Monday, October 03, 2005

Earthlink: A Lesson on Working Capital

So the newest little security in my lonely little investing world is Earthlink, Inc. (Ticker: ELNK). Many of you may know it as the formerly popular dial-up connection service that boasts 4x the speed of AOL. They aren't doing so well these days. Their subscriber bases are falling as more and more Americans switch to broadband, and the competitive branches Earthlink does have in broadband has terrible margins compared to traditional dial-up. This company is what I'd like to call a "transition" company.

If we take a look at its financials, we'll see a very strong balance sheet with virtually no debt and over 450m in cash and marketable securities. With a Market Cap of around 1.4b, that makes up close to 1/3 of their company value! Their income statement isn't so shabby either; in fact, it will probably make about 120m annually going forward if we annualize the latest quarter (but that may be a bit too liberal, since the summer months are usually the best for ISPs). With an enterprise value of around $1b, and earnings of say, 100m, it doesn't seem like too deep of a discount...

But take a look at their cash-generation. Net out the investments they put into marketable securities and the money they spend buying back their own stock... this company is generating around $100m in cash every quarter!!! Now, let this be a Working Capital lesson to all those who are interested in learning:

You see, a company's earnings, while they are important, is not the "accurate" way to measure how a company can generate money. In fact, I would argue that Income Statements serve the purpose of "normalizing" earnings instead of reporting what is actually there. For a more detailed analysis of the earning power of a company, we would have to turn to its balance sheets and its cashflow statements. Why on earth would we look at a balance sheet, you ask? What possibly can balance sheets tell me about a company's earning power? Ahh, you ask good questions, grasshopper... you see, the balance sheet is a snapshot of the financial condition of a company in a single moment in time. When you analyze the changes in the financial conditions of a business at different moments in time, you can more clearly see how assets, liabilities, and equity move around than you can with any earnings statement.

Now, let me define working capital for you. Working capital, traditionally, means Current Assets minus Current Liabilities. It's supposed to measure a firm's ability to finance it's debt or growth. Current Assets is assumed to be readily convertible into cash, and Current Liabilities is assumed to be debts that are coming due. If a firm has negative working capital in this sense, it usually is a bad sign, prognosticating the probability that a firm might go bankrupt because it will not be able to finance its operations.

But in order to measure how cash flows in and out of the business, we must let go of a traditional assumption, and assume a definition of working capital that is slightly different. Let's define working capital as All non-cash assets, minus All non-debt liabilities. We do this for one simple reason: because the changes in working capital period on period will give us a hint as to how the firm's cash flows in and out of asset and liability accounts, and how the net change affects the cash balance in the period.

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Now why is Earthlink interesting? Well for one, changes in working capital has provided this company with about $15 - $100m dollars in free cash flow per quarter over the past couple of years. Now, theoretically, this should be impossible to sustain--and it probably is. Upon closer inspection, We find that the biggest changes in working capital comes from moving in and out of large investments. You see, the working capital increases when there are either 1.) an increase in the Assets, or two, a decrease in the liabilities. Similarly, when working capital decreases, either the assets decreased or the liabilities increased. Now, we should know that when non-cash assets increase, it is probably either financed by an increase in liabilities, or a decrease in cash. And also when non-debt liabilities increase, it is either due to an increase in assets, or a decrease in cash. What we are able to do with working capital is analyzing periodic changes in a businesses balance sheet to see how the cash changed. When we subtract the working capital of one period from another, we are literally seeing the difference in cash between the two. Since any changes in assets or liabilities would already be netted into the difference, it would only be the changes in cash that we see. Did you understand that? If not, read it again.

In the case of Earthlink, they sold investments and bought into investments constantly, creating gains for their assets, the "cash and marketable securities" account would keep getting bigger, allowing Earthlink to invest in new projects and make more and more investments. But this, as you all smarty-pants will know, would not exactly provide "free cash flow" in the form of working capital to Earthlink. What DOES provide "free cash flow" is the payment of liabilities. Just go look at Earthlink's liabilities, and you will see some crazy payments going in and out all the time.

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Anyway, working capital aside... now that you know how it affects working capital... I've decided to value Earthlink without the effect of its working capital. In fact, I've even assumed a 10% loss on their investments (by decreasing the marketable securities total by 10%, and netting it into enterprise value) to see if this is a good company going forward.

What I found is interesting:
Declining margins, but increasing subscribers--attributable to decline of more profitable narrowband service and increase of less profitable broadband service. Increase in subscribers offsets decrease in margins, making the company's earnings seem constant. The question for this company is... what can make its broadband grow even more? Especially in light of all the competition from local cable service providers? This company trades at about 10x earnings going forward, about 7x cash (net out gains from investments)... The market is betting this company will be history in the next 7 years. What do you think? Can Earthlink successfully compete and provide consumer value in the highly competitive market of Broadband internet access?

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No buy for the third quarter... traditionally, 3rd quarter is much worse than 2nd quarter (summer season).

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