceptions set forth in the Credit Agreement.

 

Additionally, the Credit Agreement requires the Company to maintain a maximum consolidated leverage ratio and a minimum consolidated interest coverage ratio (as defined in the Credit Agreement). The Company was in compliance with these financial covenants as of September 30, 2011.

 

Capital Lease Obligations

 

The Company maintains capital leases relating to indefeasible right-to-use agreements, vehicles and equipment. Substantially all of these capital leases were assumed by the Company through its acquisition of One Communications. Depreciation expense related to assets under capital leases is included in depreciation and amortization expense in the Condensed Consolidated Statements of Operations. The future minimum payments due under the leases are as follows (in thousands):

 

Year Ending December 31,

 

 

 

2011 (remaining three months)

 

$

1,025

 

2012

 

3,743

 

2013

 

3,469

 

2014

 

3,219

 

2015

 

3,247

 

Thereafter

 

17,776

 

Total minimum lease payments

 

$

32,479

 

Less amounts representing interest

 

(13,512

)

Total capital lease obligations

 

$

18,967

 

 

18



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

9.  Stockholders’ Equity

 

Comprehensive Income

 

Comprehensive income includes unrealized gains and losses on certain investments classified as available-for-sale, net of tax, which are excluded from the Condensed Consolidated Statements of Operations. Comprehensive income for the three and nine months ended September 30, 2010 and 2011 was as follows:

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2010

 

2011

 

2010

 

2011

 

 

 

(in thousands)

 

Net income

 

$

21,385

 

$

7,505

 

$

76,172

 

$

30,416

 

Unrealized holding gains on certain investments, net of tax

 

250

 

 

322

 

 

Total comprehensive income

 

$

21,635

 

$

7,505

 

$

76,494

 

$

30,416

 

 

Share Repurchases

 

Since the inception of the Company’s share repurchase program, the Board of Directors has authorized a total of $750.0 million for the repurchase of EarthLink’s common stock. As of September 30, 2011, the Company had $107.3 million available under the current authorizations. The Company may repurchase its common stock from time to time in compliance with the SEC’s regulations and other legal requirements, including through the use of derivative transactions, and subject to market conditions and other factors. The share repurchase program does not require the Company to acquire any specific number of shares and may be terminated by the Board of Directors at any time.

 

The Company repurchased 0.1 million shares of its common stock for $0.9 million during the nine months ended September 30, 2010 and repurchased 5.0 million shares of its common stock for $38.6 million during the nine months ended September 30, 2011 pursuant to its share repurchase program. In addition, 0.1 million shares valued at $0.9 million were returned from the One Communications escrow fund and recorded as treasury stock during the nine months ended September 30, 2011.

 

Dividends

 

During the three months ended September 30, 2010 and 2011, cash dividends declared were $0.16 and $0.05 per common share, respectively, and total dividend payments were $17.4 million and $5.4 million, respectively. During the nine months ended September 30, 2010 and 2011, cash dividends declared were $0.46 and $0.15 per common share, respectively, and total dividend payments were $50.1 million and $17.2 million, respectively. The Company currently intends to pay regular quarterly dividends on its common stock.  Any decision to declare future dividends will be made at the discretion of the Board of Directors and will depend on, among other things, the Company’s results of operations, financial condition, cash requirements, investment opportunities and other factors the Board of Directors may deem relevant.

 

10.  Stock-Based Compensation

 

The Company measures compensation cost for all stock awards at fair value on the date of grant and recognizes compensation expense over the requisite service period for awards expected to vest. The Company estimates the fair value of stock options using the Black-Scholes valuation model, and determines the fair value of restricted stock units based on the number of shares granted and the quoted price of EarthLink’s common stock on the date of grant. Such value is recognized as expense over the requisite service period, net of estimated forfeitures, using the straight-line attribution method. For performance-based awards, the Company recognizes expense over the requisite service period, net of estimated forfeitures, using the accelerated attribution method when it is probable that the performance measure will be achieved. The estimate of awards that will ultimately

 

19



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

vest requires significant judgment, and to the extent actual results or updated estimates differ from the Company’s current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. The Company considers many factors when estimating expected forfeitures, including types of awards, employee class and historical employee attrition rates. Actual results, and future changes in estimates, may differ substantially from the Company’s current estimates.

 

Stock-based compensation expense was $2.7 million and $3.4 million during the three months ended September 30, 2010 and 2011, respectively, and $7.1 million and $10.5 million during the nine months ended September 30, 2010 and 2011, respectively.  The Company has classified stock-based compensation expense within selling, general and administrative expense, the same operating expense line item as cash compensation paid to employees.

 

Stock Incentive Plans

 

The Company has granted options to purchase the Company’s common stock and restricted stock units to employees and non-employee directors under various stock incentive plans. Under the plans, employees and non-employee directors are eligible to receive awards of various forms of equity-based incentive compensation, including stock options, restricted stock, restricted stock units and performance awards, among others. The plans are administered by the Board of Directors or the Leadership and Compensation Committee of the Board of Directors, which determine the terms of the awards granted. Stock options are generally granted with an exercise price equal to the market value of EarthLink common stock on the date of grant, have a term of ten years or less, and vest over terms of four years from the date of grant. Restricted stock units are granted with various vesting terms that range from one to four years from the date of grant.

 

Options Outstanding

 

The following table summarizes stock option activity as of and for the nine months ended September 30, 2011:

 

 

 

 

 

 

 

Weighted

 

 

 

 

 

 

 

Weighted

 

Average

 

 

 

 

 

 

 

Average

 

Remaining

 

Aggregate

 

 

 

 

 

Exercise

 

Contractual

 

Intrinsic

 

 

 

Stock Options

 

Price

 

Term (Years)

 

Value

 

 

 

(shares and dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

Outstanding as of December 31, 2010

 

2,436

 

$

9.40

 

 

 

 

 

Granted

 

 

 

 

 

 

 

Exercised

 

(78

)

7.08

 

 

 

 

 

Forfeited and expired

 

(327

)

11.06

 

 

 

 

 

Outstanding as of September 30, 2011

 

2,031

 

9.22

 

3.5

 

$

56

 

 

 

 

 

 

 

 

 

 

 

Vested and expected to vest as of September 30, 2011

 

2,021

 

$

9.23

 

3.5

 

$

56

 

 

 

 

 

 

 

 

 

 

 

Exercisable as of September 30, 2011

 

2,017

 

$

9.23

 

3.5

 

$

56

 

 

The aggregate intrinsic value amounts in the table above represent the closing price of the Company’s common stock on September 30, 2011 in excess of the exercise price, multiplied by the number of stock options outstanding or exercisable, when the closing price is greater than the exercise price. This represents the amount that would have been received by the stock option holders if they had all exercised their stock options on September 30, 2011. The total intrinsic value of options exercised during the nine months ended September 30, 2010 and 2011 was $0.9 million and $0.1 million, respectively. The intrinsic value of stock options exercised represents the difference between the market value of Company’s common stock at the time of exercise and the exercise price, multiplied by the number of stock options exercised. To the extent the forfeiture rate is different than what the Company has anticipated, stock-based compensation related to these awards will be different from the Company’s expectations.

 

20



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

The following table summarizes the status of the Company’s stock options as of September 30, 2011:

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock Options

 

Stock Options Outstanding

 

Exercisable

 

 

 

 

 

 

 

 

 

Weighted

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Average

 

Weighted

 

 

 

Weighted

 

 

 

 

 

 

 

 

 

Remaining

 

Average

 

 

 

Average

 

Range of

 

Number

 

Contractual

 

Exercise

 

Number

 

Exercise

 

Exercise Prices

 

Outstanding

 

Life

 

Price

 

Exercisable

 

Price

 

 

 

 

 

 

 

(in thousands)

 

 

 

 

 

(in thousands)

 

 

 

$

5.10

 

 

 

$

6.90

 

170

 

3.9

 

$

6.43

 

170

 

$

6.43

 

6.91

 

 

 

7.31

 

331

 

5.7

 

7.26

 

321

 

7.27

 

7.32

 

 

 

8.90

 

140

 

3.8

 

8.02

 

138

 

8.02

 

8.96

 

 

 

9.01

 

274

 

2.9

 

9.01

 

274

 

9.01

 

9.02

 

 

 

9.51

 

316

 

4.2

 

9.47

 

314

 

9.47

 

9.64

 

 

 

9.89

 

217

 

0.4

 

9.65

 

217

 

9.65

 

10.36

 

 

 

10.36

 

330

 

3.9

 

10.36

 

330

 

10.36

 

10.51

 

 

 

16.82

 

253

 

2.2

 

12.37

 

253

 

12.37

 

$

5.10

 

to

 

$

16.82

 

2,031

 

3.5

 

$

9.22

 

2,017

 

$

9.23

 

 

Restricted Stock Units

 

The following table summarizes restricted stock unit activity as of and for the nine months ended September 30, 2011:

 

 

 

 

 

Weighted

 

 

 

 

 

Average

 

 

 

Restricted

 

Grant Date

 

 

 

Stock Units

 

Fair Value

 

 

 

(in thousands)

 

 

 

Outstanding as of December 31, 2010

 

2,357

 

$

8.01

 

Granted

 

2,384

 

7.83

 

Vested

 

(1,520

)

7.82

 

Forfeited

 

(73

)

8.46

 

Outstanding as of September 30, 2011

 

3,148

 

$

7.96

 

 

The fair value of restricted stock units is determined based on the closing trading price of EarthLink’s common stock on the grant date. The weighted-average grant date fair value of restricted stock units granted during the nine months ended September 30, 2010 and 2011 was $8.36 and $7.83, respectively.  As of September 30, 2011, there was $15.3 million of total unrecognized compensation cost related to nonvested restricted stock units. That cost is expected to be recognized over a weighted-average period of 2.7 years. The total fair value of shares vested during the nine months ended September 30, 2010 and 2011 was $10.1 million and $12.4 million, respectively, which represents the closing price of the Company’s common stock on the vesting date multiplied by the number of restricted stock units that vested.

 

21



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

11. Income Taxes

 

The following table presents the components of the income tax provision for the three and nine months ended September 30, 2010 and 2011:

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2010

 

2011

 

2010

 

2011

 

 

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

Current provision

 

$

984

 

$

940

 

$

3,583

 

$

4,357

 

Deferred provision

 

14,155

 

997

 

45,530

 

11,851

 

Total income tax provision

 

$

15,139

 

$

1,937

 

$

49,113

 

$

16,208

 

 

The income tax provision for the nine months ended September 30, 2011 represents an effective rate of 34.76%, including a benefit for discrete items of -5.37%.  The current provisions were due to state income and federal and state alternative minimum tax amounts payable due to the net operating loss carryforward limitations associated with the alternative minimum tax calculation and the non-cash deferred tax provisions were due primarily to the utilization of net operating loss carryforwards.

 

The Company has a valuation allowance of $40.0 million against certain deferred tax assets. Of this amount, approximately $31.6 million relates to net operating losses generated by the tax benefits of stock-based compensation. The valuation allowance will be removed upon utilization of these net operating losses by the Company as an adjustment to additional paid-in-capital.  Approximately $8.0 million relates to net operating losses in certain jurisdictions where the Company believes it is not “more likely than not” to be realized in future periods. In addition, valuation allowance of $0.4 million was established in 2010 relating to stock compensation deferred tax assets.

 

To the extent the Company reports income in future periods, the Company intends to use its net operating loss carryforwards to the extent available to offset taxable income and reduce cash outflows for income taxes.  The Company’s ability to use its federal and state net operating loss carryforwards and federal and state tax credit carryforwards may be subject to restrictions attributable to equity transactions in the future resulting from changes in ownership as defined under the Internal Revenue Code.

 

As a result of the acquisitions of One Communications, STS Telecom and certain other acquisitions during the nine months ended September 30, 2011, EarthLink recorded net deferred tax liabilities of $53.5 million, $6.7 million and $0.7 million, respectively. Included in these amounts are $17.9 million of deferred tax assets relating to federal and state net operating losses acquired from One Communications. These amounts were recorded under acquisition accounting.

 

The Company has identified its federal tax return and its state tax returns in California, Florida, Georgia, Illinois, New York and Pennsylvania as material tax jurisdictions for purposes of calculating its uncertain tax positions.  Periods extending back to 1994 are still subject to examination for all material jurisdictions. The Company believes that its income tax filing positions and deductions through the period ended September 30, 2011 will not result in a material adverse effect on the Company’s financial condition, results of operations or cash flow. It is reasonably possible that during the next 12 months the unrecognized tax benefit may be reduced by a range of $0.5 million to $0.8 million because the statute of limitations is expected to expire in certain jurisdictions. The Company’s policy for recording interest and penalties associated with audits is to record such items as a component of income tax expense.

 

22



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

A reconciliation of changes in the amount of unrecognized tax benefits for the nine months ended September 30, 2011 is as follows:

 

 

 

Nine Months Ended

 

 

 

September 30, 2011

 

 

 

(in thousands)

 

Balance as of December 31, 2010

 

$

18,367

 

Adjustment to tax positions under acquisition accounting

 

4,374

 

Decreases for tax positions of prior years

 

(1,038

)

Balance as of September 30, 2011

 

$

21,703

 

 

12.  Commitments and Contingencies

 

Operating Leases

 

The Company leases certain of its facilities under various non-cancelable operating leases. The facility leases generally require the Company to pay operating costs, including property taxes, insurance and maintenance, and generally contain annual escalation provisions as well as renewal options.  Minimum lease commitments (including estimated operating expenses) under non-cancelable leases, including commitments associated with facilities exited as part of the Company’s restructuring plans, as of September 30, 2011 are as follows:

 

 

 

Operating

 

Year Ending December 31,

 

Leases

 

 

 

(in thousands)

 

 

 

 

 

2011 (remaining three months)

 

$

10,983

 

2012

 

39,857

 

2013

 

36,311

 

2014

 

28,590

 

2015

 

17,703

 

Thereafter

 

76,908

 

Total minimum lease payments, including estimated operating expenses

 

210,352

 

Less aggregate contracted sublease income

 

(5,531

)

 

 

$

204,821

 

 

23



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

Purchase commitments

 

The Company has entered into agreements with vendors to purchase certain telecommunications services and equipment under non-cancelable agreements. The Company also has minimum commitments under network access agreements with several carriers and obligations for certain advertising spending under non-cancelable agreements. The following table summarizes commitments under these agreements as of September 30, 2011 (in thousands):

 

Year Ending December 31,

 

 

 

 

 

 

 

2011 (remaining three months)

 

$

25,880

 

2012

 

47,175

 

2013

 

36,657

 

2014

 

13,001

 

2015

 

6,428

 

Thereafter

 

10,349

 

Total

 

$

139,490

 

 

Legal proceedings

 

The Company is party to various legal proceedings arising from normal business activities. The result of any current or future disputes, litigation or other legal proceedings is inherently unpredictable. The Company’s management, however, believes that there are no disputes, litigation or other legal proceedings asserted or pending against the Company that could have, individually or in the aggregate, a material adverse effect on its financial position, results of operations or cash flows, and believes that adequate provision for any probable and estimable losses has been made in the Company’s condensed consolidated financial statements.

 

Regulation

 

The Company’s services are subject to varying degrees of federal, state and local regulation. These regulations are subject to ongoing proceedings at federal and state administrative agencies or within state and federal judicial systems. Results of these proceedings could change, in varying degrees, the manner in which the Company operates. The Company cannot predict the outcome of these proceedings or their effect on the Company’s industry generally or upon the Company specifically.

 

Other

 

The Company is periodically involved in disputes related to its billings to other carriers for access to its network. The Company does not recognize revenue related to such matters until the period that it is reliably assured of the collection of these claims. In the event that a claim is made related to revenues previously recognized, the Company assesses the validity of the claim and adjusts the amount of revenue being recognized to the extent that the claim adjustment is considered probable and estimable.

 

The Company periodically disputes network access charges that it is assessed by other companies with which the Company interconnects. The Company maintains adequate reserves for anticipated exposure associated with these billing disputes. The reserves are reviewed on a monthly basis, but are subject to changes in estimates and management judgment as new information becomes available. In view of the length of time historically required to resolve these disputes, they may be resolved or require adjustment in future periods and relate to costs invoiced, accrued or paid in prior periods.

 

24



Table of Contents

 

EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

13.  Fair Value Measurements

 

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (an exit price). A three-tier fair value hierarchy is used to prioritize the inputs used in measuring fair value.  These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.

 

Assets measured at fair value on a recurring basis

 

As of December 31, 2010 and September 30, 2011, the Company held certain assets that are required to be measured at fair value on a recurring basis.  These included the Company’s cash equivalents and marketable securities. Cash equivalents and marketable securities as of December 31, 2010 and September 30, 2011 were valued using quoted market prices and are classified within Level 1.

 

The following tables present the Company’s assets that are measured at fair value on a recurring basis as of December 31, 2010 and September 30, 2011:

 

 

 

 

 

 

 

Fair Value Measurements as of December 31, 2010 Using

 

 

 

 

 

 

 

Quoted Prices

 

Significant

 

 

 

 

 

 

 

 

 

in Active

 

Other

 

Significant

 

 

 

 

 

 

 

Markets for

 

Observable

 

Unobservable

 

 

 

Carrying

 

Fair

 

Identical Assets

 

Inputs

 

Inputs

 

Description

 

Value

 

Value

 

(Level 1)

 

(Level 2)

 

(Level 3)

 

 

 

 

 

(in thousands)

 

Cash equivalents

 

$

184,054

 

$

184,054

 

$

184,054

 

$

 

$

 

Government and agency securities

 

284,441

 

284,441

 

284,441

 

 

 

Commercial paper

 

14,666

 

14,666

 

14,666

 

 

 

Corporate debt securities

 

21,011

 

21,011

 

21,011

 

 

 

Total

 

$

504,172

 

$

504,172

 

$

504,172

 

$

 

$

 

 

 

 

 

 

 

 

Fair Value Measurements as of September 30, 2011 Using

 

 

 

 

 

 

 

Quoted Prices

 

Significant

 

 

 

 

 

 

 

 

 

in Active

 

Other

 

Significant

 

 

 

 

 

 

 

Markets for

 

Observable

 

Unobservable

 

 

 

Carrying

 

Fair

 

Identical Assets

 

Inputs

 

Inputs

 

Description

 

Value

 

Value

 

(Level 1)

 

(Level 2)

 

(Level 3)

 

 

 

 

 

(in thousands)

 

Cash equivalents

 

$

399,985

 

$

399,985

 

$

399,985

 

$

 

$

 

Total

 

$

399,985

 

$

399,985

 

$

399,985

 

$

 

$

 

 

Assets and liabilities measured at fair value on a nonrecurring basis

 

Disclosures are required for certain assets and liabilities that are measured at fair value on a nonrecurring basis in periods subsequent to initial recognition. Such measurements of fair value relate primarily to long-lived asset impairments. There were no material long-lived asset impairments for the three and nine months ended September 30, 2010 and 2011.

 

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EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

Fair value of debt

 

The estimated fair value of the Company’s Convertible Notes and ITC^DeltaCom Notes were determined based on Level 1 input using quoted prices and the estimated fair value of the Company’s Senior Notes was determined based on Level 2 input using third-party quotes. The following table presents the fair value of the Company’s debt, excluding capital leases as of December 31, 2010 and September 30, 2011:

 

 

 

As of December 31, 2010

 

As of September 30, 2011

 

 

 

Carrying

 

 

 

Carrying

 

 

 

 

 

Amount

 

Fair Value

 

Amount

 

Fair Value

 

 

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

ITC^DeltaCom senior notes

 

$

351,251

 

$

352,625

 

$

347,943

 

$

328,048

 

EarthLink convertible senior notes

 

243,069

 

300,281

 

254,047

 

257,548

 

EarthLink senior notes

 

 

 

289,995

 

261,375

 

Total debt, excluding capital leases

 

$

594,320

 

$

652,906

 

$

891,985

 

$

846,971

 

 

14.  Segment Information

 

The Company reports segment information along the same lines that its chief executive officer reviews its operating results in assessing performance and allocating resources. The Company operates two reportable segments, Business Services and Consumer Services. The Company’s Business Services segment provides a comprehensive suite of communications and technology services, including voice, data, managed network services, cloud hosting and equipment services, to businesses, enterprise organizations and communications carriers. The results of ITC^DeltaCom, One Communications and STS Telecom are included in the Company’s Business Services segment. The Company’s Consumer Services segment provides nationwide Internet access and related value-added services to residential customers.

 

The Company’s Business Services segment earns revenue from the provision of retail services, wholesale services and other services. Retail services include data services, including managed IP-based network services and broadband Internet access services; voice services, including local exchange, long-distance, conference calling and hosted VoIP; mobile voice and data services; and data center and managed services provided to businesses and enterprise organizations. Wholesale services include the sale of transmission capacity to other telecommunications carriers. Other services include web hosting and the sale of customer premises equipment. Revenues generally consist of recurring monthly charges for such services; usage fees; installation fees; equipment fees and termination fees.

 

The Company’s Consumer Services segment earns revenue from the provision of access services and related value-added services. Access services include narrowband access services (including traditional, fully-featured narrowband access and value-priced narrowband access) and broadband access services (including high-speed access via DSL and cable and VoIP). Value-added services includes revenues from ancillary services sold as add-on features to EarthLink’s Internet access services, such as security products, premium email only, home networking, email storage and Internet call waiting; search revenues; and advertising revenues. Revenues generally consist of recurring monthly charges for such services; usage fees; installation fees; termination fees; and fees for equipment.

 

The Company evaluates performance of its segments based on segment income from operations. Segment income from operations includes revenues from external customers, related cost of revenues and operating expenses directly attributable to the segment, which include costs over which segment managers have direct discretionary control, such as advertising and marketing programs, customer support expenses, operations expenses, product development expenses, certain technology and facilities expenses, billing operations and provisions for doubtful accounts. Segment income from operations excludes other income and expense items and certain expenses over which segment managers do not have discretionary control. Costs excluded from segment income from operations include various corporate expenses (consisting of certain costs such as

 

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EARTHLINK, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED - (Continued)

 

corporate management, human resources, finance and legal), depreciation and amortization, impairment of goodwill and intangible assets, restructuring and acquisition-related costs, and stock-based compensation expense, as they are not considered in the measurement of segment performance.

 

Information on reportable segments and a reconciliation to consolidated income from operations for the three and nine months ended September 30, 2010 and 2011 is as follows:

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

 

 

2010

 

2011

 

2010

 

2011

 

 

 

(in thousands)

 

Business Services

 

 

 

 

 

 

 

 

 

Revenues

 

$

33,631

 

$

265,743

 

$

100,027

 

$

675,729

 

Cost of revenues

 

20,589

 

132,718

 

59,577

 

339,325

 

Gross margin

 

13,042

 

133,025

 

40,450

 

336,404

 

Direct segment operating expenses

 

10,313

 

82,154

 

30,019

 

214,484

 

Segment operating income

 

$