**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  March 31, 2008**                                                                                                             |
|   |                                                                                                                                                                |
| **OR** |
|   |                                                                                                                                                                |
| **o**  | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                             |
|   |                                                                                                                                                                |
|   | **For  the transition period from             to            .** |

 

**CommissionFile 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)

 

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Indicate by checkmark whether the registrant (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes xNo o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer or a smaller reporting company (as defined in Rule 12b-2of the Exchange Act):

 

See the definitions of “largeaccelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2of the Exchange Act.

 

| Large accelerated filer x | Accelerated filer o | Non-accelerated filer o                        | Smaller reporting  company o |
|---------------------------|--------------------------|------------------------------------------------|-----------------------------------|
|                      |                     | (Do not check if a  smaller reporting company) |                              |

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).     Yes oNo x

 

As of April 30,2008, 109,735,842 shares of common stock, $.01 par value per share, wereoutstanding.

 

 

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**EARTHLINK, INC.**

**Quarterly Report on Form 10-Q**

**For the Quarterly Period Ended March 31, 2008**

 

**TABLE OF CONTENTS**

 
| **Part I**                                                                                     |   |
|-----------------------------------------------------------------------------------------------------|--------|
|                                                                                                |   |
| Item 1. Financial Statements                                                                        | 1      |
|                                                                                                |   |
| Item 2. Management’s Discussion and Analysis of Financial  Condition and Results of Operations | 21     |
|                                                                                                |   |
| Item 3. Quantitative and Qualitative Disclosures About  Market Risk                                 | 37     |
|                                                                                                |   |
| Item 4. Controls and Procedures                                                                     | 38     |
|                                                                                                |   |
| **Part II**                                                                                    |   |
|                                                                                                |   |
| Item  1. Legal Proceedings                                                                          | 38     |
|                                                                                                |   |
| Item  1A. Risk Factors                                                                              | 38     |
|                                                                                                |   |
| Item 2. Unregistered Sales of Equity Securities and  Use of Proceeds                                | 38     |
|                                                                                                |   |
| Item  5. Other Information                                                                          | 39     |
|                                                                                                |   |
| Item 6.  Exhibits                                                                                   | 39     |
|                                                                                                |   |
| Signatures                                                                                          | 40     |

 

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**PART I**

 

**Item 1.  Financial Statements.**

 

**EARTHLINK, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(in thousands,except per share data)**

 
| ** **                                                                                                                                                                                                                                                                        | ** ** | **December 31,** | ** ** | **March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|--------------------|------------|
| ** **                                                                                                                                                                                                                                                                        | ** ** | **2007**              | ** ** | **2008**           | ** ** |
| ** **                                                                                                                                                                                                                                                                        | ** ** | ** **            | ** ** | **(unaudited)**    | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                        |       |
| Current assets:                                                                                                                                                                                                                                                                   |       |                  |       |               |       |
| Cash and cash  equivalents                                                                                                                                                                                                                                                        |       | $                     | 173,827    |               | $          | 240,957 |   |
| Investments in  marketable securities                                                                                                                                                                                                                                             |       | 93,204                |       | 7,065              |       |
| Accounts  receivable, net of allowance of $6,422 and $6,473 as of December 31,  2007 and March 31, 2008, respectively                                                                                                                                                   |       | 41,483                |       | 40,080             |       |
| Investments in  other companies                                                                                                                                                                                                                                                   |       | —                |       | 56,572             |       |
| Prepaid expenses                                                                                                                                                                                                                                                                  |       | 7,747                 |       | 7,463              |       |
| Current assets  of discontinued operations                                                                                                                                                                                                                                        |       | 6,744                 |       | 4,657              |       |
| Other current  assets                                                                                                                                                                                                                                                             |       | 13,732                |       | 13,875             |       |
| Total current  assets                                                                                                                                                                                                                                                             |       | 336,737               |       | 370,669            |       |
| Long-term  investments in marketable securities                                                                                                                                                                                                                                   |       | 21,564                |       | 72,001             |       |
| Property and  equipment, net                                                                                                                                                                                                                                                      |       | 57,300                |       | 51,484             |       |
| Long-term  investments in other companies                                                                                                                                                                                                                                         |       | 62,923                |       | 10,167             |       |
| Purchased  intangible assets, net                                                                                                                                                                                                                                                 |       | 46,276                |       | 42,151             |       |
| Goodwill                                                                                                                                                                                                                                                                          |       | 202,277               |       | 194,472            |       |
| Other long-term  assets                                                                                                                                                                                                                                                           |       | 8,149                 |       | 7,993              |       |
| Total assets                                                                                                                                                                                                                                                                      |       | $                     | 735,226    |               | $          | 748,937 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                                    |       |
| Current  liabilities:                                                                                                                                                                                                                                                             |       |                  |       |               |       |
| Trade accounts  payable                                                                                                                                                                                                                                                           |       | $                     | 28,808     |               | $          | 20,816 |   |
| Accrued payroll  and related expenses                                                                                                                                                                                                                                             |       | 29,118                |       | 18,634             |       |
| Other accounts  payable and accrued liabilities                                                                                                                                                                                                                                   |       | 69,867                |       | 70,123             |       |
| Current  liabilities of discontinued operations                                                                                                                                                                                                                                   |       | 15,930                |       | 8,955              |       |
| Deferred revenue                                                                                                                                                                                                                                                                  |       | 44,626                |       | 41,601             |       |
| Total current  liabilities                                                                                                                                                                                                                                                        |       | 188,349               |       | 160,129            |       |
|                                                                                                                                                                                                                                                                              |       |                  |       |               |       |
| Long-term debt                                                                                                                                                                                                                                                                    |       | 258,750               |       | 258,750            |       |
| Other long-term  liabilities                                                                                                                                                                                                                                                      |       | 26,654                |       | 16,632             |       |
| Total  liabilities                                                                                                                                                                                                                                                                |       | 473,753               |       | 435,511            |       |
|                                                                                                                                                                                                                                                                              |       |                  |       |               |       |
| Stockholders’  equity:                                                                                                                                                                                                                                                       |       |                  |       |               |       |
| Convertible  preferred stock, $0.01 par value, 100,000 shares authorized, 0 shares issued  and outstanding as of December 31, 2007 and March 31, 2008                                                                                                                   |       | —                |       | —             |       |
| Common stock,  $0.01 par value, 300,000 shares authorized, 186,490 and 186,863 shares issued  as of December 31, 2007 and March 31, 2008, respectively, and  110,547 and 109,635 shares outstanding as of December 31, 2007 and March 31,  2008, respectively |       | 1,865                 |       | 1,869              |       |
| Additional  paid-in capital                                                                                                                                                                                                                                                       |       | 2,047,268             |       | 2,054,235          |       |
| Accumulated  deficit                                                                                                                                                                                                                                                              |       | (1,184,119            | )          | (1,129,755         | )          |
| Treasury stock,  at cost, 75,943 and 77,228 shares as of December 31, 2007 and  March 31, 2008, respectively                                                                                                                                                            |       | (602,564              | )          | (611,689           | )          |
| Unrealized  losses on investments                                                                                                                                                                                                                                                 |       | (977                  | )          | (1,234             | )          |
| Total stockholders’  equity                                                                                                                                                                                                                                                  |       | 261,473               |       | 313,426            |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                                                                                                  |       | $                     | 735,226    |               | $          | 748,937 |   |

 

The accompanyingnotes are an integral part of these financial statements.

 

1

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**EARTHLINK, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

 
| ** **                                                    | ** ** | **Three Months Ended March 31,**               | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                    | ** ** | **2007**                                                           | ** ** | **2008** | ** ** |
| ** **                                                    | ** ** | **(in thousands, except per share data)** | ** ** |
| ** **                                                    | ** ** | **(unaudited)**                                                    | ** ** |
|                                                          |       |                                                               |       |   |   |
| Revenues                                                      |       | $                                                                  | 324,147    |   | $ | 263,074 |   |
|                                                          |       |                                                               |       |   |   |
| Operating costs  and expenses:                                |       |                                                               |       |   |   |
| Service and equipment  costs                                  |       | 109,791                                                            |       | 96,792 |   |
| Sales incentives                                              |       | 4,604                                                              |       | 759 |   |
| Total cost of  revenues                                       |       | 114,395                                                            |       | 97,551 |   |
|                                                          |       |                                                               |       |   |   |
| Sales and  marketing                                          |       | 99,269                                                             |       | 30,916 |   |
| Operations and  customer support                              |       | 60,072                                                             |       | 39,224 |   |
| General and  administrative                                   |       | 43,261                                                             |       | 24,926 |   |
| Amortization of  intangible assets                            |       | 3,496                                                              |       | 4,013 |   |
| Facility exit,  restructuring and other costs                 |       | —                                                             |       | 1,030 |   |
| Total operating  costs and expenses                           |       | 320,493                                                            |       | 197,660 |   |
|                                                          |       |                                                               |       |   |   |
| Income from  operations                                       |       | 3,654                                                              |       | 65,414 |   |
| Net losses of  equity affiliate                               |       | (29,346                                                            | )          | — |   |
| Interest income  and other, net                               |       | 3,503                                                              |       | 1,616 |   |
| Income (loss)  from continuing operations before income taxes |       | (22,189                                                            | )          | 67,030 |   |
| Income tax  provision                                         |       | (169                                                               | )          | (9,274 | ) |
| Income (loss)  from continuing operations                     |       | (22,358                                                            | )          | 57,756 |   |
| Loss from  discontinued operations                            |       | (7,604                                                             | )          | (3,392 | ) |
| Net income  (loss)                                            |       | $                                                                  | (29,962    | ) | $ | 54,364 |   |
|                                                          |       |                                                               |       |   |   |
| Basic net income  (loss) per share                            |       |                                                               |       |   |   |
| Continuing  operations                                        |       | $                                                                  | (0.18      | ) | $ | 0.53 |   |
| Discontinued  operations                                      |       | (0.06                                                              | )          | (0.03 | ) |
| Basic net income  (loss) per share                            |       | $                                                                  | (0.24      | ) | $ | 0.50 |   |
| Basic weighted  average common shares outstanding             |       | 123,058                                                            |       | 109,493 |   |
|                                                          |       |                                                               |       |   |   |
| Diluted net  income (loss) per share                          |       |                                                               |       |   |   |
| Continuing  operations                                        |       | $                                                                  | (0.18      | ) | $ | 0.52 |   |
| Discontinued  operations                                      |       | (0.06                                                              | )          | (0.03 | ) |
| Diluted net  income (loss) per share                          |       | $                                                                  | (0.24      | ) | $ | 0.49 |   |
| Diluted weighted  average common shares outstanding           |       | 123,058                                                            |       | 110,300 |   |

 

The accompanyingnotes are an integral part of these financial statements.

 

2

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**EARTHLINK, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                                           | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                           | ** ** | **March 31,**               | ** ** |
| ** **                                                                                           | ** ** | **2007**                         | ** ** | **2008** | ** ** |
| ** **                                                                                           | ** ** | **(in thousands)**          | ** ** |
| ** **                                                                                           | ** ** | **(unaudited)**                  | ** ** |
| Cash flows from  operating activities:                                                               |       |                             |       |   |   |
| Net income  (loss)                                                                                   |       | $                                | (29,962    | ) | $ | 54,364 |   |
| Adjustments to  reconcile net income (loss) to net cash (used in) provided by operating  activities: |       |                             |       |   |   |
| Depreciation and  amortization                                                                       |       | 13,227                           |       | 10,519 |   |
| (Gain) loss on  disposals and impairments of fixed assets                                            |       | (4                               | )          | 2,370 |   |
| Net losses of  equity affiliate                                                                      |       | 29,346                           |       | — |   |
| Stock-based compensation                                                                             |       | 7,905                            |       | 5,152 |   |
| Deferred income  taxes                                                                               |       | —                           |       | 7,219 |   |
| Other  adjustments                                                                                   |       | (24                              | )          | — |   |
| (Increase)  decrease in accounts receivable, net                                                     |       | (897                             | )          | 1,223 |   |
| Increase in  prepaid expenses and other assets                                                       |       | (3,601                           | )          | (6,303 | ) |
| Decrease in  accounts payable and accrued and other liabilities                                      |       | (16,983                          | )          | (29,852 | ) |
| Decrease in  deferred revenue                                                                        |       | (400                             | )          | (2,959 | ) |
| Net cash (used  in) provided by operating activities                                                 |       | (1,393                           | )          | 41,733 |   |
|                                                                                                 |       |                             |       |   |   |
| Cash flows from  investing activities:                                                               |       |                             |       |   |   |
| Purchases of  property and equipment                                                                 |       | (13,312                          | )          | (278 | ) |
| Purchases of  subscriber bases                                                                       |       | (1,865                           | )          | (117 | ) |
| Proceeds from  sales of fixed assets                                                                 |       | 36                               |       | — |   |
| Investments in  marketable securities:                                                               |       |                             |       |   |   |
| Purchases                                                                                            |       | (103,535                         | )          | (53,027 | ) |
| Sales and  maturities                                                                                |       | 81,385                           |       | 86,059 |   |
| Investments in  and net advances to/from equity affiliate                                            |       | (13,724                          | )          | 87 |   |
| Net cash (used  in) provided by investing activities                                                 |       | (51,015                          | )          | 32,724 |   |
|                                                                                                 |       |                             |       |   |   |
| Cash flows from  financing activities:                                                               |       |                             |       |   |   |
| Principal  payments under capital lease obligations                                                  |       | (12                              | )          | (145 | ) |
| Proceeds from  exercises of stock options and other                                                  |       | 2,775                            |       | 1,943 |   |
| Repurchases of  common stock                                                                         |       | —                           |       | (9,125 | ) |
| Net cash  provided by (used in) financing activities                                                 |       | 2,763                            |       | (7,327 | ) |
|                                                                                                 |       |                             |       |   |   |
| Net (decrease)  increase in cash and cash equivalents                                                |       | (49,645                          | )          | 67,130 |   |
| Cash and cash  equivalents, beginning of period                                                      |       | 158,369                          |       | 173,827 |   |
| Cash and cash  equivalents, end of period                                                            |       | $                                | 108,724    |   | $ | 240,957 |   |

 

The accompanyingnotes are an integral part of these financial statements.

 

3

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**UNAUDITED**

 

**1.  Organization**

 

EarthLink, Inc. (“EarthLink”or the “Company”) is an Internet service provider (“ISP”), providing nationwideInternet access and related value-added services to individual and businesscustomers. The Company’s primary service offerings include dial-up Internetaccess, high-speed Internet access, voice services and web hosting services.The Company also provides value-added services, such as search, advertising andancillary services sold as add-on features to the Company’s Internet accessservices. In addition, through the Company’s wholly-owned subsidiary, New EdgeNetworks, the Company provides secure multi-site managed data networks anddedicated Internet access for businesses and communications carriers.

 

The Company operates tworeportable segments, Consumer Services and Business Services. The Company’sConsumer Services segment provides Internet access and related value-addedservices to individual customers. These services include dial-up and high-speedInternet access and voice services, among others. The Company’s BusinessServices segment provides Internet access and related value-added services tobusinesses and communications carriers. These services include managed datanetworks, dedicated Internet access and web hosting, among others. For furtherinformation concerning the Company’s business segments, see Note 14, “SegmentInformation.”

 

**2.  Basis of Presentation**

 

*Basis ofPresentation*

 

The condensedconsolidated financial statements of EarthLink, which include the accounts ofits wholly-owned subsidiaries, for the three months ended March 31, 2007and 2008 and the related footnote information are unaudited and have beenprepared on a basis consistent with the Company’s audited consolidatedfinancial statements as of December 31, 2007 contained in the Company’sAnnual Report on Form 10-K as filed with the Securities and ExchangeCommission (the “Annual Report”).  Allsignificant intercompany transactions have been eliminated.

 

These financialstatements should be read in conjunction with the audited consolidatedfinancial statements and the related notes thereto contained in the Company’sAnnual Report.  In the opinion ofmanagement, the accompanying unaudited financial statements contain alladjustments (consisting of normal recurring adjustments), which managementconsiders necessary to present fairly the Company’s financial position, resultsof operations and cash flows for the interim periods presented.  The results of operations for the threemonths ended March 31, 2008 are not necessarily indicative of the resultsanticipated for the entire year ending December 31, 2008.

 

Thepreparation of financial statements in conformity with U.S. generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the amounts reported in the financial statements.  Actual results may differ from thoseestimates.

 

*Discontinued Operations*

 

In accordance withStatement of Financial Accounting Standards (“SFAS”) No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets,” the Company has reflectedits municipal wireless broadband results of operations as discontinuedoperations for all periods presented. As of December 31, 2007 and March 31,2008, the assets of the business were held for sale and the business hasoperations that are clearly distinguishable operationally and for financialreporting purposes from the rest of EarthLink. See Note 5, “DiscontinuedOperations,” for further discussion.

 

*Reclassifications*

 

Certain amounts in the prior period financialstatements have been reclassified to conform to the current periodpresentation.

 

4

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**UNAUDITED - (Continued)**

 

**3.  Earnings per Share**

 

Net income (loss) pershare has been computed according to SFAS No. 128, “Earnings per Share,”which requires a dual presentation of basic and diluted earnings per share (“EPS”).Basic EPS represents net income (loss) divided by the weighted average numberof common shares outstanding during a reported period. Diluted EPS reflects thepotential dilution that could occur if securities or other contracts to issuecommon stock, including stock options, warrants, restricted stock units,phantom share units, convertible debt and contingently issuable shares(collectively “Common Stock Equivalents”), were exercised or converted intocommon stock. The dilutive effect of outstanding stock options, warrants,restricted stock units and convertible debt is reflected in diluted earningsper share by application of the treasury stock method. Phantom share units andcontingently issuable shares are reflected on an if-converted basis. Inapplying the treasury stock method for stock-based compensation arrangements,the assumed proceeds are computed as the sum of the amount the employee mustpay upon exercise and the amounts of average unrecognized compensationcost attributed to future services.

 

The following table setsforth the computation for basic and diluted net income per share for the threemonths ended March 31, 2008:

 
| ** **                                          | ** ** | **Three Months Ended**          | ** ** |
|-----------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                          | ** ** | **March 31, 2008**              | ** ** |
| ** **                                          | ** ** | **(in thousands,**                   | ** ** |
| ** **                                          | ** ** | **except per share data)** | ** ** |
|                                                |       |                                      |       |
| **Numerator**                                       | ** ** | ** **                                | ** ** |
| Income from  continuing operations                  |       | $                                         | 57,756     |   |
| Loss from  discontinued operations                  |       | (3,392                                    | )          |
| Net income                                          |       | $                                         | 54,364     |   |
|                                                |       |                                      |       |
| **Denominator**                                     |       |                                      |       |
| Basic weighted  average common shares outstanding   |       | 109,493                                   |       |
| Dilutive effect  of Common Stock Equivalents        |       | 807                                       |       |
| Diluted weighted  average common shares outstanding |       | 110,300                                   |       |
|                                                |       |                                      |       |
| **Basic  net income per share**                     |       |                                      |       |
| Continuing  operations                              |       | $                                         | 0.53       |   |
| Discontinued  operations                            |       | (0.03                                     | )          |
| Basic net income  per share                         |       | $                                         | 0.50       |   |
|                                                |       |                                      |       |
| **Diluted  net income per share**                   |       |                                      |       |
| Continuing operations                               |       | $                                         | 0.52       |   |
| Discontinued  operations                            |       | (0.03                                     | )          |
| Diluted net  income per share                       |       | $                                         | 0.49       |   |

 

During the three monthsended March 31, 2008, approximately 10.1 million options and restrictedstock units were excluded from the calculation of diluted EPS because theexercise prices plus the amount of unrecognized compensation costattributed to future services exceeded the Company’s average stock price duringthe period. Approximately 28.4 million shares that underlie the Company’sconvertible debt instruments and 28.4 million warrants were also excluded fromthe calculation of diluted EPS because the exercise prices exceeded the Company’saverage stock price during the period. These securities could be dilutive infuture periods.

 

The Company has notincluded the effect of Common Stock Equivalents in the calculation of dilutedEPS for the three months ended March 31, 2007 because such inclusion wouldhave an anti-dilutive effect due to

 

5

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**UNAUDITED - (Continued)**

 

the Company’s net loss.As of March 31, 2007, the Company had 19.6 million options outstanding,1.0 million restricted stock units outstanding and 28.5 million warrantsoutstanding.

 

**4.  Facility Exit, Restructuring****and Other Costs**

 

Facility exit, restructuring andother costs consisted of the following during the three months ended March 31,2007 and 2008:

 
| ** **                  | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------|------------|------------------------------------------------------|------------|
| ** **                  | ** ** | **2007**                                             | ** ** | **2008** | ** ** |
| ** **                  | ** ** | **(in thousands)**                              | ** ** |
| ** **                  | ** ** | ** **                                           | ** ** | ** ** | ** ** |
| 2007 Restructuring  Plan    |       | $                                                    | —     |   | $ | 1,093 |   |
| Legacy  Restructuring Plans |       | —                                               |       | (63 | ) |
|                        |       | $                                                    | —     |   | $ | 1,030 |   |

 

*2007 Restructuring Plan*

 

In August 2007,EarthLink adopted a restructuring plan (the “2007 Plan”) to reduce costs andimprove the efficiency of the Company’s operations. The 2007 Plan was theresult of a comprehensive review of operations within and across the Company’sfunctions and businesses. Under the 2007 Plan, the Company reduced itsworkforce by approximately 900 employees, closed office facilities in Orlando,Florida; Knoxville, Tennessee; Harrisburg, Pennsylvania and San Francisco,California and is consolidating its office facilities in Atlanta, Georgia andPasadena, California. The 2007 Plan was primarily implemented during the latterhalf of 2007 and is expected to be completed during 2008. In connection withthe 2007 Plan, the Company expects to record total costs of approximately $73.0to $83.0 million, including $30.0 to $32.0 million for severance andpersonnel-related costs, $15.0 to $20.0 million for lease termination andfacilities-related costs, $26.0 to $28.0 million for non-cash asset impairmentsand $2.0 to $3.0 million for other associated costs.

 

As a result of the 2007Plan, EarthLink recorded facility exit and restructuring costs of $1.1 millionduring the three months ended March 31, 2008, including $0.4 million forseverance and personnel-related costs; $0.3 million for non-cash assetimpairments; and $0.4 million for other associated costs. Such costs have beenclassified as facility exit, restructuring and other costs in the CondensedConsolidated Statement of Operations. The cumulative costs incurred to date asof March 31, 2008 include $30.6 million for severance andpersonnel-related costs; $12.2 million for lease termination and facilities-relatedcosts; $21.0 million for non-cash asset impairments; and $1.5 million for otherassociated costs.

 

Management continues to evaluateEarthLink’s businesses and, therefore, there may be supplemental provisions fornew plan initiatives as well as changes in estimates to amounts previouslyrecorded, as payments are made or actions are completed.

 

The following tablesummarizes activity for the liability balances associated with the 2007 Planfor the three months ended March 31, 2008, including changes during theperiod attributable to costs incurred and charged to expense and costs paid orotherwise settled:

 
| ** **                            | ** ** | **Severance**           | ** ** | ** **     | ** ** | **Asset**       | ** ** | **Other** | ** ** | ** ** | ** ** |
|---------------------------------------|------------|-------------------------|------------|----------------|------------|-----------------|------------|-----------|------------|------------|------------|
| ** **                            | ** ** | **and Benefits**   | ** ** | **Facilities** | ** ** | **Impairments** | ** ** | **Costs** | ** ** | **Total**  | ** ** |
| ** **                            | ** ** | **(in thousands)** | ** ** |
| Balance as of  December 31, 2007 |       | $                       | 12,041     |           | $          | 16,124          |       | $         | —     |       | $          | — |   | $ | 28,165 |   |
| Accruals                              |       | 367                     |       | —         |       | 286             |       | 440       |       | 1,093      |       |
| Payments                              |       | (11,462                 | )          | (1,179         | )          | —          |       | (185      | )          | (12,826    | )          |
| Non-cash charges                      |       | —                  |       | —         |       | (286            | )          | —    |       | (286       | )          |
| Balance as of  March 31, 2008    |       | $                       | 946        |           | $          | 14,945          |       | $         | —     |       | $          | 255 |   | $ | 16,146 |   |

 

6

----

 

**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**UNAUDITED - (Continued)**

 

Facility exit andrestructuring liabilities due within one year of the balance sheet date areclassified as other accounts payable and accrued liabilities and facility exitand restructuring liabilities due after one year are classified as otherlong-term liabilities in the Condensed Consolidated Balance Sheets. Of theunpaid balance as of March 31, 2008, approximately $5.7 million associatedwith the 2007 Plan was classified as other accounts payable and accruedliabilities and $10.4 million was classified as other long-term liabilities.

 

*Legacy Restructuring Plans*

 

EarthLink periodicallyevaluates and adjusts its estimates for facility exit and restructuring costsbased on currently-available information. Such adjustments are included asfacility exit, restructuring and other costs in the Condensed ConsolidatedStatements of Operations. During the three months ended March 31, 2008,EarthLink recorded a $0.1 million reduction to facility exit, restructuring andother costs as a result of changes in estimates for legacy restructuring plans.

 

**5.  Discontinued Operations**

 

In November 2007,management concluded that the municipal wireless broadband operations were nolonger consistent with the Company’s strategic direction and the Company’sBoard of Directors authorized management to pursue the divestiture of theCompany’s municipal wireless broadband assets. As a result of that decision,the Company classified the municipal wireless broadband assets as held for saleon the Condensed Consolidated Balance Sheets and presented the municipalwireless broadband results of operations as discontinued operations for allperiods presented. The municipal wireless broadband results of operations werepreviously included in the Consumer Services segment. The Company expects tocomplete the divestiture of its municipal wireless broadband assets during2008.

 

Subsequent to March 31, 2008, the Company reachedagreements with the cities of Corpus Christi, TX and Milpitas, CA to transferownership of its municipal wireless broadband networks to those respectivecities in exchange for releasing the Company from its existing network agreements.  Additionally, the Company plans to terminateits municipal wireless broadband service in New Orleans, LA and remove itsnetwork from the market.

 

In accordance with SFAS No. 144,the Company recorded a $1.9 million charge during the three months ended March 31,2008 related to its municipal wireless broadband operations to adjust thecarrying value of the long-lived assets to their fair value less estimatedcosts to sell.  These charges arereflected within discontinued operations in the Condensed ConsolidatedStatement of Operations.

 

The following tablepresents summarized results of operations related to the Company’s discontinuedoperations for the three months ended March 31, 2007 and 2008:

 
| ** **                         | ** ** | **Three Months Ended March 31,** | ** ** |
|------------------------------------|------------|------------------------------------------------------|------------|
| ** **                         | ** ** | **2007**                                             | ** ** | **2008** | ** ** |
| ** **                         | ** ** | **(in thousands)**                              | ** ** |
| ** **                         | ** ** | ** **                                           | ** ** | ** ** | ** ** |
| Revenues                           |       | $                                                    | 259        |   | $ | 737 |   |
| Loss from  discontinued operations |       | (7,604                                               | )          | (3,392 | ) |
|                                    |            |                                                      |            |  |  |  |  |

 

The assets ofdiscontinued operations as of December 31, 2007 and March 31, 2008consisted primarily of property and equipment and the liabilities of discontinuedoperations as of December 31, 2007 and March 31, 2008 consistedprimarily of accruals for purchases of property and equipment. Pursuant to SFASNo. 144, as of December 31, 2007 and March 31, 2008, the assets werereported at their estimated fair value less costs to sell and are no longerbeing depreciated.

 

7

----

 

**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**UNAUDITED - (Continued)**

 

**6.  Investments**

 

*Investments in marketable securities*

 

Investments in marketablesecurities are accounted for in accordance with SFAS No. 115, “Accountingfor Certain Investments in Debt and Equity Securities.” The Company hasinvested in government agency notes, asset-backed debt securities (including auctionrate securities), corporate notes and commercial paper, all of which bear aminimum short-term rating of A1/P1 or a minimum long-term rating of A/A2. Allinvestments with original maturities greater than 90 days are classified asinvestments in marketable securities. Investments in marketable securities withmaturities less than one year from the balance sheet date are consideredshort-term investments in marketable securities. Investments in marketablesecurities with maturities greater than one year from the balance sheet dateare considered long-term investments in marketable securities. Long-terminvestments in marketable securities as of March 31, 2008 also includeinvestments in asset-backed, auction rate securities with interest rate resetperiods of 90 days or less but whose underlying agreements have originalmaturities of more than 90 days. These investments were included in short-terminvestments in marketable securities as of December 31, 2007.

 

As of March 31,2008, the Company’s long-term investments in marketable securities includedauction rate securities with a par value of $57.8 million and a fair value of$55.1 million. During the three months ended March 31, 2008, auctions forthese securities failed to attract sufficient buyers, resulting in the Companycontinuing to hold such securities. These securities are variable-rate debtinstruments whose underlying agreements have contractual maturities of up to 40years, but have interest rate reset periods at pre-determined intervals, usuallyevery 28 days. These securities are predominantly secured by student loansguaranteed by state related higher education agencies and reinsured by theUnited States Department of Education. The Company may not be able to accessthese funds until a successful auction occurs or until the underlying notesmature. Due to uncertainty surrounding the timing of a market recovery, theCompany has classified its auction rate securities as long-term investments inmarketable securities in the Condensed Consolidated Balance Sheet as of March 31,2008. As a result of temporary declines in the fair value of the Company’sauction rate securities, which the Company attributes to liquidity issuesrather than credit issues, it has recorded an unrealized loss of $2.7 millionas of March 31, 2008. The Company will continue to evaluate the fair valueof its investments in auction rate securities each reporting period for apotential other-than-temporary impairment.

 

The Company hasclassified all short- and long-term investments in marketable securities asavailable-for-sale. The Company may or may not hold its investments inmarketable securities until maturity. In response to changes in theavailability of and the yield on alternative investments as well as liquidityrequirements, the Company occasionally sells its investments in marketablesecurities prior to their stated maturities. Available for sale securities arecarried at fair value, with any unrealized gains and losses, net of tax,included in unrealized gains (losses) on investments as a separate component ofstockholders’ equity and in total comprehensive income (loss). As of December 31,2007, gross unrealized gains were $0.1 million and gross unrealized losses werenominal. As of March 31, 2008, gross unrealized gains were $0.1 millionand gross unrealized losses were $2.7 million. The Company believes its grossunrealized losses are temporary impairments as management has the intent andability to hold these investments until maturity or until the market price fullyrecovers, at which time the Company would expect to receive the amortized costbasis of the investments based on the underlying contractual arrangement.

 

Realized gains and lossesare included in interest income and other, net, in the accompanying Condensed ConsolidatedStatements of Operations and are determined on a specific identification basis.The Company has not experienced any significant realized gains or losses on itsinvestments in marketable securities during the periods presented.

 

8

----

 

**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**UNAUDITED - (Continued)**

 

*Investments in other companies*

 

Investmentsin other companies consisted of the following as of December 31, 2007 and March 31,2008:

 
| ** **                                 | ** ** | **As of**          | ** ** | **As of**     | ** ** |
|--------------------------------------------|------------|-------------------------|------------|--------------------|------------|
| ** **                                 | ** ** | **December 31,**   | ** ** | **March 31,** | ** ** |
| ** **                                 | ** ** | **2007**                | ** ** | **2008**           | ** ** |
| ** **                                 | ** ** | **(in thousands)** | ** ** |
| Investments  stated at fair value          |       | $                       | 52,923     |               | $          | 56,739 |   |
| Investments  stated at cost                |       | 10,000                  |       | 10,000             |       |
| Total  investments in other companies      |       | $                       | 62,923     |               | $          | 66,739 |   |
|                                       |       |                    |       |               |       |
| Reported as:                               |       |                    |       |               |       |
| Short-term  investments in other companies |       | $                       | —     |               | $          | 56,572 |   |
| Long-term  investments in other companies  |       | 62,923                  |       | 10,167             |       |
| Total  investments in other companies      |       | $                       | 62,923     |               | $          | 66,739 |   |

 

TheCompany accounts for minority investments in other companies under the costmethod of accounting and classifies investments in other companies which arepublicly traded as available-for-sale securities. Accordingly, theCompany adjusts the carrying values of those investments to market value throughunrealized gains (losses) included in stockholders’ equity and accumulatedother comprehensive income (loss). As of December 31, 2007, grossunrealized losses were $1.1 million and there were no gross unrealized gains.As of March 31, 2008, gross unrealized losses were $0.5 million and grossunrealized gains were $1.8 million.

 

The Company’s investments inother companies as of March 31, 2008 included 6.1 million shares of CovadCommunications Group, LLC (“Covad”) common stock and $50.6 million aggregateprincipal amount of 12% Senior Secured Convertible Notes due 2011 (the “CovadNotes”), which includes accrued and unpaid interest. In April 2008,Platinum Equity, LLC completed a transaction in which all outstanding shares ofCovad were acquired. Upon closing of the transaction, a change of control ofCovad occurred, resulting in Covad’s repurchase of all Covad Notes held byEarthLink at a purchase price equal to 100% of the principal amount thereofplus accrued and unpaid interest. As a result, in April 2008, the Companyreceived cash of $50.8 million for the aggregate principal amount of the CovadNotes plus accrued interest. The Company expects to receive cash of $6.3million for the 6.1 million shares of common stock in May 2008.

 

Management regularlyevaluates the recoverability of its investments in other companies based on theperformance and the financial position of those companies as well as otherevidence of market value. Such evaluation includes, but is not limited to,reviewing the investee’s cash position, recent financings, projected andhistorical financial performance, cash flow forecasts and financing needs.During the three months ended March 31, 2007 and 2008, the Company did notrecognize any losses due to other-than-temporary declines of the value of itsinvestments in other companies.

 

*Investmentin equity affiliate*

 

The Company has a jointventure with SK Telecom Co., Ltd. (“SK Telecom”), HELIO. HELIO is anon-facilities-based mobile virtual network operator (“MVNO”) offering mobilecommunications services and handsets to U.S. consumers.  HELIO was formed in March 2005 and beganoffering its products and services in April 2006. As of March 31,2008, EarthLink had an approximate 29% economic ownership interest and 30%voting interest in HELIO, while SK Telecom had an approximate 67% economicownership interest and 70% voting interest in HELIO.

 

9

----

 

**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**UNAUDITED - (Continued)**

 

The Company accounts forits investment in HELIO under the equity method of accounting because theCompany can exert significant influence over HELIO’s operating and financialpolicies.  The Company had been recordingits proportionate share of HELIO’s net loss in its Consolidated Statements ofOperations and amortizing the difference between the book value and fair valueof non-cash assets contributed to HELIO over their estimated useful lives. Theamortization increased the carrying value of the Company’s investment anddecreased the net losses of equity affiliate included in the ConsolidatedStatements of Operations. During the three months ended March 31, 2007,the Company recorded $29.3 million of net losses of equity affiliate related toits HELIO investment, which is net of amortization of basis differences andcertain other equity method accounting adjustments. During 2007, EarthLinkdiscontinued recording additional net losses of equity affiliate because thecarrying value of its investments in HELIO were reduced to zero, and EarthLinkis not committed to provide further financial support to HELIO.

 

**7.  Purchased Intangible Assets and Goodwill**

 

*Goodwill*

 

During the three monthsended March 31, 2008, the carrying amount of goodwill decreased $7.8 milliondue to the utilization of net operating loss carryforwards acquired fromOneMain.com, Inc., Cidco Incorporated, PeoplePC Inc., and New EdgeNetworks.

 

*Purchased Intangible Assets*

 

The following tablepresents the components of the Company’s acquired identifiable intangibleassets included in the accompanying Condensed Consolidated Balance Sheets as ofDecember 31, 2007 and March 31, 2008:

 
| ** **                                      | ** ** | **As of December 31, 2007** | ** ** | **As of March 31, 2008** | ** ** |
|-------------------------------------------------|------------|-------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                      | ** ** | **Gross**                                       | ** ** | ** **                                   | ** ** | **Net** | ** ** | **Gross** | ** ** | ** ** | ** ** | **Net** | ** ** |
| ** **                                      | ** ** | **Carrying**                                    | ** ** | **Accumulated**                              | ** ** | **Carrying** | ** ** | **Carrying** | ** ** | **Accumulated** | ** ** | **Carrying** | ** ** |
| ** **                                      | ** ** | **Value**                                       | ** ** | **Amortization**                             | ** ** | **Value** | ** ** | **Value** | ** ** | **Amortization** | ** ** | **Value** | ** ** |
| ** **                                      | ** ** | **(in thousands)**                         | ** ** |
| Intangible  assets subject to amortization:     |       |                                            |       |                                         |       |   |   |   |   |   |   |   |   |
| Subscriber bases  and customer relationships    |       | $                                               | 118,702    |                                         | $          | (79,763 | ) | $ | 38,939 |   | $ | 118,590 |   | $ | (83,450 | ) | $ | 35,140 |   |
| Software,  technology and other                 |       | 3,892                                           |       | (3,161                                       | )          | 731 |   | 3,892 |   | (3,411 | ) | 481 |   |
| Trade names                                     |       | —                                          |       | —                                       |       | — |   | 1,521 |   | (76 | ) | 1,445 |   |
|                                            |       | 122,594                                         |       | (82,924                                      | )          | 39,670 |   | 124,003 |   | (86,937 | ) | 37,066 |   |
| Intangible  assets not subject to amortization: |       |                                            |       |                                         |       |   |   |   |   |   |   |   |   |
| Trade names                                     |       | 6,606                                           |       | —                                       |       | 6,606 |   | 5,085 |   | — |   | 5,085 |   |
|                                            |       | $                                               | 129,200    |                                         | $          | (82,924 | ) | $ | 46,276 |   | $ | 129,088 |   | $ | (86,937 | ) | $ | 42,151 |   |

 

Amortization ofintangible assets in the Condensed Consolidated Statements of Operations for thethree months ended March 31, 2007 and 2008 represents the amortization ofdefinite lived intangible assets.  TheCompany’s definite lived intangible assets primarily consist of subscriberbases and customer relationships, acquired software and technology, certaintrade names and other assets acquired in conjunction with the purchases ofbusinesses and subscriber bases from other companies that are not deemed tohave indefinite lives. The Company’s identifiable indefinite lived intangibleassets consist of certain trade names. Definite lived intangible assets areamortized on a straight-line basis over their estimated useful lives, which aregenerally three to six years for subscriber bases and customer relationshipsand one to six years for acquired software and technology.  As of March 31, 2008, the weightedaverage amortization periods were 3.9 years for subscriber base assets andcustomer relationships, 4.1 years for software and technology and 5.0 years fortrade names. Based on the current amount of definite lived intangible assets,the Company expects to record amortization expense of approximately $10.3million during the remaining nine months in the year ending December 31,2008 and $11.0 million, $7.4 million, $6.3 million and $2.0 million during theyears ending December 31, 2009, 2010, 2011 and

 

10

----

 

**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**UNAUDITED - (Continued)**

 

2012, respectively. Actual amortization expense to bereported in future periods could differ materially from these estimates as aresult of asset acquisitions, changes in useful lives and other relevantfactors.

 

**8.  Long-Term Debt**

 

In November 2006,the Company issued $258.8 million aggregate principal amount of ConvertibleSenior Notes due November 15, 2026 (the “Notes”) in a registered offering,which reflects the exercise by the underwriters of their option to purchase anadditional $33.8 million of principal to cover over-allotments. The Companyreceived net proceeds of $251.6 million after transaction fees of $7.2 million.The Notes bear interest at 3.25% per year on the principal amount of the Notesuntil November 15, 2011, and 3.50% interest per year on the principalamount of the Notes thereafter, payable semi-annually in May and November ofeach year. The Notes rank as senior unsecured obligations of the Company.

 

The Notes are payablewith cash and, if applicable, convertible into shares of the Company’s commonstock based on an initial conversion rate, subject to adjustment, of 109.6491shares per $1,000 principal amount of Notes (which represents an initialconversion price of approximately $9.12 per share). Upon conversion, a holderwill receive cash up to the principal amount of the Notes and, at the Company’soption, cash, or shares of the Company’s common stock or a combination of cashand shares of common stock for the remainder, if any, of the conversionobligation. The conversion obligation is based on the sum of the “dailysettlement amounts” for the 20 consecutive trading days that begin on, andinclude, the second trading day after the day the Notes are surrenderedfor conversion. The Notes will be convertible only in the followingcircumstances: (1) during any calendar quarter after the calendar quarterending December 31, 2006 (and only during such calendar quarter), if theclosing sale price of the Company’s common stock for each of 20 or more tradingdays in a period of 30 consecutive trading days ending on the last trading dayof the immediately preceding calendar quarter exceeds 130% of the conversionprice in effect on the last trading day of the immediately preceding calendarquarter; (2) during the five consecutive business days immediately afterany five consecutive trading day period in which the average trading price per$1,000 principal amount of Notes was equal to or less than 98% of the averageconversion value of the Notes during the note measurement period; (3) uponthe occurrence of specified corporate transactions; (4) if the Company hascalled the 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.  The Company has the option toredeem the Notes, in whole or in part, for cash, on or after November 15,2011, provided that the Company had made at least ten semi-annual interestpayments. In addition, the holders may require the Company to purchase all or aportion of their notes on each of November 15, 2011, November 15,2016 and November 15, 2021.

 

As of December 31,2007 and March 31, 2008, the fair value of the Notes was approximately$262.0 million and $277.5 million, respectively, based on the quoted marketprices.

 

In connectionwith the issuance of the Notes, the Company entered into separate convertiblenote hedge transactions and separate warrant transactions with respect to theCompany’s common stock to reduce the potential dilution upon conversion of theNotes (collectively referred to as the “Call Spread Transactions”). The Companypurchased call options to cover approximately 28.4 million shares of theCompany’s common stock, subject to adjustment in certain circumstances, whichis the number of shares underlying the Notes. In addition, the Company soldwarrants permitting the purchasers to acquire up to approximately 28.4 millionshares of the Company’s common stock, subject to adjustment in certaincircumstances. See Note 9, “Stockholders’ Equity,” for more information on theCall Spread Transactions.

 

11

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**UNAUDITED - (Continued)**

 

**9.  Stockholders’ Equity**

 

*Comprehensive Income (Loss)*

 

Comprehensive income(loss) includes unrealized gains and losses on certain investments classifiedas available-for-sale, net of tax, which are excluded from the CondensedConsolidated Statements of Operations in accordance with SFAS No. 130, “ReportingComprehensive Income.” Comprehensive income (loss) for the three months ended March 31,2007 and 2008 was as follows:

 
| ** **                                      | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|
| ** **                                      | ** ** | **March 31,**               | ** ** |
| ** **                                      | ** ** | **2007**                         | ** ** | **2008** | ** ** |
| ** **                                      | ** ** | **(in thousands)**          | ** ** |
| Net income  (loss)                              |       | $                                | (29,962    | ) | $ | 54,364 |   |
| Net change in  unrealized losses on investments |       | (4,543                           | )          | (257 | ) |
| Total  comprehensive income (loss)              |       | $                                | (34,505    | ) | $ | 54,107 |   |

 

*ShareRepurchases*

 

Since the inception ofthe Company’s share repurchase program, the Board of Directors has authorized atotal of $750.0 million for the repurchase of EarthLink’s common stock. As of March 31,2008, the Company had $191.8 million available under the currentauthorizations. The Company may repurchase its common stock from time to timein compliance with Securities and Exchange Commission regulations and otherlegal requirements, including through the use of derivative transactions, andsubject to market conditions and other factors. The share repurchase programdoes not require the Company to acquire any specific number of shares and maybe terminated by the Board of Directors at any time.

 

The Company repurchased1.3 million shares of its common stock for $9.1 million during the three monthsended March 31, 2008. The Company did not repurchase any shares of itscommon stock during the three months ended March 31, 2007.

 

*Call Spread Transactions*

 

In connection with theissuance of the Notes (see Note 8, “Long-Term Debt”), the Company entered intoseparate convertible note hedge transactions and separate warrant transactionswith respect to the Company’s common stock to minimize the impact of thepotential dilution upon conversion of the Notes.  The Company purchased call options in privatetransactions to cover approximately 28.4 million shares of the Company’s commonstock at a strike price of $9.12 per share, subject to adjustment in certaincircumstances, for $47.2 million. The call options generally allow the Companyto receive shares of the Company’s common stock from counterparties equal tothe number of shares of common stock payable to the holders of the Notes uponconversion. These call options will terminate at the earlier of the maturitydates of the related senior convertible notes or the first day all of therelated senior convertible notes are no longer outstanding due to conversion orotherwise.  As of December 31, 2007and March 31, 2008, the estimated fair value of the call options was $43.8million and $44.7 million, respectively.

 

The Company also soldwarrants permitting the purchasers to acquire up to approximately 28.4 millionshares of the Company’s common stock at an exercise price of $11.20 per share,subject to adjustments in certain circumstances, in private transactions fortotal proceeds of approximately $32.1 million. The warrants expire at variousdates in March 2012 through July 2012.  The warrants provide for net share settlement.In no event shall the Company be required to deliver a number of shares inconnection with the transaction in excess of twice the aggregate number ofwarrants. As of December 31, 2007 and March 31, 2008, the estimatedfair value of the warrants was $28.0 million and $29.4 million, respectively.

 

12

----

 

**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**UNAUDITED - (Continued)**

 

The Company has analyzedthe Call Spread Transactions under Emerging Issues Task Force Issue No. 00-19,“Accounting for Derivative Financial Instruments Indexed to, and PotentiallySettled In, a Company’s Own Stock,” and other relevant literature, anddetermined that they meet the criteria for classification as equity transactions.As a result, the Company recorded the purchase of the call options as areduction in additional paid-in capital and the proceeds of the warrants as anaddition to paid-in capital, and the Company will not recognize subsequentchanges in fair value of the agreements.

 

**10.  Stock-Based Compensation**

 

The Company accounts forstock-based compensation pursuant to SFAS No. 123(R), “Share-BasedPayment,” which requires measurement of compensation cost for all stock awardsat fair value on the date of grant and recognition of compensation expense overthe requisite service period for awards expected to vest. The Company estimatesthe fair value of stock options using the Black-Scholes valuation model, anddetermines the fair value of restricted stock units based on the number ofshares granted and the quoted price of EarthLink’s common stock on the date ofgrant*.* Such value is recognizedas expense over the requisite service period, net of estimated forfeitures,using the straight-line attribution method. The estimate of awards that willultimately vest requires significant judgment, and to the extent actual resultsor updated estimates differ from the Company’s current estimates, such amountswill be recorded as a cumulative adjustment in the period estimates arerevised. The Company considers many factors when estimating expectedforfeitures, including types of awards, employee class and historical employeeattrition rates. Actual results, and future changes in estimates, may differsubstantially from the Company’s current estimates.

 

Stock-based compensationexpense under SFAS No. 123(R) was $7.9 million and $5.2 millionduring the three months ended March 31, 2007 and 2008, respectively.  In accordance with Staff Accounting Bulletin No. 107,the Company has classified stock-based compensation expense during the threemonths ended March 31, 2007 and 2008 within the same operating expenseline items as cash compensation paid to employees.

 

*Stock Incentive Plans*

 

The Company has grantedoptions to employees and directors to purchase the Company’s common stock undervarious stock incentive plans. The Company has also granted restricted stockunits to employees and directors under various stock incentive plans. Under theplans, employees and non-employee directors are eligible to receive awards ofvarious forms of equity-based incentive compensation, including stock options,restricted stock, restricted stock units, phantom share units and performanceawards, among others. The plans are administered by the Board of Directors orthe Leadership and Compensation Committee of the Board of Directors, whichdetermine the terms of the awards granted. Stock options are generally grantedwith an exercise price equal to the market value of EarthLink, Inc. commonstock on the date of grant, have a term of ten years or less, and vest overterms of four to six years from the date of grant. Restricted stock unitsgenerally vest over terms of three to six years from the date of grant.

 

*Deferred Compensation Plan*

 

The Company’s SecondDeferred Compensation Plan for Directors and Certain Key Employees permitsmembers of the Board of Directors and eligible employees to elect to deferreceipt of shares of common stock pursuant to vested restricted stock units andvarious cash consideration, such as directors’ fees and bonuses. The cashconsideration is converted into phantom share units at the closing price on thedate the consideration would otherwise be paid, and vested restricted stockunits are converted into phantom share units on a one-for-one basis. Phantomshare units are fully vested at the date of grant and are converted to commonstock upon the occurrence of various events. As of December 31, 2007 and March 31,2008, approximately 43,000 phantom share units were outstanding.

 

13

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**EARTHLINK,INC.**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED- (Continued)**

 

*Options Outstanding*

 

The following table summarizes information concerningstock option activity as of and for three months ended March 31, 2008:

 
| ** **                                             | ** ** | ** **                                                | ** ** | ** **   | ** ** | **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, 2007              |       | 13,427                                                    |       | $            | 10.69      |                  |       |          |       |   |
| Granted                                                |       | 114                                                       |       | 7.06         |       |                  |       |          |       |
| Exercised                                              |       | (320                                                      | )          | 6.00         |       |                  |       |          |       |
| Forfeited  and expired                                 |       | (1,734                                                    | )          | 11.30        |       |                  |       |          |       |
| Outstanding as of  March 31, 2008                 |       | 11,487                                                    |       | 10.69        |       | 6.1                   |       | $             | 2,991      |   |
| Vested and expected to  vest as of March 31, 2008 |       | 10,856                                                    |       | $            | 10.85      |                  | 5.9        |          | $          | 2,785 |   |
| Exercisable as of  March 31, 2008                 |       | 8,057                                                     |       | $            | 11.88      |                  | 5.1        |          | $          | 1,782 |   |

 

The aggregate intrinsic value amounts in the tableabove represent the closing price of the Company’s common stock on March 31,2008 in excess of the exercise price, multiplied by the number of stock optionsoutstanding or exercisable, when the closing price is greater than the exerciseprice. This represents the amount that would have been received by the stockoption holders if they had all exercised their stock options on March 31,2008. The total intrinsic value of options exercised during the three monthsended March 31, 2007 and 2008 was $0.5 million and $0.5 million,respectively. The intrinsic value of stock options exercised represents thedifference between the price of the Company’s common stock at the time ofexercise and the exercise price, multiplied by the number of stock optionsexercised. To the extent the forfeiture rate is different than what the Companyhas anticipated, stock-based compensation related to these awards will bedifferent from the Company’s expectations.

 

The following table summarizes the status of theCompany’s stock options as of March 31, 2008:

 
| ** **                    | ** ** | **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  | to                      | $          | 6.86 |   | 1,139 |   | 5.6 |   | $ | 5.90 |   | 750 |   | $ | 5.72 |   |
| 6.90                     | to         | 7.10                    |       | 985 |   | 8.7 |   | 6.93 |   | 250 |   | 6.91 |   |
| 7.16                     | to         | 7.31                    |       | 1,872 |   | 9.1 |   | 7.29 |   | 947 |   | 7.29 |   |
| 7.32                     | to         | 9.01                    |       | 1,564 |   | 6.9 |   | 8.55 |   | 1,026 |   | 8.78 |   |
| 9.24                     | to         | 9.89                    |       | 1,179 |   | 5.7 |   | 9.55 |   | 738 |   | 9.58 |   |
| 10.06                    | to         | 10.06                   |       | 1,134 |   | 2.4 |   | 10.06 |   | 1,134 |   | 10.06 |   |
| 10.36                    | to         | 11.38                   |       | 1,810 |   | 7.0 |   | 10.56 |   | 1,439 |   | 10.57 |   |
| 11.45                    | to         | 48.61                   |       | 1,804 |   | 2.8 |   | 22.43 |   | 1,773 |   | 22.61 |   |
| $                             | 5.10  | to                      | $          | 48.61 |   | 11,487 |   | 6.1 |   | $ | 10.69 |   | 8,057 |   | $ | 11.88 |   |

 

14

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**EARTHLINK,INC.**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED- (Continued)**

 

*ValuationAssumptions for Stock Options*

 

The fair value of stock options granted during thethree months ended March 31, 2007 and 2008 was estimated using theBlack-Scholes option-pricing model with the following assumptions:

 
| ** **               | ** ** | **Three Months Ended March 31,** | ** ** |
|--------------------------|------------|------------------------------------------------------|------------|
| ** **               | ** ** | **2007**                                             | ** ** | **2008** | ** ** |
|                     |       |                                                 |       |   |   |
| Dividend  yield          |       | 0                                                    | %          | 0 | % |
| Expected  volatility     |       | 43                                                   | %          | 39 | % |
| Risk-free  interest rate |       | 4.80                                                 | %          | 3.00 | % |
| Expected  life           |       | 4.3 years                                            |       | 4.2 years |   |

 

The weighted averagegrant date fair value of options granted during the three months ended March 31,2007 and 2008 was $2.98 and $2.51, respectively.

 

The dividend yieldassumption is based on the Company’s history and expectation of future dividendpayouts. The expected volatility is based on a combination of the Company’shistorical stock price and implied volatility. The selection of impliedvolatility data to estimate expected volatility is based upon the availabilityof prices for actively traded options on the Company’s stock. The risk-freeinterest rate assumption is based upon the U.S. Treasury yield curve in effectat the time of grant for periods corresponding with the expected life of theoption. The expected life of employee stock options represents theweighted-average period the stock options are expected to remain outstanding.

 

*Restricted Stock Units*

 

The following table summarizes the Company’srestricted stock units as of and for the three months ended March 31,2008:

 
| ** **                              | ** ** | ** **           | ** ** | **Weighted**        | ** ** |
|-----------------------------------------|------------|----------------------|------------|---------------------|------------|
| ** **                              | ** ** | ** **           | ** ** | **Average**         | ** ** |
| ** **                              | ** ** | **Restricted**       | ** ** | **Grant Date** | ** ** |
| ** **                              | ** ** | **Stock Units** | ** ** | **Fair Value** | ** ** |
|                                    |       |                 |       |                |       |
| Nonvested  as of December 31, 2007 |       | 2,061,000            |       | $                   | 7.17       |   |
| Granted                                 |       | 3,290,000            |       | 7.16                |       |
| Vested                                  |       | (58,000              | )          | 6.86                |       |
| Forfeited                               |       | (218,000             | )          | 7.12                |       |
| Nonvested  as of March 31, 2008    |       | 5,075,000            |       | 7.17                |       |
|                                         |            |                      |            |                     |            |  |

 

The fair value of restricted stock units is determinedbased on the closing trading price of EarthLink’s common stock on the grantdate. The weighted-average grant date fair value of restricted stock unitsgranted during the three months ended March 31, 2007 and 2008 was $7.32and $7.16, respectively. As March 31, 2008, there was $28.2 million oftotal unrecognized compensation cost related to nonvested restricted stockunits. That cost is expected to be recognized over a weighted-average period of2.6 years. The total fair value of shares vested during the three months ended March 31,2007 and 2008 was $0.9 million and $0.4 million, respectively, which representsthe closing price of the Company’s common stock on the vesting date multipliedby the number of restricted stock units that vested.

 

15

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

**11. Income Taxes**

 

EarthLink recorded anincome tax provision of $9.3 million during the three months ended March 31,2008 based on management’s current expectations for the results of operationsfor the year ending December 31, 2008 in accordance with the interimreporting requirements of SFAS No. 109, “Accounting for Income Taxes,” APBOpinion No. 28, “Interim Financial Reporting,” and FASB Interpretation No. 18“Accounting for Income Taxes in Interim Periods — an interpretation of APBOpinion No. 28.”  The majorcomponents of the provision for current income taxes during the three monthsended March 31, 2008 were $1.2 million of federal alternative minimum tax(“AMT”) and $0.8 million of state income tax. A discrete item has been recorded during the three months ended March31, 2008 for a change in valuation allowance resulting from a change inclassification of an indefinite lived intangible asset to a definite livedintangible asset, corresponding to a decrease in the valuation allowance whichresulted in a tax benefit of $0.5 million.  A non-cash deferred taxprovision of $7.8 million has been recorded for estimated utilization offederal and state net operating loss carryforwards acquired from OneMain.com, Inc.,Cidco Incorporated, PeoplePC Inc., and New Edge Networks.  The associated reduction in the valuationallowance due to the expected utilization of these acquired federal and statenet operating losses has been recorded as a reduction to goodwill and not as abenefit to income taxes.  The current AMTliability is payable as a result of net operating loss carryforward limitationsassociated with the AMT calculation.

 

EarthLink continues tomaintain a full valuation allowance against its unrealized deferred tax assets,which include net operating loss carryforwards. EarthLink may recognize deferred tax assets in future periods when theyare determined to be more likely than not realizable.  To the extent EarthLink reports income infuture periods, EarthLink intends to use its net operating loss carryforwardsto the extent available to offset taxable income and reduce cash outflows forincome taxes.  The Company’s ability touse its federal and state net operating loss carryforwards and federal andstate tax credit carryforwards may be subject to restrictions attributable toequity transactions in the future resulting from changes in ownership asdefined under the Internal Revenue Code.

 

On January 1, 2007,EarthLink adopted Financial Interpretation (“FIN”) No. 48.  The Company has identified its federal taxreturn and its state tax returns in California, Florida, Georgia and Illinoisas “major” tax jurisdictions, as defined in FIN No. 48.  Periods extending back to 1994 are stillsubject to examination for all “major” jurisdictions. The adoption of FIN No. 48on January 1, 2007 did not result in a material cumulative-effectadjustment. The Company believes that its income tax filing positions anddeductions will be sustained on audit and does not anticipate any adjustmentsthat will result in material adverse effect on the Company’s financial condition,results of operations or cash flows.  TheCompany’s policy for recording interest and penalties associated with audits isto record such items as a component of income taxes.

 

**12. Related Party Transactions**

 

EarthLink and HELIO haveentered into a services agreement pursuant to which EarthLink provides HELIObilling and other support services in exchange for management fees. Themanagement fees were determined based on EarthLink’s costs to provide theservices, and management believes such fees are reasonable.  The total amount of fees that HELIO pays toEarthLink depends on the extent to which HELIO utilizes EarthLink’sservices.  Fees for services provided toHELIO are reflected as reductions to the associated expenses incurred byEarthLink to provide such services. During the three months ended March 31,2007 and 2008, fees received for services provided to HELIO were $0.5 millionand $0.4 million, respectively.

 

EarthLink purchaseswireless Internet access devices and services from HELIO. During the threemonths ended March 31, 2007 and 2008, fees paid for products and servicesreceived from HELIO were $0.2 million and $0.1 million, respectively.

 

16

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**EARTHLINK,INC.**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED- (Continued)**

 

As of December 31,2007 and March 31, 2008, the Company had accounts receivable from HELIO ofapproximately $0.2 million and $0.1 million, respectively.

 

**13.  Fair Value Measurements**

 

On January 1, 2008,the Company adopted SFAS No. 157, “Fair Value Measurements,” whichestablishes a framework for reporting fair value and expands disclosuresrequired for fair value measurements. Although the adoption of SFAS No. 157did not materially impact its financial condition, results of operations orcash flow, the Company is now required to provide additional disclosures aspart of its financial statements.

 

SFAS No. 157 definesfair value as the price that would be received to sell an asset or paid totransfer a liability in an orderly transaction between market participants atthe measurement date (an exit price). SFAS No. 157 establishes athree-tier fair value hierarchy, which prioritizes the inputs used in measuringfair value.  These tiers include: Level 1, defined as observableinputs such as quoted prices in active markets; Level 2, defined as inputsother than quoted prices in active markets that are either directly orindirectly observable; and Level 3, defined as unobservable inputs in whichlittle or no market data exists, therefore requiring an entity to develop itsown assumptions.

 

As of March 31,2008, the Company held certain assets that are required to be measured at fairvalue on a recurring basis.  These included the Company’s investmentsin marketable securities, including auction rate securities, and investments inother companies.

 

The following tablepresents the Company’s assets measured at fair value on a recurring basissubject to the disclosure requirements of SFAS No. 157 as of March 31,2008:

** **
| ** **                                  | ** ** | ** **                   | ** ** | **Fair Value Measurements as of March 31, 2008 Using** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|------------------------------------------------------------------------------------------------|------------|
| ** **                                  | ** ** | ** **                   | ** ** | **Quoted Prices in**                                                                 | ** ** | **Significant Other** | ** ** | **Significant** | ** ** |
| ** **                                  | ** ** | ** **                   | ** ** | **Active Markets for**                                                               | ** ** | **Observable** | ** ** | **Unobservable** | ** ** |
| ** **                                  | ** ** | **Balance as of**  | ** ** | **Identical Assets**                                                                      | ** ** | **Inputs** | ** ** | **Inputs** | ** ** |
| **Description**                             | ** ** | **March 31, 2008** | ** ** | **(Level 1)**                                                                             | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| ** **                                  | ** ** | **(in thousands)**      | ** ** |
| Auction  rate securities                    |       | $                            | 55,073     |                                                                                           | $          | — |   | $ | — |   | $ | 55,073 |   |
| Other  investments in marketable securities |       | 23,993                       |       | 23,993                                                                                         |       | — |   | — |   |
| Investments  in other companies             |       | 56,739                       |       | 6,179                                                                                          |       | 50,560 |   | — |   |
| Total                                       |       | $                            | 135,805    |                                                                                           | $          | 30,172 |   | $ | 50,560 |   | $ | 55,073 |   |

 

Investmentsin marketable securities, other than auction rate securities, and equity investments in other companies are measured at fairvalue using quoted market prices and are classified within Level 1 of thevaluation hierarchy. Debtinvestments in other companies are measured at fair value usingquoted market prices for similar assets and are classified within Level 2 ofthe valuation hierarchy. The Company has consistently applied these valuation techniques in allperiods presented.

 

TheCompany has invested in auction rate securities, which are more fully describedin Note 6, “Investments.”  Due to recent events in the creditmarkets, these instruments held by the Company failed to attract sufficient buyers during the three monthsended March 31, 2008.  Due to the lack of availability ofobservable market quotes, the fair values of the Company’s auction ratesecurities were estimated utilizing a discounted cash flow analysis as of March 31,2008.  These analyses consider, among other items, thecollateralization underlying the security investments, the creditworthiness ofthe counterparty, and the timing and value of expected future cashflows.  These securities were also compared, when possible, to otherobservable market data with similar characteristics to the securities held bythe Company.

 

Basedon market conditions, the Company changed its valuation methodology for auctionrate securities to a discounted cash flow analysis during the three monthsended March 31, 2008.  Accordingly, 

 

17

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

thesesecurities changed from Level 1 to Level 3 within SFAS No. 157’s hierarchysince the Company’s initial adoption of SFAS No. 157 on January 1,2008.

 

Thefollowing table presents the Company’s assets measured at fair value on arecurring basis using significant unobservable inputs (Level 3) as defined inSFAS No. 157 as of March 31, 2008:

** **
| ** **                               | ** ** | **Auction**             | ** ** |
|------------------------------------------|------------|-------------------------|------------|
| ** **                               | ** ** | **Rate**                | ** ** |
| ** **                               | ** ** | **Securities**          | ** ** |
| ** **                               | ** ** | **(in thousands)** | ** ** |
| **Balance as of December 31, 2007** |       | $                       | —     |   |
| Transfers  to Level 3                    |       | 38,900                  |       |
| Total  unrealized losses                 |       | (2,677                  | )          |
| Purchases  and settlements (net)         |       | 18,850                  |       |
| **Balance as of March 31, 2008**    |       | $                       | 55,073     |   |

 

The $2.7 million of unrealized losses are included inunrealized gains (losses) on investments as a separate component ofstockholders’ equity and in total comprehensive income (loss) and relate toassets held as of March 31, 2008.

 

**14.  Segment Information**

 

In accordance with SFAS No. 131,“Disclosures about Segments of an Enterprise and Related Information,” theCompany reports segment information along the same lines that its chiefexecutive reviews its operating results in assessing performance and allocatingresources. The Company operates two reportable segments, Consumer Services andBusiness Services, which are described below in more detail.

 

The Company’s segmentsare strategic business units that are managed based upon differences incustomers, services and marketing channels. The Company’s Consumer Servicessegment provides Internet access services and related value-added services toindividual customers. These services include dial-up and high-speed Internetaccess and voice services, among others. The Company’s Business Servicessegment provides Internet access services and related value-added services tobusinesses and communications carriers. These services include managed datanetworks, dedicated Internet access and web hosting, among others.

 

The Company evaluatesperformance of its segments based on segment income from operations. Segmentincome from operations includes revenues from external customers, related costof revenues and operating expenses directly attributable to the segment, whichinclude costs over which segment managers have direct discretionary control,such as advertising and marketing programs, customer support expenses, siteoperations expenses, product development expenses, certain technology andfacilities expenses, billing operations and provisions for doubtful accounts.Segment income from operations excludes other income and expense items andcertain expenses over which segment managers do not have discretionary control.Costs excluded from segment income from operations include various corporateexpenses (consisting of certain costs such as corporate management, humanresources, finance and legal), amortization of intangible assets, facility exitand restructuring costs, and stock-based compensation expense under SFAS No. 123(R),as they are not considered in the measurement of segment performance.

 

18

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**EARTHLINK,INC.**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED- (Continued)**

 

Information onreportable segments and a reconciliation to consolidated income from operationsfor the three months ended March 31, 2007 and 2008 is as follows:

 
| ** **                                    | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                    | ** ** | **2007**                                             | ** ** | **2008** | ** ** |
| ** **                                    | ** ** | **(in thousands)**                              | ** ** |
| **Consumer Services**                         |       |                                                 |       |   |   |
| Revenues                                      |       | $                                                    | 276,393    |   | $ | 216,344 |   |
| Cost  of revenues                             |       | 84,353                                               |       | 71,173 |   |
| Gross  margin                                 |       | 192,040                                              |       | 145,171 |   |
| Direct  segment operating expenses            |       | 159,333                                              |       | 61,001 |   |
| Segment  operating income                     |       | $                                                    | 32,707     |   | $ | 84,170 |   |
|                                          |       |                                                 |       |   |   |
| **Business Services**                         |       |                                                 |       |   |   |
| Revenues                                      |       | $                                                    | 47,754     |   | $ | 46,730 |   |
| Cost  of revenues                             |       | 30,042                                               |       | 26,378 |   |
| Gross  margin                                 |       | 17,712                                               |       | 20,352 |   |
| Direct  segment operating expenses            |       | 16,668                                               |       | 14,871 |   |
| Segment  operating income                     |       | $                                                    | 1,044      |   | $ | 5,481 |   |
|                                          |       |                                                 |       |   |   |
| **Consolidated**                              |       |                                                 |       |   |   |
| Revenues                                      |       | $                                                    | 324,147    |   | $ | 263,074 |   |
| Cost  of revenues                             |       | 114,395                                              |       | 97,551 |   |
| Gross  margin                                 |       | 209,752                                              |       | 165,523 |   |
| Direct  segment operating expenses            |       | 176,001                                              |       | 75,872 |   |
| Segment  operating income                     |       | 33,751                                               |       | 89,651 |   |
| Stock-based  compensation expense             |       | 7,880                                                |       | 5,152 |   |
| Amortization  of intangible assets            |       | 3,496                                                |       | 4,013 |   |
| Facility  exit, restructuring and other costs |       | —                                               |       | 1,030 |   |
| Other  operating expenses                     |       | 18,721                                               |       | 14,042 |   |
| Income  from operations                       |       | $                                                    | 3,654      |   | $ | 65,414 |   |

 

The primary component ofthe Company’s revenues is access and service revenues, which consist ofnarrowband access services (including traditional, fully-featured narrowbandaccess and value-priced narrowband access); broadband access services(including high-speed access via DSL, cable and satellite technologies,IP-based voice and fees charged for high-speed data networks to small andmedium-sized businesses); and web hosting services. The Company also earnsrevenues from value-added services, which include ancillary services sold asadd-on features to the Company’s access services, search and advertisingrevenues.

 

Consumer access andservice revenues consist of narrowband access, broadband access and voiceservices. These revenues are derived from monthly fees charged to customers fordial-up Internet access; monthly retail and wholesale fees charged forhigh-speed, high-capacity access services including DSL, cable and satellite;fees charged for IP-based voice services; usage fees; installation fees;termination fees; and fees for equipment. Consumer value-added servicesrevenues consist of search revenues; advertising revenues; revenues fromancillary services sold as add-on features to the Company’s Internet services,such as security products, email by phone, Internet call waiting and emailstorage; and revenues from home networking products and services.

 

Business access and servicerevenues consist of retail and wholesale fees charged for high-speed,high-capacity access services including DSL, cable, satellite and dedicatedcircuit services; fees charged for high-speed data networks for small andmedium-sized businesses; installation fees; termination fees; fees forequipment; regulatory surcharges billed to customers; and web hosting.

 

19

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**EARTHLINK,INC.**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED- (Continued)**

 

Information on revenuesby groups of similar services and by segment for the three months ended March 31,2007 and 2008 is as follows:

 
| ** **            | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------|------------|--------------------------------------------------|------------|
| ** **            | ** ** | **2007**                                         | ** ** | **2008** | ** ** |
| ** **            | ** ** | **(in thousands)**                          | ** ** |
| **Consumer Services** |       |                                             |       |   |   |
| Access  and service   |       | $                                                | 242,800    |   | $ | 188,971 |   |
| Value-added  services |       | 33,593                                           |       | 27,373 |   |
| Total  revenues       |       | $                                                | 276,393    |   | $ | 216,344 |   |
|                  |       |                                             |       |   |   |
| **Business Services** |       |                                             |       |   |   |
| Access  and service   |       | $                                                | 46,955     |   | $ | 45,878 |   |
| Value-added  services |       | 799                                              |       | 852 |   |
| Total  revenues       |       | $                                                | 47,754     |   | $ | 46,730 |   |
|                  |       |                                             |       |   |   |
| **Consolidated**      |       |                                             |       |   |   |
| Access  and service   |       | $                                                | 289,755    |   | $ | 234,849 |   |
| Value-added  services |       | 34,392                                           |       | 28,225 |   |
| Total  revenues       |       | $                                                | 324,147    |   | $ | 263,074 |   |

 

The Company manages itsworking capital on a consolidated basis and does not allocate long-lived assetsto segments. In addition, segment assets are not reported to, or used by, thechief operating decision maker and therefore, pursuant to SFAS No. 131,total segment assets have not been disclosed.

 

The Company has notprovided information about geographic segments because substantially all of theCompany’s revenues, results of operations and identifiable assets are in theUnited States.

 

20

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**Item 2.   Management’s Discussion and Analysis ofFinancial Condition and Results of Operations.**

 

Certain statementsin this Quarterly Report on Form 10-Q are forward-looking statementswithin the meaning of the Private Securities Litigation Reform Act of 1995, Section 27Aof the Securities Act of 1933, and Section 21E of the Securities ExchangeAct of 1934. The words “estimate,” “plan,” “intend,” “expect,” “anticipate,” “believe”and similar expressions are intended to identify forward-looking statements.These forward-looking statements are found at various places throughout thisreport. EarthLink disclaims any intention or obligation to update or revise anyforward-looking statements, whether as a result of new information, futureevents or otherwise. Although EarthLink believes that its expectations arebased on reasonable assumptions, it can give no assurance that its goals willbe achieved. Important factors that could cause actual results to differ fromestimates or projections contained in the forward-looking statements aredescribed under “Safe Harbor Statement” in this Item 2.

 

*The following discussion shouldbe read in conjunction with the accompanying unaudited Condensed ConsolidatedFinancial Statements and related Notes thereto and with “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andthe audited Consolidated Financial Statements and the Notes thereto containedin the Annual Report on Form 10-K for the year ended December 31,2007.*

 

**Overview**

 

EarthLink, Inc. isan Internet service provider, or ISP, providing nationwide Internet access andrelated value-added services to individual and business customers. Our primaryservice offerings include dial-up Internet access, high-speed Internet access,voice services and web hosting services. We also provide value-added services,such as search, advertising and ancillary services sold as add-on features toour Internet access services. In addition, through our wholly-owned subsidiary,New Edge Networks, we provide secure multi-site managed data networks anddedicated Internet access for businesses and communications carriers.

 

We operate two reportablesegments, Consumer Services and Business Services. Our Consumer Servicessegment provides Internet access and related value-added services to individualcustomers. These services include dial-up and high-speed Internet access andvoice services, among others. Our Business Services segment provides Internetaccess and related value-added services to businesses and communicationscarriers. These services include managed data networks, dedicated Internetaccess and web hosting, among others.

 

*Industry Background*

 

We operate in theInternet access market, which is characterized by intense competition, changingtechnology, evolving industry standards, changes in customer needs and new serviceand product introductions. The Internet access market has reached a maturestage of growth; however, growth is expected to continue at a slow rate as moreservices become available online, Internet access prices remain low, computerprices continue to decline and consumers increasingly gain access at placesoutside the home.

 

In the last few years,the composition of the Internet access market has changed and the number ofhouseholds with broadband access surpassed the number of households with dial-upaccess. Consumers continue to migrate to broadband due to the faster connectionand download speeds provided by broadband access, the ability to free up theirphone lines and the more reliable and “always on” connection. The pricing forbroadband services, particularly for introductory promotional periods, servicesbundled with video and telephone services, and services with slower speeds, hasbeen declining and is approaching prices for traditional dial-up services,making it a more viable option for consumers that continue to rely on dial-upconnections for Internet access. In addition, advanced applications such asonline gaming, music downloads and photo sharing require greater bandwidth foroptimal performance, which adds to the demand for broadband access. However,analysts predict a continuing market for dial-up customers.

 

Currently, mostresidential broadband consumers access the Internet via DSL or cable. One ofthe outgrowths from the rapid deployment of broadband connectivity has been theadoption of Voice over Internet Protocol (“VoIP”). VoIP is a technology thatenables voice communications over the Internet through the 

 

21

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conversion of voicesignals into data packets. VoIP technology presents several advantages over thetechnology used in traditional wireline telephone networks and enables VoIPproviders to operate with lower capital expenditures and operating costs whileoffering both traditional and innovative service features.

 

*Revenue Sources*

 

We provide accessservices (including traditional, fully-featured narrowband access andvalue-priced narrowband access; high-speed access via DSL, cable and satellite;IP-based voice; and high-speed data networks for small and medium-sizedbusinesses and communications carriers) and value-added services (includingancillary services sold as an add-on feature to our services, search andadvertising). We earn revenues primarily from monthly fees charged to customersfor services. We also earn revenues from usage fees; installation fees;termination fees; and fees for equipment used to access our services. Totalrevenues were $324.1 million and $263.1 million during the three months ended March 31,2007 and 2008, respectively. Our traditional, premium-priced narrowbandrevenues have been declining due to the maturity of this service. In addition,our revenues declined over the past year due to a change in our businessstrategy to reduce sales and marketing activities which resulted in addingcustomers that did not provide an acceptable rate of return or that had apattern of early life churn.

 

*Business Strategy and Risks*

 

In response to decliningrevenues, changes in our industry and changes in consumer behavior, wecompleted a comprehensive review of our core access services during the latterhalf of 2007. We also reviewed each of our prior growth initiatives to evaluatewhether these initiatives were complementary to our long-term strategy andallowed us to maximize shareholder value. As a result of these reviews, weimplemented a restructuring plan (“the 2007 Plan”) to reduce operating costsand improve the efficiency of our organization. Under the 2007 Plan, wesignificantly reduced employees, closed or consolidated certain facilities,discontinued certain projects and reduced sales and marketing efforts. For ourcore access services, we reduced the back-office cost structure and reducedsales and marketing efforts aimed at customers that had high acquisition costsand early life churn. For our IP-based voice and business services, wesignificantly reduced the cost structure. For our municipal wireless broadbandoperations, we concluded that the operations were no longer consistent with ourstrategic direction and we have committed to a plan to divest our municipalwireless broadband assets. Finally, we decided to discontinue furtherinvestments in HELIO, our joint venture with SK Telecom Co., Ltd. (“SK Telecom”),and entered into amended and restated joint venture agreements with SK Telecomto eliminate any future requirement to invest in HELIO.

 

Our current businessfocus is the following:

 

·                  *Operational Efficiency*. We are focused on improving the coststructure of our business and aligning our cost structure with trends in ourrevenue, without impacting the quality of services we provide. In addition toimplementing our corporate restructuring plan which reduced back-office supportcosts and subscriber acquisition costs, we are focused on delivering ourservices more cost effectively by reducing and more efficiently handling thenumber of calls to contact centers, managing cost effective outsourcingopportunities and streamlining our internal processes and operations.

 

·                  *Customer Retention*. We are focused on retaining ourexisting tenured customers. We continue to focus on offering reasonably pricedaccess with high-quality customer service and technical support. We believefocusing on the customer relationship will increase loyalty and reduce churn.

 

·                  *Opportunities for growth*. In response to changes in our business, we have significantly reducedour sales and marketing spending. However, we are focused on continuing to addcustomers that generate an acceptable rate of return and increasing the numberof subscribers we add through partnerships and acquisitions from otherISPs.  We will evaluate potentialstrategic transactions that could complement our business. We are also focusedon adding customers organically by growing our services to business 

 

22

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customers throughNew Edge, our wholly-owned subsidiary. We believe this is a growth market andwe will continue to differentiate ourselves by providing customers with choicesfor our business services.

 

The primary challenges weface in executing our business strategy are responding to competition, reducingchurn, maintaining profitability in our access services and purchasingcost-effective wholesale broadband access. The factors we believe areinstrumental to the achievement of our goals and targets, including the factorsidentified above, may be subject to competitive, regulatory and other eventsand circumstances that are beyond our control. Further, we can provide no assurancethat we will be successful in achieving any or all of the factors identifiedabove, that the achievement or existence of such factors will favorably impactprofitability, or that other factors will not arise that would adversely affectfuture profitability.

 

*First Quarter 2008 Highlights*

 

Total revenues decreasedduring the three months ended March 31, 2008 compared to the prior yearperiod. In addition, our subscriber base decreased from approximately 5.3million paying subscribers as of March 31, 2007 to approximately 3.6million paying subscribers as of March 31, 2008. The decrease in payingsubscribers was primarily due to the removal of approximately 753,000 wholesalebroadband subscribers under our marketing relationship with Embarq Corporation (“Embarq”),a decrease in premium narrowband subscribers and a decrease in PeoplePCvalue-priced narrowband subscribers. Overall operating expenses decreasedduring the three months ended March 31, 2008 compared to the prior yearperiod primarily due to cost savings realized as a result of our 2007 corporaterestructuring plan and a decrease in costs to acquire and support newsubscribers. We recognized net income of $54.4 million during the three monthsended March 31, 2008 compared to a net loss of $30.0 million during thethree months ended March 31, 2007. This was due to the decrease in totaloperating costs and expenses and a decrease in net losses of HELIO, as wediscontinued recording equity method losses during 2007. These improvementswere partially offset by the decrease in revenues and an increase in our incometax provision.

 

*Looking Ahead*

 

We expect total revenuesto continue to decrease as we reduce sales and marketing efforts aimed atcustomers that have a high acquisition cost and early life churn. However, weexpect overall profits to increase in 2008 compared to the prior year as thebenefits realized from our corporate restructuring plan, the decreased salesand marketing activities, the decreased support costs and the decrease in lossfrom equity affiliate more than offset our decline in revenues.

 

**Joint Venture**

 

We have a joint venturewith SK Telecom, HELIO. HELIO is a non-facilities-based mobile virtual networkoperator (MVNO) offering mobile communications services and handsets to consumersin the U.S. HELIO was formed in March 2005 and began offering its productsand services in April 2006. As of March 31, 2008, we had anapproximate 29% economic ownership interest and 30% voting interest in HELIO,while SK Telecom had an approximate 67% economic ownership interest and 70%voting interest in HELIO. We currently have no plans to make furtherinvestments in HELIO.

 

**Marketing Alliance**

 

We have an agreement with Time Warner Cable and BrightHouse Networks, companies whose networks pass more than 30 million homes,to offer our broadband Internet access services over their systems.  In connection with the agreement, Time WarnerCable and Bright House Networks receive consideration from EarthLink forcarrying the EarthLink service and related Internet traffic. As of March 31,2008, more than 40% of our consumer broadband subscribers were serviced viaeither the Time Warner Cable or Bright House Networks network.

 

23

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**Key OperatingMetrics**

 

We utilize certainnon-financial and operating measures to assess our financial performance. Termssuch as churn and average revenue per user (“ARPU”) are terms commonly used inour industry. The following table sets forth subscriber and operating datafor the periods indicated:

** **
| ** **                                   | ** ** | **March 31,** | ** ** | **December 31,** | ** ** | **March 31,** | ** ** |
|----------------------------------------------|------------|--------------------|------------|-----------------------|------------|--------------------|------------|
| ** **                                   | ** ** | **2007**           | ** ** | **2007**              | ** ** | **2008**           | ** ** |
| **Subscriber  Data (a)**                     |       |               |       |                  |       |               |       |
| **Consumer  Services**                       |       |               |       |                  |       |               |       |
| Narrowband  access subscribers               |       | 3,208,000          |       | 2,624,000             |       | 2,368,000          |       |
| Broadband access  subscribers (b)            |       | 1,847,000          |       | 1,059,000             |       | 1,026,000          |       |
| Total consumer  services                     |       | 5,055,000          |       | 3,683,000             |       | 3,394,000          |       |
| **Business  Services**                       |       |               |       |                  |       |               |       |
| Narrowband  access subscribers               |       | 36,000             |       | 27,000                |       | 25,000             |       |
| Broadband access  subscribers                |       | 69,000             |       | 66,000                |       | 65,000             |       |
| Web hosting  accounts                        |       | 109,000            |       | 100,000               |       | 97,000             |       |
| Total business  services                     |       | 214,000            |       | 193,000               |       | 187,000            |       |
| **Total  subscriber count at end of period** |       | 5,269,000          |       | 3,876,000             |       | 3,581,000          |       |

 
| ** **                          | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------|------------|--------------------------------------------------|------------|
| ** **                          | ** ** | **2007**                                         | ** ** | **2008** | ** ** |
| **Subscriber  Activity**            |       |                                             |       |   |   |
| Subscribers at  beginning of period |       | 5,313,000                                        |       | 3,876,000 |   |
| Gross organic  subscriber additions |       | 668,000                                          |       | 253,000 |   |
| Churn                               |       | (712,000                                         | )          | (548,000 | ) |
| Subscribers at  end of period       |       | 5,269,000                                        |       | 3,581,000 |   |
|                                |       |                                             |       |   |   |
| **Churn  rate (c)**                 |       | 4.5                                              | %          | 4.9 | % |
|                                |       |                                             |       |   |   |
| **Consumer  Services Data**         |       |                                             |       |   |   |
| Average  subscribers (d)            |       | 5,085,000                                        |       | 3,538,000 |   |
| ARPU (e)                            |       | $                                                | 18.13      |   | $ | 20.38 |   |
| Churn rate (c)                      |       | 4.6                                              | %          | 5.0 | % |
|                                |       |                                             |       |   |   |
| **Business  Services Data**         |       |                                             |       |   |   |
| Average  subscribers (d)            |       | 217,000                                          |       | 190,000 |   |
| ARPU (e)                            |       | $                                                | 73.32      |   | $ | 81.88 |   |
| Churn rate (c)                      |       | 2.7                                              | %          | 2.7 | % |

 

----

(a) Subscribercounts do not include nonpaying customers. Customers receiving service underpromotional programs that include periods of free service at inception are notincluded in subscriber counts until they become paying customers.

 

(b) Customers whosubscribe to our EarthLink DSL and Home Phone service are counted as both abroadband subscriber and a voice subscriber.

 

24

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(c)  Churn rate isused to measure the rate at which subscribers discontinue service on avoluntary or involuntary basis.  Churnrate is computed by dividing the average monthly number of subscribers thatdiscontinued service during the period by the average subscribers for theperiod.

 

(d)  Average subscribers or accounts for thethree month periods is calculated by averaging the ending monthly subscribers or accounts for the fourmonths preceding and including the end of the quarterly period.

 

(e) ARPU representsthe average monthly revenue per user (subscriber). ARPU is computed by dividingaverage monthly revenue for the period by the average number of subscribers forthe period. Average monthly revenue used to calculate ARPU includes recurringservice revenue as well as nonrecurring revenues associated with equipment andother one-time charges associated with initiating or discontinuing services.

 

**Results of Operations**

 

***ConsolidatedResults of Operations***

 

The following table setsforth statement of operations data for the periods indicated:

 
| ** **                                                    | ** ** | **Three Months Ended  March 31,** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------------|------------|------------|------------|
| ** **                                                    | ** ** | **2007**                                         | ** ** | **2008**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                                    | ** ** | **(dollars in thousands)**             | ** ** |
|                                                          |       |                                             |       |       |       |   |   |   |   |
| Revenues                                                      |       | $                                                | 324,147    |       | $          | 263,074 |   | (61,073 | ) | -19 | % |
|                                                          |       |                                             |       |       |       |   |   |   |   |
| Operating costs  and expenses:                                |       |                                             |       |       |       |   |   |   |   |
| Service and  equipment costs                                  |       | 109,791                                          |       | 96,792     |       | (12,999 | ) | -12 | % |
| Sales incentives                                              |       | 4,604                                            |       | 759        |       | (3,845 | ) | -84 | % |
| Total cost of  revenues                                       |       | 114,395                                          |       | 97,551     |       | (16,844 | ) | -15 | % |
|                                                          |       |                                             |       |       |       |   |   |   |   |
| Sales and  marketing                                          |       | 99,269                                           |       | 30,916     |       | (68,353 | ) | -69 | % |
| Operations and  customer support                              |       | 60,072                                           |       | 39,224     |       | (20,848 | ) | -35 | % |
| General and  administrative                                   |       | 43,261                                           |       | 24,926     |       | (18,335 | ) | -42 | % |
| Amortization of  intangible assets                            |       | 3,496                                            |       | 4,013      |       | 517 |   | 15 | % |
| Facility exit,  restructuring and other costs                 |       | —                                           |       | 1,030      |       | 1,030 |   |   | * |
| Total operating  costs and expenses                           |       | 320,493                                          |       | 197,660    |       | (122,833 | ) | -38 | % |
|                                                          |       |                                             |       |       |       |   |   |   |   |
| Income from  operations                                       |       | 3,654                                            |       | 65,414     |       | 61,760 |   |   | * |
| Net losses of  equity affiliate                               |       | (29,346                                          | )          | —     |       | 29,346 |   | -100 | % |
| Interest income  and other, net                               |       | 3,503                                            |       | 1,616      |       | (1,887 | ) | -54 | % |
| Income (loss)  from continuing operations before income taxes |       | (22,189                                          | )          | 67,030     |       | 89,219 |   |   | * |
| Income tax  provision                                         |       | (169                                             | )          | (9,274     | )          | (9,105 | ) |   | * |
| Income (loss)  from continuing operations                     |       | (22,358                                          | )          | 57,756     |       | 80,114 |   |   | * |
| Loss from  discontinued operations                            |       | (7,604                                           | )          | (3,392     | )          | 4,212 |   | -55 | % |
| Net income  (loss)                                            |       | $                                                | (29,962    | )          | $          | 54,364 |   | $ | 84,326 |   |   | * |
|                                                               |            |                                                  |            |            |            |  |  |  |  |  |  |  |

 

----

* denotes percentage isnot meaningful

 

25

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***SegmentResults of Operations***

 

Our business segments arestrategic business units that are managed based upon differences in customers,services and marketing channels. Our Consumer Services segment provides dial-upInternet access, high-speed Internet access and voice services, among others,to individual customers. Our Business Services segment provides managed datanetworks, dedicated Internet access and web hosting, among others, tobusinesses and communications carriers.

 

We evaluate theperformance of our operating 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 thesegment, which include expenses over which segment managers have directdiscretionary control, such as advertising and marketing programs, customersupport expenses, site operations expenses, product development expenses,certain technology and facilities expenses, billing operations and provisionsfor doubtful accounts. Segment income from operations excludes other income andexpense items and certain expenses over which segment managers do not havediscretionary control. Costs excluded from segment income from operationsinclude various corporate expenses (consisting of certain costs such ascorporate management, human resources, finance and legal), amortization ofintangible assets, facility exit and restructuring costs and stock-basedcompensation expense under Statement of Financial Accounting Standards (“SFAS”)No. 123(R), as they are not considered in the measurement of segmentperformance.

 

The following tables setforth segment data for the three months ended March 31, 2007 and 2008:

 
| ** **                                    | ** ** | **Three Months Ended March 31,** | ** ** | ** ** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------|------------|------------|------------|
| ** **                                    | ** ** | **2007**                                        | ** ** | **2008**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                    | ** ** | **(dollars in thousands)**            | ** ** |
| **Consumer  Services**                        |       |                                            |       |       |       |   |   |   |   |
| Revenues                                      |       | $                                               | 276,393    |       | $          | 216,344 |   | $ | (60,049 | ) | -22 | % |
| Cost of revenues                              |       | 84,353                                          |       | 71,173     |       | (13,180 | ) | -16 | % |
| Gross margin                                  |       | 192,040                                         |       | 145,171    |       | (46,869 | ) | -24 | % |
| Direct segment  operating expenses            |       | 159,333                                         |       | 61,001     |       | (98,332 | ) | -62 | % |
| Segment  operating income                     |       | $                                               | 32,707     |       | $          | 84,170 |   | $ | 51,463 |   | 157 | % |
|                                          |       |                                            |       |       |       |   |   |   |   |
| **Business  Services**                        |       |                                            |       |       |       |   |   |   |   |
| Revenues                                      |       | $                                               | 47,754     |       | $          | 46,730 |   | $ | (1,024 | ) | -2 | % |
| Cost of revenues                              |       | 30,042                                          |       | 26,378     |       | (3,664 | ) | -12 | % |
| Gross margin                                  |       | 17,712                                          |       | 20,352     |       | 2,640 |   | 15 | % |
| Direct segment  operating expenses            |       | 16,668                                          |       | 14,871     |       | (1,797 | ) | -11 | % |
| Segment  operating income                     |       | $                                               | 1,044      |       | $          | 5,481 |   | $ | 4,437 |   | 425 | % |
|                                          |       |                                            |       |       |       |   |   |   |   |
| **Consolidated**                              |       |                                            |       |       |       |   |   |   |   |
| Revenues                                      |       | $                                               | 324,147    |       | $          | 263,074 |   | $ | (61,073 | ) | -19 | % |
| Cost of revenues                              |       | 114,395                                         |       | 97,551     |       | (16,844 | ) | -15 | % |
| Gross margin                                  |       | 209,752                                         |       | 165,523    |       | (44,229 | ) | -21 | % |
| Direct segment  operating expenses            |       | 176,001                                         |       | 75,872     |       | (100,129 | ) | -57 | % |
| Segment  operating income                     |       | 33,751                                          |       | 89,651     |       | 55,900 |   | 166 | % |
| Stock-based  compensation expense             |       | 7,880                                           |       | 5,152      |       | (2,728 | ) | -35 | % |
| Amortization of  intangible assets            |       | 3,496                                           |       | 4,013      |       | 517 |   | 15 | % |
| Facility exit,  restructuring and other costs |       | —                                          |       | 1,030      |       | 1,030 |   |   | * |
| Other operating  expenses                     |       | 18,721                                          |       | 14,042     |       | (4,679 | ) | -25 | % |
| Income from  operations                       |       | $                                               | 3,654      |       | $          | 65,414 |   | $ | 61,760 |   |   | * |

 

----

* denotes percentage isnot meaningful

 

26

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***Revenues***

 

The following table presents revenues by groups ofsimilar services and by segment for the three months ended March 31, 2007and 2008:

 
| ** **             | ** ** | **Three Months Ended  March 31,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|------------------------|------------|--------------------------------------------------|------------|------------|------------|-------------------|------------|
| ** **             | ** ** | **2007**                                         | ** ** | **2008**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **             | ** ** | **(dollars in thousands)**             | ** ** |
| **Consumer  Services** |       |                                             |       |       |       |              |       |   |   |
| Access and  service    |       | $                                                | 242,800    |       | $          | 188,971           |       | $ | (53,829 | ) | -22 | % |
| Value-added  services  |       | 33,593                                           |       | 27,373     |       | (6,220            | )          | -19 | % |
| Total revenues         |       | $                                                | 276,393    |       | $          | 216,344           |       | $ | (60,049 | ) | -22 | % |
|                   |       |                                             |       |       |       |              |       |   |   |
| **Business  Services** |       |                                             |       |       |       |              |       |   |   |
| Access and  service    |       | $                                                | 46,955     |       | $          | 45,878            |       | $ | (1,077 | ) | -2 | % |
| Value-added  services  |       | 799                                              |       | 852        |       | 53                |       | 7 | % |
| Total revenues         |       | $                                                | 47,754     |       | $          | 46,730            |       | $ | (1,024 | ) | -2 | % |
|                   |       |                                             |       |       |       |              |       |   |   |
| **Consolidated**       |       |                                             |       |       |       |              |       |   |   |
| Access and  service    |       | $                                                | 289,755    |       | $          | 234,849           |       | $ | (54,906 | ) | -19 | % |
| Value-added  services  |       | 34,392                                           |       | 28,225     |       | (6,167            | )          | -18 | % |
| Total revenues         |       | $                                                | 324,147    |       | $          | 263,074           |       | $ | (61,073 | ) | -19 | % |

 

*Consolidated revenues*

 

The primary component ofour revenues is access and service revenues, which consist of narrowband accessservices (including traditional, fully-featured narrowband access andvalue-priced narrowband access); broadband access services (includinghigh-speed access via DSL, cable and satellite; IP-based voice; and feescharged for high-speed data networks to small and medium-sized businesses andcommunications carriers); and web hosting services. We also earn revenues fromvalue-added services, which include search, advertising and ancillary servicessold as add-on features to our access services. Total revenues decreased from$324.1 million during the three months ended March 31, 2007 to $263.1million during the three months ended March 31, 2008. This was comprisedof a $60.0 million decrease in consumer services revenue and a $1.0 milliondecrease in business services revenue.

 

The decrease in consumerservices revenue was primarily attributable to a decrease in average consumersubscribers, which were approximately 5.1 million and 3.5 million during thethree months ended March 31, 2007 and 2008, respectively. The decrease wasdriven primarily by the removal of 753,000 Embarq subscribers in April 2007,a decrease in average premium narrowband subscribers and a decrease in averagevalue-priced narrowband subscribers. The decrease in business services revenuewas attributable to a decrease in average business subscribers, offset by anincrease in business services ARPU.

 

*Consumer services revenue*

 

*Access and service*. Consumeraccess and service revenues consist of narrowband access, broadband access andvoice services. These revenues are derived from monthly fees charged tocustomers for dial-up Internet access; monthly retail and wholesale feescharged for high-speed, high-capacity access services including DSL, cable andsatellite; fees charged for IP-based voice services; usage fees; installationfees; termination fees; and fees for equipment. Consumer access and servicerevenues decreased from $242.8 million during the three months ended March 31,2007 to $189.0 million during the three months ended March 31, 2008.  The decrease in consumer access and servicerevenues was primarily due to a decrease in average consumer access and servicesubscribers.

 

27

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Average consumer access and service subscribersdecreased largely due to the removal of 753,000 Embarq subscribers from oursubscriber count effective April 2007. We had a marketing relationshipwith Embarq, a spin-off of Sprint Nextel Corporation’s local communicationsbusiness. The relationship provided that EarthLink was the wholesale high-speedISP for Embarq’s local residential and small business customers. The contractsassociated with these arrangements expired in April 2007, and we andEmbarq did not renew the wholesale broadband contract. Effective April 2007,we removed approximately 753,000 wholesale broadband subscribers under themarketing relationship from our broadband subscriber count and total subscribercount.

 

Average consumer access and service subscribers alsodecreased due to a decrease in premium narrowband subscribers resulting fromthe continued maturing and ongoing competitiveness of the market for narrowbandInternet access and a decrease in average value-priced narrowband subscribersresulting from the change in our business strategy. During the three monthsended March 31, 2008, we reduced sales and marketing efforts that resultedin adding customers that did not provide and acceptable rate of return or thathad a pattern of early life churn. We are focusing efforts primarily on theretention of tenured customers and adding customers that have similarcharacteristics of our tenured customer base and are more likely to produce anacceptable rate of return. We expect our consumer access and service subscriberbase to continue to decrease due to the continued maturation of the market forpremium narrowband access and due to the change in our business strategy.However, as our customers become more tenured, we expect our churn rates todecline.

 

Consumer access and service ARPU increased from $18.13during the three months ended March 31, 2007 to $20.38 during the threemonths ended March 31, 2008. ARPU depends on a variety of factors,including changes in the mix of customers and their related pricing plans; theuse of promotions and discounted pricing plans to obtain or retain subscribers;increases or decreases in the prices of our existing services; and the additionof new services. We currently offer several consumer access services atdifferent price plans, and we provide services through retail and wholesalerelationships. All of these have an effect on our overall ARPU.

 

The increase in consumer access and service ARPU wasprimarily due to an increase in broadband access and service ARPU. The increasein broadband access and service ARPU during the three months ended March 31,2008 compared to the prior year was primarily due to a shift in the mix of ourbroadband customer base from wholesale DSL subscribers to retail DSLsubscribers and to retail cable subscribers due to the removal of Embarqwholesale subscribers and an increase in our voice subscribers. Offsetting thisincrease was general declines in retail DSL prices introduced as a result ofdeclines in costs from our DSL service providers.

 

*Value-addedservices revenues.*Value-added services revenues consist ofsearch revenues; advertising revenues; revenues from ancillary services sold asadd-on features to our Internet access services, such as security products,email by phone, Internet call waiting and email storage; and revenues from homenetworking products and services.* *We derive these revenues by paidplacements for searches; delivering traffic to our partners in the form ofsubscribers, page views or e-commerce transactions; advertising ourpartners’ products and services in our various online properties and electronicpublications, including the Personal Start PageTM; referring ourcustomers to our partners’ products and services; and monthly fees charged forancillary services.

 

Value-added servicesrevenues decreased from $33.6 million the three months ended March 31,2007 to $27.4 million during the three months ended March 31, 2008. Thedecrease over the prior year period was due primarily to a decrease in searchadvertising revenues resulting from the decline in average consumer servicessubscribers and a decrease in partnership advertising revenues.  Offsetting these decreases was an increase insales of security products, anti-spam products and premium mail products.

 

*Business services revenue*

 

The primary component of business services revenues isaccess and service revenues. Business access and service revenues consist ofretail and wholesale fees charged for high-speed, high-capacity access servicesincluding DSL, cable, satellite and dedicated circuit services; fees chargedfor high-speed data networks for small and medium-sized businesses;installation fees; termination fees; fees for equipment; regulatory surchargesbilled to customers; and web hosting. We earn web hosting revenues by leasingserver space and providing web services to individuals and businesses wishingto have a web or e-commerce presence on the Internet.

 

28

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Business access and service revenues decreased from $47.0million during the three months ended March 31, 2007 to $45.9 millionduring the three months ended March 31, 2008. The decrease was primarilydue to a decrease in average business access and service subscribers, driven bya decrease in average in web hosting accounts and business narrowbandcustomers. This decrease was offset by an increase in business access andservice ARPU, which was driven by New Edge.

 

Our business broadband subscriber base consists ofcustomers which are added through retail and wholesale relationships. Retailbusiness services generally have an ARPU between $100 and $130 fornon-networked solutions and an ARPU between $175 and $225 for networkedsolutions. Wholesale business services generally have an ARPU between $75 and$95. The pricing of broadband services for small and medium-sized businessesdepends upon customer requirements for different service delivery methods,amounts of bandwidth, quality of service and distance from the points ofpresence, and may vary widely from these ranges. The number of customers beingadded or served at any point in time through our wholesale efforts is subjectto the business and marketing circumstances of our telecommunications partners.

 

***Cost of revenues***

 

Service and equipmentcosts are the primary component of our cost of revenues and consist oftelecommunications fees, set-up fees, network equipment costs incurred toprovide our Internet access services, depreciation of our network equipment andsurcharges due to regulatory agencies. Service and equipment costs also includethe cost of Internet appliances. Our principal provider for narrowbandtelecommunications services is Level 3 Communications, Inc., and ourlargest providers of broadband connectivity are Covad Communications Group, Inc.(“Covad”) and Time Warner Cable. We also do lesser amounts of business with awide variety of local, regional and other national providers. We purchasebroadband access from Incumbent Local Exchange Carriers, Competitive LocalExchange Carriers and cable providers. Cost of revenues also includes salesincentives. We offer sales incentives such as free modems and Internet accesson a trial basis.

 

Total cost of revenuesdecreased 15% from $114.4 million during the three months ended March 31,2007 to $97.6 million during the three months ended March 31, 2008. Thedecrease during the three months ended March 31, 2008 compared to theprior year period was comprised of a $13.2 million decrease in consumerservices cost of revenues and a $3.7 million decrease in business services costof revenues. Consumer services cost of revenues decreased due to the decline inaverage consumer services subscribers and a decrease in sales incentives due toa decrease in gross subscriber additions as we reduced our sales and marketingactivities during the period. Business services cost of revenues decreased dueto the decrease in average business services subscribers and a decrease inaverage monthly costs per subscriber, primarily as a result of a decrease inNew Edge cost of revenues due to more favorable agreements withtelecommunications service providers.

 

***Salesand marketing***

 

Sales and marketing expenses include advertising andpromotion expenses, fees paid to distribution partners to acquire new payingsubscribers, personnel-related expenses and telemarketing costs incurred toacquire subscribers. Sales and marketing expenses decreased 69% from $99.3million during the three months ended March 31, 2007 to $30.9 millionduring the three months ended March 31, 2008. This decrease consistedprimarily of a decrease in consumer services sales and marketing expenses as wedecreased spending aimed at customers that had high acquisition costs and earlylife churn and as we realized benefits from the 2007 Plan. We expect tocontinue to realize benefits during the remainder of 2008 as we continue toscale back sales and marketing efforts in connection with our refocusedstrategy.

 

29

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***Operationsand customer support***

 

Operations and customersupport expenses consist of costs associated with technical support andcustomer service, providing our subscribers with toll-free access to ourtechnical support and customer service centers, maintenance of customerinformation systems, software development and network operations. Operationsand customer support expenses decreased 35% from $60.1 million during the threemonths ended March 31, 2007 to $39.2 million during the three months endedMarch 31, 2008. The decrease was attributable to benefits realized as aresult of our corporate restructuring plan and our efforts to reduce ourback-office cost structure. In addition, we experienced a decrease in callvolumes for customer service and technical support as our subscriber base hasdecreased and become more tenured. The decrease in operations and customersupport expenses consisted of decreases in personnel-related costs, outsourcedlabor, professional fees and occupancy costs. We expect operations and customersupport expenses to continue to decrease in 2008 as a result of the 2007 Planand our refocused strategy.

 

***Generaland administrative***

 

General and administrative expenses consist of fullyburdened costs associated with the executive, finance, legal and humanresources departments; outside professional services; payment processing;credit card fees; collections and bad debt. General and administrative expensesdecreased 42% from $43.3 million during the three months ended March 31,2007 to $24.9 million during the three months ended March 31, 2008.  The decrease was attributable to benefitsrealized as a result of our corporate restructuring plan and our efforts toreduce our back-office cost structure. The decrease in general andadministrative expenses consisted of decreases in personnel-related costs,stock-based compensation expense and professional and legal fees. In addition,bad debt and payment processing decreased as a result of the decrease in ouroverall subscriber base. We expect general and administrative expenses tocontinue to decrease in 2008 compared to the prior year as a result of the 2007Plan.

 

Included in general and administrative expenses duringthe three months ended March 31, 2007 was $6.4 million of cash andnon-cash compensation expense related to the death of our former ChiefExecutive Officer, Charles G. Betty, on January 2, 2007. This compensationexpense included $3.5 million of stock-based compensation expense related tothe accelerated vesting of 1.1 million stock options and 0.1 million restrictedstock units, $1.4 million of stock-based compensation expense related to theextension of the exercise period for Mr. Betty’s stock options and $1.5million of compensation expense for a payment to Mr. Betty’s estate inaccordance with his employment agreement.

 

***Stock-basedcompensation expense***

 

Stock-based compensationexpense in accordance with SFAS No. 123(R) was allocated as followsfor the three months ended March 31, 2007 and 2008:

 
| ** **                       | ** ** | **Three Months Ended March 31,** | ** ** |
|----------------------------------|------------|------------------------------------------------------|------------|
| ** **                       | ** ** | **2007**                                             | ** ** | **2008** | ** ** |
| ** **                       | ** ** | **(in thousands)**                              | ** ** |
| Sales and  marketing             |       | $                                                    | 710        |   | $ | 1,534 |   |
| Operations and  customer support |       | 1,396                                                |       | 2,536 |   |
| General and  administrative      |       | 5,774                                                |       | 1,082 |   |
|                             |       | $                                                    | 7,880      |   | $ | 5,152 |   |

 

***Amortizationof intangible assets***

 

Amortization ofintangible assets represents the amortization of definite lived intangibleassets acquired in purchases of businesses and purchases of customer bases fromother companies. Definite lived intangible assets, which primarily consist ofsubscriber bases and customer relationships, acquired software and technology, tradenames and other assets, are amortized on a straight-line basis over theirestimated useful lives, which range from one to six years. Amortization ofintangible assets was $3.5 million and $4.0 million during the three monthsended 

 

30

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March 31, 2007 and2008, respectively. The increase in amortization of intangible assets duringthe three months ended March 31, 2008 compared to the prior year period wasprimarily due to amortization of identifiable definite lived intangible assetsresulting from acquisitions of subscriber bases from ISPs over the past year.

 

***Facilityexit, restructuring and other costs***

 

In August 2007, we adopted a restructuring planto reduce costs and improve the efficiency of our operations. The 2007 Plan wasthe result of a comprehensive review of operations within and across ourfunctions and businesses. Under the 2007 Plan, we reduced our workforce byapproximately 900 employees, closed office facilities in Orlando, Florida;Knoxville, Tennessee; Harrisburg, Pennsylvania and San Francisco, Californiaand are consolidating our office facilities in Atlanta, Georgia and Pasadena,California. The Plan was primarily implemented during the latter half of 2007and is expected to be completed during 2008. As a result of the 2007 Plan, werecorded facility exit and restructuring costs of $1.1 million during the threemonths ended March 31, 2008, including $0.4 million for severance andpersonnel-related costs; $0.3 million for non-cash asset impairments; and $0.4million for other associated costs.

 

Management continues to evaluateour businesses and, therefore, there may be supplemental provisions for newplan initiatives as well as changes in estimates to amounts previouslyrecorded, as payments are made or actions are completed.

 

We periodically evaluate and adjust our estimates forfacility exit and restructuring costs based on currently-available informationand record such adjustments as facility exit, restructuring and other costs. Facility exit, restructuring and other costsduring the three months ended March 31, 2008 also included a $0.1million reduction to facility exit, restructuring and other costs as a resultof changes in estimates for restructuring plans implemented during the yearsended December 31, 2003 and 2004 (“Legacy Plans”).

 

***Netlosses of equity affiliate***

 

We account for our investment in HELIO under theequity method of accounting because we can exert significant influence overHELIO’s operating and financial policies. Accordingly, we record ourproportionate share of HELIO’s net losses. These equity method losses have beenoffset by increases in the carrying value of our investment associated withamortizing the difference between the book value of non-cash assets contributedto HELIO and their fair value.

 

Net losses of equity affiliate for the three monthsended March 31, 2007 of $29.3 million included our proportionate share ofHELIO’s net losses offset by amortization associated with recognizing thedifference between the carrying value and fair value of non-cash assetscontributed. During the year ended December 31, 2007, we stopped recordingadditional net losses of equity affiliate because the carrying value of ourinvestments in HELIO were reduced to zero, and we are not committed to providefurther financial support. As a result, we did not record any net losses ofequity affiliate during the three months ended March 31, 2008 and we donot expect to record net losses of equity affiliate for the foreseeable future.

 

***Interestincome and other, net***

 

Interest income and other, net, is primarily comprisedof interest earned on our cash, cash equivalents and marketable securities;interest earned on our Covad investment; interest expense incurred on ourConvertible Senior Notes due November 15, 2026; and other miscellaneousincome and expense items. Interest income and other, net, decreased from $3.5million during the three months ended March 31, 2007 to $1.6 millionduring the three months ended March 31, 2008. This was primarily due to adecrease in interest earned on our cash, cash equivalents and marketablesecurities due to lower investment yields and a decrease in our average cashand marketable securities balance. Our average cash and marketable securitiesbalance decreased over the past year due to cash payments resulting from the2007 Plan, share repurchases and investments in HELIO.

 

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***Provisionfor income taxes***

 

We have recorded incometaxes during the three months ended March 31, 2008 based on management’scurrent annual operating expectations in accordance with the interim reportingrequirements of SFAS No. 109, “Accounting for Income Taxes,” andAccounting Principles Board Opinion No. 28, “Interim Financial Reporting.”

 

We continue to maintain afull valuation allowance against our unrealized deferred tax assets, whichinclude net operating loss carryforwards. We may recognize deferred tax assets in future periods when they aredetermined to be more likely than not realizable. To the extent we reportincome in future periods, we intend to use our net operating loss carryforwardsto the extent available to offset taxable income and reduce cash outflows forincome taxes.  Our ability to use ourfederal and state net operating loss carryforwards and federal and state taxcredit carryforwards may be subject to restrictions attributable to equitytransactions in the future resulting from changes in ownership as defined underthe Internal Revenue Code.

 

***Lossfrom discontinued operations***

 

                Loss from discontinued operations for the threemonths ended March 31, 2007 and 2008 reflects our municipal wirelessbroadband operations. In November 2007, management concluded that ourmunicipal wireless broadband operations were no longer consistent with ourstrategic direction and our Board of Directors authorized management to pursuethe sale of our municipal wireless broadband assets. The municipal wirelessresults of operations were previously included in our Consumer Servicessegment.

 

Subsequent to March 31,2008, we reached agreements with the cities of Corpus Christi, TX and Milpitas,CA to transfer ownership of our municipal wireless broadband networks to thoserespective cities in exchange for releasing us from our existing network agreements.  Additionally, we plan to terminate ourmunicipal wireless broadband service in New Orleans, LA and remove our networkfrom the market.

 

                In accordance with SFAS No. 144, “Accounting forthe Impairment or Disposal of Long-Lived Assets,” we recorded a $1.9 millioncharge during the three months ended March 31, 2008 to adjust the carryingvalue of the long-lived assets to their fair value less estimated costs tosell.  These charges are reflected withinloss from discontinued operations.

 

The following tablepresents summarized results of operations related to our discontinuedoperations for the three months ended March 31, 2007 and 2008:

 
| ** **                         | ** ** | **Three Months Ended March 31,** | ** ** |
|------------------------------------|------------|------------------------------------------------------|------------|
| ** **                         | ** ** | **2007**                                             | ** ** | **2008** | ** ** |
| ** **                         | ** ** | **(in thousands)**                              | ** ** |
| ** **                         | ** ** | ** **                                           | ** ** | ** ** | ** ** |
| Revenues                           |       | $                                                    | 259        |   | $ | 737 |   |
| Operating costs  and expenses      |       | (7,863                                               | )          | (2,180 | ) |
| Impairment  charges                |       | —                                               |       | (1,949 | ) |
| Loss from  discontinued operations |       | $                                                    | (7,604     | ) | $ | (3,392 | ) |

 

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**Facility Exit and RestructuringCosts**

 

*2007 Plan*.* *We expect to incur future cashoutflows for real estate obligations through 2014 related to the 2007 Plan. Thefollowing table summarizes activity for the liability balances associated withthe 2007 Plan for the three months ended March 31, 2008, including changesduring the year attributable to costs incurred and charged to expense and costspaid or otherwise settled:

 
| ** **                            | ** ** | **Severance**           | ** ** | ** **     | ** ** | **Asset**       | ** ** | **Other** | ** ** | ** ** | ** ** |
|---------------------------------------|------------|-------------------------|------------|----------------|------------|-----------------|------------|-----------|------------|------------|------------|
| ** **                            | ** ** | **and Benefits**   | ** ** | **Facilities** | ** ** | **Impairments** | ** ** | **Costs** | ** ** | **Total**  | ** ** |
| ** **                            | ** ** | **(in thousands)** | ** ** |
| Balance as of  December 31, 2007 |       | $                       | 12,041     |           | $          | 16,124          |       | $         | —     |       | $          | — |   | $ | 28,165 |   |
| Accruals                              |       | 367                     |       | —         |       | 286             |       | 440       |       | 1,093      |       |
| Payments                              |       | (11,462                 | )          | (1,179         | )          | —          |       | (185      | )          | (12,826    | )          |
| Non-cash charges                      |       | —                  |       | —         |       | (286            | )          | —    |       | (286       | )          |
| Balance as of  March 31, 2008    |       | $                       | 946        |           | $          | 14,945          |       | $         | —     |       | $          | 255 |   | $ | 16,146 |   |

 

*LegacyPlans*. As of March 31, 2008, we had $2.4 millionremaining for real estate commitments associated with the Legacy Plans. Allother costs have been paid or otherwise settled. We expect to incur future cashoutflows for real estate obligations through 2010 related to the Legacy Plans.

 

**Liquidityand Capital Resources**

 

The following table sets forthsummarized cash flow data for the three months ended March 31, 2007 and2008:

 
| ** **                                           | ** ** | **Three Months Ended March 31,** | ** ** |
|------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                           | ** ** | **2007**                                             | ** ** | **2008** | ** ** |
| ** **                                           | ** ** | **(in thousands)**                              | ** ** |
|                                                 |       |                                                 |       |   |   |
| Net income  (loss)                                   |       | $                                                    | (29,962    | ) | $ | 54,364 |   |
| Non-cash items                                       |       | 50,450                                               |       | 25,260 |   |
| Changes in  working capital                          |       | (21,881                                              | )          | (37,891 | ) |
| Net cash (used  in) provided by operating activities |       | $                                                    | (1,393     | ) | $ | 41,733 |   |
|                                                 |       |                                                 |       |   |   |
| Net cash (used  in) provided by investing activities |       | $                                                    | (51,015    | ) | $ | 32,724 |   |
|                                                 |       |                                                 |       |   |   |
| Net cash  provided by (used in) financing activities |       | $                                                    | 2,763      |   | $ | (7,327 | ) |

 

*Operating activities*

 

Net cash provided byoperating activities increased during the three months ended March 31,2008 compared to the prior year period primarily due to a decrease in operatingcosts and expenses as we realized benefits from our 2007 corporaterestructuring plan and a decrease in costs to acquire and support newcustomers. In addition, cash provided by operating activities was negativelyimpacted during the three months ended March 31, 2007 due to spending forour prior growth initiatives.

 

Non-cash items includeitems that are not expected to generate or require the use of cash, such asdepreciation and amortization relating to our network, facilities andintangible assets, net losses of equity affiliate, deferred income taxes,stock-based compensation, non-cash disposals and impairments of fixed assetsand gain (loss) on investments in other companies, net. Non-cash itemsdecreased during the three months ended March 31, 2008 compared to theprior year period due to decreases in net losses of equity affiliate,stock-based compensation expense and depreciation expense. These decreases wereoffset by an increase in deferred income taxes.

 

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Changes in workingcapital requirements include changes in accounts receivable, prepaid and otherassets, accounts payable, accrued and other liabilities and deferred revenue.Cash used for working capital requirements increased during the three months endedMarch 31, 2008 compared to the prior year period primarily due to cashpayments resulting of our 2007 corporate restructuring plan.

 

*Investing activities*

 

Our investing activities used cashof $51.0 million during the three months ended March 31, 2007. Thisconsisted primarily of $22.2 million of purchases of investments in marketablesecurities, net of sales and maturities, our $13.5 million scheduledcontribution to HELIO and $13.3 million of capital expenditures, primarilyassociated with network and technology center related projects. Ourinvesting activities provided cash of $32.7 million during the three monthsended March 31, 2008, which consisted primarily of sales and maturities ofinvestments in marketable securities, net of purchases.

 

*Financing activities*

 

Our financing activities providedcash of $2.8 million during the three months ended March 31, 2007, whichprimarily consisted of proceeds from the exercise of stock options. Ourfinancing activities used cash of $7.3 million during the three months ended March 31,2008. This consisted primarily of $9.1 million used to repurchase 1.3 millionshares of our common stock, offset by $1.9 million of proceeds from theexercise of stock options

 

**Off-Balance Sheet Arrangements**

 

As of March 31, 2008, we didnot have any off-balance sheet arrangements that have or are reasonably likelyto have a current or future effect on our financial condition, changes infinancial condition, revenues or expenses, results of operations, liquidity,capital expenditures or capital resources that are material to investors.

 

**Share RepurchaseProgram**

 

The Board of Directorshas authorized a total of $750.0 million to repurchase our common stock underour share repurchase program. As of March 31, 2008, we had utilized approximately$558.2 million pursuant to the authorizations and had $191.8 million availableunder the current authorization. We may repurchase our common stock from timeto time in compliance with the Securities and Exchange Commission’s regulationsand other legal requirements, and subject to market conditions and otherfactors. The share repurchase program does not require us to acquire anyspecific number of shares and may be terminated by the Board of Directors atany time.

 

**Income Taxes**

 

We continue to maintain a fullvaluation allowance against our deferred tax assets of approximately $406.9million, consisting primarily of net operating loss carryforwards. We mayrecognize deferred tax assets in future periods when they are determined to berealizable. To the extent we may owe income taxes in future periods, we intendto use our net operating loss carryforwards to the extent available to reducecash outflows for income taxes.

 

**Future Uses ofCash and Funding Sources**

 

We expect to use andinvest cash during the year ending December 31, 2008 for a number ofreasons. We expect to continue to use cash to acquire and retain new andexisting subscribers for our services, including purchases of subscriber basesfrom other ISPs. We will also use cash to pay the remaining severance andrelated benefits to employees terminated in connection with our restructuringplan and to pay real estate obligations associated with facilities exited inour restructuring plan. We may also incur costs to exit our municipal wirelessbroadband operations. We also expect to incur capital expenditures to maintainand upgrade our network and 

 

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technologyinfrastructure. The actual amount of capital expenditures may fluctuate due toa number of factors which are difficult to predict and could changesignificantly over time. Additionally, technological advances may require us tomake capital expenditures to develop or acquire new equipment or technology inorder to replace aging or technologically obsolete equipment. Finally, we mayalso use cash to repurchase common stock under our existing share repurchaseprogram.

 

Our cash requirementsdepend on numerous factors, including the pricing of our access services ourability to maintain our customer base, the costs required to maintain ournetwork infrastructure, the size and types of acquisitions in which we mayengage and the level of resources used for our sales and marketing activities,among others.

 

Our principal sources ofliquidity are our cash, cash equivalents and investments in marketablesecurities, as well as the cash flow we generate from our operations. As of March 31,2008, we had $240.9 million in cash and cash equivalents. In addition, we heldshort- and long-term investments in marketable securities valued at $7.1million and $72.0 million, respectively. Short-term investments in marketablesecurities consist of investments that have maturity dates of up to one yearfrom the balance sheet date, and long-term investments in marketable securitiesconsist of investments that have maturity dates of more than one year from thebalance sheet date.

 

As of March 31,2008, $55.1 million of our long-term investments in marketable securities wereauction rate securities. These securities are variable-rate debt instrumentswhose underlying agreements have contractual maturities of up to 40 years. Thesecurities are issued by various state related higher education agencies. Thehigher education securities are secured by student loans guaranteed by theagencies and reinsured by the United States Department of Education. Liquidityfor these auction rate securities is typically provided by an auction processthat resets the applicable interest rate at pre-determined intervals, usuallyevery 28 days. During the three months ended March 31, 2008, all of ourauction rate securities failed to attract sufficient buyers, resulting in ourcontinuing to hold such securities. We may not be able to access these fundsuntil a successful auction occurs or until the final maturity of the underlyingnotes. In addition, while all of our auction rate securities are currentlyrated AAA, if the auctions continue to fail or if the credit ratings on thesecurities deteriorate, we may in the future be required to record another-than-temporary impairment charge on these investments. Based on ourremaining cash and marketable securities and operating cash flows, we do notanticipate the current lack of liquidity on these investments will affect ourability to operate our business as usual.

 

As of March 31, 2008, our investmentsin other companies included 6.1 million shares of Covad common stock and $50.6million aggregate principal amount of 12% Senior Secured Convertible Notes due2011 (the “Covad Notes”), which includes accrued and unpaid interest. In April 2008,Platinum Equity, LLC completed a transaction in which all outstanding shares ofCovad were acquired. As a result, in April 2008, we received cash of $50.8million for the aggregate principal amount of the Covad Notes held by us plusaccrued interest. We expect to receive cash of $6.3 million for the 6.1 millionshares of common stock in May 2008.

 

Our available cash andmarketable securities, together with our results of operations, are expected tobe sufficient to meet our operating expenses, capital requirements andinvestment and other obligations for the next 12 months. However, as a resultof other investment activities and possible acquisition opportunities, we mayseek additional financing in the future. We have no commitments for anyadditional financing and have no lines of credit or similar sources offinancing. We cannot be sure that we can obtain additional financing onfavorable terms, if at all, through the issuance of equity securities or the incurrenceof additional debt. Additional equity financing may dilute our stockholders,and debt financing, if available, may restrict our ability to repurchase commonstock, declare and pay dividends and raise future capital. If we are unable toobtain additional needed financing, it may prohibit us from makingacquisitions, capital expenditures and/or investments, which could materiallyand adversely affect our prospects for long-term growth.

 

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**Related Party Transactions**

 

*HELIO*

 

EarthLink and HELIO haveentered into a services agreement pursuant to which we provide HELIO billingand other support services in exchange for management fees. The management feeswere determined based on our costs to provide the services, and managementbelieves such fees are reasonable.  Thetotal amount of fees that HELIO pays to us depends on the extent to which HELIOutilizes our services.  Fees for servicesprovided to HELIO are reflected as reductions to the associated expensesincurred by us to provide such services. During the three months ended March 31,2007 and 2008, fees received for services provided to HELIO were $0.5 millionand $0.4 million, respectively.

 

We purchase wirelessInternet access devices and services from HELIO. During the three months ended March 31,2007 and 2008, fees paid for products and services received from HELIO were$0.2 million and $0.1 million, respectively.

 

As of December 31,2007 and March 31, 2008, we had accounts receivable from HELIO of approximately$0.2 million and $0.1 million, respectively.

 

**Safe Harbor Statement**

 

TheManagement’s Discussion and Analysis and other portions of this QuarterlyReport on Form   10-Q include “forward-looking”statements (rather than historical facts) that are subject to risks anduncertainties that could cause actual results to differ materially from thosedescribed. Although we believe that the expectations expressed in theseforward-looking statements are reasonable, we cannot promise that ourexpectations will turn out to be correct. Our actual results could bematerially different from and worse than our expectations. With respect to suchforward-looking statements, we seek the protections afforded by the PrivateSecurities Litigation Reform Act of 1995. These risks include, withoutlimitation, (1) that changes to our business strategy will reduce ourrevenues; (2) that the continued decline of our consumer access servicesrevenues could adversely affect our profitability; (3) that prices forcertain of our consumer access services have been decreasing, which couldadversely affect our revenues and profitability; (4) that our corporaterestructuring plan announced in August 2007 might have a negative effecton our efforts to maintain our subscribers and our relationships with ourbusiness partners; (5) that as a result of our continuing review of ourbusiness, we may have to undertake further restructuring plans that wouldrequire additional charges including incurring facility exit and restructuringcharges; (6) that we face significant competition which could reduce ourmarket share and reduce our profitability; (7) that we may be unsuccessfulin making and integrating acquisitions and investments into our business, whichcould result in operating difficulties, losses and other adverse consequences; (8) thatwe may not be able to successfully manage the costs associated with deliveringour broadband services, which could adversely affect our results of operations;(9) that companies may not provide access to us on a wholesale basis or onreasonable terms or prices, which could cause our operating results to suffer; (10) thatif we do not continue to innovate and provide products and services that areuseful to subscribers, we may not remain competitive, and our revenues andoperating results could suffer; (11) that our commercial and alliancearrangements may be terminated or may not be as beneficial as anticipated,which could adversely affect our ability to retain or increase our subscriberbase; (12) that our business may suffer if third parties used for technical andcustomer support and certain billing services are unable to provide theseservices, cannot expand to meet our needs or terminate their relationships withus; (13) that service interruptions or impediments could harm our business;(14) that government regulations could adversely affect our business or forceus to change our business practices; (15) that we may not be able to protectour proprietary technologies; (16) that we may be accused of infringing uponthe intellectual property rights of third parties, which is costly to defendand could limit our ability to use certain technologies in the future; (17)that we could face substantial liabilities if we are unable to successfullydefend against legal actions; (18) that our business depends on the continueddevelopment of effective business support systems, processes and personnel;(19) that we may be unable to hire and retain sufficient qualified personnel,and the loss of any of our key executive officers could adversely affect us;(20) that our VoIP business exposes us to certain risks that could cause us tolose customers, expose us to significant liability or otherwise harm ourbusiness; (21) that we may incur additional losses related to our municipalwireless broadband operations; (22) 

 

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that we may not realizethe benefits we sought from our investments in the HELIO joint venture; (23)that the use of our net operating losses and certain other tax attributes couldbe limited in the future; (24) that our stock price has been volatilehistorically and may continue to be volatile; (25) that our indebtedness couldadversely affect our financial health and limit our ability to react to changesin our industry; (26) that the convertible notes hedge and warrant transactionsmay affect the value of our common stock; and (27) that provisions of oursecond restated certificate of incorporation, amended and restated bylaws andother elements of our capital structure could limit our share price and delay achange of management. Theserisks and uncertainties, as well as other risks and uncertainties that couldcause our actual results to differ significantly from management’sexpectations, are not intended to represent a complete list of all risks anduncertainties inherent in our business, and should be read in conjunction withthe more detailed cautionary statements and risk factors included in our Annual Report on Form 10-K for the yearended December 31, 2007.

 

**Item 3.   Quantitative andQualitative Disclosures About Market Risk.**

 

There have been no material changes in market riskfrom the information provided in Part II, Item 7A “Quantitative andQualitative Disclosures About Market Risk” in our Annual Report on Form 10-Kfor the year ended December 31, 2007, other than those discussed below.

 

*Auction Rate Securities*

 

The Company is exposed torisk with respect to its auction rate securities. These securities arevariable-rate debt instruments whose underlying agreements have contractualmaturities of up to 40 years. These securities are issued by various stateregulated higher education agencies. The securities are predominantly securedby student loans guaranteed by the agencies and reinsured by the United StatesDepartment of Education. Liquidity for these auction rate securities istypically provided by an auction process that resets the applicable interestrate at pre-determined intervals, usually every 28 days. During the threemonths ended March 31, 2008, the Company’s auction rate securities failedto attract sufficient buyers, resulting in our continuing to hold suchsecurities. The Company may not be able to access these funds until asuccessful auction occurs or until the final maturity of the underlying notes.

 

Due tothe lack of availability of observable market quotes, the fair values of theCompany’s auction rate securities were estimated utilizing a discounted cashflow analysis as of March 31, 2008.  These analyses consider,among other items, the collateralization underlying the security investments,the creditworthiness of the counterparty and the timing and value of expectedfuture cash flows.  As a result of temporary declines in the fairvalue of the Company’s auction rate securities, which the Company attributes toliquidity issues rather than credit issues, it has recorded an unrealized lossof $2.7 million as of March 31, 2008 to reduce the cost basis of $57.8million to the estimated fair value of $55.1 million. The Company will continueto evaluate the fair value of its investments in auction rate securities eachreporting period for a potential other-than-temporary impairment. While all ofthe Company’s auction rate securities are currently rated AAA, if the marketdoes not recover or if the credit ratings on the securities deteriorate, it mayin the future be required to record an other-than-temporary impairment chargeon these investments.

 

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**Item4. Controls and Procedures.**

 

**Evaluation of Disclosure Controlsand Procedures**

 

Pursuant to Rule 13a-15(b) underthe Securities Exchange Act of 1934, as amended (the “Exchange Act”), wecarried out an evaluation, with the participation of our management, includingour Chief Executive Officer and Chief Financial Officer, of the effectivenessof our disclosure controls and procedures (as defined under Rule 13a-15(e) underthe Exchange Act) as of the end of the period covered by this report.  Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures are effective to ensure that information required to bedisclosed in the reports that are filed or submitted under the Exchange Act, isrecorded, processed, summarized and reported, within the time periods specifiedin the Securities and Exchange Commission’s rules and forms, and that suchinformation is accumulated and communicated to management, including our ChiefExecutive Officer and Chief Financial Officer, as appropriate, to allow timelydecisions regarding required disclosure.

 

**Changes in Internal Control overFinancial Reporting**

 

There were no changes inour internal control over financial reporting during the three months ended March 31,2008 that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

**Part II**

 

**Item 1.  Legal Proceedings.**

 

EarthLink is a party tovarious legal proceedings that are ordinary and incidental to its business.Management does not expect that any currently pending legal proceedings willhave a material adverse effect on EarthLink’s results of operations orfinancial position.

 

**Item 1A.  Risk Factors.**

 

Therewere no material changes from the risk factors disclosed in EarthLink’s AnnualReport on Form 10-K for the year ended December 31, 2007.

 

**Item 2.  ****Unregistered Sales of Equity Securities and Use ofProceeds****.**

 

The number of shares repurchasedand the average price paid per share for each month in the three months ended March 31,2008 are as follows:

 
| ** **                                | ** ** | ** **                                                                                 | ** ** | ** **          | ** ** | **Total Number of**          | ** ** | **Maximum Dollar**         | ** ** |
|-------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|---------------------|------------|----------------------------------------|------------|---------------------------------|------------|
| ** **                                | ** ** | **Total Number**                                                                      | ** ** | **Average**         | ** ** | **Shares Repurchased**            | ** ** | **Value that May**    | ** ** |
| ** **                                | ** ** | **of Shares**                                                                         | ** ** | **Price Paid** | ** ** | **as Part of Publicly** | ** ** | **Yet be Purchased**  | ** ** |
| **2008**                                  | ** ** | **Repurchased**                                                                            | ** ** | **per Share**  | ** ** | **Announced Program (1)**    | ** ** | **Under the Program** | ** ** |
| ** **                                | ** ** | **(in thousands, except average price paid per share)** | ** ** |
| January 1  through January 31   |       | 1,285                                                                                      |       | $                   | 7.10       |                                   | 1,285      |                            | $          | 191,839 |   |
| February 1  through February 29 |       | —                                                                                     |       | —              |       | —                                 |       | 191,839                         |       |
| March 1  through March 31       |       | —                                                                                     |       | —              |       | —                                 |       | 191,839                         |       |
| Total                                     |       | 1,285                                                                                      |       |                |       | 1,285                                  |       |                            |       |
|                                           |            |                                                                                            |            |                     |            |                                        |            |                                 |            |  |  |

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(1)  Sincethe inception of the share repurchase program (“Repurchase Program”), the Boardof Directors has authorized a total of $750.0 million for the repurchase of ourcommon stock. The Board of Directors has also approved repurchasing commonstock pursuant to plans under Rule 10b5-1 of the Securities Exchange Actof 1934, as amended. We may repurchase our common stock 

 

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from time to time in compliancewith the Securities and Exchange Commission’s regulations and other legalrequirements, including through the use of derivative transactions, and subjectto market conditions and other factors. The Repurchase Program does not requireEarthLink to acquire any specific number of shares and may be terminated at anytime.

 

**Item 5.  Other Information.**

 

None.

 

**Item 6.   Exhibits.**

 

(a)          Exhibits.   The following exhibits are filed as part ofthis report**:**

 

31.1    Certification of Chief Executive Officer pursuantto Securities Exchange Act Rules 13a-14 and 15d-14, as adopted pursuant toSection 302 of the Sarbanes-Oxley Act of 2002.

 

31.2    Certification of Chief Financial Officer pursuantto Securities Exchange Act Rules 13a-14 and 15d-14, as adopted pursuant toSection 302 of the Sarbanes-Oxley Act of 2002.

 

32.1    Certification of Chief Executive Officer pursuantto 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002.

 

32.2    Certification of Chief Financial Officer pursuantto 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002.

 

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#### **SIGNATURES**

#### ** **

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|   |                                                        |   | EARTHLINK, INC.                                                                                   |
|--------|-------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------|
|   |                                                        |   |                                                                                              |
|   |                                                        |   |                                                                                              |
| Date:  |        May 2,  2008 |   | /s/ ROLLA P. HUFF                                                                                 |
|   |                                                        |   | Rolla P. Huff, Chairman of the Board and  Chief   Executive Officer (principal executive officer) |
|   |                                                        |   |                                                                                              |
|   |                                                        |   |                                                                                              |
| Date:  |        May 2,  2008 |   | /s/ KEVIN M. DOTTS                                                                                |
|   |                                                        |   | Kevin M. Dotts, Chief Financial Officer                                                           |
|   |                                                        |   | (principal financial and accounting  officer)                                                     |

 

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