Earthlink: Why Haven’t They Bought AOL’s Dial-Up Unit?

Earthlink (ELNK) is an odd company: it continues to generate more and more cash from the terminally ill (and steadily shrinking) dial-up Internet access business. It’s coffers are bursting at the seams. Judging by the company’s valuation, the Street doesn’t see a whole lot of value in the core business. But there certainly is intrigue over the cash - including whether the company will eventually buy the AOL dial-up access business.

This morning, Earthlink posted Q4 revenues of $216.1 million, right in line with the Street at $216.2 million. But the dial-up Internet access provider posted profits for the quarter of 25 cents a share, falling short of the Street by 13 cents. Note, however, that results include a $78.7 million non-cash impairment charge, partially offset by a $56.1 million tax benefit. Revenues dropped 23.4% from a year ago.

For the full year, the company repeated its adjusted EBITDA projection of $210 million to $225 million. The company upped its free cash flow guidance to $190 million to $225 million; however, it reducted its forecast for income from continuing operations of $75 million to $95 million, down from a previously projected $135 million to $155 million, apparently due to some adjustments to the company’s valuation allowance related to deferred tax assets.

Earthlink has largely shed most of its non-access businesses - no more Helio, no more muni WiFi projects - and focused instead on milking its dial-up business. Ergo, the company in the quarter reported a 40% drop in spending on sales, marketing, operations, customer support and general and administrative expenses versus the year-ago quarter. For the full year, those expenses were down 49%.

For investors in the company, the real issue is what to do with its mounting pile of cash. The company finished the year with $534.4 million in cash and securities, up $245.8 million from a year ago. In its release, the company said that it “has an expanded set of strategic alternatives that we are considering.”

CEO Rolla Huff addressed the question at some length in the company’s post-earnings conference call.

On the call, according to a transcript prepared by Seeking Alpha, Huff said that in the third quarter the company began “to more aggressively consider strategic investment alternatives in businesses that we are currently in, beyond just narrowband access. As evidenced by our not announcing any transactions, we found no deals that were compelling in terms of shareholder value creation.”

Huff said that He said that the company could make several moves: “”the combination of caution and execution that we demonstrated to date has created the possibility for us” to leverage the current chaos in the capital markets to the advantage of Earthlink holders. “I don’t see a strategic transaction or a program to return cash as being necessarily mutually exclusive,” he said. “Nothing is off the table, in my mind.”

Anyway, Huff also said that most large Earthlink holders “with very few exceptions” have advised him to hold onto the cash for a while longer given the ongoing financial crisis. But he added that “to be clear with you, I did not take their shareholder feedback as a view that they were encouraging me to go out and start buying stuff.”

“As a meaningful shareholder that bought shares when I arrived and as the guide who would have to deliver the value of any transaction, I am sensitive to taking on integration risk in this difficult environment,” he said. “But I also recognize that it is precisely in this kind of environment that real value emerges for those strong enough to take advantage of it.” And he added that he is “aware of the technology and churn risk that has put an incredibly low terminal value on our business.”

Huff concluded that he is convinced that “keeping all of the options on the table a bit longer including programs to return cash is the most prudent course of action while this volatile environment plays itself out.”

One other thing. There has been considerable speculation that Earthlink would be the most logical buyer for AOL’s dial-up business, which Time-Warner has on the block separately from the rest of AOL. Huff made some not-so-subtle comments suggesting without naming names that Time-Warner by taking so much time to sell the business has been frittering away its value:

Over the first half of last year we outlined the merits of dial up industry consolidation and why we believed we were logical consolidator.

Our view was and actually continues to be that this industry needs to be consolidated and the substantial shareholder value could be created for industry shareholders. However, as time has elapsed, its clear that we were much more focused on this strategy than others in the industry.

I think it’s a pity because as we all know, you can not recover the value of lost operating synergies ever.

Or to look at this another way: Why won’t Time Warner take Earthlink’s money?

Earthlink today is down 25 cents, or 3.2%, to $7.53. The company has a market cap of $819 million; cash accounts for 66% of that.