Tableof Contents

 

 

 

**UNITED STATES SECURITIES ANDEXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**x****     ****QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

 

**For the quarterly periodended March 31, 2010**

 

**OR**

 

**o****        ****TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

 

**For the transitionperiod from            to          .**

 

**Commission File Number: 001-15605**

 

**EARTHLINK, INC.**

(Exact name of registrant asspecified 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 andformer fiscal year, if changed since last report date)

 

----

 

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

 

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

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer or a smaller reporting company. Seethe definitions of “large accelerated filer,” “accelerated filer” and “smallerreporting company” in Rule 12b-2 of the Exchange Act.

 

| Large accelerated filer x |   | Accelerated filer o         |
|---------------------------|--------|-----------------------------|
|                      |   |                        |
| Non-accelerated filer o   |   | Smaller reporting company o |

 

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

 

As of April 27, 2010, 107,918,177 shares of common stock, $.01 parvalue per share, were outstanding.

 

 

 

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**EARTHLINK, INC.**

**Quarterly Report on Form 10-Q**

**For the Quarterly Period Ended March 31,2010**

** **

**TABLE OFCONTENTS**

 
| **Part I**                                                                                     |
|-----------------------------------------------------------------------------------------------------|
|                                                                                                |   |   |
| Item  1. Financial Statements                                                                       |   | 1 |
|                                                                                                |   |   |
| Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations |   | 20 |
|                                                                                                |   |   |
| Item 3. Quantitative and Qualitative Disclosures About  Market Risk                                 |   | 37 |
|                                                                                                |   |   |
| Item 4. Controls and Procedures                                                                     |   | 37 |
|                                                                                                |   |   |
| **Part II**                                                                                    |
|                                                                                                |   |   |
| Item  1. Legal Proceedings                                                                          |   | 38 |
|                                                                                                |   |   |
| Item  1A. Risk Factors                                                                              |   | 38 |
|                                                                                                |   |   |
| Item  5. Other Information                                                                          |   | 38 |
|                                                                                                |   |   |
| Item 6.  Exhibits                                                                                   |   | 38 |
|                                                                                                |   |   |
| Signatures                                                                                          |   | 39 |

 

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**PART I**

 

**Item 1.  Financial Statements.**

 

**EARTHLINK, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

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

 
| ** **                                                                                                                                                                                                                                                                        | ** ** | **December 31,** | ** ** | **March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|--------------------|------------|
| ** **                                                                                                                                                                                                                                                                        | ** ** | **2009**              | ** ** | **2010**           | ** ** |
| ** **                                                                                                                                                                                                                                                                        | ** ** | ** **            | ** ** | **(unaudited)**    | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                        | ** ** |
| Current  assets:                                                                                                                                                                                                                                                                  |       |                  |       |               |       |
| Cash  and cash equivalents                                                                                                                                                                                                                                                        |       | $                     | 610,995    |               | $          | 629,119 |   |
| Accounts  receivable, net of allowance of $1,736 and $1,359 as of December 31,  2009 and March 31, 2010, respectively                                                                                                                                                   |       | 20,560                |       | 20,561             |       |
| Marketable  securities                                                                                                                                                                                                                                                            |       | 84,966                |       | 78,658             |       |
| Prepaid  expenses                                                                                                                                                                                                                                                                 |       | 4,374                 |       | 4,785              |       |
| Deferred  income taxes, net                                                                                                                                                                                                                                                       |       | 46,063                |       | 38,329             |       |
| Other  current assets                                                                                                                                                                                                                                                             |       | 16,423                |       | 15,837             |       |
| Total  current assets                                                                                                                                                                                                                                                             |       | 783,381               |       | 787,289            |       |
| Property  and equipment, net                                                                                                                                                                                                                                                      |       | 34,267                |       | 32,601             |       |
| Deferred  income taxes, net                                                                                                                                                                                                                                                       |       | 153,132               |       | 145,552            |       |
| Purchased  intangible assets, net                                                                                                                                                                                                                                                 |       | 11,550                |       | 10,286             |       |
| Goodwill                                                                                                                                                                                                                                                                          |       | 88,920                |       | 88,920             |       |
| Other  long-term assets                                                                                                                                                                                                                                                           |       | 3,368                 |       | 3,270              |       |
| Total  assets                                                                                                                                                                                                                                                                     |       | $                     | 1,074,618  |               | $          | 1,067,918 |   |
|                                                                                                                                                                                                                                                                              |       |                  |       |               |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                                     | ** ** |
| Current  liabilities:                                                                                                                                                                                                                                                             |       |                  |       |               |       |
| Accounts  payable                                                                                                                                                                                                                                                                 |       | $                     | 6,270      |               | $          | 7,137 |   |
| Accrued  payroll and related expenses                                                                                                                                                                                                                                             |       | 25,093                |       | 9,179              |       |
| Other  accrued liabilities                                                                                                                                                                                                                                                        |       | 34,659                |       | 32,413             |       |
| Deferred  revenue                                                                                                                                                                                                                                                                 |       | 25,728                |       | 24,510             |       |
| Convertible  senior notes, net of discount of $26,502 and $22,948 as of December 31,  2009 and March 31, 2010, respectively                                                                                                                                             |       | 232,248               |       | 232,843            |       |
| Total  current liabilities                                                                                                                                                                                                                                                        |       | 323,998               |       | 306,082            |       |
|                                                                                                                                                                                                                                                                              |       |                  |       |               |       |
| Other  long-term liabilities                                                                                                                                                                                                                                                      |       | 16,596                |       | 16,595             |       |
| Total  liabilities                                                                                                                                                                                                                                                                |       | 340,594               |       | 322,677            |       |
|                                                                                                                                                                                                                                                                              |       |                  |       |               |       |
| Stockholders’  equity:                                                                                                                                                                                                                                                       |       |                  |       |               |       |
| Convertible  preferred stock, $0.01 par value, 100,000 shares authorized, 0 shares issued  and outstanding as of December 31, 2009 and March 31, 2010                                                                                                                   |       | —                |       | —             |       |
| Common  stock, $0.01 par value, 300,000 shares authorized, 190,472 and 191,237 shares  issued as of December 31, 2009 and March 31, 2010, respectively, and  107,132 and 107,897 shares outstanding as of December 31, 2009 and March 31,  2010, respectively |       | 1,905                 |       | 1,912              |       |
| Additional  paid-in capital                                                                                                                                                                                                                                                       |       | 2,118,100             |       | 2,103,045          |       |
| Accumulated  deficit                                                                                                                                                                                                                                                              |       | (729,715              | )          | (702,968           | )          |
| Treasury  stock, at cost, 83,340 shares as of December 31, 2009 and March 31,  2010                                                                                                                                                                                     |       | (656,760              | )          | (656,760           | )          |
| Accumulated  other comprehensive income                                                                                                                                                                                                                                           |       | 494                   |       | 12                 |       |
| Total  stockholders’ equity                                                                                                                                                                                                                                                  |       | 734,024               |       | 745,241            |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                                                                                                  |       | $                     | 1,074,618  |               | $          | 1,067,918 |   |

 

The accompanying notes are anintegral part of these financial statements.

 

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**EARTHLINK, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                                  | ** ** | **Three Months Ended March 31,**     | ** ** |
|---------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                  | ** ** | **2009**                                  | ** ** | **2010** | ** ** |
| ** **                                  | ** ** | **(in thousands, except per share data)** | ** ** |
|                                        |       | **(unaudited)**                           |       |
|                                        |       |                                      |       |   |   |
| Revenues                                    |       | $                                         | 199,063    |   | $ | 157,258 |   |
|                                        |       |                                      |       |   |   |
| Operating  costs and expenses:              |       |                                      |       |   |   |
| Cost  of revenues                           |       | 75,565                                    |       | 60,814 |   |
| Sales  and marketing                        |       | 17,022                                    |       | 11,301 |   |
| Operations  and customer support            |       | 27,746                                    |       | 19,657 |   |
| General  and administrative                 |       | 18,622                                    |       | 14,374 |   |
| Amortization  of intangible assets          |       | 2,147                                     |       | 1,264 |   |
| Facility  exit and restructuring costs      |       | 488                                       |       | 1,435 |   |
| Total  operating costs and expenses         |       | 141,590                                   |       | 108,845 |   |
|                                        |       |                                      |       |   |   |
| Income  from operations                     |       | 57,473                                    |       | 48,413 |   |
| Gain  on investments, net                   |       | 259                                       |       | 418 |   |
| Interest  expense and other, net            |       | (4,291                                    | )          | (5,292 | ) |
| Income  before income taxes                 |       | 53,441                                    |       | 43,539 |   |
| Income  tax provision                       |       | (20,944                                   | )          | (16,792 | ) |
| Net  income                                 |       | $                                         | 32,497     |   | $ | 26,747 |   |
|                                        |       |                                      |       |   |   |
| Net  income per share                       |       |                                      |       |   |   |
| Basic                                       |       | $                                         | 0.30       |   | $ | 0.25 |   |
| Diluted                                     |       | $                                         | 0.30       |   | $ | 0.25 |   |
|                                        |       |                                      |       |   |   |
| Weighted  average common shares outstanding |       |                                      |       |   |   |
| Basic                                       |       | 108,071                                   |       | 107,623 |   |
| Diluted                                     |       | 109,168                                   |       | 108,478 |   |
|                                        |       |                                      |       |   |   |
| Dividends  declared per share               |       | $                                         | —     |   | $ | 0.14 |   |

 

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

 

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**EARTHLINK, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASHFLOWS**

 
| ** **                                                                         | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                         | ** ** | **March 31,**     | ** ** |
| ** **                                                                         | ** ** | **2009**               | ** ** | **2010** | ** ** |
| ** **                                                                         | ** ** | **(in thousands)**     | ** ** |
| ** **                                                                         | ** ** | **(unaudited)**        | ** ** |
| Cash  flows from operating activities:                                             |       |                   |       |   |   |
| Net  income                                                                        |       | $                      | 32,497     |   | $ | 26,747 |   |
| Adjustments  to reconcile net income to net cash provided by operating activities: |       |                   |       |   |   |
| Depreciation  and amortization                                                     |       | 6,509                  |       | 4,748 |   |
| Loss  on disposals and impairments of fixed assets                                 |       | 61                     |       | 187 |   |
| Stock-based  compensation                                                          |       | 4,390                  |       | 2,667 |   |
| Non-cash  income taxes                                                             |       | 18,512                 |       | 15,604 |   |
| Accretion  of debt discount and amortization of debt issuance costs                |       | 3,301                  |       | 3,553 |   |
| Gain  on investments, net                                                          |       | (259                   | )          | (418 | ) |
| Gain  on debt surrendered for conversion                                           |       | —                 |       | (172 | ) |
| Decrease  (increase) in accounts receivable, net                                   |       | 5,617                  |       | (1 | ) |
| Decrease  (increase) in prepaid expenses and other assets                          |       | 3,789                  |       | (718 | ) |
| Decrease  in accounts payable and accrued and other liabilities                    |       | (17,884                | )          | (18,834 | ) |
| Decrease  in deferred revenue                                                      |       | (2,609                 | )          | (1,093 | ) |
| Net  cash provided by operating activities                                         |       | 53,924                 |       | 32,270 |   |
|                                                                               |       |                   |       |   |   |
| Cash  flows from investing activities:                                             |       |                   |       |   |   |
| Purchases  of property and equipment                                               |       | (3,133                 | )          | (3,072 | ) |
| Purchases  of marketable securities                                                |       | (44,075                | )          | (19,958 | ) |
| Sales  and maturities of marketable securities                                     |       | —                 |       | 26,167 |   |
| Proceeds  received from investments in other companies                             |       | —                 |       | 541 |   |
| Other  investing activities                                                        |       | 200                    |       | — |   |
| Net  cash (used in) provided by investing activities                               |       | (47,008                | )          | 3,678 |   |
|                                                                               |       |                   |       |   |   |
| Cash  flows from financing activities:                                             |       |                   |       |   |   |
| Principal  payments under capital lease obligations                                |       | (8                     | )          | (8 | ) |
| Proceeds  from exercises of stock options                                          |       | 378                    |       | 341 |   |
| Repurchases  of common stock                                                       |       | (22,340                | )          | — |   |
| Payment  of dividends                                                              |       | —                 |       | (15,389 | ) |
| Payment  for debt surrendered for conversion                                       |       | —                 |       | (2,768 | ) |
| Net  cash used in financing activities                                             |       | (21,970                | )          | (17,824 | ) |
|                                                                               |       |                   |       |   |   |
| Net  (decrease) increase in cash and cash equivalents                              |       | (15,054                | )          | 18,124 |   |
| Cash  and cash equivalents, beginning of period                                    |       | 486,564                |       | 610,995 |   |
| Cash  and cash equivalents, end of period                                          |       | $                      | 471,510    |   | $ | 629,119 |   |

 

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

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED**

 

**1.  Organization**

 

EarthLink, Inc.(“EarthLink” or the “Company”) is an Internet service provider (“ISP”),providing nationwide Internet access and related value-added services toindividual and business customers. The Company’s primary service offerings aredial-up and high-speed Internet access services and related value-addedservices, such as ancillary services sold as add-on features to the Company’sInternet access services, search and advertising. In addition, through theCompany’s wholly-owned subsidiary, New Edge Networks (“New Edge”), the Companybuilds and manages IP-based wide area networks for businesses andcommunications carriers.

 

TheCompany operates two reportable segments, Consumer Services and BusinessServices. The Company’s Consumer Services segment provides Internet access andrelated value-added services to individual customers. These services includedial-up and high-speed Internet access and voice-over-Internet protocol (“VoIP”)services, among others. The Company’s Business Services segment providesintegrated communications services and related value-added services tobusinesses and communications carriers. These services include managed IP-basedwide area networks, dedicated Internet access and web hosting, among others.For further information concerning the Company’s business segments, see Note12, “Segment Information.”

 

**2. ****Summaryof Significant Accounting Policies**

 

*Basis ofPresentation*

 

Thecondensed consolidated financial statements of EarthLink, which include theaccounts of its wholly-owned subsidiaries, for the three months ended March 31,2009 and 2010 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, 2009 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.

 

Thesefinancial statements should be read in conjunction with the auditedconsolidated financial statements and the related notes thereto contained inthe Company’s Annual Report.  In theopinion of management, the accompanying unaudited financial statements containall adjustments (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, 2010 are not necessarily indicative of the resultsanticipated for the entire year ending December 31, 2010.

 

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.

 

*Fair Value ofFinancial Instruments*

 

Thecarrying amounts of the Company’s cash, cash equivalents, trade receivables andtrade payables approximate their fair values because of their nature andrespective durations. The Company’s short-term marketable securities consist ofavailable-for-sale and trading securities that are carried at fair value. TheCompany’s equity investments in publicly-held companies are stated at fairvalue, which is based on quoted market prices, with unrealized gains and lossesincluded in stockholders’ equity. The Company’s investments in privately-heldcompanies are stated at cost, net of other-than-temporary impairments, becauseit is impracticable to estimate fair value.

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

*Recently Issued Accounting Pronouncement*

 

In September 2009,the Financial Accounting Standards Board issued new guidance on revenuerecognition. The new guidance addresses the accounting for multiple-deliverablearrangements to enable vendors to account for products or services(deliverables) separately rather than as a combined unit and to modify themanner in which the transaction consideration is allocated across theseparately identifiable deliverables and how revenue is recognized. The newguidance also significantly expands the disclosure requirements formultiple-element arrangements. The new guidance is effective prospectively forrevenue arrangements entered into or materially modified in fiscal years beginningon or after June 15, 2010. The Company does not expect the adoption of thenew guidance to have a material impact on its financial statements.

 

**3.  Earnings per Share**

 

TheCompany presents a dual presentation of basic and diluted earnings per share.Basic earnings per share represents net income divided by the weighted averagenumber of common shares outstanding during the reported period. Dilutedearnings per share reflects the potential dilution that could occur ifsecurities or other contracts to issue common stock, including stock options,restricted stock units, phantom share units and convertible debt (collectively “CommonStock Equivalents”), were exercised or converted into common stock. Thedilutive effect of outstanding stock options, restricted stock units andconvertible debt is reflected in diluted earnings per share by application ofthe treasury stock method. Phantom share units are reflected on an if-convertedbasis. In applying the treasury stock method for stock-based compensationarrangements, the assumed proceeds are computed as the sum of the amount theemployee must pay upon exercise, the amount of compensation cost attributed tofuture services and not yet recognized and the amount of excess tax benefits,if any, that would be credited to additional paid-in capital assuming exerciseof the awards.

 

Thefollowing table sets forth the computation for basic and diluted net income pershare for the three months ended March 31, 2009 and 2010:

 
| ** **                                          | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                          | ** ** | **2009**                              | ** ** | **2010** | ** ** |
| ** **                                          | ** ** | **(in thousands,**                    | ** ** |
| ** **                                          | ** ** | **except per share data)**            | ** ** |
| **Numerator**                                       | ** ** | ** **                            | ** ** | ** ** | ** ** |
| Net  income                                         |       | $                                     | 32,497     |   | $ | 26,747 |   |
|                                                |       |                                  |       |   |   |
| **Denominator**                                     |       |                                  |       |   |   |
| Basic  weighted average common shares outstanding   |       | 108,071                               |       | 107,623 |   |
| Dilutive  effect of Common Stock Equivalents        |       | 1,097                                 |       | 855 |   |
| Diluted  weighted average common shares outstanding |       | 109,168                               |       | 108,478 |   |
|                                                |       |                                  |       |   |   |
| **Basic net income per share**                      |       | $                                     | 0.30       |   | $ | 0.25 |   |
| **Diluted net income per share**                    |       | $                                     | 0.30       |   | $ | 0.25 |   |

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

Duringthe three months ended March 31, 2009 and 2010, approximately 6.7 millionand 3.2 million, respectively, stock options and restricted stock units wereexcluded from the calculation of diluted earnings per share because theexercise prices plus the amount of unrecognized compensation costattributed to future services and the amount of excess tax benefits exceededthe Company’s average stock price during the respective periods. Approximately28.4 million shares and 29.5 million shares that underlie the Company’sconvertible debt instruments were also excluded from the calculation of dilutedearnings per share during the three months ended March 31, 2009 and 2010,respectively, because the exercise price exceeded the Company’s average stockprice during the periods. These securities could be dilutive in future periods.

 

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

 

In August 2007, EarthLinkadopted a restructuring plan (the “2007 Plan”) to reduce costs and improve theefficiency of the Company’s operations. The 2007 Plan was the result of acomprehensive review of operations within and across the Company’s functions andbusinesses. Under the 2007 Plan, the Company reduced its workforce byapproximately 900 employees, closed office facilities in Orlando, Florida;Knoxville, Tennessee; Harrisburg, Pennsylvania and San Francisco, Californiaand consolidated its office facilities in Atlanta, Georgia and Pasadena,California. The 2007 Plan was primarily implemented during the latter half of2007 and during the year ended December 31, 2008. However, sincemanagement continues to evaluate EarthLink’s businesses, there have been andmay continue to be supplemental provisions for new cost savings initiatives aswell as changes in estimates to amounts previously recorded. The Companyrecorded $0.5 million and $1.4 million of facility exit and restructuring costsduring the three months ended March 31, 2009 and 2010, respectively,primarily as a result of changes to sublease estimates in its exited facilitiesand further consolidation in its Atlanta, Georgia facility.

 

Thefollowing table summarizes facility exit and restructuring costs during thethree months ended March 31, 2009 and 2010 and the cumulative costsincurred to date as a result of the 2007 Plan. Such costs have been classifiedas facility exit and restructuring costs in the Condensed ConsolidatedStatements of Operations.

 
| ** **                                      | ** ** | ** **                            | ** ** | ** **   | ** ** | **Cumulative** | ** ** |
|-------------------------------------------------|------------|---------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                      | ** ** | ** **                            | ** ** | ** **   | ** ** | **Costs**      | ** ** |
| ** **                                      | ** ** | **Three Months Ended March 31,** | ** ** | **Incurred** | ** ** |
| ** **                                      | ** ** | **2009**                              | ** ** | **2010**     | ** ** | **To Date**    | ** ** |
| ** **                                      | ** ** | **(in thousands)**                    | ** ** |
|                                            |       |                                  |       |         |       |           |       |
| Severance  and personnel-related costs          |       | $                                     | —     |         | $          | —         |       | $ | 30,764 |   |
| Lease  termination and facilities-related costs |       | 488                                   |       | 1,326        |       | 24,047         |       |
| Non-cash  asset impairments                     |       | —                                |       | 109          |       | 24,901         |       |
| Other  associated costs                         |       | —                                |       | —       |       | 1,131          |       |
|                                            |       | $                                     | 488        |         | $          | 1,435          |       | $ | 80,843 |   |

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

Thefollowing table reconciles the beginning and ending liability balancesassociated with the 2007 Plan as of March 31, 2010, including changesduring the period attributable to costs incurred and charged to expense andcosts paid or otherwise settled:

 
| ** **                            | ** ** | ** **     | ** ** | **Asset**       | ** ** | ** ** | ** ** |
|---------------------------------------|------------|----------------|------------|-----------------|------------|------------|------------|
| ** **                            | ** ** | **Facilities** | ** ** | **Impairments** | ** ** | **Total**  | ** ** |
| ** **                            | ** ** | ** **     | ** ** | ** **      | ** ** | ** ** | ** ** |
| Balance  as of December 31, 2009 |       | $              | 17,438     |            | $          | —     |       | $ | 17,438 |   |
| Accruals                              |       | 1,326          |       | 109             |       | 1,435      |       |
| Payments                              |       | (1,027         | )          | —          |       | (1,027     | )          |
| Non-cash  charges                     |       | 368            |       | (109            | )          | 259        |       |
| Balance  as of March 31, 2010    |       | $              | 18,105     |            | $          | —     |       | $ | 18,105 |   |

 

Facilityexit and restructuring liabilities due within one year of the balance sheetdate are classified as other accrued liabilities and facility exit andrestructuring liabilities due after one year are classified as other long-termliabilities in the Condensed Consolidated Balance Sheets. Of the unpaid balanceas of December 31, 2009 and March 31, 2010, approximately $5.1million and $5.5 million, respectively, was classified as other accruedliabilities and approximately $12.3 million and $12.6 million, respectively,was classified as other long-term liabilities.

 

**5.  Investments**

 

*Marketable Securities*

 

TheCompany’s marketable securities consisted of the following as of December 31,2009 and March 31, 2010:

 
| ** **                   | ** ** | **As of**             | ** ** | **As of**          | ** ** |
|------------------------------|------------|-----------------------|------------|--------------------|------------|
| ** **                   | ** ** | **December 31,** | ** ** | **March 31,** | ** ** |
| ** **                   | ** ** | **2009**              | ** ** | **2010**           | ** ** |
| ** **                   | ** ** | **(in thousands)**    | ** ** |
| Auction  rate securities     |       | $                     | 42,906     |               | $          | 42,665 |   |
| Government  agency notes     |       | 42,060                |       | 35,993             |       |
| Total  marketable securities |       | $                     | 84,966     |               | $          | 78,658 |   |

 

The Company’s auction ratesecurities are variable-rate debt instruments whose underlying agreements havecontractual maturities of up to 40 years, but have interest rate reset periodsat pre-determined intervals, usually every 28 days. These securities arepredominantly secured by student loans guaranteed by state related highereducation agencies and reinsured by the U.S. Department of Education. Beginningin February 2008, auctions for these securities failed to attract sufficientbuyers, resulting in the Company continuing to hold such securities. In October 2008,EarthLink entered into an agreement with the broker that sold the Company itsauction rate securities that gives the Company the right to sell its existingauction rate securities back to the broker at par plus accrued interest,beginning on June 30, 2010 until July 2, 2012 (herein referred to as “putright”). The agreement also grants the broker the right to buy the Company’sauction rate securities at par plus accrued interest, until July 2, 2012.As a result of the put right, these securities were classified as short-termmarketable securities in the Condensed Consolidated Balance Sheets as of December 31,2009 and March 31, 2010. The Company’s auction rate securities areclassified as trading securities and are carried at fair value, with anyunrealized gains and losses included in gain on investments, net, in theCondensed Consolidated Statement of Operations. See Note 11, “Fair ValueMeasurements,” for a table that reconciles the beginning and ending balances ofthe auction rate securities.

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

TheCompany’s government agency notes consist of government-sponsored debtsecurities and are classified as available for sale. Available-for-salesecurities are carried at fair value, with any unrealized gains and losses, netof tax, included in accumulated other comprehensive income as a separatecomponent of stockholders’ equity and in total comprehensive income. Amountsreclassified out of accumulated other comprehensive income into earnings aredetermined on a specific identification basis. Realized gains and losses onmarketable securities are included in gain on investments, net, in theCondensed Consolidated Statements of Operations and are determined on aspecific identification basis.  Theamortized cost and aggregate fair value of the government agency notes was$42.1 million as of December 31, 2009. The amortized cost and aggregatefair value of the government agency notes was $36.0 million as of March 31,2010. Gross unrealized losses and gross unrealized gains as of December 31,2009 and March 31, 2010 were nominal. These securities were classified asshort-term marketable securities in the Condensed Consolidated Balance Sheet asof December 31, 2009 and March 31, 2010.

 

*Investments*

 

TheCompany’s investments as of December 31, 2009 and March 31, 2010consisted of equity investments in other companies and the Company’s put right.The Company’s equity investments in other companies had a carrying value andfair value of $1.5 million and $0.9 million, respectively, as of December 31,2009 and March 31, 2010 and were classified as other current assets in theCondensed Consolidated Balance Sheets. The Company’s put right had a carryingvalue and fair value of $5.2 million and $5.3 million, respectively, as of December 31,2009 and March 31, 2010 and was classified as other current assets in theCondensed Consolidated Balance Sheets.

 

Equityinvestments in other companies are accounted for under the cost method ofaccounting because the Company does not have the ability to exercisesignificant influence over the companies’ operations. Under the cost method ofaccounting, investments in private companies are carried at cost and are onlyadjusted for other-than-temporary declines in fair value and distributions ofearnings. For cost method investments in public companies that have readilydeterminable fair values, the Company classifies its investments asavailable-for-sale and, accordingly, records these investments at their fairvalues with unrealized gains and losses, net of tax, included as a separatecomponent of stockholders’ equity and in total comprehensive income. Upon saleor liquidation, realized gains and losses are included in the CondensedConsolidated Statement of Operations. Amounts reclassified out of accumulatedother comprehensive income into earnings are determined on a specificidentification basis. As of December 31, 2009, gross unrealized losseswere nominal and gross unrealized gains were $0.5 million. As of March 31,2010, gross unrealized losses and gross unrealized gains were nominal.

 

The Company has a put right to sellits existing auction rate securities back to the broker beginning on June 30,2010. The Company elected the fair value option for the put right to offsetchanges in fair value of its auction rate securities. The fair value of the putright is estimated using a discounted cash flow analysis.   Changes in fair value are recognized as gainon investments, net, in the Condensed Consolidated Statement of Operations. SeeNote 11, “Fair Value Measurements,” for a table that reconciles the beginningand ending balances of the put right.

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED -(Continued)**

 

*Gain on investments, net*

 

The Company’s gain on investments,net, in the Condensed Consolidated Statement of Operations consisted of thefollowing during the three months ended March 31, 2009 and 2010:

 
| ** **                                                         | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                         | ** ** | **March 31,**     | ** ** |
| ** **                                                         | ** ** | **2009**               | ** ** | **2010** | ** ** |
| ** **                                                         | ** ** | **(in thousands)**     | ** ** |
| ** **                                                         | ** ** | ** **             | ** ** | ** ** | ** ** |
| Cash  distributions from investments                               |       | $                      | 200        |   | $ | — |   |
| Gain  from sale of investments                                     |       | —                 |       | 416 |   |
| Net  change in fair value of auction rate securities and put right |       | 59                     |       | 2 |   |
|                                                               |       | $                      | 259        |   | $ | 418 |   |

 

During the three months ended March 31,2009, the Company received $0.2 million in cash distributions from eCompaniesVenture Group, L.P., a limited partnership that invested in domestic emergingInternet-related companies, and recorded a net gain of $0.1 million related tochanges in fair value of its auction rate securities and put right. During thethree months ended March 31, 2010, the Company sold certain of itsinvestments in other companies for proceeds of $0.5 million and recognized arealized gain on investments of $0.4 million.

 

**6.  Purchased Intangible Assets and Goodwill**

 

*Goodwill*

 

Therewere no changes in the carrying amount of goodwill during the three monthsended March 31, 2010.

 

*PurchasedIntangible Assets*

 

Thefollowing table presents the components of the Company’s acquired identifiableintangible assets included in the accompanying Condensed Consolidated BalanceSheets as of December 31, 2009 and March 31, 2010:

 
| ** **                                     | ** ** | **As of December 31, 2009** | ** ** | **As of March 31, 2010** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|-------------------------------|------------|
| ** **                                     | ** ** | **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    |       | $                                | 79,413     |                          | $          | (70,487 | ) | $ | 8,926 |   | $ | 79,413 |   | $ | (71,675 | ) | $ | 7,738 |   |
| Software and technology                        |       | 711                              |       | (711                          | )          | — |   | 711 |   | (711 | ) | — |   |
| Trade names                                    |       | 1,521                            |       | (608                          | )          | 913 |   | 1,521 |   | (684 | ) | 837 |   |
|                                           |       | 81,645                           |       | (71,806                       | )          | 9,839 |   | 81,645 |   | (73,070 | ) | 8,575 |   |
| Intangible assets not subject to amortization: |       |                             |       |                          |       |   |   |   |   |   |   |   |   |
| Trade names                                    |       | 1,711                            |       | —                        |       | 1,711 |   | 1,711 |   | — |   | 1,711 |   |
|                                           |       | $                                | 83,356     |                          | $          | (71,806 | ) | $ | 11,550 |   | $ | 83,356 |   | $ | (73,070 | ) | $ | 10,286 |   |

 

Amortizationof intangible assets in the Condensed Consolidated Statements of Operations forthe three months ended March 31, 2009 and 2010 represents the amortizationof definite-lived intangible assets.  TheCompany’s definite-lived intangible assets primarily consist of subscriberbases and customer 

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**UNAUDITED -(Continued)**

 

relationships, acquired softwareand technology and trade names 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 three years for acquired software and technology.  As of March 31, 2010, the weightedaverage amortization periods were 4.4 years for subscriber base assets andcustomer relationships, 3.0 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 $2.9million during the remaining nine months in the year ending December 31,2010 and $2.9 million, $1.5 million, $0.8 million and $0.5 million during theyears ending December 31, 2011, 2012, 2013 and 2014, respectively. Actualamortization expense to be reported in future periods could differ materiallyfrom these estimates as a result of asset acquisitions, changes in useful livesand other relevant factors.

 

**7.  Convertible SeniorNotes**

 

*General*

 

InNovember 2006, the Company issued $258.8 million aggregate principalamount of Convertible Senior Notes due November 15, 2026 in a registeredoffering. The Company received net proceeds of $251.6 million after transactionfees of $7.2 million. The Notes bear interest at 3.25% per year on theprincipal amount of the Notes until November 15, 2011, and 3.50% interestper year on the principal amount of the Notes thereafter, payable semi-annuallyin May and November of each year. The Notes rank as senior unsecuredobligations of the Company.

 

TheNotes are payable with cash and, if applicable, are convertible into shares ofthe Company’s common stock. The initial conversion rate was 109.6491 shares per$1,000 principal amount of Notes (which represented an initial conversion priceof approximately $9.12 per share). As a result of the Company’s cash dividendpayments, the conversion rate has been adjusted and was 115.3313 shares per$1,000 principal amount of Notes as of March 31, 2010 (which represents aconversion price of approximately $8.67 per share), subject to furtheradjustment. Upon conversion, a holder will receive cash up to the principalamount of the Notes and, at the Company’s option, cash, or shares of theCompany’s common stock or a combination of cash and shares of common stock forthe remainder, if any, of the conversion obligation. The conversion obligationis based on the sum of the “daily settlement amounts” for the20 consecutive trading days that begin on, and include, the second tradingday after the day the notes are surrendered for conversion. The Notes willbe convertible only in the following circumstances: (1) during anycalendar quarter after the calendar quarter ending December 31, 2006 (andonly during such calendar quarter), if the closing sale price of the Company’scommon stock for each of 20 or more trading days in a period of 30 consecutivetrading days ending on the last trading day of the immediately precedingcalendar quarter exceeds 130% of the conversion price in effect on the lasttrading day of the immediately preceding calendar quarter; (2) during thefive consecutive business days immediately after any five consecutive tradingday period in which the average trading price per $1,000 principal amount ofNotes was equal to or less than 98% of the average conversion value of theNotes during the note measurement period; (3) upon the occurrence of specifiedcorporate transactions, including the payment of dividends in certaincircumstances; (4) if the Company has called the Notes for redemption; and(5) at any time from, and including, October 15, 2011 to, andincluding, 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 has 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, 2009 and March 31,2010, the fair value of the Notes was approximately $279.8 million and $281.7million, respectively, based on quoted market prices.

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**UNAUDITED -(Continued)**

 

Underthe terms of the indenture governing the Notes, the Company’s payment of cashdividends requires an adjustment to the conversion rate for the Notes. Inaddition, as a result of the adjustment, the Notes may be surrendered forconversion for a period of time between the declaration date and the recorddate, as defined in the indenture, for the consideration provided for in theindenture. During the three months ended March 31, 2010, $3.0 millionprincipal amount of Notes were surrendered for conversion for cash payment of$2.8 million, resulting in a gain on conversion of debt of $0.2 million. Suchgain is included in interest expense and other, net, in the CondensedConsolidated Statement of Operations.

 

TheCompany accounts for the liability and equity components of the Notesseparately. The Company is accreting the debt discount related to the equitycomponent to non-cash interest expense over the estimated five-year life of theNotes, which represents the first redemption date of November 2011.  The principal amount, unamortized discountand net carrying amount of the debt and equity components as of December 31,2009 and March 31, 2010 are presented below:

 
| ** **                               | ** ** | **As of**             | ** ** | **As of**          | ** ** |
|------------------------------------------|------------|-----------------------|------------|--------------------|------------|
| ** **                               | ** ** | **December 31,** | ** ** | **March 31,** | ** ** |
| ** **                               | ** ** | **2009**              | ** ** | **2010**           | ** ** |
| ** **                               | ** ** | **(in thousands)**    | ** ** |
| Principal  amount                        |       | $                     | 258,750    |               | $          | 255,791 |   |
| Unamortized  discount                    |       | (26,502               | )          | (22,948            | )          |
| Net  carrying amount                     |       | $                     | 232,248    |               | $          | 232,843 |   |
|                                     |       |                  |       |               |       |
| Carrying  amount of the equity component |       | $                     | 62,095     |               | $          | 61,847 |   |

 

As of March 31, 2010, theremaining amortization period for the discount was 19 months. As of March 31,2010, the conversion price was approximately $8.67 per share, resulting in 29.5million shares issuable upon conversion.

 

The following table presents theassociated interest cost related to the Notes during the three months ended March 31,2009 and 2010, which consists of both the contractual interest coupon andamortization of the discount on the equity component:

 
| ** **                       | ** ** | **Three Months Ended March 31,** | ** ** |
|----------------------------------|------------|---------------------------------------|------------|
| ** **                       | ** ** | **2009**                              | ** ** | **2010** | ** ** |
| ** **                       | ** ** | **(in thousands)**                    | ** ** |
|                             |       |                                  |       |   |   |
| Contractual  interest recognized |       | $                                     | 2,224      |   | $ | 2,226 |   |
| Discount  amortization           |       | 3,019                                 |       | 3,251 |   |
|                             |       |                                  |       |   |   |
| Effective  interest rate         |       | 9.5                                   | %          | 9.5 | % |
|                                  |            |                                       |            |  |  |  |  |

 

*Classification*

 

In 2009, the Company began payingquarterly cash dividends on its common stock. The Company currently intends topay regular quarterly dividends on its common stock.  Under the terms of the indenture governingthe Notes, the Company’s payment of cash dividends requires an adjustment tothe conversion rate for the Notes. In addition, as a result of the adjustment,the Notes may be surrendered for conversion for a period of time between thedeclaration date and the record date, as defined in the indenture, for theconsideration provided for in the indenture. As a result, the Companyclassified the Notes as a current liability in the Condensed ConsolidatedBalance Sheets as of December 31, 2009 and March 31, 2010.

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**UNAUDITED -(Continued)**

 

**8.  Stockholders’ Equity**

 

*Comprehensive Income*

 

Comprehensiveincome includes unrealized gains and losses on certain investments classifiedas available-for-sale, net of tax, which are excluded from the CondensedConsolidated Statements of Operations. Comprehensive income for the threemonths ended March 31, 2009 and 2010 was as follows:

 
| ** **                                                   | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                   | ** ** | **March 31,**     | ** ** |
| ** **                                                   | ** ** | **2009**               | ** ** | **2010** | ** ** |
| ** **                                                   | ** ** | **(in thousands)**     | ** ** |
| Net  income                                                  |       | $                      | 32,497     |   | $ | 26,747 |   |
| Unrealized  holding gains on certain investments, net of tax |       | 1,231                  |       | 18 |   |
| Total  comprehensive income                                  |       | $                      | 33,728     |   | $ | 26,765 |   |

 

*ShareRepurchases*

 

Sincethe inception of the Company’s share repurchase program, the Board of Directorshas authorized a total of $750.0 million for the repurchase of EarthLink’scommon stock. As of March 31, 2010, the Company had $146.8 millionavailable under the current authorizations. The Company may repurchase itscommon stock from time to time in compliance with the Securities and ExchangeCommission’s regulations and other legal requirements, including through theuse of derivative transactions, and subject to market conditions and otherfactors. The share repurchase program does not require the Company to acquire anyspecific number of shares and may be terminated by the Board of Directors atany time.

 

TheCompany repurchased 3.6 million shares of its common stock for $22.3 millionduring the three months ended March 31, 2009. The Company did notrepurchase any shares of its common stock during the three months ended March 31,2010.

 

*Dividends*

 

During the three months ended March 31,2010, cash dividends declared were $0.14 per common share and total dividendpayments were $15.4 million. The Company currently intends to pay regularquarterly dividends on its common stock. Any decision to declare future dividends will be made at the discretionof the Board of Directors and will depend on, among other things, the Company’sresults of operations, financial condition, cash requirements, investmentopportunities and other factors the Board of Directors may deem relevant.

 

**9.  Stock-Based Compensation**

 

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

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**UNAUDITED -(Continued)**

 

classand historical employee attrition rates. Actual results, and future changes inestimates, may differ substantially from the Company’s current estimates.

 

Stock-basedcompensation expense was $4.4 million and $2.7 million during the three monthsended March 31, 2009 and 2010, respectively.  The Company classifies stock-basedcompensation expense within the same operating expense line items as cashcompensation paid to employees.

 

*StockIncentive Plans*

 

The Company has granted options toemployees and non-employee directors to purchase the Company’s common stockunder various stock incentive plans. The Company has also granted restrictedstock units to employees and non-employee directors under various stockincentive plans. Under the plans, employees and non-employee directors areeligible to receive awards of various forms of equity-based incentivecompensation, including stock options, restricted stock, restricted stock unitsand performance awards, among others. The plans are administered by the Boardof Directors or the Leadership and Compensation Committee of the Board ofDirectors, which determine the terms of the awards granted. Stock options aregenerally granted with an exercise price equal to the market value of EarthLink, Inc.common stock on the date of grant, have a term of ten years or less, and vestover terms of four years from the date of grant. Restricted stock units aregranted with various vesting terms that range from one to six years from thedate of grant.

 

*OptionsOutstanding*

 

Thefollowing table summarizes stock option activity as of and for the three monthsended March 31, 2010:

 
| ** **                                            | ** ** | ** **                                                | ** ** | ** **   | ** ** | **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, 2009              |       | 3,916                                                     |       | $            | 9.61       |             |       |          |       |   |
| Granted                                               |       | —                                                    |       | —       |       |             |       |          |       |
| Exercised                                             |       | (168                                                      | )          | 7.08         |       |             |       |          |       |
| Forfeited and expired                                 |       | (239                                                      | )          | 16.73        |       |             |       |          |       |
| Outstanding as of March 31, 2010                 |       | 3,509                                                     |       | 9.25         |       | 4.4              |       | $             | 1,693      |   |
|                                                  |       |                                                      |       |         |       |             |       |          |       |
| Vested and expected to vest as of March 31, 2010 |       | 3,433                                                     |       | $            | 9.29       |             | 4.3        |          | $          | 1,597 |   |
|                                                  |       |                                                      |       |         |       |             |       |          |       |
| Exercisable as of March 31, 2010                 |       | 2,870                                                     |       | $            | 9.58       |             | 3.8        |          | $          | 1,048 |   |

 

The aggregate intrinsic valueamounts in the table above represent the closing price of the Company’s commonstock on March 31, 2010 in excess of the exercise price, multiplied by thenumber of stock options outstanding or exercisable, when the closing price isgreater than the exercise price. This represents the amount that would havebeen received by the stock option holders if they had all exercised their stockoptions on March 31, 2010. The total intrinsic value of options exercisedduring the three months ended March 31, 2009 and 2010 was $0.1 million and$0.2 million, respectively. The intrinsic value of stock options exercisedrepresents the difference between the market value of Company’s common stock atthe time of exercise and the exercise price, multiplied by the number of stockoptions exercised. To the extent the forfeiture rate is different than what theCompany has anticipated, stock-based compensation related to these awards willbe different from the Company’s expectations. As of March 31, 2010, therewas $1.4 million of total unrecognized compensation cost related to stockoptions. That cost is expected to be recognized over a weighted-average periodof 1.2 years.

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**UNAUDITED -(Continued)**

 

Thefollowing table summarizes the status of the Company’s stock options as of March 31,2010:

 
| ** **                    | ** ** | ** **      | ** ** | ** **      | ** ** | ** **         | ** ** | ** **      | ** ** | ** **   | ** ** | **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               |       | 307             |       | 4.9          |       | $                  | 6.25       |   | 251 |   | $ | 6.12 |   |
| 6.90                          |       | to              |       | 7.25            |       | 316                |       | 6.9             |       | 7.00         |       | 187                |       | 7.00 |   |
| 7.31                          |       | to              |       | 7.31            |       | 283                |       | 7.2             |       | 7.31         |       | 33                 |       | 7.31 |   |
| 7.32                          |       | to              |       | 8.96            |       | 284                |       | 4.9             |       | 8.10         |       | 236                |       | 8.19 |   |
| 9.01                          |       | to              |       | 9.01            |       | 347                |       | 4.3             |       | 9.01         |       | 347                |       | 9.01 |   |
| 9.23                          |       | to              |       | 9.51            |       | 423                |       | 5.7             |       | 9.44         |       | 267                |       | 9.42 |   |
| 9.64                          |       | to              |       | 10.06           |       | 662                |       | 1.1             |       | 9.89         |       | 662                |       | 9.89 |   |
| 10.36                         |       | to              |       | 18.88           |       | 887                |       | 4.1             |       | 11.59        |       | 887                |       | 11.59 |   |
| $                             | 5.10       |            | to         |            | $          | 18.88              |       | 3,509           |       | 4.4          |       | $                  | 9.25       |   | 2,870 |   | $ | 9.58 |   |

 

*RestrictedStock Units*

 

The following table summarizesrestricted stock unit activity as of and for the three months ended March 31,2010:

 
| ** **                              | ** ** | ** **         | ** ** | **Weighted**   | ** ** |
|-----------------------------------------|------------|--------------------|------------|----------------|------------|
| ** **                              | ** ** | ** **         | ** ** | **Average**    | ** ** |
| ** **                              | ** ** | **Restricted**     | ** ** | **Grant Date** | ** ** |
| ** **                              | ** ** | **Stock Units**    | ** ** | **Fair Value** | ** ** |
| ** **                              | ** ** | **(in thousands)** | ** ** | ** **     | ** ** |
| Nonvested  as of December 31, 2009 |       | 2,166              |       | $              | 7.25       |   |
| Granted                                 |       | 248                |       | 8.21           |       |
| Vested                                  |       | (974               | )          | 7.15           |       |
| Forfeited                               |       | —             |       | —         |       |
| Nonvested  as of March 31, 2010    |       | 1,440              |       | $              | 7.49       |   |

 

The fair value of restricted stockunits is determined based on the closing trading price of EarthLink’s commonstock on the grant date. The weighted-average grant date fair value ofrestricted stock units granted during the three months ended March 31,2009 and 2010 was $6.74 and $8.21, respectively.  As of March 31, 2010, there was $5.5million of total unrecognized compensation cost related to nonvested restrictedstock units. That cost is expected to be recognized over a weighted-averageperiod of 1.7 years. The total fair value of shares vested during the threemonths ended March 31, 2009 and 2010 was $7.0 million and $8.1 million,respectively, which represents the closing price of the Company’s common stockon the vesting date multiplied by the number of restricted stock units thatvested.

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**UNAUDITED -(Continued)**

 

**10. Income Taxes**

 

EarthLinkrecorded an income tax provision of $20.9 million and $16.8 million during thethree months ended March 31, 2009 and 2010, respectively.  The major components of the income taxprovision for the three months ended March 31, 2009 and 2010 are asfollows:

 
| ** **                       | ** ** | **Three Months Ended** | ** ** |
|----------------------------------|------------|------------------------|------------|
| ** **                       | ** ** | **March 31,**     | ** ** |
| ** **                       | ** ** | **2009**               | ** ** | **2010** | ** ** |
| ** **                       | ** ** | **(in thousands)**     | ** ** |
|                             |       |                   |       |   |   |
| Federal  alternative minumum tax |       | $                      | 1,033      |   | $ | 807 |   |
| State  income tax                |       | 1,354                  |       | 381 |   |
| Current  provision               |       | 2,387                  |       | 1,188 |   |
|                             |       |                   |       |   |   |
| Deferred  provision              |       | 18,557                 |       | 15,604 |   |
|                             |       |                   |       |   |   |
| Total                            |       | $                      | 20,944     |   | $ | 16,792 |   |

 

The income tax provision of $16.8 million for thethree months ended March 31, 2010 represents an annual effective rate of38.6%.

 

The current federal andstate tax provisions recorded during the three months ended March 31, 2009and 2010 were the result of limitations on net operating loss utilizationassociated with the alternative minimum tax calculation and state laws. Thenon-cash deferred tax provision recorded during the three months ended March 31,2009 and 2010 was primarily a result of the utilization of net operating losstax carryforwards.

 

The Company has avaluation allowance of $34.1 million against certain deferred tax assets.Of this amount, $31.7 million relates to net operating losses generated bythe tax benefits of stock-based compensation. The valuation allowance will beremoved upon utilization of these net operating losses by the Company as anadjustment to additional paid-in-capital. The remaining $2.4 millionrelates to net operating losses in certain jurisdictions where the Companybelieves it is not more likely than not to be realized in future periods.

 

To the extent EarthLinkreports income in future periods, EarthLink intends to use its net operatingloss carryforwards to the extent available to offset taxable income and reducecash outflows for income taxes.  The Company’s ability to use its federaland state net operating loss carryforwards and federal and state tax creditcarryforwards may be subject to restrictions attributable to equitytransactions in the future resulting from changes in ownership as defined underthe Internal Revenue Code.

 

The Company hasidentified its federal tax return and its state tax returns in California,Florida, Georgia and Illinois as “major” tax jurisdictions, for purposes ofcalculating its uncertain tax positions.  Periods extending back to 1994are still subject to examination for all “major” jurisdictions. The Companybelieves that its income tax filing positions and deductions through the periodended March 31, 2010 will not result in a material adverse effect on theCompany’s financial condition, results of operations or cash flow. The Company’spolicy for recording interest and penalties associated with audits is to recordsuch items as a component of income tax expense.  No material changes were identified duringthe quarter.

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**UNAUDITED -(Continued)**

 

**11.  Fair Value Measurements**

 

As of December 31,2009 and March 31, 2010, the Company held certain assets that are requiredto be measured at fair value on a recurring basis.  These includedthe Company’s cash equivalents, marketable securities, auction rate securities,equity investments in other companies and the Company’s put right.

 

Fairvalue is defined as the price that would be received to sell an asset or paidto transfer a liability in an orderly transaction between market participantsat the measurement date (an exit price). A three-tier fair value hierarchy isused to prioritize the inputs used in measuring fair value.  Thesetiers include: Level 1, defined as observable inputs such as quoted prices inactive markets; Level 2, defined as inputs other than quoted prices in activemarkets that are either directly or indirectly observable; and Level 3, definedas unobservable inputs in which little or no market data exists, thereforerequiring an entity to develop its own assumptions.

 

Thefollowing tables present the Company’s assets that are measured at fair valueon a recurring basis as of December 31, 2009 and March 31, 2010:

** **
| ** **                             | ** ** | ** **   | ** ** | ** **         | ** ** | **Fair Value Measurements as of  December 31, 2009 Using** | ** ** |
|----------------------------------------|------------|--------------|------------|--------------------|------------|-----------------------------------------------------------------|------------|
| ** **                             | ** ** | ** **   | ** ** | ** **         | ** ** | **Quoted Prices**                                               | ** ** | **Significant** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | ** **   | ** ** | ** **         | ** ** | **in Active**                                                   | ** ** | **Other** | ** ** | **Significant** | ** ** |
| ** **                             | ** ** | ** **   | ** ** | ** **         | ** ** | **Markets for**                                                 | ** ** | **Observable** | ** ** | **Unobservable** | ** ** |
| ** **                             | ** ** | **Carrying** | ** ** | **Fair**           | ** ** | **Identical Assets**                                            | ** ** | **Inputs** | ** ** | **Inputs** | ** ** |
| **Description**                        | ** ** | **Value**    | ** ** | **Value**          | ** ** | **(Level 1)**                                                   | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| ** **                             | ** ** | ** **   | ** ** | **(in thousands)** | ** ** |
| Cash  equivalents                      |       | $            | 588,666    |               | $          | 588,666                                                         |       | $ | 588,666 |   | $ | — |   | $ | — |   |
| Marketable  securities                 |       | 42,060       |       | 42,060             |       | 42,060                                                          |       | — |   | — |   |
| Auction  rate securities               |       | 42,906       |       | 42,906             |       | —                                                          |       | — |   | 42,906 |   |
| Equity  investments in other companies |       | 1,529        |       | 1,529              |       | 1,529                                                           |       | — |   | — |   |
| Put  right                             |       | 5,239        |       | 5,239              |       | —                                                          |       | — |   | 5,239 |   |
| Total                                  |       | $            | 680,400    |               | $          | 680,400                                                         |       | $ | 632,255 |   | $ | — |   | $ | 48,145 |   |

 
| ** **                             | ** ** | ** **   | ** ** | ** **         | ** ** | **Fair Value Measurements as of  March 31, 2010 Using** | ** ** |
|----------------------------------------|------------|--------------|------------|--------------------|------------|--------------------------------------------------------------|------------|
| ** **                             | ** ** | ** **   | ** ** | ** **         | ** ** | **Quoted Prices**                                            | ** ** | **Significant** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | ** **   | ** ** | ** **         | ** ** | **in Active**                                                | ** ** | **Other** | ** ** | **Significant** | ** ** |
| ** **                             | ** ** | ** **   | ** ** | ** **         | ** ** | **Markets for**                                              | ** ** | **Observable** | ** ** | **Unobservable** | ** ** |
| ** **                             | ** ** | **Carrying** | ** ** | **Fair**           | ** ** | **Identical Assets**                                         | ** ** | **Inputs** | ** ** | **Inputs** | ** ** |
| **Description**                        | ** ** | **Value**    | ** ** | **Value**          | ** ** | **(Level 1)**                                                | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| ** **                             | ** ** | ** **   | ** ** | **(in thousands)** | ** ** |
| Cash  equivalents                      |       | $            | 619,816    |               | $          | 619,816                                                      |       | $ | 619,816 |   | $ | — |   | $ | — |   |
| Marketable  securities                 |       | 35,993       |       | 35,993             |       | 35,993                                                       |       | — |   | — |   |
| Auction  rate securities               |       | 42,665       |       | 42,665             |       | —                                                       |       | — |   | 42,665 |   |
| Equity  investments in other companies |       | 938          |       | 938                |       | 938                                                          |       | — |   | — |   |
| Put  right                             |       | 5,332        |       | 5,332              |       | —                                                       |       | — |   | 5,332 |   |
| Total                                  |       | $            | 704,744    |               | $          | 704,744                                                      |       | $ | 656,747 |   | $ | — |   | $ | 47,997 |   |

 

Cash equivalents, marketablesecurities and equity investments in other companies are valued using quotedmarket prices and are classified within Level 1. Investments in auction ratesecurities and the Company’s put right are classified within Level 3 becausethey are valued using a discounted cash flow model. Some of the inputs to thismodel are unobservable in the market and are significant. The Company hasconsistently applied these valuation techniques in all periods presented.

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**UNAUDITED -(Continued)**

 

TheCompany has invested in auction rate securities, which are more fully describedin Note 5, “Investments.”  Beginning in February 2008, theseinstruments held by the Company failed to attract sufficientbuyers.  As a result, these securities do not have a readilydeterminable market value and are not liquid. In October 2008, EarthLinkentered into an agreement with the broker that sold the Company its auctionrate securities that gives the Company the right to sell its existing auctionrate securities back to the broker at par plus accrued interest, beginning on June 30,2010 until July 2, 2012. As a result, the Company classifies its auctionrate securities as trading, with changes in fair value included in gain oninvestments, net, in the Condensed Consolidated Statement of Operations.  The Company elected the fair value option forthe put right to offset the fair value changes of the auction rate securities.The fair values of the Company’s auction rate securities and put right as of December 31,2009 and March 31, 2010 were estimated utilizing a discounted cash flowanalysis.  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.

 

Thefollowing table presents a reconciliation of the beginning and ending balancesof the Company’s assets measured at fair value on a recurring basis usingsignificant unobservable inputs (Level 3) as of March 31, 2010:

** **
| ** **                               | ** ** | **Auction**        | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------------------|------------|--------------------|------------|------------|------------|------------|------------|
| ** **                               | ** ** | **Rate**           | ** ** | **Put**    | ** ** | ** ** | ** ** |
| ** **                               | ** ** | **Securities**     | ** ** | **Right**  | ** ** | **Total**  | ** ** |
| ** **                               | ** ** | **(in thousands)** | ** ** |
| **Balance as of December 31, 2009** |       | $                  | 42,906     |       | $          | 5,239      |       | $ | 48,145 |   |
| Total  realized losses                   |       | (91                | )          | —     |       | (91        | )          |
| Total  realized gains                    |       | —             |       | 93         |       | 93         |       |
| Settlements                              |       | (150               | )          | —     |       | (150       | )          |
| **Balance as of March 31, 2010**    |       | $                  | 42,665     |       | $          | 5,332      |       | $ | 47,997 |   |

 

TheCompany’s realized losses for its auction rate securities and put right areincluded in gain on investments, net, in the Condensed Consolidated Statementof Operations.

 

**12.  Segment Information**

 

TheCompany reports segment information along the same lines that its chiefoperating decision maker reviews its operating results in assessing performanceand allocating resources. The Company operates two reportable segments,Consumer Services and Business Services. The Company’s Consumer Services segmentprovides Internet access services and related value-added services toindividual customers. These services include dial-up and high-speed Internetaccess and VoIP services, among others. The Company’s Business Services segmentprovides integrated communications services and related value-added services tobusinesses and communications carriers. These services include managed IP-basedwide area networks, dedicated Internet access and web hosting, among others.

 

TheCompany evaluates performance of its segments based on segment income fromoperations. Segment income from operations includes revenues from externalcustomers, related cost of revenues and operating expenses directlyattributable to the segment, which include costs over which segment managers havedirect discretionary control, such as advertising and marketing programs,customer support expenses, 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, impairment of goodwill and

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**UNAUDITED -(Continued)**

 

intangibleassets, facility exit and restructuring costs, and stock-based compensationexpense, as they are not considered in the measurement of segment performance.

 

Information on reportable segments and a reconciliation to consolidatedincome from operations for the three months ended March 31, 2009 and 2010is as follows:

 
| ** **                             | ** ** | **Three Months Ended March 31,** | ** ** |
|----------------------------------------|------------|---------------------------------------|------------|
| ** **                             | ** ** | **2009**                              | ** ** | **2010** | ** ** |
| ** **                             | ** ** | **(in thousands)**                    | ** ** |
| **Consumer Services**                  |       |                                  |       |   |   |
| Revenues                               |       | $                                     | 159,562    |   | $ | 123,564 |   |
| Cost  of revenues                      |       | 52,334                                |       | 40,461 |   |
| Gross  margin                          |       | 107,228                               |       | 83,103 |   |
| Direct  segment operating expenses     |       | 37,206                                |       | 23,965 |   |
| Segment  operating income              |       | $                                     | 70,022     |   | $ | 59,138 |   |
|                                   |       |                                  |       |   |   |
| **Business Services**                  |       |                                  |       |   |   |
| Revenues                               |       | $                                     | 39,501     |   | $ | 33,694 |   |
| Cost  of revenues                      |       | 23,231                                |       | 20,353 |   |
| Gross  margin                          |       | 16,270                                |       | 13,341 |   |
| Direct  segment operating expenses     |       | 11,259                                |       | 9,941 |   |
| Segment  operating income              |       | $                                     | 5,011      |   | $ | 3,400 |   |
|                                   |       |                                  |       |   |   |
| **Consolidated**                       |       |                                  |       |   |   |
| Revenues                               |       | $                                     | 199,063    |   | $ | 157,258 |   |
| Cost  of revenues                      |       | 75,565                                |       | 60,814 |   |
| Gross  margin                          |       | 123,498                               |       | 96,444 |   |
| Direct  segment operating expenses     |       | 48,465                                |       | 33,906 |   |
| Segment  operating income              |       | 75,033                                |       | 62,538 |   |
| Stock-based  compensation expense      |       | 4,390                                 |       | 2,667 |   |
| Amortization  of intangible assets     |       | 2,147                                 |       | 1,264 |   |
| Facility  exit and restructuring costs |       | 488                                   |       | 1,435 |   |
| Other  operating expenses              |       | 10,535                                |       | 8,759 |   |
| Income  from operations                |       | $                                     | 57,473     |   | $ | 48,413 |   |

 

Theprimary component of the Company’s revenues is access and service revenues,which consist of narrowband access services (including traditional,fully-featured narrowband access and value-priced narrowband access); broadbandaccess services (including high-speed access via DSL and cable, VoIP andmanaged IP-based wide area networks); and web hosting services. The Companyalso earns revenues from value-added services, which include ancillary servicessold as add-on features to the Company’s access services, search andadvertising revenues.

 

Consumeraccess and service revenues consist of narrowband access and broadband accessservices. These revenues are derived from fees charged to customers for dial-upInternet access; fees charged for high-speed access services; fees charged forVoIP services; usage fees; shipping and handling fees; and termination fees. Consumervalue-added services revenues consist of revenues from ancillary services soldas add-on features to the Company’s Internet services, such as securityproducts, premium email only, home networking, email storage and Internet callwaiting; search revenues; and advertising revenues.

 

Businessaccess and service revenues consist of fees charged for managed IP-based widearea networks; fees charged for Internet access services; installation fees;termination fees; fees for equipment; usage fees; cost

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

recoveryfees billed to customers; and fees charged for leasing server space andproviding web services  that enablecustomers to build and maintain an effective online presence.

 

Informationon revenues by groups of similar services and by segment for the three monthsended March 31, 2009 and 2010 is as follows:

 
| ** **            | ** ** | **Three Months Ended** | ** ** |
|-----------------------|------------|------------------------|------------|
| ** **            | ** ** | **March 31,**     | ** ** |
| ** **            | ** ** | **2009**               | ** ** | **2010** | ** ** |
| ** **            | ** ** | **(in thousands)**     | ** ** |
| **Consumer Services** |       |                   |       |   |   |
| Access  and service   |       | $                      | 139,790    |   | $ | 108,198 |   |
| Value-added  services |       | 19,772                 |       | 15,366 |   |
| Total  revenues       |       | $                      | 159,562    |   | $ | 123,564 |   |
|                  |       |                   |       |   |   |
| **Business Services** |       |                   |       |   |   |
| Access  and service   |       | $                      | 38,908     |   | $ | 33,139 |   |
| Value-added  services |       | 593                    |       | 555 |   |
| Total  revenues       |       | $                      | 39,501     |   | $ | 33,694 |   |
|                  |       |                   |       |   |   |
| **Consolidated**      |       |                   |       |   |   |
| Access  and service   |       | $                      | 178,698    |   | $ | 141,337 |   |
| Value-added  services |       | 20,365                 |       | 15,921 |   |
| Total  revenues       |       | $                      | 199,063    |   | $ | 157,258 |   |

 

TheCompany manages its working capital on a consolidated basis and does notallocate long-lived assets to segments. In addition, segment assets are notreported to, or used by, the chief operating decision maker and therefore,total segment assets have not been disclosed.

 

TheCompany has not provided information about geographic segments becausesubstantially all of the Company’s revenues, results of operations andidentifiable assets are in the United States.

 

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

 

Certain statements in thisQuarterly Report on Form 10-Q are forward-looking statements within themeaning 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 discussionshould be read in conjunction with the accompanying unaudited CondensedConsolidated Financial 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 31,2009.*

 

**Overview**

 

EarthLink, Inc.is an Internet service provider (“ISP”), providing nationwide Internet accessand related value-added services to individual and business customers. Ourprimary service offerings are dial-up and high-speed Internet access servicesand related value-added services, such as ancillary services sold as add-onfeatures to our Internet access services, search and advertising. In addition,through our wholly-owned subsidiary, New Edge Networks (“New Edge”), we buildand manage IP-based wide area networks for businesses and communicationscarriers.

 

Weoperate two reportable segments, Consumer Services and Business Services. OurConsumer Services segment provides Internet access and related value-addedservices to individual customers. These services include dial-up and high-speedInternet access and voice-over-Internet Protocol (“VoIP”) services, amongothers. Our Business Services segment provides integrated communicationsservices and related value-added services to businesses and communicationscarriers. These services include managed IP-based wide area networks, dedicatedInternet access and web hosting, among others.

 

*BusinessStrategy*

 

Ourbusiness strategy is to maximize the cash flows generated by our business byfocusing on customer retention, operational efficiency and opportunities forgrowth.

 

·                  *Customer Retention*. We are focused on retaining ourcustomers. We believe focusing on the customer relationship increases loyaltyand reduces churn.  We also believe thatsatisfied customers provide cost benefits, including reduced call centersupport costs and reduced bad debt expense. We continue to focus on offeringour access services with high-quality customer service and technical support.

 

·                  *Operational Efficiency*. We are focused onimproving the cost structure of our business and aligning our cost structurewith trends in our revenue, without impacting the quality of services weprovide. We are focused on delivering our services more cost effectively byreducing and more efficiently handling the number of calls to contact centers,managing cost-effective outsourcing opportunities, managing our network costs,implementing workforce reduction initiatives and streamlining our internalprocesses and operations.

 

·                  *Opportunities for Growth*.  In response to changes in our business, wehave significantly reduced our sales and marketing spending. However, wecontinue to seek to add customers that generate an acceptable rate of returnand increase the number of subscribers we add through alliances, partnerships 

 

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and acquisitions from other ISPs. We continue to evaluate and considerpotential strategic transactions that may complement our business. We are alsoseeking ways to create more scale within our New Edge business.

 

Theprimary challenges we face in executing our business strategy are managing therate of decline in our revenues, aligning costs with trends in our revenue,responding to competition, reducing churn, purchasing cost-effective networkservices from third-party telecommunications service providers and addingcustomers that generate an acceptable rate of return. The factors we believeare instrumental to the achievement of our business strategy may be subject tocompetitive, regulatory and other events and circumstances that are beyond ourcontrol. Further, we can provide no assurance that we will be successful inachieving any or all of the strategies identified above, that the achievementor existence of such strategies will favorably impact profitability, or thatother factors will not arise that would adversely affect future profitability.

 

*RevenueSources*

 

The primary component of our revenues is access and servicerevenues, which consist of narrowband access services (including traditional,fully-featured narrowband access and value-priced narrowband access); broadbandaccess services (including high-speed access via DSL and cable; managedIP-based wide area networks; and VoIP); and web hosting services. We also earnrevenues from value-added services, which include revenues from ancillaryservices sold as add-on features to our Internet access services, such assecurity products, premium email only, home networking, email storage andInternet call waiting; search revenues; and advertising revenues.

 

Narrowbandaccess revenues primarily consist of fees charged to customers for dial-upInternet access. Broadband access revenues primarily consist of fees chargedfor high-speed access services; fees charged for managing IP-based wide areanetworks; and fees charged for VoIP services. Web hosting revenues consist offees charged for leasing server space and providing web services that enablecustomers to build and maintain an effective online presence. Value-addedservices revenues consist of fees charged for ancillary services; fees chargedfor paid placements for searches; delivering traffic to EarthLink’s partners inthe form of subscribers, page views or e-commerce transactions;advertising EarthLink partners’ products and services in EarthLink’s variousonline properties and electronic publications; and referring EarthLinkcustomers to partners’ products and services.

 

*Trends in ourBusiness*

 

*Consumer services*. We operate in the Internet access market, which ischaracterized by intense competition, changing technology, changes in customerneeds and new service and product introductions. Consumers continue to migratefrom dial-up to broadband access service due to the faster connection anddownload speeds provided by broadband access, the ability to free up theirphone lines and the more reliable and “always on” connection. The pricing forbroadband services has been declining, making it a more viable option forconsumers who continue to rely on dial-up connections for Internet access. Inaddition, advanced applications such as online gaming, music downloads, videosand social networking require greater bandwidth for optimal performance, whichadds to the demand for broadband access. Our narrowband subscriber base andrevenues have been declining and are expected to continue to decline due to thecontinued maturation of the market for narrowband access. Additionally, ourconsumer access services are discretionary and dependent upon levels ofconsumer spending. Unfavorable economic conditions could cause customers toslow spending in the future, which could adversely affect our revenues andchurn.

 

In light of the continued maturation of the market fornarrowband access, we continue to reduce our sales and marketing efforts and tofocus instead on retention of customers and on marketing channels that webelieve will produce an acceptable rate of return. While this strategy hasresulted in a decline in our revenues, we expect the rate of revenue decline todecrease as our subscriber base becomes more tenured and churn rates decline.Our consumer subscriber churn rate improved from 4.0% during the three monthsended March 31, 2009 to 3.1% during the three months ended March 31,2010.

 

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Consistent with trends in the Internetaccess industry, the mix of our consumer access subscriber base has beenshifting from narrowband access to broadband access customers. Consumerbroadband access revenues have lower gross margins than narrowband revenues dueto the costs associated with delivering broadband services. This change in mixhas negatively affected our profitability and we expect this trend to continueas broadband subscribers continue to become a greater proportion of ourconsumer access subscriber base. However, our consumer broadband accesscustomers also have lower churn rates than our consumer narrowband accesscustomers. Accordingly, we expect to realize benefits from a more tenuredsubscriber base, such as reduced support costs and lower bad debt expense.

 

*Business services.*The markets in which we operate ourbusiness services are characterized by industry consolidation, an evolvingregulatory environment, the emergence of new technologies and intensecompetition. We sell our services to end user business customers and to wholesalecustomers. Our end users range from large enterprises with many locations, tosmall and medium-sized multi-site businesses to business customers with onesite, often a home-based location. Many of our end user customers are retailbusinesses. Our wholesale customers consist primarily of telecommunicationscarriers and network resellers. Our business has become more focused on endusers as a result of consolidation in the telecommunications industry. Inaddition, our business customers, including retail businesses, are particularlyexposed to a weak economy. We have experienced pressure on revenue andoperating expenses for our business services, given the current state of theeconomy, including increased subscriber acquisition and retention costsnecessary to attract and retain subscribers. However, we are seeking ways togrow our business services revenue while operating this segment moreefficiently.

 

*First Quarter2010 Highlights*

 

Totalrevenues decreased $41.8 million, or 21%, from the three months ended March 31,2009 to the three months ended March 31, 2010, as our subscriber basedecreased from approximately 2.6 million paying subscribers as of March 31,2009 to approximately 2.0 million paying subscribers as of March 31, 2010.The decrease in subscribers was attributable to reduced sales and marketingactivities, continued competitive pressures and continued maturation of thenarrowband Internet access market. Offsetting the decline in total revenues wasa $32.7 million, or 23%, decline in total operating costs and expenses. Totaloperating costs and expenses decreased as our overall subscriber base hasdecreased and become longer tenured. Our longer tenured customers require lesscustomer service and technical support and have a lower frequency of non-payment.We also experienced benefits from workforce reduction initiatives and othercost cutting initiatives. Net income decreased $5.8 million, or 18%, from $32.5million during the three months ended March 31, 2009 to $26.7 millionduring the three months ended March 31, 2010. The decrease in net incomewas due to the decrease in revenues, offset by the decrease in total operatingexpenses and a $4.2 million decrease in our income tax provision.

 

*Looking Ahead*

 

We expect total revenues to continue to decrease during2010 as we continue to reduce our sales and marketing efforts and as the marketfor Internet access continues to mature. However, we expect the rate of revenuedecline to decelerate as our customer base becomes longer tenured and churnrates go down. Consistent with trends in the Internet access industry, weexpect the mix of our consumer access subscriber base to continue to shift fromnarrowband access to broadband access customers, which will negatively affectour profitability due to the higher costs associated with delivering broadbandservices. We also expect economic conditions and competitive pressures to putcontinued pressure on revenue and churn rates for our business services. Wewill continue to evaluate ways to grow revenues or create more scale for ourbusiness services. We expect cost savings in the remainder of 2010 from a lowerand longer tenured customer base and reduced sales and marketing activities. Wewill continue to seek cost reduction initiatives. However, we believe thatlarge-scale cost reduction opportunities will be more limited in the future. Inaddition, we do not expect to be able to reduce our cost structure to the sameextent as our revenue declines.

 

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**Key OperatingMetrics**

 

Weutilize certain non-financial and operating measures to assess our financialperformance. Terms such as churn and average revenue per user (“ARPU”) areterms commonly used in our industry. The following table sets forthsubscriber and operating data for the periods indicated:

** **
| ** **                                  | ** ** | **March 31,** | ** ** | **December 31,** | ** ** | **March 31,** | ** ** |
|---------------------------------------------|------------|--------------------|------------|-----------------------|------------|--------------------|------------|
| ** **                                  | ** ** | **2009**           | ** ** | **2009**              | ** ** | **2010**           | ** ** |
| **Subscriber Data (a)**                     |       |               |       |                  |       |               |       |
| **Consumer Services**                       |       |               |       |                  |       |               |       |
| Narrowband  access subscribers (b)          |       | 1,587,000          |       | 1,225,000             |       | 1,134,000          |       |
| Broadband  access subscribers (c)           |       | 856,000            |       | 804,000               |       | 781,000            |       |
| Total  consumer services                    |       | 2,443,000          |       | 2,029,000             |       | 1,915,000          |       |
| **Business Services**                       |       |               |       |                  |       |               |       |
| Narrowband  access subscribers              |       | 14,000             |       | 8,000                 |       | 8,000              |       |
| Broadband  access subscribers               |       | 57,000             |       | 54,000                |       | 52,000             |       |
| Web  hosting accounts                       |       | 84,000             |       | 75,000                |       | 73,000             |       |
| Total  business services                    |       | 155,000            |       | 137,000               |       | 133,000            |       |
| **Total subscriber count at end of period** |       | 2,598,000          |       | 2,166,000             |       | 2,048,000          |       |
|                                        |       |               |       |                  |       |               |       |
| ** **                                  | ** ** | **March 31,** | ** ** | **December 31,** | ** ** | **March 31,** | ** ** |
| ** **                                  | ** ** | **2009**           | ** ** | **2009**              | ** ** | **2010**           | ** ** |
| **Employee Data**                           |       |               |       |                  |       |               |       |
| Consumer  Services                          |       | 417                |       | 339                   |       | 309                |       |
| Business  Services                          |       | 300                |       | 284                   |       | 291                |       |
| Total  number of employees (d)              |       | 717                |       | 623                   |       | 600                |       |
|                                        |       |               |       |                  |       |               |       |
| Operations  and customer support            |       | 384                |       | 333                   |       | 317                |       |
| Sales  and marketing                        |       | 197                |       | 178                   |       | 178                |       |
| General  and administrative                 |       | 136                |       | 112                   |       | 105                |       |
| Total  number of employees (d)              |       | 717                |       | 623                   |       | 600                |       |

 
| ** **                          | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------|------------|------------------------|------------|
| ** **                          | ** ** | **March 31,**     | ** ** |
| ** **                          | ** ** | **2009**               | ** ** | **2010** | ** ** |
| **Subscriber Activity**             |       |                   |       |   |   |
| Subscribers  at beginning of period |       | 2,806,000              |       | 2,166,000 |   |
| Gross  organic subscriber additions |       | 116,000                |       | 77,000 |   |
| Adjustment  (e)                     |       | (7,000                 | )          | — |   |
| Churn                               |       | (317,000               | )          | (195,000 | ) |
| Subscribers  at end of period       |       | 2,598,000              |       | 2,048,000 |   |
|                                |       |                   |       |   |   |
| **Churn rate (f)**                  |       | 3.9                    | %          | 3.1 | % |
|                                |       |                   |       |   |   |
| **Consumer Services Data**          |       |                   |       |   |   |
| Average  subscribers (g)            |       | 2,539,000              |       | 1,970,000 |   |
| ARPU  (h)                           |       | $                      | 20.95      |   | $ | 20.91 |   |
| Churn  rate (f)                     |       | 4.0                    | %          | 3.1 | % |
|                                |       |                   |       |   |   |
| **Business Services Data**          |       |                   |       |   |   |
| Average  subscribers (g)            |       | 160,000                |       | 135,000 |   |
| ARPU  (h)                           |       | $                      | 82.37      |   | $ | 83.23 |   |
| Churn  rate (f)                     |       | 3.1                    | %          | 1.9 | % |

 

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(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) Narrowbandaccess subscribers include customers who subscribe to our premium and valuepriced dial-up Internet access services and customers who subscribe to ourpremium email only service.

 

(c) Customerswho subscribe to our EarthLink DSL and Home Phone service are counted as both abroadband subscriber and a voice subscriber.

 

(d) Representsfull-time equivalents.

 

(e) Duringthe three months ended March 31, 2009, we removed approximately 7,000satellite subscribers from our broadband subscriber count and total subscribercount as a result of our sale of these subscriber accounts.

 

(f) Churnrate is used 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.

 

(g) Average subscribers oraccounts for the three month periods is calculated by averaging the endingmonthly subscribers or accounts for the four months preceding and including theend of the quarterly period.

 

(h) ARPUrepresents the average monthly revenue per user (subscriber). ARPU is computedby dividing average monthly revenue for the period by the average number ofsubscribers for the period. Average monthly revenue used to calculate ARPUincludes recurring service revenue as well as nonrecurring revenues associatedwith equipment and other one-time charges associated with initiating ordiscontinuing services.

 

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**Results ofOperations**

 

***Consolidated Results of Operations***

 

Thefollowing table sets forth statement of operations data for the three monthsended March 31, 2009 and 2010:

 
| ** **                             | ** ** | **Three Months Ended March 31,** | ** ** | **Change Between** | ** ** |
|----------------------------------------|------------|---------------------------------------|------------|--------------------|------------|
| ** **                             | ** ** | **2009**                              | ** ** | **2010**           | ** ** | **2009 and 2010** | ** ** |
| ** **                             | ** ** | ** **                            | ** ** | **% of**           | ** ** | ** ** | ** ** | **% of** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Amount**                            | ** ** | **Revenue**        | ** ** | **Amount** | ** ** | **Revenue** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                             | ** ** | **(dollars in thousands)**            | ** ** |
|                                   |       |                                  |       |               |       |   |   |   |   |   |   |   |   |
| Revenues                               |       | $                                     | 199,063    |               | 100%       |   | $ | 157,258 |   | 100% |   | $ | (41,805 | ) | -21% |   |
|                                   |       |                                  |       |               |       |   |   |   |   |   |   |   |   |
| Operating  costs and expenses:         |       |                                  |       |               |       |   |   |   |   |   |   |   |   |
| Cost  of revenues                      |       | 75,565                                |       | 38%                |       | 60,814 |   | 39% |   | (14,751 | ) | -20% |   |
| Sales  and marketing                   |       | 17,022                                |       | 9%                 |       | 11,301 |   | 7% |   | (5,721 | ) | -34% |   |
| Operations  and customer support       |       | 27,746                                |       | 14%                |       | 19,657 |   | 12% |   | (8,089 | ) | -29% |   |
| General  and administrative            |       | 18,622                                |       | 9%                 |       | 14,374 |   | 9% |   | (4,248 | ) | -23% |   |
| Amortization  of intangible assets     |       | 2,147                                 |       | 1%                 |       | 1,264 |   | 1% |   | (883 | ) | -41% |   |
| Facility  exit and restructuring costs |       | 488                                   |       | 0%                 |       | 1,435 |   | 1% |   | 947 |   | 194% |   |
| Total  operating costs and expenses    |       | 141,590                               |       | 71%                |       | 108,845 |   | 69% |   | (32,745 | ) | -23% |   |
|                                   |       |                                  |       |               |       |   |   |   |   |   |   |   |   |
| Income  from operations                |       | 57,473                                |       | 29%                |       | 48,413 |   | 31% |   | (9,060 | ) | -16% |   |
| Gain  on investments, net              |       | 259                                   |       | 0%                 |       | 418 |   | 0% |   | 159 |   | 61% |   |
| Interest  expense and other, net       |       | (4,291                                | )          | -2%                |       | (5,292 | ) | -3% |   | (1,001 | ) | 23% |   |
| Income  before income taxes            |       | 53,441                                |       | 27%                |       | 43,539 |   | 28% |   | (9,902 | ) | -19% |   |
| Income  tax provision                  |       | (20,944                               | )          | -11%               |       | (16,792 | ) | -11% |   | 4,152 |   | -20% |   |
| Net  income                            |       | $                                     | 32,497     |               | 16%        |   | $ | 26,747 |   | 17% |   | $ | (5,750 | ) | -18% |   |

 

***Segment Results of Operations***

 

Weoperate two reportable segments, Consumer Services and Business Services. Wepresent our segment information along the same lines that our chief operatingdecision maker reviews our operating results in assessing performance andallocating resources. Our Consumer Services segment provides Internet accessservices and related value-added services to individual customers. Theseservices include dial-up and high-speed Internet access and VoIP services,among others. Our Business Services segment provides integrated communicationsservices and related value-added services to businesses and communicationscarriers. These services include managed IP-based wide area networks, dedicatedInternet access and web hosting, among others.

 

Weevaluate the performance of our operating segments based on segment income fromoperations. Segment income from operations includes revenues from externalcustomers, related cost of revenues and operating expenses directlyattributable to the segment, which include expenses over which segment managershave direct discretionary control, such as advertising and marketing programs,customer support expenses, operations expenses, product development expenses,certain technology and facilities expenses, billing operations and provisionsfor doubtful accounts. Segment income from operations excludes other income andexpense items and certain expenses over which segment managers do not have discretionarycontrol. Costs excluded from segment income from operations include variouscorporate expenses (consisting of certain costs such as corporate management,human resources, finance and legal), amortization of intangible assets,impairment of goodwill and intangible assets, facility exit and restructuringcosts and stock-based compensation expense, as they are not considered in themeasurement of segment performance.

 

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Thefollowing table sets forth segment data for the three months ended March 31,2009 and 2010:

 
| ** **                             | ** ** | **Three Months Ended March 31,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|----------------------------------------|------------|---------------------------------------|------------|------------|------------|-------------------|------------|
| ** **                             | ** ** | **2009**                              | ** ** | **2010**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                             | ** ** | **(dollars in thousands)**            | ** ** |
| **Consumer Services**                  |       |                                  |       |       |       |              |       |   |   |
| Revenues                               |       | $                                     | 159,562    |       | $          | 123,564           |       | $ | (35,998 | ) | -23 | % |
| Cost  of revenues                      |       | 52,334                                |       | 40,461     |       | (11,873           | )          | -23 | % |
| Gross  margin                          |       | 107,228                               |       | 83,103     |       | (24,125           | )          | -22 | % |
| Direct  segment operating expenses     |       | 37,206                                |       | 23,965     |       | (13,241           | )          | -36 | % |
| Segment  operating income              |       | $                                     | 70,022     |       | $          | 59,138            |       | $ | (10,884 | ) | -16 | % |
|                                   |       |                                  |       |       |       |              |       |   |   |
| **Business Services**                  |       |                                  |       |       |       |              |       |   |   |
| Revenues                               |       | $                                     | 39,501     |       | $          | 33,694            |       | $ | (5,807 | ) | -15 | % |
| Cost  of revenues                      |       | 23,231                                |       | 20,353     |       | (2,878            | )          | -12 | % |
| Gross  margin                          |       | 16,270                                |       | 13,341     |       | (2,929            | )          | -18 | % |
| Direct  segment operating expenses     |       | 11,259                                |       | 9,941      |       | (1,318            | )          | -12 | % |
| Segment  operating income              |       | $                                     | 5,011      |       | $          | 3,400             |       | $ | (1,611 | ) | -32 | % |
|                                   |       |                                  |       |       |       |              |       |   |   |
| **Consolidated**                       |       |                                  |       |       |       |              |       |   |   |
| Revenues                               |       | $                                     | 199,063    |       | $          | 157,258           |       | $ | (41,805 | ) | -21 | % |
| Cost  of revenues                      |       | 75,565                                |       | 60,814     |       | (14,751           | )          | -20 | % |
| Gross  margin                          |       | 123,498                               |       | 96,444     |       | (27,054           | )          | -22 | % |
| Direct  segment operating expenses     |       | 48,465                                |       | 33,906     |       | (14,559           | )          | -30 | % |
| Segment  operating income              |       | 75,033                                |       | 62,538     |       | (12,495           | )          | -17 | % |
| Stock-based  compensation expense      |       | 4,390                                 |       | 2,667      |       | (1,723            | )          | -39 | % |
| Amortization  of intangible assets     |       | 2,147                                 |       | 1,264      |       | (883              | )          | -41 | % |
| Facility  exit and restructuring costs |       | 488                                   |       | 1,435      |       | 947               |       | 194 | % |
| Other  operating expenses              |       | 10,535                                |       | 8,759      |       | (1,776            | )          | -17 | % |
| Income  from operations                |       | $                                     | 57,473     |       | $          | 48,413            |       | $ | (9,060 | ) | -16 | % |

 

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***Revenues***

 

Thefollowing table presents revenues by groups of similar services and by segmentfor the three months ended March 31, 2009 and 2010:

 
| ** **            | ** ** | **Three Months Ended**     | ** ** | ** ** | ** ** | ** **        | ** ** |
|-----------------------|------------|----------------------------|------------|------------|------------|-------------------|------------|
| ** **            | ** ** | **March 31,**         | ** ** | ** ** | ** ** | ** **        | ** ** |
| ** **            | ** ** | **2009**                   | ** ** | **2010**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **(dollars in thousands)** | ** ** |
| **Consumer Services** |       |                       |       |       |       |              |       |   |   |
| Access  and service   |       | $                          | 139,790    |       | $          | 108,198           |       | $ | (31,592 | ) | -23 | % |
| Value-added  services |       | 19,772                     |       | 15,366     |       | (4,406            | )          | -22 | % |
| Total  revenues       |       | $                          | 159,562    |       | $          | 123,564           |       | $ | (35,998 | ) | -23 | % |
|                  |       |                       |       |       |       |              |       |   |   |
| **Business Services** |       |                       |       |       |       |              |       |   |   |
| Access  and service   |       | $                          | 38,908     |       | $          | 33,139            |       | $ | (5,769 | ) | -15 | % |
| Value-added  services |       | 593                        |       | 555        |       | (38               | )          | -6 | % |
| Total  revenues       |       | $                          | 39,501     |       | $          | 33,694            |       | $ | (5,807 | ) | -15 | % |
|                  |       |                       |       |       |       |              |       |   |   |
| **Consolidated**      |       |                       |       |       |       |              |       |   |   |
| Access  and service   |       | $                          | 178,698    |       | $          | 141,337           |       | $ | (37,361 | ) | -21 | % |
| Value-added  services |       | 20,365                     |       | 15,921     |       | (4,444            | )          | -22 | % |
| Total  revenues       |       | $                          | 199,063    |       | $          | 157,258           |       | $ | (41,805 | ) | -21 | % |

 

*Consolidatedrevenues*

 

The primary component of our revenues is access and servicerevenues, which consist of narrowband access services (including traditional,fully-featured narrowband access and value-priced narrowband access); broadbandaccess services (including high-speed access via DSL and cable; VoIP; and managedIP-based wide area networks); and web hosting services. We also earn revenuesfrom value-added services, which include revenues from ancillary services soldas add-on features to our Internet access services, search and advertising.Total revenues were $199.1 million and $157.3 million during the three monthsended March 31, 2009 and 2010, respectively. The decrease from the prioryear period was due to a $36.0 million decrease in Consumer Services revenueand a $5.8 million decrease in Business Services revenue. The decrease inConsumer Services revenue was primarily due to a decrease in average consumersubscribers, which were approximately 2.5 million and 2.0 million during thethree months ended March 31, 2009 and 2010, respectively. The decrease wasdriven by reduced sales and marketing efforts and continued maturation in themarket for Internet access. The decrease in Business Services revenue wasprimarily due to a decrease in average business subscribers, which wereapproximately 160,000 and 135,000 during the three months ended March 31,2009 and 2010, respectively. Slightly offsetting the decrease in our averagebusiness subscribers was an increase in business services ARPU, which increaseddue to the shift in mix of our business access subscriber base from businessdial-up and high-speed services to IP-based network services.

 

*Consumerservices revenue*

 

*Access and service*. Consumer access and servicerevenues consist of narrowband access (including traditional, fully-featurednarrowband access and value-priced narrowband access) and broadband accessservices (including high-speed access via DSL and cable and VoIP services).These revenues are derived from fees charged to customers for dial-up Internetaccess; fees charged for high-speed access services; fees charged for VoIPservices; usage fees; shipping and handling fees; and termination fees.

 

Consumer access and service revenues decreased $31.6million, or 23%, from the three months ended March 31, 2009 to the threemonths ended March 31, 2010.  Thedecrease in consumer access and service revenues was due to decreases innarrowband access and broadband access revenues.  Narrowband access 

 

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revenuesdecreased due to a decrease in average premium narrowband and value-pricednarrowband subscribers resulting from reduced sales and marketing activitiesand the continued maturation of and competition in the market for narrowbandInternet access. We continue to focus on the retention of customers and onmarketing channels that we believe will produce an acceptable rate of return.Average consumer narrowband subscribers were 1.7 million and 1.2 million duringthe three months ended March 31, 2009 and 2010, respectively. Ourvalue-priced narrowband services comprised a larger proportion of thisdecrease, as average PeoplePC access subscribers were approximately 42% and 34%of our average consumer narrowband customer base during the three months ended March 31,2009 and 2010, respectively. Broadband access revenues decreased due to adecline in average broadband subscribers resulting from reduced sales andmarketing efforts and competitive pressures. Average consumer broadbandsubscribers were 0.9 million and 0.8 million during the three months ended March 31,2009 and 2010, respectively.

 

Offsetting the decline in average consumer subscribers wasan improvement in consumer subscriber churn rates, which were 4.0% and 3.1%during the three months ended March 31, 2009 and 2010, respectively. Weexpect our consumer access and service subscriber base to continue to decreasedue to decreased sales and marketing activities, competitive pressures and thecontinued maturation of the market for narrowband Internet access. However, asour customers become more tenured, we expect our churn rates to decline.

 

*Value-added services revenues.*Value-added services revenuesconsist of revenues from ancillary services sold as add-on features to ourInternet access services, such as security products, premium email only, homenetworking, email storage and Internet call waiting; search revenues; andadvertising revenues.* *We derive these revenues from feescharged for ancillary services; paid placements for searches; deliveringtraffic to our partners in the form of subscribers, page views ore-commerce transactions; advertising our partners’ products and services in ourvarious online properties and electronic publications; and referring ourcustomers to our partners’ products and services.

 

Value-addedservices revenues decreased $4.4 million, or 22%, from the three months ended March 31,2009 to the three months ended March 31, 2010.  This was due primarily to decreases insubscribers for ancillary services, primarily security services, and in searchadvertising revenues. The decreases resulted from the decline in total averageconsumer subscribers from 2.5 million during the three months ended March 31,2009 to 2.0 million during the three months ended March 31, 2010.  However, partially offsetting these decreaseswas an increase in subscription revenue per subscriber.

 

*Businessservices revenue*

 

The primary component of business services revenues isaccess and service revenues, and includes New Edge access and service revenues.Business access and service revenues consist of fees charged for managedIP-based wide area networks; fees charged for Internet access services;installation fees; termination fees; fees for equipment; usage fees; and costrecovery fees billed to customers. Business access and service revenues alsoconsist of web hosting revenues from leasing server space and providing webservices to enable customers to build and maintain an effective onlinepresence. We sell our services to end-user business customers and to wholesalecustomers. Our end users range from large enterprises with many locations, tosmall and medium-sized multi-site businesses to business customers with onesite, often a home-based location. Many of our end user customers are retailbusinesses. Our wholesale customers consist primarily of telecommunicationscarriers.

 

Businessaccess and service revenues decreased $5.8 million, or 15%, from the threemonths ended March 31, 2009 to the three months ended March 31,2010.  The decrease was primarily due toa decrease in New Edge revenues resulting from a decrease in averagesubscribers and an increase in promotions and retention incentives necessary toattract and retain subscribers in a difficult economic and competitiveenvironment. Although our churn rates improved during the three months ended March 31,2010 compared to the prior year period, the number of new customers we wereable to add was negatively impacted by economic and competitive pressures. Alsocontributing to the decrease in business access and service revenues weredecreases in average web hosting accounts, average business broadband customersand average business narrowband customers. Business access and service ARPUincreased during the three months ended March 31, 2010 compared to the

 

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prior yearperiod due to a shift in mix of our business access subscriber base frombusiness dial-up and high-speed services to IP-based network services.

 

***Cost of revenues***

 

Costof revenues consist of telecommunications fees, set-up fees, the costs ofequipment sold to customers for use with our services, depreciation of ournetwork equipment and surcharges due to regulatory agencies. Our principalprovider for narrowband services is Level 3 Communications, Inc. Duringthe three months ended March 31, 2010, we extended our agreement withLevel 3 Communications, Inc. through December 2011. Our principalproviders of broadband connectivity are AT&T Inc., Comcast Corporation,Covad Communications Group, Inc., Qwest Corporation, Time Warner Cable andVerizon Communications, Inc. We also purchase lesser amounts of narrowbandservices from certain regional and local providers. Cost of revenues alsoincludes sales incentives. We offer sales incentives, such as free modems andInternet access on a trial basis, for certain products and promotions.

 

Totalcost of revenues decreased $14.8 million, or 20%, from the three months ended March 31,2009 to the three months ended March 31, 2010.  This decrease was comprised of a $11.9million decrease in consumer services cost of revenues and $2.9 milliondecrease in business services cost of revenue. Consumer services cost ofrevenues decreased primarily due to the decline in average consumer servicessubscribers. Also contributing was a decline in average consumer cost ofrevenue per subscriber resulting from contract renegotiations with networkservice providers and internal network cost management efforts. Businessservices cost of revenues decreased primarily due to a decrease in averagebusiness services subscribers. Total cost of revenues increased from 38% ofrevenues to 39% of revenues due to the effect of the change in mix of oursubscriber base to broadband subscribers.

 

***Sales and marketing***

 

Sales and marketing expenses include advertising andpromotion expenses, fees paid to distribution partners to acquire new payingsubscribers and compensation and related costs (including stock-basedcompensation).

 

Sales and marketing expenses decreased $5.7 million, or34%, from the three months ended March 31, 2009 to the three months ended March 31,2010. The decrease consisted primarily of decreases in advertising andpromotions expense, personnel-related costs, outsourced labor and occupancy andrelated costs resulting from reduced headcount and continued cost reductioninitiatives. Sales and marketing expenses decreased from 9% of revenues duringthe three months ended March 31, 2009 to 7% of revenues during threemonths ended March 31, 2010, as we continued to reduce sales and marketingefforts and focused our efforts primarily on the retention of customers and onmarketing channels that we believe will produce an acceptable rate of return.

 

***Operations and customer support***

 

Operationsand customer support expenses consist of costs associated with technicalsupport and customer service, maintenance of customer information systems,software development, network operations and compensation and related costs(including stock-based compensation).

 

Operations and customer support expenses decreased $8.1million, or 29%, from the three months ended March 31, 2009 to the threemonths ended March 31, 2010. The decrease in operations and customersupport expenses consisted of decreases in personnel-related costs, outsourcedlabor and occupancy and related costs. These decreases were primarilyattributable to our efforts to reduce our back-office cost structure, includingreduced headcount and continued cost reduction initiatives, and a decrease in callvolumes for customer service and technical support as our overall subscriberbase has decreased and become longer tenured. In addition, during 2009 weconsolidated to primarily one outsourced customer service and technical supportprovider for our consumer services, which resulted in cost benefits. Operationsand customer support expenses decreased from 14% of revenues during the threemonths ended March 31, 2009 to 12% of revenues during three months ended March 31,2010.

 

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***General and administrative***

 

General and administrative expenses consist of compensationand related costs (including stock-based compensation) associated with ourfinance, legal, facilities and human resources organizations; fees forprofessional services; payment processing; credit card fees; collections andbad debt.

 

Generaland administrative expenses decreased $4.2 million, or 23%, from the threemonths ended March 31, 2009 to the three months ended March 31,2010.  The decreases in general andadministrative expenses consisted primarily of decreases in personnel-relatedcosts, bad debt and payment processing fees, professional fees and occupancyand related costs. Bad debt and payment processing fees decreased due to thedecrease in our overall subscriber base and due to our subscriber baseconsisting of longer tenured customers, who have a lower frequency ofnon-payment. The decrease in personnel-related costs and occupancy and relatedcosts was attributable to reduced headcount and continued cost reductioninitiatives. General and administrative expenses remained constant as a percentof revenues at 9% during the three months ended March 31, 2009 and 2010.

 

***Amortization of intangible assets***

 

Amortizationof intangible 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,trade names and other assets, are amortized on a straight-line basis over theirestimated useful lives, which range from three to six years. Amortization ofintangible assets decreased $0.9 million, or 41%, from the three months ended March 31,2009 to the three months ended March 31, 2010.  The decrease in amortization of intangibleassets compared to the prior year period was due to certain identifiabledefinite-lived intangible assets becoming fully amortized over the past year.

 

***Facility exit and restructuring costs***

 

In August 2007, we adopted a restructuring plan toreduce costs and improve the efficiency of our operations (“the 2007 Plan”).The 2007 Plan was the result of a comprehensive review of operations within andacross our functions and businesses. Under the 2007 Plan, we reduced ourworkforce by approximately 900 employees, consolidated our office facilities inAtlanta, Georgia and Pasadena, California and closed office facilities inOrlando, Florida; Knoxville, Tennessee; Harrisburg, Pennsylvania and SanFrancisco, California. The 2007 Plan was primarily implemented during thelatter half of 2007 and during 2008. Since management continues to evaluateEarthLink’s businesses, there have been and may continue to be supplementalprovisions for new plan initiatives as well as changes in estimates to amountspreviously recorded. As a result of the 2007 Plan, we recorded facility exitand restructuring costs of $0.5 million and $1.4 million during the threemonths ended March 31, 2009 and 2010, respectively, primarily as a resultof changes to sublease estimates in our exited facilities and furtherconsolidation in our Atlanta, Georgia facility.

 

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***Gain on investments, net***

 

Gain on investments, net, consisted of the following duringthe three months ended March 31, 2009 and 2010:

 
| ** **                                                         | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                         | ** ** | **March 31,**     | ** ** |
| ** **                                                         | ** ** | **2009**               | ** ** | **2010** | ** ** |
| ** **                                                         | ** ** | **(in thousands)**     | ** ** |
| ** **                                                         | ** ** | ** **             | ** ** | ** ** | ** ** |
| Cash  distributions from investments                               |       | $                      | 200        |   | $ | — |   |
| Gain  from sale of investments                                     |       | —                 |       | 416 |   |
| Net  change in fair value of auction rate securities and put right |       | 59                     |       | 2 |   |
|                                                               |       | $                      | 259        |   | $ | 418 |   |

 

Duringthe three months ended March 31, 2009, we received $0.2 million in cashdistributions from eCompanies Venture Group, L.P., a limited partnership thatinvested in domestic emerging Internet-related companies, and recorded a netgain of $0.1 million related to changes in fair value of our auction ratesecurities and put right. These amounts were included in gain on investments,net, in the Condensed Consolidated Statement of Operations. During the threemonths ended March 31, 2010, we sold certain of our investments in othercompanies for proceeds of $0.5 million and recognized a realized gain oninvestments of $0.4 million. This gain was included in gain on investments,net, in the Condensed Consolidated Statement of Operations.

 

As of December 31,2009 and March 31, 2010, we held auction rate securities with a carryingvalue and fair value of $42.9 million and $42.7 million, respectively. Thesesecurities are variable-rate debt instruments whose underlying agreements havecontractual maturities of up to 40 years, but have interest rate reset periodsat pre-determined intervals, usually every 28 days. These securities arepredominantly secured by student loans guaranteed by state related higher educationagencies and reinsured by the U.S. Department of Education. Beginning in February 2008,auctions for these securities failed to attract sufficient buyers, resulting inus continuing to hold such securities. In October 2008, we entered into anagreement with the broker that sold us our auction rate securities that givesus the right to sell our existing auction rate securities back to the broker atpar plus accrued interest, beginning on June 30, 2010 until July 2,2012 (herein referred to as “put right”). As a result, we classify our auctionrate securities as trading, with changes in fair value included in gain oninvestments, net, in the Condensed Consolidated Statement of Operations.  We elected the fair value option for the putright to offset the fair value changes of the auction rate securities.

 

***Interest expense and other, net***

 

Interest expense and other, net, is primarily comprised ofinterest expense incurred on our Convertible Senior Notes due November 15,2026 (“Notes”); interest earned on our cash, cash equivalents and marketablesecurities; and other miscellaneous income and expense items. Interest expenseand other, net, increased $1.0 million, from $4.3 million during the threemonths ended March 31, 2009 to $5.3 million during the three months ended March 31,2010. The increase was primarily due to a decrease in interest earned on ourcash, cash equivalents and marketable securities, despite an increase in ouraverage cash and marketable securities balance, due to lower investment yields.  Also contributing to the increase was anincrease in interest expense resulting from an increase in accretion of thedebt discount relating to our Notes.

 

***Income tax provision***

 

We recognized an income tax provision of $20.9 million during three monthsended March 31, 2009. This consisted of $2.4 million state income andfederal and state alternative minimum tax (“AMT”) amounts payable due to thenet operating loss carryforward limitations associated with the AMT calculationand $18.5 million for non-cash deferred tax provisions associated with theutilization of net operating loss carryforwards. We recognized an income taxprovision of $16.8 million during three months ended March 31, 2010. This 

 

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consistedof $1.2 million state income and federal and state AMT amounts payable and$15.6 million for non-cash deferred tax provisions associated with theutilization of net operating loss carryforwards.

 

Wecontinue to maintain a valuation allowance of $34.1 million against ourunrealized deferred tax assets, which include net operating losscarryforwards.  Of this amount, $31.7million relates to net operating losses generated by the tax benefits ofcertain stock compensation arrangements. The valuation allowance will beremoved upon utilization of these net operating losses as an adjustment toadditional paid-in-capital.  The remaining$2.4 million valuation allowance is retained for net operating losses incertain jurisdictions where there is uncertainty regarding realization.

 

To theextent we report income in future periods, we intend to use our net operatingloss carryforwards to the extent available to offset taxable income and reducecash outflows for income taxes.  Ourability to use our federal and state net operating loss carryforwards andfederal and state tax credit carryforwards may be subject to restrictionsattributable to equity transactions in the future resulting from changes inownership as defined under the Internal Revenue Code.

 

**Stock-BasedCompensation**

 

Wemeasure stock-based compensation cost for all stock awards at fair value on thedate of grant and recognition of compensation over the requisite service periodfor awards expected to vest. The fair value of our stock options is estimatedusing the Black-Scholes valuation model, and the fair value of restricted stockunits is determined based on the number of shares granted and the quoted priceof our common stock on the date of grant*.*Such value is recognized as expense over the requisite service period, net ofestimated forfeitures, using the straight-line attribution method. Forperformance-based awards, we recognize expense over the requisite service period,net of estimated forfeitures, using the accelerated attribution method when itis probable that the performance measure will be achieved. The estimate ofawards that will ultimately vest requires significant judgment, and to theextent actual results or updated estimates differ from management’s currentestimates, such amounts will be recorded as a cumulative adjustment in theperiod estimates are revised. We consider 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 our current estimates.

 

Stock-basedcompensation expense was $4.4 million and $2.7 million during the three monthsended March 31, 2009 and 2010, respectively. Stock-based compensationexpense is classified within the same operating expense line items as cashcompensation paid to employees. Stock-based compensation expense was allocatedas follows for the three months ended March 31, 2009 and 2010:

 
| ** **                       | ** ** | **Three Months Ended March 31,** | ** ** |
|----------------------------------|------------|---------------------------------------|------------|
| ** **                       | ** ** | **2009**                              | ** ** | **2010** | ** ** |
| ** **                       | ** ** | **(in thousands)**                    | ** ** |
| Sales  and marketing             |       | $                                     | 1,211      |   | $ | 715 |   |
| Operations  and customer support |       | 2,113                                 |       | 1,378 |   |
| General  and administrative      |       | 1,066                                 |       | 574 |   |
|                             |       | $                                     | 4,390      |   | $ | 2,667 |   |

 

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**Facility Exitand Restructuring Costs**

 

*2007 Plan*. * *We expect to incur future cashoutflows for real estate obligations through 2014 related to the 2007 Plan. Thefollowing table reconciles the beginning and ending liability balancesassociated with the 2007 Plan as of March 31, 2010, including changesduring the period attributable to costs incurred and charged to expense andcosts paid or otherwise settled:

 
| ** **                            | ** ** | ** **     | ** ** | **Asset**       | ** ** | ** ** | ** ** |
|---------------------------------------|------------|----------------|------------|-----------------|------------|------------|------------|
| ** **                            | ** ** | **Facilities** | ** ** | **Impairments** | ** ** | **Total**  | ** ** |
| ** **                            | ** ** | ** **     | ** ** | ** **      | ** ** | ** ** | ** ** |
| Balance  as of December 31, 2009 |       | $              | 17,438     |            | $          | —     |       | $ | 17,438 |   |
| Accruals                              |       | 1,326          |       | 109             |       | 1,435      |       |
| Payments                              |       | (1,027         | )          | —          |       | (1,027     | )          |
| Non-cash  charges                     |       | 368            |       | (109            | )          | 259        |       |
| Balance  as of March 31, 2010    |       | $              | 18,105     |            | $          | —     |       | $ | 18,105 |   |

 

*Legacy Plan*.  During the yearended December 31, 2003, we executed a plan to restructure and streamlineour contact center operations and outsource certain internal functions (“LegacyPlan”). As of March 31, 2010, we had $0.3 million remaining for realestate commitments associated with the Legacy Plan. All other costs have beenpaid or otherwise settled. We expect to incur future cash outflows for realestate obligations through September 2010 related to the Legacy Plan.

 

**Liquidity andCapital Resources**

 

The following table sets forthsummarized cash flow data for the three months ended March 31, 2009 and2010:

 
| ** **                                           | ** ** | **Three Months Ended March 31,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                           | ** ** | **2009**                              | ** ** | **2010** | ** ** |
| ** **                                           | ** ** | **(in thousands)**                    | ** ** |
|                                                 |       |                                  |       |   |   |
| Net  income                                          |       | $                                     | 32,497     |   | $ | 26,747 |   |
| Non-cash  items                                      |       | 32,514                                |       | 26,169 |   |
| Changes  in working capital                          |       | (11,087                               | )          | (20,646 | ) |
| Net  cash provided by operating activities           |       | $                                     | 53,924     |   | $ | 32,270 |   |
|                                                 |       |                                  |       |   |   |
| Net  cash (used in) provided by investing activities |       | $                                     | (47,008    | ) | $ | 3,678 |   |
|                                                 |       |                                  |       |   |   |
| Net  cash used in financing activities               |       | $                                     | (21,970    | ) | $ | (17,824 | ) |

 

*Operatingactivities*

 

Netcash provided by operating activities decreased during the three months ended March 31,2010 compared to the three months ended March 31, 2009 primarily due to adecrease in revenues as our overall subscriber base has decreased over the pastyear. However, this decrease was partially offset by reduced sales andmarketing spending, reduced telecommunication costs, reduced back-officesupport costs and reduced customer support and bad debt expense as our overallsubscriber base has decreased and become longer tenured.

 

Non-cashitems include items that are not expected to generate or require the use ofcash, such as depreciation and amortization relating to our network, facilitiesand intangible assets, net losses of equity affiliate, deferred income taxes,stock-based compensation, non-cash disposals and impairments of fixed assets,impairments of goodwill and intangible assets, gain on investments, net,accretion of debt discount and amortization of debt issuance costs. Non-cashitems decreased during the three months ended March 31, 2010 

 

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comparedto the prior year period primarily due to decreases in depreciation andamortization expense and stock-based compensation expense.

 

Changesin working capital requirements include changes in accounts receivable, prepaidand other assets, accounts payable, accrued and other liabilities and deferredrevenue. Cash used for working capital requirements increased during the threemonths ended March 31, 2010 compared to the prior year period primarilydue to payments for certain legal settlements and certain state and local taxaudits, an increase in payments for workforce reduction initiatives and changesin accounts receivable.

 

*Investingactivities*

 

Our investing activities used cashof $47.0 million during the three months ended March 31, 2009. This consistedprimarily of $44.1 million of purchases of investments in marketable securitiesand $3.1 million of capital expenditures, primarily associated with network andtechnology center related projects. Our investing activities provided cash of$3.7 million during the three months ended March 31, 2010. This consistedprimarily of $6.2 million of sales and maturities of investments in marketablesecurities, net of purchases, and $0.5 million of proceeds received from thesale of certain investments. Partially offsetting these amounts was $3.1million of capital expenditures, primarily associated with network andtechnology center related projects.

 

*Financingactivities*

 

Ourfinancing activities used cash of $22.0 million during the three months ended March 31,2009. This consisted primarily of $22.3 million used to repurchase 3.6 millionshares of our common stock, offset by $0.4 million of proceeds from theexercise of stock options. Our financing activities used cash of $17.8 millionduring the three months ended March 31, 2010. This consisted primarily of$15.4 million of dividend payments. We also used $2.8 million to pay for earlyconversion of a portion of our Notes. Under the terms of the indenturegoverning the Notes, our payment of cash dividends requires an adjustment tothe conversion rate for the Notes. In addition, as a result of the adjustment,the Notes may be surrendered for conversion for a period of time between thedeclaration date and the record date, as defined in the indenture, for theconsideration provided for in the indenture. These uses of cash were partiallyoffset by $0.3 million of proceeds from the exercise of stock options.

 

**Off-BalanceSheet Arrangements**

 

As of March 31, 2010, 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**

 

TheBoard of Directors has authorized a total of $750.0 million to repurchase ourcommon stock under our share repurchase program. As of March 31, 2010, wehad utilized approximately $603.2 million pursuant to the authorizations andhad $146.8 million available under the current authorization. We may repurchaseour common stock from time to time in compliance with the Securities andExchange Commission’s regulations and other legal requirements, and subject tomarket conditions and other factors. The share repurchase program does notrequire us to acquire any specific number of shares and may be terminated bythe Board of Directors at any time.

 

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**Future Uses ofCash and Funding Sources**

 

*Uses of cash*. We expect to incur capital expenditures to maintain andupgrade our network and technology infrastructure. The actual amount of capitalexpenditures may fluctuate due to a number of factors which are difficult topredict and could change significantly over time. Additionally, technologicaladvances may require us to make capital expenditures to develop or acquire newequipment or technology in order to replace aging or technologically obsoleteequipment. In April 2010, we increased the amount of our quarterly cashdividend from $0.14 per share to $0.16 per share. We currently intend tocontinue to pay regular quarterly dividends on our common stock. However, anydecision to declare future dividends will be made at the discretion of theBoard of Directors and will depend on, among other things, our results ofoperations, financial condition, cash requirements, investment opportunitiesand other factors the Board of Directors may deem relevant.  We expect to continue to use cash to retainexisting and acquire new subscribers for our services, which may includepurchases of subscriber bases from other ISPs. We will also use cash to payreal estate obligations associated with facilities exited in our restructuringplans and for workforce reduction initiatives or other cost reductioninitiatives. Finally, we may also use cash to invest in or acquire othercompanies, to pay additional dividends, to repurchase common stock, torepurchase Notes or in connection with holders’ conversion of Notes. Althoughwe continue to consider and evaluate potential investments or acquisitions,there can be no assurance that we will be able to consummate any suchtransaction.

 

Ourcash requirements depend on numerous factors, including our ability to maintainour customer base, the costs required to maintain our network infrastructure,the size and types of acquisitions in which we may engage, the pricing of ouraccess services, and the level of resources used for our sales and marketingactivities, among others.

 

*Sources of cash*. Our principal sources of liquidity are our cash,cash equivalents and investments in marketable securities, as well as the cashflow we generate from our operations. During the three months ended March 31,2009 and 2010, we generated $53.9 million and $32.3 million in cash fromoperations, respectively. As of March 31, 2010, we had $629.1 million incash and cash equivalents. In addition, we held short-term marketablesecurities valued at $78.7 million. Short-term marketable securities consist ofinvestments that have effective maturity dates of up to one year from thebalance sheet date. Our cash, cash equivalents and marketable securities aresubject to general credit, liquidity, market, and interest rate risks, whichmay be exacerbated by unfavorable economic conditions. If financial marketsexperience prolonged periods of decline, the value or liquidity of our cash,cash equivalents and marketable securities could decline and result in another-than-temporary decline in fair value, which could adversely affect ourfinancial condition.

 

Ourshort-term marketable securities as of March 31, 2010 included $42.7million of auction rate securities. These securities are variable-rate debtinstruments whose underlying agreements have contractual maturities of up to 40years. The securities are issued by various state related higher educationagencies and predominantly secured by student loans guaranteed by the agenciesand reinsured by the United States Department of Education. Liquidity for theseauction rate securities is typically provided by an auction process that resetsthe applicable interest rate at pre-determined intervals, usually every 28days. Beginning in February 2008, all of our auction rate securitiesfailed to attract sufficient buyers, resulting in our continuing to hold suchsecurities. In October 2008, we entered into an agreement with the brokerthat sold us our auction rate securities that gives us the right to sell ourexisting auction rate securities back to the broker at par plus accruedinterest, beginning on June 30, 2010 until July 2, 2012. Theagreement also grants the broker the right to buy our auction rate securitiesat par plus accrued interest, until July 2, 2012. Based on our remainingcash and marketable securities and operating cash flows, we do not anticipatethe current lack of liquidity on these investments will affect our ability tooperate our business as usual.

 

Ouravailable cash and marketable securities, together with our results ofoperations, are expected to be sufficient to meet our operating expenses,capital requirements and investment and other obligations for the next 12months. However, as a result of other investment activities, possibleacquisition opportunities or other strategic uses of cash, we may seekadditional financing in the future. We have no commitments for any additionalfinancing and have no lines of credit or similar sources of financing. We cannotbe sure that we can obtain additional financing on favorable terms, if at all,through the issuance of equity securities or the incurrence 

 

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ofadditional debt. Additional equity financing may dilute our stockholders, anddebt financing, if available, may restrict our ability to repurchase commonstock or debt, declare and pay dividends and raise future capital. If we areunable to obtain additional needed financing, it may prohibit us from makingacquisitions, capital expenditures and/or investments, which could materiallyand adversely affect our business.

 

**Recently Issued Accounting Pronouncement**

 

In September 2009,the Financial Accounting Standards Board issued new guidance on revenuerecognition. The new guidance addresses the accounting for multiple-deliverablearrangements to enable vendors to account for products or services(deliverables) separately rather than as a combined unit and to modify themanner in which the transaction consideration is allocated across theseparately identifiable deliverables and how revenue is recognized. The newguidance also significantly expands the disclosure requirements for multiple-elementarrangements. The new guidance is effective prospectively for revenuearrangements entered into or materially modified in fiscal years beginning onor after June 15, 2010. We do not expect the adoption of the new guidanceto have a material impact on our financial statements.

 

**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 the continued decline of our consumer accesssubscribers, combined with the change in mix of our consumer access subscriberbase from narrowband to broadband, will adversely affect our results ofoperations; (2) that we will have less ability in the future to implementcost reduction initiatives to offset our revenue declines, which will adverselyaffect our results of operations; (3) that we face significant competitionwhich could reduce our profitability; (4) that adverse economic conditionsmay harm our business; (5) that we may not be able to execute our businessstrategy for our Business Services segment, which could adversely impact ourresults of operations and cash flows; (6) that our commercial and alliancearrangements may not be renewed or may not generate expected benefits, whichcould adversely affect our results of operations; (7) that our business isdependent on the availability of third-party telecommunications serviceproviders; (8) that we may be unable to retain sufficient qualifiedpersonnel, and the loss of any of our key executive officers could adverselyaffect us; (9) that we may be unsuccessful in making and integratingacquisitions into our business, which could result in operating difficulties,losses and other adverse consequences; (10) that if we do not continue toinnovate and provide products and services that are useful to subscribers, wemay not remain competitive, and our revenues and operating results couldsuffer; (11) that our business may suffer if third parties used for customerservice and technical support and certain billing services are unable toprovide these services or terminate their relationships with us; (12) that interruption orfailure of our network and information systems and other technologies couldimpair our ability to provide our services, which could damage our reputationand harm our operating results; (13) that government regulations couldadversely affect our business or force us to change our business practices;(14) that privacy concerns relating to our business could damage our reputationand deter current and potential users from using our services;  (15) that we may not be able to protect ourintellectual property; (16) that we may be accused of infringing upon the intellectualproperty rights of third parties, which is costly to defend and could limit ourability to use certain technologies in the future; (17) that if we are unableto successfully defend against legal actions we could face substantialliabilities; (18) that our business depends on effective business supportsystems, processes and personnel; (19) that as a result of our continuingreview of our business, we may have to undertake further restructuring plansthat would require additional charges, including incurring facility exit andrestructuring charges; (20) that we may be required to recognize additionalimpairment charges on our goodwill and intangible assets, which would adverselyaffect our results of operations and financial position; (21) that we may haveexposure to greater than anticipated tax liabilities and the use of our netoperating losses and certain other tax attributes could be limited in thefuture; (22) that we may change our cash return strategy; (23) that our stockprice may be volatile; (24) that our indebtedness could adversely affect ourfinancial health and limit our ability 

 

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toreact to changes in our industry; and (25) that provisions of our secondrestated certificate of incorporation, amended and restated bylaws and otherelements of our capital structure could limit our share price and delay achange of management. These risks and uncertainties, as well as other risks anduncertainties that could cause our actual results to differ significantly frommanagement’s expectations, are not intended to represent a complete list of allrisks and uncertainties inherent in our business, and should be read inconjunction with the more detailed cautionary statements and risk factorsincluded in our Annual Report on Form 10-K for the year ended December 31,2009.

 

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

 

There have been no material changesin market risk from the information provided in Part II, Item 7A “Quantitativeand Qualitative Disclosures About Market Risk” in our Annual Report on Form 10-Kfor the year ended December 31, 2009.

 

**Item 4. Controls and Procedures.**

 

**Evaluation ofDisclosure Controls and Procedures**

 

Pursuantto Rule 13a-15(b) under the Securities Exchange Act of 1934, asamended (the “Exchange Act”), we carried out an evaluation, with theparticipation of our management, including our Chief Executive Officer andChief Financial Officer, of the effectiveness of our disclosure controls andprocedures (as defined under Rule 13a-15(e) under the 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 inInternal Control over Financial Reporting**

 

Therewere no changes in our internal control over financial reporting during thethree months ended March 31, 2010 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

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**Part II**

 

**Item 1.    Legal Proceedings.**

 

EarthLink is a party to various legal proceedings that are ordinary andincidental to its business. Management does not expect that any currentlypending legal proceedings will have a material adverse effect on EarthLink’sresults of operations or financial position.

 

**Item 1A.  Risk Factors.**

 

There were no material changes from the risk factors disclosed inEarthLink’s Annual Report on Form 10-K for the year ended December 31,2009.

 

**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 pursuant to Securities Exchange  Act Rules 13a-14 and 15d-14, as adopted pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002. |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                    |
| 31.2   |   | Certification of Chief Financial Officer pursuant to Securities Exchange  Act Rules 13a-14 and 15d-14, as adopted pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002. |
|   |   |                                                                                                                                                                                    |
| 32.1   |   | Certification of Chief Executive Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                          |
|   |   |                                                                                                                                                                                    |
| 32.2   |   | Certification of Chief Financial Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                          |

 

 

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#### **SIGNATURES**

#### ** **

Pursuant to the requirements of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|   |                |   | EARTHLINK,  INC.                                                                                 |
|--------|---------------------|--------|--------------------------------------------------------------------------------------------------|
|   |                |   |                                                                                             |
|   |                |   |                                                                                             |
| Date:  | April 29, 2010 |   | /s/  ROLLA P. HUFF                                                                               |
|   |                |   | Rolla  P. Huff, Chairman of the Board and Chief  Executive Officer (principal executive officer) |
|   |                |   |                                                                                             |
|   |                |   |                                                                                             |
| Date:  | April 29, 2010 |   | /s/  BRADLEY A. FERGUSON                                                                         |
|   |                |   | Bradley  A. Ferguson, Chief Financial Officer                                                    |
|   |                |   | (principal financial and accounting officer)                                                     |

 

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