** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-Q**
| **x**      | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                           |
|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** **                                                                                                                                                                             |
| ** ** | **For the quarterly period ended September 30,  2006**                                                                                                                                 |
| ** ** | ** **                                                                                                                                                                             |
| ** ** | **OR**                                                                                                                                                                                 |
| ** ** | ** **                                                                                                                                                                             |
| **o**      | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                          |
| ** ** | ** **                                                                                                                                                                             |
| ** ** | **For the transition period from            to             .** |

** **

**CommissionFile Number: 001-15605**

**EARTHLINK, INC.**

(Exact name of registrant as specified in its charter)

| **Delaware**                                                    |   | **58-2511877**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |   | (I.R.S. Employer  Identification No.) |

 

| **1375 Peachtree St., Atlanta, Georgia**  |   | **30309**  |
|-------------------------------------------|--------|------------|
| (Address of  principal executive offices) |   | (Zip Code) |

 

**(404)815-0770**

(Registrant’s telephone number, including area code)

----

 

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

----

Indicate by check mark whether the registrant (1) hasfiled all reports 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 xNo o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer (asdefined in Rule 12b-2 of the Exchange Act):

| Large accelerated filer x | Accelerated  filer o | Non-accelerated filer o |
|---------------------------|----------------------|-------------------------|

 

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

As of October 31, 2006, 122,601,874 shares of commonstock, $.01 par value per share, were outstanding.

 

----

**EARTHLINK,INC.**

**QuarterlyReport on Form 10-Q**

**For the Quarterly Period Ended September 30, 2006**

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

 

----

**PART I**

 

**Item1.  Financial Statements.**

 

 

**EARTHLINK, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 

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

 

**ASSETS**

 
| ** **                                                                                                                                                                                                                                                                        | ** ** | **December 31,**                                                                                                            | ** ** | **September 30,**                                                                                                           | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                                                                                                        | ** ** | **          2005          ** | ** ** | **          2006          ** | ** ** |
| ** **                                                                                                                                                                                                                                                                        | ** ** | ** **                                                                                                                       | ** ** | **(unaudited)**                                                                                                                  | ** ** |
| Current assets:                                                                                                                                                                                                                                                                   |       |                                                                                                                             |       |                                                                                                                             |       |
| Cash and cash  equivalents                                                                                                                                                                                                                                                        |       | $                                                                                                                                | 173,294    |                                                                                                                             | $          | 33,653 |   |
| Investments in  marketable securities                                                                                                                                                                                                                                             |       | 207,845                                                                                                                          |       | 104,870                                                                                                                          |       |
| Accounts  receivable, net of allowance of $8,054 and $8,864 as of December 31, 2005 and  September 30, 2006, respectively                                                                                                                                                         |       | 35,733                                                                                                                           |       | 45,197                                                                                                                           |       |
| Due from equity  affiliate                                                                                                                                                                                                                                                        |       | 300                                                                                                                              |       | —                                                                                                                           |       |
| Prepaid expenses                                                                                                                                                                                                                                                                  |       | 14,225                                                                                                                           |       | 13,770                                                                                                                           |       |
| Other current  assets                                                                                                                                                                                                                                                             |       | 13,121                                                                                                                           |       | 17,699                                                                                                                           |       |
| Total current  assets                                                                                                                                                                                                                                                             |       | 444,518                                                                                                                          |       | 215,189                                                                                                                          |       |
| Long-term investments  in marketable securities                                                                                                                                                                                                                                   |       | 40,980                                                                                                                           |       | 19,664                                                                                                                           |       |
| Investment in equity  affiliate                                                                                                                                                                                                                                                   |       | 67,143                                                                                                                           |       | 97,348                                                                                                                           |       |
| Investments in other  companies                                                                                                                                                                                                                                                   |       | 1,417                                                                                                                            |       | 58,837                                                                                                                           |       |
| Property and equipment,  net                                                                                                                                                                                                                                                      |       | 73,177                                                                                                                           |       | 94,208                                                                                                                           |       |
| Purchased intangible  assets, net                                                                                                                                                                                                                                                 |       | 16,278                                                                                                                           |       | 54,639                                                                                                                           |       |
| Goodwill                                                                                                                                                                                                                                                                          |       | 101,125                                                                                                                          |       | 198,508                                                                                                                          |       |
| Other long-term assets                                                                                                                                                                                                                                                            |       | 4,511                                                                                                                            |       | 3,063                                                                                                                            |       |
| Total assets                                                                                                                                                                                                                                                                      |       | $                                                                                                                                | 749,149    |                                                                                                                             | $          | 741,456 |   |
|                                                                                                                                                                                                                                                                              |       |                                                                                                                             |       |                                                                                                                             |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                                     | ** ** |
| Current liabilities:                                                                                                                                                                                                                                                              |       |                                                                                                                             |       |                                                                                                                             |       |
| Trade accounts  payable                                                                                                                                                                                                                                                           |       | $                                                                                                                                | 31,578     |                                                                                                                             | $          | 40,513 |   |
| Accrued payroll  and related expenses                                                                                                                                                                                                                                             |       | 37,741                                                                                                                           |       | 33,274                                                                                                                           |       |
| Other accounts  payable and accrued liabilities                                                                                                                                                                                                                                   |       | 84,139                                                                                                                           |       | 97,318                                                                                                                           |       |
| Deferred revenue                                                                                                                                                                                                                                                                  |       | 58,359                                                                                                                           |       | 54,766                                                                                                                           |       |
| Total current  liabilities                                                                                                                                                                                                                                                        |       | 211,817                                                                                                                          |       | 225,871                                                                                                                          |       |
|                                                                                                                                                                                                                                                                              |       |                                                                                                                             |       |                                                                                                                             |       |
| Deferred revenue, net  of current portion                                                                                                                                                                                                                                         |       | 716                                                                                                                              |       | 854                                                                                                                              |       |
| Other long-term  liabilities                                                                                                                                                                                                                                                      |       | 14,752                                                                                                                           |       | 13,436                                                                                                                           |       |
| Total  liabilities                                                                                                                                                                                                                                                                |       | 227,285                                                                                                                          |       | 240,161                                                                                                                          |       |
|                                                                                                                                                                                                                                                                              |       |                                                                                                                             |       |                                                                                                                             |       |
| Stockholders’ equity:                                                                                                                                                                                                                                                        |       |                                                                                                                             |       |                                                                                                                             |       |
| Convertible  preferred stock, $0.01 par value, 100,000 shares authorized, 0 shares issued  and outstanding as of December 31, 2005 and September 30, 2006                                                                                                                         |       | —                                                                                                                           |       | —                                                                                                                           |       |
| Common stock,  $0.01 par value, 300,000 shares authorized, 181,962 and 184,487 shares issued  as of December 31, 2005 and September 30, 2006, respectively,  and 131,390 and 123,376 shares outstanding  as of December 31, 2005 and  September  30, 2006, respectively |       | 1,820                                                                                                                            |       | 1,845                                                                                                                            |       |
| Additional  paid-in capital                                                                                                                                                                                                                                                       |       | 1,997,906                                                                                                                        |       | 2,027,884                                                                                                                        |       |
| Warrants to  purchase common stock                                                                                                                                                                                                                                                |       | 259                                                                                                                              |       | 259                                                                                                                              |       |
| Accumulated  deficit                                                                                                                                                                                                                                                              |       | (1,049,982                                                                                                                       | )          | (1,020,243                                                                                                                       | )          |
| Treasury stock,  at cost, 50,572 and 61,111 shares as of December 31, 2005 and September 30,  2006, respectively                                                                                                                                                                  |       | (422,619                                                                                                                         | )          | (502,466                                                                                                                         | )          |
| Unrealized  losses on investments                                                                                                                                                                                                                                                 |       | (653                                                                                                                             | )          | (5,984                                                                                                                           | )          |
| Deferred compensation                                                                                                                                                                                                                                                             |       | (4,867                                                                                                                           | )          | —                                                                                                                           |       |
| Total  stockholders’ equity                                                                                                                                                                                                                                                  |       | 521,864                                                                                                                          |       | 501,295                                                                                                                          |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                                                                                                  |       | $                                                                                                                                | 749,149    |                                                                                                                             | $          | 741,456 |   |

 

The accompanying notesare an integral part of these financial statements.

1

----

 

**EARTHLINK, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                                          | ** ** | **Three Months Ended**                                   | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                          | ** ** | **September 30,**                                             | ** ** | **September 30,**          | ** ** |
| ** **                                          | ** ** | **2005**                                                           | ** ** | **2006**                        | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                          | ** ** | **(in thousands, except per share data)** | ** ** |
| ** **                                          | ** ** | **(unaudited)**                                                    | ** ** |
| Revenues:                                           | ** ** | ** **                                                         |       |                            |       |   |   |   |   |
| Narrowband access                                   |       | $                                                                  | 181,242    |                            | $          | 150,842 |   | $ | 570,420 |   | $ | 472,797 |   |
| Broadband access                                    |       | 109,308                                                            |       | 149,404                         |       | 330,382 |   | 409,355 |   |
| Advertising and other value-added services          |       | 16,507                                                             |       | 22,375                          |       | 45,547 |   | 63,921 |   |
| Web hosting                                         |       | 9,939                                                              |       | 8,688                           |       | 31,075 |   | 27,044 |   |
| Total revenues                                      |       | 316,996                                                            |       | 331,309                         |       | 977,424 |   | 973,117 |   |
|                                                |       |                                                               |       |                            |       |   |   |   |   |
| Operating costs  and expenses:                      |       |                                                               |       |                            |       |   |   |   |   |
| Telecommunications service and equipment costs      |       | 90,156                                                             |       | 112,790                         |       | 279,017 |   | 313,163 |   |
| Sales incentives                                    |       | 2,222                                                              |       | 1,626                           |       | 6,744 |   | 4,535 |   |
| Total cost of revenues                              |       | 92,378                                                             |       | 114,416                         |       | 285,761 |   | 317,698 |   |
|                                                |       |                                                               |       |                            |       |   |   |   |   |
| Sales and marketing                                 |       | 92,749                                                             |       | 93,926                          |       | 291,249 |   | 290,701 |   |
| Operations and customer support                     |       | 57,821                                                             |       | 66,683                          |       | 178,729 |   | 193,904 |   |
| General and administrative                          |       | 26,891                                                             |       | 33,286                          |       | 82,328 |   | 95,937 |   |
| Acquisition-related amortization                    |       | 2,828                                                              |       | 3,372                           |       | 9,668 |   | 8,407 |   |
| Facility exit and restructuring costs               |       | 1,301                                                              |       | -                               |       | 2,008 |   | (117 | ) |
| Total operating costs and expenses                  |       | 273,968                                                            |       | 311,683                         |       | 849,743 |   | 906,530 |   |
|                                                |       |                                                               |       |                            |       |   |   |   |   |
| Income from operations                              |       | 43,028                                                             |       | 19,626                          |       | 127,681 |   | 66,587 |   |
| Gain on  investments in other companies, net        |       | —                                                             |       | 25                              |       | 2,437 |   | 377 |   |
| Net losses of  equity affiliate                     |       | (4,592                                                             | )          | (26,174                         | )          | (6,934 | ) | (49,116 | ) |
| Interest income  and other, net                     |       | 3,400                                                              |       | 3,272                           |       | 9,211 |   | 11,822 |   |
| Income (loss) before income taxes                   |       | 41,836                                                             |       | (3,251                          | )          | 132,395 |   | 29,670 |   |
| Provision  (benefit) for income taxes               |       | 5,401                                                              |       | (69                             | )          | 18,765 |   | (69 | ) |
| Net income (loss)                                   |       | $                                                                  | 36,435     |                            | $          | (3,182 | ) | $ | 113,630 |   | $ | 29,739 |   |
|                                                |       |                                                               |       |                            |       |   |   |   |   |
| Basic net income  (loss) per share                  |       | $                                                                  | 0.28       |                            | $          | (0.02 | ) | $ | 0.82 |   | $ | 0.23 |   |
| Diluted net  income (loss) per share                |       | $                                                                  | 0.27       |                            | $          | (0.02 | ) | $ | 0.80 |   | $ | 0.22 |   |
|                                                |       |                                                               |       |                            |       |   |   |   |   |
| Basic weighted  average common shares outstanding   |       | 132,444                                                            |       | 128,321                         |       | 139,056 |   | 130,863 |   |
| Diluted weighted  average common shares outstanding |       | 134,709                                                            |       | 128,321                         |       | 141,621 |   | 132,769 |   |

 

The accompanying notes are an integral part of these financialstatements.

2

----

 

**EARTHLINK, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS**

 
| ** **                                                                         | ** ** | **Nine Months Ended**      | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                         | ** ** | **September 30,**               | ** ** |
| ** **                                                                         | ** ** | **2005**                             | ** ** | **2006** | ** ** |
| ** **                                                                         | ** ** | **(in thousands)  (unaudited)** | ** ** |
| Cash flows from  operating activities:                                             | ** ** | ** **                           |       |   |   |
| Net income                                                                         |       | $                                    | 113,630    |   | $ | 29,739 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                                 |       |   |   |
| Depreciation and amortization                                                      |       | 36,704                               |       | 33,796 |   |
| Loss on disposals and impairments of fixed assets                                  |       | 34                                   |       | 820 |   |
| Gain on investments in other companies, net                                        |       | (2,437                               | )          | (377 | ) |
| Net losses of equity affiliate                                                     |       | 6,934                                |       | 49,116 |   |
| Stock-based compensation expense                                                   |       | 1,128                                |       | 10,869 |   |
| Deferred income taxes                                                              |       | 14,367                               |       | 221 |   |
| Other adjustments                                                                  |       | (200                                 | )          | (797 | ) |
| (Increase) decrease in accounts receivable, net                                    |       | (2,655                               | )          | 1,468 |   |
| Decrease (increase) in prepaid expenses and other  assets                          |       | 10,374                               |       | (2,582 | ) |
| Decrease in accounts payable and accrued and other  liabilities                    |       | (10,546                              | )          | (30,344 | ) |
| Decrease in deferred revenue                                                       |       | (6,615                               | )          | (3,696 | ) |
| Net cash provided by operating activities                                          |       | 160,718                              |       | 88,233 |   |
|                                                                               |       |                                 |       |   |   |
| Cash flows from  investing activities:                                             |       |                                 |       |   |   |
| Purchases of property and equipment                                                |       | (26,659                              | )          | (24,395 | ) |
| Purchases of subscriber bases                                                      |       | (4,806                               | )          | (2,636 | ) |
| Proceeds from sales of fixed assets                                                |       | 20                                   |       | 8 |   |
| Investments in marketable securities:                                              |       |                                 |       |   |   |
| Purchases                                                                          |       | (273,978                             | )          | (68,174 | ) |
| Sales and maturities                                                               |       | 401,893                              |       | 192,828 |   |
| Purchase of businesses, net                                                        |       | (9,219                               | )          | (108,663 | ) |
| Investments in and net advances to and from equity  affiliate                      |       | (81,745                              | )          | (78,232 | ) |
| Amounts paid for sale of net liabilities to equity  affiliate                      |       | (929                                 | )          | — |   |
| Investments in other companies                                                     |       | —                               |       | (60,000 | ) |
| Loan origination fees                                                              |       | —                               |       | (803 | ) |
| Distributions received from investments in other  companies                        |       | 4,000                                |       | 377 |   |
| Net cash provided by (used in) investing activities                                |       | 8,577                                |       | (149,690 | ) |
|                                                                               |       |                                 |       |   |   |
| Cash flows from  financing activities:                                             |       |                                 |       |   |   |
| Repayment of note payable                                                          |       | —                               |       | (2,000 | ) |
| Principal payments under capital lease obligations                                 |       | (16                                  | )          | (26 | ) |
| Proceeds from stock options exercised and employee stock  purchase plan purchases  |       | 9,553                                |       | 3,689 |   |
| Purchases of treasury stock                                                        |       | (181,333                             | )          | (79,847 | ) |
| Net cash used in financing activities                                              |       | (171,796                             | )          | (78,184 | ) |
|                                                                               |       |                                 |       |   |   |
| Net decrease in  cash and cash equivalents                                         |       | (2,501                               | )          | (139,641 | ) |
| Cash and cash  equivalents, beginning of period                                    |       | 218,910                              |       | 173,294 |   |
| Cash and cash  equivalents, end of period                                          |       | $                                    | 216,409    |   | $ | 33,653 |   |

 

The accompanying notes are an integral part of thesefinancial statements.

3

----

**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**UNAUDITED**

 

**1.  Organization **

EarthLink, Inc. (“EarthLink”or the “Company”) is an Internet serviceprovider (“ISP”), providing nationwide Internet access and relatedvalue-added services to its individual and business customers.  EarthLink’s primary service offerings arenarrowband and broadband Internet access services, advertising and relatedmarketing services, and web hosting services. The Company provides a broadrange of products and services to more than five million paying customers througha nationwide network of dial-up points of presence (“POPs”) and a nationwidebroadband footprint.

**2.  Basis of Presentation**                                                                            

*Basis of Presentation*

Thecondensed consolidated financial statements of EarthLink, which include theaccounts of its wholly-owned subsidiaries, for the three and nine months ended September30, 2005 and 2006 and the related footnote information are unaudited and havebeen prepared on a basis consistent with the Company’s audited consolidatedfinancial statements as of December 31, 2005 contained in the Company’s AnnualReport on Form 10-K, as filed with the Securities and Exchange Commission (the “AnnualReport”).  All significant intercompanytransactions 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 the opinionof management, the accompanying unaudited financial statements contain alladjustments (consisting of normal recurring adjustments), which managementconsiders necessary to present fairly the Company’s financial position, resultsof operations and cash flows for the interim periods presented.  The results of operations for the three and ninemonths ended September 30, 2006 are not necessarily indicative of the resultsanticipated for the entire year ending December 31, 2006.  

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

*Reclassifications*

Certain amounts in theprior period financial statements have been reclassified to conform to thecurrent period presentation. 

**3.  Recent Accounting Pronouncements**

In June 2006, the FinancialAccounting Standards Board (“FASB”) ratified the consensus reached in EmergingIssues Task Force (“EITF”) Issue No. 06-2, “Accounting for Sabbatical Leave andOther Similar Benefits Pursuant to FASB Statement No. 43.” EITF Issue No. 06-2provides recognition guidance on the accrual of employees’ rights to compensatedabsences under a sabbatical or other similar benefit arrangement. EITF IssueNo. 06-2 is effective for the Company for all financial statements afterDecember 31, 2006. The Company is currently assessing the impact of theadoption of EITF Issue No. 06-2 on its financial statements.

In July 2006, theFASB issued FASB Interpretation (“FIN”) No. 48, “Accounting forUncertainty in Income Taxes,” which prescribes a comprehensive model for how acompany should recognize, measure, present and disclose in its financialstatements uncertain tax positions that the company has taken or expects totake on a tax return (including a decision whether to file or not to file areturn in a particular jurisdiction). The accounting provisions of FIN No. 48are effective for fiscalyears beginning after December 15, 2006. The Company is in the processof determining the effect, if any, the adoption of FIN No. 48 will have on itsfinancial statements.

4

----

InSeptember 2006, the FASB issued Statement of Financial Accounting Standards(“SFAS”) No. 157, “Fair Value Measurements”, which establishes a frameworkfor reporting fair value and expands disclosures about fair value measurements.SFAS No. 157 is effective for financial statements issued for fiscal yearsbeginning after November 15, 2007 and interim periods within those fiscalyears. The Company is currently assessing the impact of the adoption of thisstandard on its financial statements. 

**4.  Stock-Based Compensation**

*StockIncentive Plans*

TheCompany has granted options to employees and directors to purchase the Company’scommon stock under various stock incentive plans. The Company has also grantedrestricted stock units to employees and directors under various stock incentiveplans. Under the plans, employees and non-employee directors are eligible toreceive awards of various forms of equity-based incentive compensation,including stock options, restricted stock, restricted stock units, phantomshare units and performance awards, among others. The plans are administered bythe Board of Directors or the Compensation Committee of the Board of Directors,which determine the terms of the awards granted. Stock options are generallygranted 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 to six years from the date of grant. Restricted stock unitsgenerally vest over terms of three to six years from the date of grant.

*Deferred Compensation Plan*

TheCompany’s Second Deferred Compensation Plan for Directors and Certain KeyEmployees permits members of the Board of Directors and eligible employees toelect to defer receipt of shares of common stock pursuant to vested restrictedstock units and various cash consideration, such as directors’ fees andbonuses. The cash consideration is converted into phantom share units at theclosing price on the date the consideration would otherwise be paid, and vestedrestricted stock units are converted into phantom share units on a one-for-onebasis. Phantom share units are fully vested at the date of grant and areconverted to common stock upon the occurrence of various events. As of September30, 2006, approximately 26,000 phantom share units were outstanding.

*Adoptionof SFAS 123(R)*

Priorto January 1, 2006, the Company accounted for stock-based compensationusing the intrinsic value method, which follows the recognition and measurementprinciples of Accounting Principles Board (“APB”) Opinion No. 25, “Accountingfor Stock Issued to Employees,” and FIN No. 44, ‘‘Accounting for CertainTransactions Involving Stock Compensation.’’ Generally, no stock-based employee compensation cost related to stockoptions was reflected in net income (loss) prior to January 1, 2006, as alloptions granted under stock-based compensation plans had an exercise priceequal to the market value of the underlying common stock on the grant date.However, to the extent that the Company modified stock options subsequent tothe grant date, the Company recorded compensation expense based on themodification, as required by SFAS No. 123 and APB Opinion No. 25. Compensation cost related to restricted stock units granted to non-employeedirectors and certain key employees was reflected in net income as services wererendered. 

OnJanuary 1, 2006, the Company adopted SFAS No. 123(R), “Share-BasedPayment,” using the modified prospective method, which requires measurement ofcompensation cost for all stock awards at fair value on the date of grant andrecognition of compensation over the requisite service period for awardsexpected to vest. In accordance with the modified prospective method, theCompany’s financial statements for periods prior to implementation have notbeen restated to reflect, and do not include, the impact of SFAS No. 123(R). TheCompany estimates the fair value of stock options using the Black-Scholesvaluation model, and determines the fair value of restricted stock units basedon the number of shares granted and the quoted price of EarthLink’s commonstock on the date of grant*.* Suchvalue is recognized as expense over the requisite service period, net of estimatedforfeitures, using the straight-line attribution method. The estimate of awardsthat will ultimately

5

----

vest requiressignificant judgment, and to the extent actual results or updated estimatesdiffer from the Company’s current estimates, such amounts will be recorded as acumulative adjustment in the period estimates are revised. The Companyconsiders many factors when estimating expected forfeitures, including types ofawards, employee class and historical employee attrition rates. Actual results,and future changes in estimates, may differ substantially from the Company’scurrent estimates. 

InMarch 2005, the SEC published SAB No. 107, which provides the Staff’sviews on a variety of matters relating to stock-based payments. SAB No. 107requires stock-based compensation be classified in the same expense line itemsas cash compensation. The Company has classified stock-based compensation expenseduring the three and nine months ended September 30, 2006 within the sameoperating expense line items as cash compensation paid to employees. 

InNovember 2005, the FASB issued FASB Staff Position No. FAS 123(R)-3, “TransitionElection Related to Accounting for Tax Effects of Share-Based Payment Awards,”which provides an elective transition method for calculating the initial poolof excess tax benefits available to absorb tax deficiencies recognizedsubsequent to the adoption of SFAS No. 123(R). Companies may take up to oneyear from the effective date of this FASB Staff Position to evaluate theavailable transition alternatives and make a one-time election as to whichmethod to adopt. The Company is currently in the process of evaluating thealternative methods.

Thecumulative effect of adoption of SFAS No. 123(R) using the modified prospectivetransition method, which resulted from estimating forfeitures on nonvestedshares of restricted stock rather than accounting for forfeitures as theyoccurred, was not material. Prior to the adoption of SFAS No. 123(R), deferredcompensation relating to restricted stock units was presented as a separatecomponent of stockholders’ equity. Upon adoption of SFAS No. 123(R) on January1, 2006, the deferred compensation balance of $4.9 million was reclassified toadditional paid-in capital.

Stock-basedcompensation expense under SFAS No. 123(R) was $3.4 million and $10.8 million duringthe three and nine months ended September 30, 2006, respectively, of which $3.0million and $9.4 million, respectively, related to stock options and $0.4million and $1.4 million, respectively, related to restricted stock units.  Stock-based compensation expense during thethree and nine months ended September 30, 2005 included $0.3 million and $0.8million related to restricted stock units, respectively, and stock-basedcompensation expense during the nine months ended September 30, 2005 included $0.4million of stock-based compensation expense arising from modifications toextend the exercise periods of certain vested stock options for EarthLinkemployees transferring to HELIO. As a result of adopting SFAS No. 123(R) onJanuary 1, 2006, the Company’s income from operations and net income for thethree and nine months ended September 30, 2006 were $2.9 million and $9.1 millionlower, respectively, than if it had continued to account for share-basedcompensation using the intrinsic method of accounting under APB Opinion No. 25.Basic and diluted net income per share for the three and nine months ended September30, 2006 were $0.02 per share and $0.07 per share lower, respectively, than ifthe Company had continued to account for share-based compensation using theintrinsic method of accounting under APB Opinion No. 25. The incremental impactof SFAS No. 123(R) during the three and nine months ended September 30,2006 represents stock-based compensation expense related to stock optionsand the impact of estimating forfeitures related to nonvested shares ofrestricted stock.

6

----

*ValuationAssumptions for Stock Options*

The fair value ofstock options granted during the nine months ended September 30, 2005 and 2006was estimated using the Black-Scholes option-pricing model with the followingassumptions: 

|                          | ** ** | **Nine Months Ended September 30,**                                                                                                  | ** ** |
|--------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **               | ** ** | **            2005            ** | ** ** | **            2006            ** | ** ** |
|                     |       |                                                                                                                                                     |       |   |   |
| Dividend yield           |       | 0                                                                                                                                                        | %          | 0 | % |
| Expected  volatility     |       | 50                                                                                                                                                       | %          | 44 | % |
| Risk-free  interest rate |       | 3.96                                                                                                                                                     | %          | 4.90 | % |
| Expected life            |       | 4.8 years                                                                                                                                                |       | 4.4 years |   |

 

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

*Optionsand Warrants Outstanding*

The followingtable summarizes information concerning stock option and warrant activityduring the nine months ended September 30, 2006: 
| ** **                                            | ** ** | ** **                                                | ** ** | ** **   | ** ** | **Weighted**          | ** ** | ** **    | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------------------|------------|--------------|------------|-----------------------|------------|---------------|------------|
| ** **                                            | ** ** | ** **                                                | ** ** | **Weighted** | ** ** | **Average**           | ** ** | ** **    | ** ** |
| ** **                                            | ** ** | ** **                                                | ** ** | **Average**  | ** ** | **Remaining**         | ** ** | **Aggregate** | ** ** |
| ** **                                            | ** ** | **Stock Options**                                    | ** ** | **Exercise** | ** ** | **Contractual**       | ** ** | **Intrinsic** | ** ** |
| ** **                                            | ** ** | **and Warrants**                                     | ** ** | **Price**    | ** ** | **Term (Years)** | ** ** | **Value**     | ** ** |
| ** **                                            | ** ** | **(shares and dollars in thousands)** | ** ** |
|                                                  | ** ** | ** **                                                |       |         |       |                  |       |          |       |
| Outstanding as  of December 31, 2005                  |       | 19,908                                                    |       | $            | 11.87      |                  |       |          |       |   |
| Granted                                               |       | 1,949                                                     |       | 8.89         |       |                  |       |          |       |
| Exercised                                             |       | (673                                                      | )          | 6.01         |       |                  |       |          |       |
| Forfeited                                             |       | (1,534                                                    | )          | 12.69        |       |                  |       |          |       |
| Outstanding as  of September 30, 2006                 |       | 19,650                                                    |       | 11.71        |       | 6.3                   |       | $             | 5,021      |   |
|                                                  |       |                                                      |       |         |       |                  |       |          |       |
| Vested and  expected to vest as of September 30, 2006 |       | 18,052                                                    |       | $            | 11.91      |                  | 6.0        |          | $          | 4,927 |   |
|                                                  |       |                                                      |       |         |       |                  |       |          |       |
| Exercisable as of  September 30, 2006                 |       | 12,205                                                    |       | $            | 13.26      |                  | 4.9        |          | $          | 3,330 |   |

 

The weighted averageestimated fair value of stock options granted during the nine months ended September30, 2006 was $3.73 per share.  Theaggregate intrinsic value amounts in the table above represent the differencebetween the closing price of the Company’s common stock on September 30, 2006and the exercise price, multiplied by the number of in-the-money stock optionsas of the same date. This represents the amount that would have been receivedby the stock option holders if they had all exercised their stock options on September30, 2006. The total intrinsic value of options exercised during the nine monthsended September 30, 2006 was $2.4 million.

7

----

*RestrictedStock Units*

As of December 31, 2005and September 30, 2006, approximately 658,000 and 740,000 restricted stockunits, respectively, issued to non-employee directors and certain key employeeswere outstanding. During the nine months ended September 30, 2006, 345,000 restrictedstock units were granted, 159,000 restricted stock units vested and 104,000restricted stock units were forfeited. The weighted average grant date fairvalue of restricted stock units as of December 31, 2005 and September 30, 2006was $9.82 and $9.73 per unit, respectively. As of September 30, 2006, there was$4.8 million of total unrecognized compensation cost related to nonvestedshare-based compensation arrangements. That cost is expected to be recognizedover a weighted-average period of 2.7 years.

*ProForma Information for Period Prior to SFAS 123(R) Adoption*

Ifthe Company had elected to adopt the optional recognition provisions of SFASNo. 123, which uses the fair value based method for stock-basedcompensation, and amortized the grant date fair value of stock options tocompensation expense on a straight-line basis over the vesting period of theoptions, net income and basic and diluted net income per share would have beenchanged to the pro forma amounts indicated below:

|                                                                                                       | ** ** | **Three Months**                                                                                              | ** ** | **Nine Months**             | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                            | ** ** | **Ended**                                                                                                          | ** ** | **Ended**                        | ** ** |
| ** **                                                                                            | ** ** | **September 30, 2005**                                                                                   | ** ** | **September 30, 2005** | ** ** |
| ** **                                                                                            | ** ** | **    (in thousands, except per share data)    ** | ** ** |
|                                                                                                  |       |                                                                                                               |       |                             |       |
| Net income, as  reported                                                                              |       | $                                                                                                                  | 36,435     |                             | $          | 113,630 |   |
| Add: Stock-based  compensation expense associated with stock options included in reported net  income |       | —                                                                                                             |       | 366                              |       |
| Deduct:  Stock-based compensation expense determined using a fair value based method  for all awards  |       | (3,234                                                                                                             | )          | (11,680                          | )          |
| Pro forma net  income                                                                                 |       | $                                                                                                                  | 33,201     |                             | $          | 102,316 |   |
|                                                                                                  |       |                                                                                                               |       |                             |       |
| Basic net income  per share:                                                                          |       |                                                                                                               |       |                             |       |
| As reported                                                                                           |       | $                                                                                                                  | 0.28       |                             | $          | 0.82 |   |
| Pro forma                                                                                             |       | $                                                                                                                  | 0.25       |                             | $          | 0.74 |   |
|                                                                                                  |       |                                                                                                               |       |                             |       |
| Diluted net  income per share:                                                                        |       |                                                                                                               |       |                             |       |
| As reported                                                                                           |       | $                                                                                                                  | 0.27       |                             | $          | 0.80 |   |
| Pro forma                                                                                             |       | $                                                                                                                  | 0.25       |                             | $          | 0.73 |   |

 

**5.  Acquisition**

In April 2006, EarthLinkcompleted its acquisition of New Edge Holding Company (“New Edge”), asingle-source national provider of secure multi-site managed data networks anddedicated Internet access for businesses and communications carriers. Throughthis acquisition, EarthLink expanded its business in the small and medium-sizedbusiness market. New Edge is a wholly-owned subsidiary of EarthLink andcontinues to operate under its current name. The results of operations of NewEdge are included in the condensed consolidated financial statements from thedate of the acquisition.

The acquisition wasaccounted for pursuant to SFAS No. 141, “Business Combinations.” The total purchase price of $142.2million consisted of $108.7 million net cash paid, including direct transactioncosts;

8

----

$20.2 million in EarthLink, Inc. common stock,representing approximately 1.7 million shares; and estimated net liabilitiesassumed of $13.3 million. In addition, approximately 0.9 million shares ofEarthLink, Inc. common stock are being held in escrow and will be used to coverliabilities that may arise under EarthLink’s indemnification rights under themerger agreement. To the extent escrow shares are not used to satisfyliabilities, the shares will be issued as additional purchase price on thefifteen month anniversary of the closing date. The fair value of EarthLink, Inc. common stock was determined based onthe average market price per share the three days before and the three daysafter the announcement of the execution of the merger agreement.

EarthLink allocated $44.8million of the total purchase price to identifiable intangible assets,consisting of acquired customer relationships, trade names and software. Thefair values of identifiable intangible assets acquired were based on anindependent appraisal. The preliminary purchase price allocation resulted in$97.4 million of goodwill. The purchase price was allocated to the assetsacquired and liabilities assumed based on their estimated fair values,including identifiable intangible assets. The acquired customer relationshipsand software are being amortized on a straight-line basis from the date of theacquisition over the estimated useful lives of the assets, which range fromthree to nine years. The weighted average amortizable life of the acquiredintangible assets is 5.9 years. The acquired trade names were deemed to haveindefinite useful lives. The amounts of liabilities assumed and identifiableassets acquired will continue to be subject to adjustment for up to one yearfrom the date of acquisition. Any change will change the amount of purchaseprice allocable to goodwill. The pro forma effect of the transaction is notmaterial.

**6.  Earnings per Share**

Netincome (loss) per share has been computed according to SFAS No. 128, “Earningsper Share,” which requires a dual presentation of basic and diluted earningsper share (“EPS”).  Basic EPS representsnet income divided by the weighted average number of common shares outstandingduring a reported period.  Diluted EPSreflects the potential dilution that could occur if securities or othercontracts to issue common stock, including stock options, warrants, restrictedstock units, phantom share units and contingently issuable shares (commonly andhereinafter referred to as “Common Stock Equivalents”), were exercised orconverted into common stock. In applying the treasury stock method forstock-based compensation arrangements during the nine months ended September30, 2006, the assumed proceeds were computed as the sum of the amount theemployee must pay upon exercise and the amounts of compensation costattributed to future services and not yet recognized.

Thefollowing table sets forth the computation for basic and diluted net income pershare for the three months ended September 30, 2005 and the nine months endedSeptember 30, 2005 and 2006:

|                                                            | ** ** | **Three Months Ended**                                   | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                 | ** ** | **September 30,**                                             | ** ** | **September 30,**          | ** ** |
| ** **                                                 | ** ** | **2005**                                                           | ** ** | **2005**                        | ** ** | **2006** | ** ** |
| ** **                                                 | ** ** | **(in thousands, except per share data)** | ** ** |
|                                                       |       |                                                               |       |                            |       |   |   |
| Net income (A)                                             |       | $                                                                  | 36,435     |                            | $          | 113,630 |   | $ | 29,739 |   |
|                                                       |       |                                                               |       |                            |       |   |   |
| Basic weighted average  common shares outstanding (B) |       | 132,444                                                            |       | 139,056                         |       | 130,863 |   |
| Dilutive effect of  Common Stock Equivalents               |       | 2,265                                                              |       | 2,565                           |       | 1,906 |   |
| Diluted weighted  average common shares outstanding (C)    |       | 134,709                                                            |       | 141,621                         |       | 132,769 |   |
|                                                       |       |                                                               |       |                            |       |   |   |
| Basic net income per  share (A/B)                          |       | $                                                                  | 0.28       |                            | $          | 0.82 |   | $ | 0.23 |   |
| Diluted net income per  share (A/C)                        |       | $                                                                  | 0.27       |                            | $          | 0.80 |   | $ | 0.22 |   |

 

9

----

Common Stock Equivalentsfor the three and nine months ended September 30, 2005 included an average of9.5 million stock options, warrants, phantom share units and restricted stockunits which had a dilutive effect based on application of the treasury stockmethod.  Common Stock Equivalents for thethree and nine months ended September 30, 2005 excluded 11.9 million and 11.8million, respectively, average stock options, warrants and restricted stockunits outstanding which were deemed anti-dilutive because the exercise pricesexceeded the Company’s average stock price during the three and nine monthsended September 30, 2005.

Common Stock Equivalentsfor the nine months ended September 30, 2006 included an average of 5.6 millionoptions, warrants, phantom share units and restricted stock units which had adilutive effect based on application of the treasury stock method, but excluded14.8 million average options, warrants and restricted stock units outstandingwhich were deemed anti-dilutive because the assumed proceeds exceeded theCompany’s average stock price during the nine months ended September 30, 2006,but these options, warrants and restricted stock units could be dilutive infuture periods. The Company has not included the effect of Common StockEquivalents in the calculation of diluted EPS for the three months endedSeptember 30, 2006 because such inclusion would have an anti-dilutive effect.

**7. Comprehensive Income**

Comprehensive income includes unrealized gains and losses on investments which are excluded from the Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2005 and 2006 as follows:

|                                                 | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                      | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                      | ** ** | **2005**                         | ** ** | **2006**                        | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                      | ** ** | **(in thousands)**          | ** ** |
| Net income (loss)                               |       | $                                | 36,435     |                            | $          | (3,182 | ) | $ | 113,630 |   | $ | 29,739 |   |
| Net change in  unrealized losses on investments |       | (112                             | )          | (10,715                         | )          | (393 | ) | (5,331 | ) |
| Total comprehensive income (loss)               |       | $                                | 36,323     |                            | $          | (13,897 | ) | $ | 113,237 |   | $ | 24,408 |   |

 

Thenet change in unrealized losses on investments for the three and nine monthsended September 30, 2006 was primarily due to the change in the estimatedfair value of the Company’s investments in other companies as a result of adecrease in the closing stock price of these companies as of September 30,2006 compared to the prior period end.

**8.  Facility Exit Costs**

Duringthe year ended December 31, 2003, EarthLink executed a plan to streamline itscontact center facilities (the “2003 Plan”). In connection with the 2003 Plan,EarthLink closed contact center facilities in Dallas, Texas; Sacramento,California; Pasadena, California; and Seattle, Washington. The closure of thefour contact center facilities resulted in the termination of 1,220 employeesand the net reduction of 920 employees, primarily customer support personnel.

Duringthe year ended December 31, 2004, EarthLink executed a plan to restructure andfurther streamline its contact center operations (the “2004 Plan”). Under the2004 Plan, EarthLink closed contact center operations in Harrisburg,Pennsylvania; Roseville, California; San Jose, California; and Pasadena,California; and reduced its contact center operations in Atlanta, Georgia.Approximately 1,140 employees were directly impacted, primarily customersupport personnel.

During the year endedDecember 31, 2005, EarthLink executed plans to further streamline operations byoutsourcing certain contact center and credit and collections activities (the “2005Plans”). Approximately 227 employees were directly impacted.

10

----

The following tablesummarizes activity for the liability balances associated with the 2003 Plan,the 2004 Plan and the 2005 Plans for the period December 31, 2005 throughSeptember 30, 2006, including costs paid or otherwise settled and adjustmentsto the liabilities:
| ** **                                                                 | ** ** | **Balance**             | ** ** | ** **   | ** ** | ** **      | ** ** | **Balance**            | ** ** |
|----------------------------------------------------------------------------|------------|-------------------------|------------|--------------|------------|-----------------|------------|------------------------|------------|
| ** **                                                                 | ** ** | **December 31,**   | ** ** | ** **   | ** ** | ** **      | ** ** | **September 30,** | ** ** |
| ** **                                                                 | ** ** | **2005**                | ** ** | **Payments** | ** ** | **Adjustments** | ** ** | **2006**               | ** ** |
| ** **                                                                 | ** ** | **(in thousands)** | ** ** |
| Severance and  personnel-related costs                                     |       | $                       | 65         |         | $          | (34             | )          | $                      | (31        | ) | $ | — |   |
| Real estate and  telecommunications costs, including non-cancelable leases |       | 5,594                   |       | (1,321       | )          | (86             | )          | 4,187                  |       |
|                                                                       |       | $                       | 5,659      |         | $          | (1,355          | )          | $                      | (117       | ) | $ | 4,187 |   |

 

**9.  Investments**

*Investmentsin marketable securities*

Short- and long-terminvestments in marketable securities consist of investments in debt securitiesclassified as available-for-sale and have original maturities greater than 90days from the date of acquisition.  Short-terminvestments in marketable securities consist of investments that have maturitydates of up to one year from the balance sheet date. Short-term investments inmarketable securities also include investments in asset-backed, auction ratedebt securities with interest rate reset periods of 90 days or less but whoseunderlying agreements have original maturities of more than 90 days, based onthe provisions of Accounting Research Bulletin No. 43, Chapter 3A, WorkingCapital-Current Assets and Liabilities, which allows classification ofinvestments based on management’s view. Long-term investments in marketable securities consist of investmentsthat have maturity dates of more than one year from the balance sheet date,excluding investments in asset-backed, auction rate debt securities withinterest reset periods of 90 days or less, which are classified as short-terminvestments in marketable securities. The Company has invested primarily in government agency notes, asset-backeddebt securities (including auction rate debt securities), corporate notes andcommercial paper, all of which bear a minimum short-term rating of A1/P1 or aminimum long-term rating of A/A2. Realized gains and losses are included in interest income and other,net, in the accompanying Condensed Consolidated Statements of Operations andare determined on a specific identification basis.  During the three and nine months endedSeptember 30, 2005 and 2006, gains and losses realized from sales of investmentsin marketable securities were nominal. As of December 31, 2005 and September30, 2006, gross unrealized losses were $0.2 million and gross unrealized gainswere nominal.

*Investmentsin other companies*

As of December 31, 2005and September 30, 2006, minority investments in other companies were $1.4million and $58.8 million, respectively, and are classified as investments inother companies in the Condensed Consolidated Balance Sheets. The Companyaccounts for minority investments in other companies under the cost method ofaccounting and classifies investments in other companies which are publiclytraded as available-for-sale securities. Accordingly, the Company adjusts thecarrying values of those investments to market value through unrealized(losses) gains included in stockholders’ equity and accumulated othercomprehensive income (loss). Minority investments in other companies as ofDecember 31, 2005 and September 30, 2006 included $1.0 million and $11.0million, respectively, of investments carried at cost, and $0.4 million and$47.8 million, respectively, of investments recorded at fair value. As ofDecember 31, 2005, gross unrealized losses were $0.1 million and there were nogross unrealized gains. As of September 30, 2006, gross unrealized losses were$5.9 million and gross unrealized gains were $0.1 million.

In March 2006, theCompany invested $50.0 million in Covad Communications Group, LLC (“Covad”),which consisted of 6.1 million shares of Covad common stock for an aggregatepurchase price of $10.0 million and $40.0 million aggregate principal amount of12% Senior Secured Convertible Notes due 2011

11

----

(the “Notes”). The Company cannot exert significantinfluence over Covad’s operating and financial policies and, as such, accountsfor its investment in Covad under the cost method of accounting and classifiesthe investment as available-for-sale. The Company deferred $0.8 million ofdirect loan origination costs that will be recognized as a reduction in theeffective yield over the term of the Notes.

In April 2006, theCompany invested $10.0 million in Current Communications Group, LLC (“Current”),a privately-held broadband-over-powerline provider. The Company accounts forits investment in Current under the cost method of accounting because theCompany cannot exert significant influence over Current’s operating andfinancial policies.

InJune 2005, the Company received a $4.0 million cash distribution fromeCompanies Venture Group, L.P. (“EVG”), a limited partnership that invested indomestic emerging Internet-related companies. In applying the cost method,EarthLink recorded $0.7 million as a return of EarthLink’s investment based onthe carrying value of the investment, and the remaining $3.3 million wasrecorded as a gain on investments in other companies, net, in the CondensedConsolidated Statements of Operations. During the nine months ended September30, 2006, the Company recorded a $0.4 million gain on investments in othercompanies resulting from an additional EVG dividend.

During the three months ended March 31, 2005, the Companyrecognized a loss of $0.9 million on certain of its investments in othercompanies as a result of a decline in fair value that was consideredother-than- temporary. This loss is included in loss on investments inother companies in the Condensed Consolidated Statements of Operations.Management regularly evaluates the recoverability of its investments in othercompanies based on the performance and the financial position of thosecompanies as well as other evidence of market value.

*Investmentin equity affiliate*

In March 2005, theCompany completed the formation of HELIO, a joint venture with SK Telecom Co.,Ltd. (“SK Telecom”). HELIO is a non-facilities-based mobile virtual networkoperator (“MVNO”) offering mobile communications services and handsets to U.S.consumers. EarthLink and SK Telecom each have an equal voting and economicownership interest in HELIO. EarthLink and SK Telecom, as partners,invested an aggregate of $166.0 million of cash and non-cash assets uponcompleting the formation of HELIO, invested an aggregate of $78.0 million ofcash in August 2005, invested an aggregate $79.0 million in February 2006,invested an aggregate of $78.0 million in August 2006 and have committed toinvest additional cash of $39.0 million in 2007.

InJanuary and July 2006, HELIO received minority investments, which reducedEarthLink’s and SK Telecom’s economic ownership interest in HELIO from 50percent at formation to 48 percent. However, EarthLink’s and SK Telecom’svoting interest remains the same.

12

----

The Company accounts forits investment in HELIO under the equity method of accounting because theCompany can exert significant influence over HELIO’s operating and financialpolicies.  As a result, the Companyrecords its proportionate share of HELIO’s net loss in its statement ofoperations. The Company is amortizing the difference between the book value andfair value of definite-lived non-cash assets contributed to HELIO over theestimated useful lives of the definite-lived non-cash assets contributed. Theamortization increases the carrying value of the Company’s investment anddecreases the net losses of equity affiliate included in the statement ofoperations. The following table presents the components of net losses ofaffiliate for the three and nine months ended September 30, 2005 and 2006:

 

|                                | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                     | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                     | ** ** | **2005**                         | ** ** | **2006**                        | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                     | ** ** | **(in thousands)**          | ** ** |
| Equity method losses           |       | $                                | (6,200     | )                               | $          | (27,991 | ) | $ | (10,272 | ) | $ | (54,823 | ) |
| Amortization                   |       | 1,608                            |       | 1,817                           |       | 3,338 |   | 5,707 |   |
| Net losses of equity affiliate |       | $                                | (4,592     | )                               | $          | (26,174 | ) | $ | (6,934 | ) | $ | (49,116 | ) |

 

Summarizedstatement of operations information of HELIO for the three and nine monthsended September 30, 2005 and 2006 is as follows:

|                | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **     | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **     | ** ** | **2005**                         | ** ** | **2006**                        | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **     | ** ** | **(in thousands)**          | ** ** |
|           |       |                             |       |                            |       |   |   |   |   |
| Revenues       |       | $                                | 5,316      |                            | $          | 12,795 |   | $ | 11,077 |   | $ | 23,987 |   |
| Operating loss |       | (13,713                          | )          | (64,837                         | )          | (22,783 | ) | (124,732 | ) |
| Net loss       |       | (12,514                          | )          | (62,275                         | )          | (20,659 | ) | (117,652 | ) |
|                |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |

 

**10.  Purchased Intangible Assets and Goodwill**

*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, 2005 and September 30, 2006:
| ** **                         | ** ** | **As of December 31, 2005** | ** ** | **As of September 30, 2006** | ** ** |
|------------------------------------|------------|-------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                         | ** ** | **Gross**                                       | ** ** | **Net**                                          | ** ** | **Gross** | ** ** | **Net** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                         | ** ** | **Carrying**                                    | ** ** | **Accumulated**                                  | ** ** | **Carrying** | ** ** | **Carrying** | ** ** | **Accumulated** | ** ** | **Carrying** | ** ** |
| ** **                         | ** ** | **Value**                                       | ** ** | **Amortization**                                 | ** ** | **Value** | ** ** | **Value** | ** ** | **Amortization** | ** ** | **Value** | ** ** |
| ** **                         | ** ** | **(in thousands)**                         | ** ** |
|                               |       |                                            |       |                                             |       |   |   |   |   |   |   |   |   |
| Definite life  intangible assets   |       | $                                               | 340,636    |                                             | $          | (327,358 | ) | $ | 13,278 |   | $ | 379,546 |   | $ | (335,764 | ) | $ | 43,782 |   |
| Indefinite life  intangible assets |       |                                            |       |                                             |       | 3,000 |   |   |   |   |   | 10,857 |   |
|                               |       |                                            |       |                                             |       |   |   |   |   |   |   |   |   |
| Total                              |       |                                            |       |                                             |       | $ | 16,278 |   |   |   |   |   | $ | 54,639 |   |
|                                    |            |                                                 |            |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

13

----

The Company’s definitelife intangible assets primarily consist of subscriber bases and customerrelationships, acquired software and technology and other assets acquired inconjunction with the purchases of businesses and subscriber bases from otherISPs that are not deemed to have indefinite lives. The Company’s indefinitelife intangible assets primarily consist of trade names.  Definite life intangible assets are amortizedon a straight-line basis over their estimated useful lives, which are generallythree to six years for subscriber bases and customer relationships and one tosix years for acquired software and technology. Acquisition-relatedamortization in the Condensed Consolidated Statements of Operations for thethree and nine months ended September 30, 2005 and 2006 represents theamortization of definite life intangible assets.  Based on the current amount of definite lifeintangible assets, the Company expects to record amortization expense ofapproximately $3.0 million for the remaining three months in the year endingDecember 31, 2006 and $10.9 million, $9.0 million, $6.6 million, $6.4 millionand $7.9 million for the years ending December 31, 2007, 2008, 2009, 2010 andthereafter, 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.

 

*Goodwill*

During the nine monthsended September 30, 2006, goodwill increased $97.4 million due to the Company’sacquisition of New Edge. During the nine months ended September 30, 2006, goodwillalso decreased $0.1 million due to the realization of tax benefits associatedwith net operating loss carryforwards which were acquired in connection withthe acquisitions of OneMain.com, Inc. and PeoplePC Inc. The net operating losscarryforwards were utilized to offset taxable income for the nine months endedSeptember 30, 2006.

**11.  Share Repurchases**

Since the inception ofthe Company’s share repurchase program, the Board of Directors has authorized atotal of $550.0 million for the repurchase of EarthLink’s common stock. TheBoard of Directors has also approved repurchasing common stock pursuant toplans under Rule 10b5-1 of the Securities Exchange Act of 1934, as amended. TheCompany may purchase its common stock from time to time in compliance with theSEC’s regulations and other legal requirements, including through the use ofderivative transactions, subject to market conditions and other factors. Theshare repurchase program does not require the Company to acquire any specificnumber of shares and may be terminated at any time. During the three monthsended March 31, 2006, the Company suspended repurchases of common stock,including termination of its 10b5-1 repurchase plan. During the three monthsended June 30, 2006, the Company resumed repurchases of common stock. As ofSeptember 30, 2006, the Company had $101.1 million available under its currentauthorization by the Board of Directors.

The following tablesummarizes share purchases during the three and nine months ended September 30,2005 and 2006 pursuant to previously existing authorizations by the Board ofDirectors, which have been recorded as treasury stock:

|                             | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                  | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                  | ** ** | **2005**                         | ** ** | **2006**                        | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                  | ** ** | **(in thousands)**          | ** ** |
| Number of shares  purchased |       | 4,980                            |       | 8,049                           |       | 19,482 |   | 10,539 |   |
| Aggregate purchase price    |       | $                                | 46,530     |                            | $          | 58,705 |   | $ | 181,333 |   | $ | 79,847 |   |
|                             |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |

 

14

----

**12.Income Taxes**

The provision for incometaxes during the three and nine months ended September 30, 2005 consisted of$1.0 million and $2.2 million, respectively, of state income taxes due and avaluation allowance of $0.7 million and $2.2 million, respectively, establishedfor federal and state alternative minimum tax (“AMT”) amounts due.  The AMT may be used to offset tax due infuture periods and was payable primarily due to the net operating losscarryforward limitations associated with the AMT calculation. The provision forincome taxes for the three and nine months ended September 30, 2005 alsoincluded a non-cash, deferred tax provision of $3.7 million and $14.4 million,respectively, associated with the utilization of net operating losscarryforwards which were acquired in connection with the acquisitions ofOneMain.com, Inc., PeoplePC Inc. and Cidco Incorporated.

EarthLink has recorded income taxes at an effectiveannual tax rate of 0% for the three and nine months ended September 30, 2006based on management’s current expectations for the results of operations forthe year ending December 31, 2006 in accordance with the interim reportingrequirements of SFAS No. 109, “Accounting for Income Taxes,” and APB OpinionNo. 28, “Interim Financial Reporting.”

EarthLink continues tomaintain a full valuation allowance against its unrealized deferred tax assets,consisting primarily of net operating loss carryforwards, and EarthLink mayrecognize deferred tax assets in future periods when they are estimated to berealizable. To the extent EarthLink may owe income taxes in future periods,EarthLink intends to use its net operating loss carryforwards to the extentavailable to offset taxable income and reduce cash outflows for income taxes.

**13. Related Party Transactions**

UponHELIO’s formation, EarthLink and HELIO entered into a services agreement forEarthLink to provide to HELIO facilities, accounting, tax, billing,procurement, risk management, payroll, human resource, employee benefitadministration and other support services in exchange for management fees.However, as HELIO develops it business, the extent to which HELIO relies onEarthLink to provide these services has decreased. EarthLink believes thatproviding these services to HELIO enabled HELIO to more quickly and costeffectively launch its business than if it had purchased these services fromthird parties.  The management fees weredetermined based on EarthLink’s costs to provide the services, and managementbelieves such fees are reasonable.  Thetotal amount of fees that HELIO pays to EarthLink depends on the extent towhich HELIO utilizes EarthLink’s services. Fees for services provided to HELIO are reflected as reductions to theassociated expenses incurred by EarthLink to provide such services. During thethree and nine months ended September 30, 2005, fees received for servicesprovided to HELIO were $1.0 million and $2.4 million, respectively. During thethree and nine months ended September 30, 2006, fees received for servicesprovided to HELIO were $0.6 million and $1.8 million, respectively.

EarthLinkalso markets HELIO’s products and services and purchase wireless Internetaccess devices and services from HELIO. During the three and nine months endedSeptember 30, 2005 and 2006, revenues generated from HELIO and fees paid forproducts and services from HELIO were minimal.

*eCompanies*

During the nine monthsended September 30, 2005, the Company received a $4.0 million cash distributionfrom its investment in EVG. Sky Dayton, a member of EarthLink’s Board ofDirectors, is a founding partner in EVG.

15

----

**Item2.   Management’s Discussion and Analysisof Financial Condition and Results of Operations.**

Certain statementsin this Quarterly Report on Form 10-Q are forward-looking statementswithin the meaning of the Private Securities Litigation Reform Act of 1995,Section 27A of the Securities Act of 1933, and Section 21E of theSecurities Exchange Act of 1934. The words “estimate,” “plan,” “intend,” “expect,”“anticipate,” “believe” and similar expressions are intended to identifyforward-looking statements. These forward-looking statements are found at variousplaces throughout this report. EarthLink disclaims any intention or obligationto update or revise any forward-looking statements, whether as a result of newinformation, future events or otherwise. Although EarthLink believes that itsexpectations are based on reasonable assumptions, it can give no assurance thatits goals will be achieved. Important factors that could cause actual resultsto differ from estimates or projections contained in the forward-lookingstatements are described under “Safe Harbor Statement” in this Item 2.

*The following discussion should be read in conjunction with theaccompanying unaudited Condensed Consolidated Financial Statements and relatedNotes thereto and with “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” and the audited Consolidated Financial Statementsand the Notes thereto contained in the Annual Report on Form 10-K for the yearended December 31, 2005.*

**Overview**

EarthLink, Inc.(“EarthLink,” “we,” “us” or “our”) is an Internet service provider (“ISP”),providing nationwide Internet access and related value-added services toindividual and business customers.  Ourprimary service offerings are narrowband and broadband Internet accessservices, advertising and related marketing services and web hostingservices.  We provide our broad range ofservices to more than five million paying customers through a nationwidenetwork of dial-up points of presence (“POPs”) and a nationwide broadbandfootprint.  We are currently focused on variousstrategic growth initiatives, including IP-based voice services, municipalwireless broadband services and wireless voice and data services, in ourevolution to become a total communications provider.

*IndustryBackground*

TheInternet access market in the U.S. grew dramatically from the mid-1990s through2000 but has experienced slower growth subsequently as the market has reached amature stage of growth. Approximately 77 million households were estimated tohave had Internet access services as of December 31, 2005, and three to fourmillion new households are currently adding Internet access each year. Withinthe total Internet access market, there are three distinct markets: broadbandaccess, premium narrowband access and value narrowband access. Broadband, orhigh-speed, access is typically priced at $20 to $50 per month and generallyoffers users faster connection and download speeds than narrowband access. Themarket for broadband access is rapidly growing; however, new subscriber growthis gradually slowing as the market matures and competition for customerswithout broadband access continues to intensify. Broadband service providersincreasingly pursue aggressive price-based competitive strategies. As a result,pricing for broadband services, particularly for introductory promotionalperiods, services bundled with cable and telephone services, and services withslower speeds, has been declining and is approaching prices for traditionaldial-up services. Premium narrowband access services, which are typicallypriced at $17.95 to $25.90 per subscriber per month, offer service withadditional features such as telephone technical support, proprietary content,parental controls, pop-up blockers, security functions, extra email storage andaccelerator capabilities. Value-priced narrowband access providers offerservices with a limited set of features priced typically at $9.95 to $14.95 permonth and are attracting households new to the Internet or current Internetusers interested in reducing their cost of Internet access. The market forpremium narrowband access has been shrinking, as consumers move to broadbandand value narrowband services.

Asthe Internet has become a larger part of people’s lives and advancedapplications have come to require greater bandwidth, broadband use has becomemore widespread. Currently, residential broadband consumers access the Internetprincipally through cable modems and digital subscriber lines (“DSL”). However,an increasing array of alternative broadband access technologies, such aswireless broadband and broadband over

16

----

power lines, isbecoming available. The availability of these alternatives is expected tofurther encourage future broadband deployment and penetration. In addition, oneof the outgrowths from the rapid deployment of broadband connectivity has beenthe adoption of Voice over Internet Protocol (“VoIP”). VoIP is a technologythat enables voice communications over the Internet through the conversion ofvoice signals into data packets. VoIP technology presents several advantagesover the technology used in traditional wireline telephone networks and enablesVoIP providers to operate with lower capital expenditures and operating costswhile offering both traditional and innovative service features.

*RevenueSources*

EarthLinkprovides all three types of Internet access services described above (premiumnarrowband access; value narrowband access; and broadband access), web hostingservices and advertising and other value-added services, such as mail storageand security. During 2006, we began providing VoIP services, managed datanetwork services through our acquisition of New Edge Holding Company (“New Edge”)and municipal Wi-Fi services. Our subscriber base remained consistent atapproximately 5.3 million paying subscribers as of September 30, 2005 and 2006.Total revenues increased from $317.0 million during the three months endedSeptember 30, 2005 to $331.3 million during the three months ended September30, 2006, and decreased from $977.4 million during the nine months endedSeptember 30, 2005 to $973.1 million during the nine months ended September 30,2006. In addition, the mix of customers has shifted toward broadband services,reflecting the growth of this component of the Internet access market and our expandingbroadband footprint and offerings; and toward value-priced narrowband Internetaccess services for consumers that are slower to adopt broadband services. Ourtraditional, premium-priced narrowband subscriber base and revenues have beendeclining reflecting the maturity of this service.

Wederive substantially all revenues from services and related fees. The remainingrevenues relate to sales of equipment and devices used by our customers toaccess our services. We had approximately 3.3 million narrowband subscribers,1.9 million broadband subscribers and 116,000 web hosting accounts as ofSeptember 30, 2006. Narrowband access revenues, broadband access revenues,advertising and other value-added services revenues and web hosting revenuesrepresented 48%, 42%, 7% and 3%, respectively, of total revenues for the ninemonths ended September 30, 2006. We expect broadband access revenues toeventually account for a greater percentage of total revenues than narrowbandaccess revenues.

*BusinessStrategy and Risks*

Ourbusiness strategy is to sustain and build upon our strong position in the U.S.Internet access market by focusing on broadband and value-priced narrowbandaccess to generate organic subscriber growth; become a total communicationsprovider by expanding into new markets, such as VoIP services, municipal Wi-Fiservices and wireless voice and data services; market high quality,differentiated products and services; and improve or maintain operating marginson our existing service offerings to fund growth. We believe the most importantfactors for us to execute our business strategy are the following:

·                  Exploring,identifying and investing in growth opportunities, such as VoIP services andmunicipal Wi-Fi services, and successfully implementing strategies to addcustomers and deliver these services cost effectively

·                  Managing therate of decline of our traditional, premium-priced narrowband access subscriberbase and revenues and balancing aggressive promotional pricing with the numberof subscribers we are able to add and/or retain while continuing to manageoperating costs

·                  Continuing thegrowth of our PeoplePC-branded, value-priced narrowband access and ourbroadband service offerings in spite of competition from current and newcompetitors

·                  Differentiatingour products and services to enable us to deliver high quality services thatimprove customers’ Internet experiences

·                  Continuing toidentify opportunities to improve the cost structure of our business withoutimpacting the quality of services we provide

17

----

·                  Renewing,extending or otherwise entering into wholesale broadband access agreements withtelecommunications providers at competitive and improved wholesale broadbandaccess prices and, in the event there are adverse changes in the retail pricingenvironment for broadband access services, at wholesale broadband access pricesthat decrease sufficiently to at least coincide with declines in retail prices

·                  Exploringand evaluating potential strategic transactions that we believe may complementour current and future business activities and successfully integrating any newacquisitions and investments into our business

Theprimary challenges we face in executing our business strategy are successfullydeveloping and implementing new products and services on a timely basis,competition, purchasing cost-effective wholesale broadband access, andmaintaining profitability in our Internet access services.

*LookingAhead*

Asthe market for premium narrowband continues to decline, we will continue tofocus our efforts on broadband services and value-priced narrowband services.We also expect to use the cash generated from these services to fund ourstrategic growth initiatives. These initiatives will be focused on expandingour marketing efforts for VoIP services, widening our municipal broadband Wi-Fifootprint and the various Wi-Fi services we offer, expanding the marketing anddistribution efforts for HELIO, and increasing our small and medium enterprise(“SME”) service offerings. Overall profits declined during the three and ninemonths ended September 30, 2006 compared to the prior year periods, and weexpect this trend to continue for the remainder of 2006 due to theimplementation of these strategic growth initiatives, as well as theproportionate share of losses we expect to incur as a result of the start-upnature of HELIO’s operations. Implementation of new services involves initialproduct development and infrastructure costs in addition to sales and marketingcosts. The operating models for these services are similar to the ISP operatingmodel upon which we have based our current operations. Specifically, afterdeveloping an infrastructure to support the offering, we plan to invest insales and marketing to add customers who generate recurring revenues, while weincur customer support and telecommunications costs to provide these services.Because this year was one in which we invested in product development,infrastructure and sales and marketing efforts for our new services, ourprofitability thus far in 2006 was adversely impacted because revenues forthese services did not exceed these initial costs. We expect this trend tocontinue for the remainder of 2006. However, we believe management can exercisediscretion in deploying product development and sales and marketing resourcesto manage the growth of the VoIP and municipal broadband customer bases. Wealso expect HELIO to continue to incur losses, as HELIO is in a similar stagewith respect to its service offerings. We record our proportionate share ofHELIO’s losses in our results of operations, so our profitability for theremainder of 2006 will also be adversely impacted because of HELIO’s losses.

Thefactors we believe are instrumental to the achievement of our goals andtargets, including the factors identified above, may be subject to competitive,regulatory and other events and circumstances that are beyond our control.Further, we can provide no assurance that we will be successful in achievingany or all of the factors identified above, that the achievement or existenceof such factors will favorably impact profitability, or that other factors willnot arise that would adversely affect future profitability.

18

----

**Strategic Growth Initiatives**

*MunicipalWireless Access*

Oneof our strategic growth initiatives is to invest in wireless broadband accessto deploy a competitive alternative to DSL and cable for delivering broadbandInternet access services. We began this initiative during 2005 by winningproposals to finance, build and manage wireless broadband networks for thecities of Philadelphia, Pennsylvania and Anaheim, California. During 2006, wecompleted the initial phase for these networks and began offering our Wi-Fiservices.  The following additionaldevelopments were made during 2006:

·                  In April 2006,the San Francisco TechConnect Committee selected our joint ‘Request ForProposal’ (RFP) with Google, to the city of San Francisco to build a citywidewireless municipal network. This will allow us to leverage the strengths ofboth companies and to offer services to different customers on the network thatfit with their individual needs and wants. We are currently in negotiations toreach a contract with the city of San Francisco.

·                  In March 2006, the city of Milpitas,California selected EarthLink to build a wireless broadband network. Under theterms of the proposed contract, we intend to finance, build and manage thewireless network, which would cover approximately 6.5 square miles.

·                  In May 2006, we received approvalfrom the New Orleans City Council to enable us to build a Wi-Fi broadbandnetwork in the city of New Orleans. The initial 15 square mile deployment willreplace the city-owned network.

·                  In August 2006, we were selected bythe city of Pasadena to enter into negotiations to build, own and operate a 23square mile citywide municipal wireless network.

Weare currently pursuing additional similar arrangements with othermunicipalities. We expect to significantly expand our wireless broadbandfootprint and grow our wireless broadband subscriber base to increase revenues.These initiatives may result in significant capital expenditures and operatingcosts in future periods to develop, implement and build wireless broadband networksin these municipalities, as well as increased costs to market the new services.

*Wireless Voice and Data Services*

Effective March 24, 2005,we completed the formation of HELIO, a joint venture with SK Telecom Co., Ltd.(“SK Telecom”). HELIO is a non-facilities-based mobile virtual network operator(MVNO) offering mobile communications services and handsets to consumers in theU.S. EarthLink and SK Telecom invested an aggregate of $166.0 million of cashand non-cash assets upon completing the formation of HELIO, invested anaggregate of $78.0 million of cash in August 2005, invested an aggregate of$79.0 million of cash in February 2006, invested an aggregate of $78.0 millionin August 2006 and have committed to invest additional cash of $39.0 million in2007. As of September 30, 2006, EarthLink and SK Telecom each had a 50percent voting interest and a 48 percent economic ownership interest in HELIO.Through this joint venture, we have a share in the market for wireless voiceand data services.

During the second quarterof 2006, HELIO launched its first two handheld devices, which are based onproducts SK Telecom offers in Korea. HELIO targets young, connected consumerswith an extensive array of features, including MySpace Mobile, video services,3D and multiplayer games, and video, picture and text messaging, in addition toits wireless voice and data services. HELIO is currently marketing its services through a variety of means.During the third quarter of 2006, HELIO had distribution of its devices in over2,200 retail and agent locations and began its national television and printmarketing campaign.

19

----

 

*IP-Based Voice Services*

In late 2005 and early2006, we launched DSL and Home Phone Service in Dallas, Seattle, San Franciscoand San Jose with Covad Communications Group, Inc. (“Covad”). The new DSL andVoIP service, which uses Covad line-powered voice access, allows us to offerconsumers low-cost phone services along with high-speed Internet access.

In March 2006, weinvested $50.0 million in Covad to fund the network build-out of DSL and HomePhone Service access in eight additional cities.  In September 2006, we launched service inthese markets, which include Atlanta, Chicago, Los Angeles, Miami, New YorkCity, Philadelphia, San Diego and Washington, D.C. We plan to begin marketingthe EarthLink DSL and Home Phone Service in these markets during the fourthquarter of 2006. We will continue to invest in the development of additionalapplications and services and the marketing efforts for our IP-based voiceservices.

**Acquisition**

In April 2006, we closedour acquisition of New Edge, a single-source national provider of securemulti-site managed data networks and dedicated Internet access for businessesand communications carriers. The acquisition of New Edge expands our businessto small and medium-sized enterprises. Under the terms of the merger agreement,we acquired 100% of New Edge in a merger transaction for 1.7 million shares ofEarthLink common stock and $108.7 million in net cash, including cash to beused to satisfy certain New Edge liabilities and direct transaction costs.

Weexpect to build upon our existing portfolio of SME products, including webhosting, security and VoIP services, and we expect to expand into new growthmarkets, such as Virtual Private Networks (VPN), wide area networking andwholesale solutions.

**Marketing Alliances and Other**

We have a marketingrelationship with Embarq Corporation (“Embarq”), a spin-off of Sprint NextelCorporation’s local communications business. The relationship provides thatEarthLink is the wholesale high-speed ISP for Embarq’s local residential andsmall business customers. In addition, we provide Embarq with wholesalenarrowband access services. The contracts associated with these arrangementsexpire in April 2007. During the third quarter of 2006, EarthLink and Embarqdecided not to renew the wholesale broadband contract. During the three andnine months ended September 30, 2005 and 2006, our relationship with Embarqgenerated more than 10% of our total gross organic subscriber additions. As ofSeptember 30, 2006, our broadband subscriber count and total subscriber countincluded approximately 751,000 subscribers under the marketing relationship.During the three months ended September 30, 2006, the relationship generatedrevenues of approximately $7.7 million.

We have an agreement withTime Warner Cable and Bright House Networks, companies whose networks pass morethan 19 million homes, to offer our broadband Internet access services overtheir systems. In connection with the agreement, Time Warner Cable and BrightHouse Networks receive consideration from EarthLink for carrying the EarthLinkservice and related Internet traffic. As of September 30, 2006, more than 25%of our broadband subscribers were serviced via either the Time Warner Cable orBright House Networks network. In July 2006, we entered into a new agreementwith Time Warner Cable to provide our broadband services over their systemsthrough November 2011.

InFebruary 2006, we extended our commercial agreement with BellSouth Corporation(“BellSouth”) to provide DSL service to customers in BellSouth’s coverage areathrough the end of 2008.

20

----

 

**KeyOperating Metrics**

Weutilize certain non-financial and operating measures to assess our financialperformance. Terms such as churn and average revenue per user (“ARPU”) are termscommonly used in our industry. The following table sets forth subscriberand operating data for the periods indicated:
| ** **                               | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|------------------------------------------|------------|------------------------|------------|-----------------------|------------|-------------------|------------|------------------------|------------|
| ** **                               | ** ** | **2005**               | ** ** | **2005**              | ** ** | **2006**          | ** ** | **2006**               | ** ** |
| **Subscriber  Data (a)**                 | ** ** | ** **             | ** ** | ** **            | ** ** | ** **        | ** ** | ** **             | ** ** |
| Narrowband  subscribers                  |       | 3,650,000              |       | 3,580,000             |       | 3,411,000         |       | 3,330,000              |       |
| Broadband  subscribers                   |       | 1,544,000              |       | 1,608,000             |       | 1,810,000         |       | 1,857,000              |       |
| Web hosting  accounts                    |       | 131,000                |       | 127,000               |       | 119,000           |       | 116,000                |       |
| Total subscriber  count at end of period |       | 5,325,000              |       | 5,315,000             |       | 5,340,000         |       | 5,303,000              |       |

 
| ** **                          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                          | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
| ** **                          | ** ** | **2005**               | ** ** | **2006**              | ** ** | **2005** | ** ** | **2006** | ** ** |
| **Subscriber  Activity**            | ** ** | ** **             | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Subscribers at  beginning of period |       | 5,384,000              |       | 5,340,000             |       | 5,388,000 |   | 5,315,000 |   |
| Gross organic  subscriber additions |       | 696,000                |       | 678,000               |       | 2,112,000 |   | 2,088,000 |   |
| Acquired  subscribers (b)           |       | 6,000                  |       | 6,000                 |       | 101,000 |   | 76,000 |   |
| Adjustment (c)                      |       | —                 |       | —                |       | (27,000 | ) | — |   |
| Churn                               |       | (761,000               | )          | (721,000              | )          | (2,249,000 | ) | (2,176,000 | ) |
| Subscribers at  end of period       |       | 5,325,000              |       | 5,303,000             |       | 5,325,000 |   | 5,303,000 |   |
|                                |       |                   |       |                  |       |   |   |   |   |
| **Churn  rate (d)**                 |       | 4.7                    | %          | 4.5                   | %          | 4.7 | % | 4.5 | % |
|                                |       |                   |       |                  |       |   |   |   |   |
| **Narrowband  Data**                | ** ** | ** **             | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Average  subscribers (e)            |       | 3,700,000              |       | 3,375,000             |       | 3,763,000 |   | 3,466,000 |   |
| ARPU (f)                            |       | $                      | 16.33      |                  | $          | 14.90 |   | $ | 16.84 |   | $ | 15.16 |   |
| Churn rate (d)                      |       | 5.6                    | %          | 5.6                   | %          | 5.5 | % | 5.7 | % |
|                                |       |                   |       |                  |       |   |   |   |   |
| **Broadband  Data**                 | ** ** | ** **             | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Average  subscribers (e)            |       | 1,519,000              |       | 1,833,000             |       | 1,468,000 |   | 1,751,000 |   |
| ARPU (f)                            |       | $                      | 23.98      |                  | $          | 27.17 |   | $ | 25.00 |   | $ | 25.98 |   |
| Churn rate (d)                      |       | 2.8                    | %          | 2.6                   | %          | 2.7 | % | 2.4 | % |
|                                |       |                   |       |                  |       |   |   |   |   |
| **Web  Hosting Data**               | ** ** | ** **             | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Average accounts  (e)               |       | 133,000                |       | 118,000               |       | 138,000 |   | 121,000 |   |
| ARPU (f)                            |       | $                      | 24.82      |                  | $          | 24.63 |   | $ | 25.04 |   | $ | 24.75 |   |
| Churn rate (d)                      |       | 2.0                    | %          | 2.0                   | %          | 2.2 | % | 2.1 | % |

 

----

(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) Acquiredsubscribers for the nine months ended September 30, 2006 includes approximately58,000 broadband subscribers acquired in the New Edge merger transaction.Acquired subscribers for the three and nine months ended September 30, 2005 andthree months ended September 30, 2006 includes purchases of subscriber basesfrom other ISPs.

21

----

 

(c)  Effective March 24, 2005, we transferredapproximately 27,000 wireless subscribers to HELIO in connection withcompleting the formation of HELIO.

(d)  Churn rate is used to measure the rate atwhich subscribers discontinue service on a voluntary or involuntary basis.  Churn rate is computed by dividing the averagemonthly number of subscribers that discontinued service during the period bythe average subscribers for the period.

(e)  Averagesubscribers or accounts for the three month periods is calculated by averagingthe ending monthly subscribers or accounts for the four months preceding andincluding the end of the quarterly period. Average subscribers or accounts forthe nine month periods is calculated by averaging the ending monthlysubscribers or accounts for the ten months preceding and including the end ofthe period.

(f)  ARPU represents the average monthly revenueper user (subscriber). ARPU is computed by dividing average monthly revenue forthe period by the average number of subscribers for the period. Average monthlyrevenue used to calculate ARPU includes recurring service revenue as well asnonrecurring revenues associated with equipment and other one-time chargesassociated with initiating or discontinuing services.

22

----

 

**Resultsof Operations**

Thefollowing table sets forth statement of operations data for the periodsindicated:
| ** **                                     | ** ** | **Three Months Ended** | ** ** | ** ** | ** ** | ** **        | ** ** | **Nine Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|------------|------------|-------------------|------------|---------------------------------|------------|------------|------------|------------|------------|
| ** **                                     | ** ** | **September 30,**           | ** ** | ** ** | ** ** | ** **        | ** ** | **September 30,**          | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **2005**                         | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change**               | ** ** | **2005**   | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                     | ** ** | **(dollars in thousands)**       | ** ** |
| ** **                                     | ** ** | ** **                       | ** ** | ** ** | ** ** | ** **        | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues:                                      |       |                             |       |       |       |              |       |                            |       |       |       |       |       |   |   |   |   |
| Narrowband access                              |       | $                                | 181,242    |       | $          | 150,842           |       | $                               | (30,400    | )          | -17%       |       | $          | 570,420 |   | $ | 472,797 |   | $ | (97,623 | ) | -17 | % |
| Broadband access                               |       | 109,308                          |       | 149,404    |       | 40,096            |       | 37%                             |       | 330,382    |       | 409,355    |       | 78,973 |   | 24 | % |
| Advertising and other value-added services     |       | 16,507                           |       | 22,375     |       | 5,868             |       | 36%                             |       | 45,547     |       | 63,921     |       | 18,374 |   | 40 | % |
| Web hosting                                    |       | 9,939                            |       | 8,688      |       | (1,251            | )          | -13%                            |       | 31,075     |       | 27,044     |       | (4,031 | ) | -13 | % |
| Total revenues                                 |       | 316,996                          |       | 331,309    |       | 14,313            |       | 5%                              |       | 977,424    |       | 973,117    |       | (4,307 | ) | 0 | % |
|                                           |       |                             |       |       |       |              |       |                            |       |       |       |       |       |   |   |   |   |
| Operating costs  and expenses:                 |       |                             |       |       |       |              |       |                            |       |       |       |       |       |   |   |   |   |
| Telecommunications service and equipment costs |       | 90,156                           |       | 112,790    |       | 22,634            |       | 25%                             |       | 279,017    |       | 313,163    |       | 34,146 |   | 12 | % |
| Sales incentives                               |       | 2,222                            |       | 1,626      |       | (596              | )          | -27%                            |       | 6,744      |       | 4,535      |       | (2,209 | ) | -33 | % |
| Total cost of revenues                         |       | 92,378                           |       | 114,416    |       | 22,038            |       | 24%                             |       | 285,761    |       | 317,698    |       | 31,937 |   | 11 | % |
|                                           |       |                             |       |       |       |              |       |                            |       |       |       |       |       |   |   |   |   |
| Sales and marketing                            |       | 92,749                           |       | 93,926     |       | 1,177             |       | 1%                              |       | 291,249    |       | 290,701    |       | (548 | ) | 0 | % |
| Operations and customer support                |       | 57,821                           |       | 66,683     |       | 8,862             |       | 15%                             |       | 178,729    |       | 193,904    |       | 15,175 |   | 8 | % |
| General and administrative                     |       | 26,891                           |       | 33,286     |       | 6,395             |       | 24%                             |       | 82,328     |       | 95,937     |       | 13,609 |   | 17 | % |
| Acquisition-related amortization               |       | 2,828                            |       | 3,372      |       | 544               |       | 19%                             |       | 9,668      |       | 8,407      |       | (1,261 | ) | -13 | % |
| Facility exit costs                            |       | 1,301                            |       | —     |       | (1,301            | )          | -100%                           |       | 2,008      |       | (117       | )          | (2,125 | ) | -106 | % |
| Total operating costs and expenses             |       | 273,968                          |       | 311,683    |       | 37,715            |       | 14%                             |       | 849,743    |       | 906,530    |       | 56,787 |   | 7 | % |
|                                           |       |                             |       |       |       |              |       |                            |       |       |       |       |       |   |   |   |   |
| Income from operations                         |       | 43,028                           |       | 19,626     |       | (23,402           | )          | -54%                            |       | 127,681    |       | 66,587     |       | (61,094 | ) | -48 | % |
| Gain on investments in other companies, net    |       | —                           |       | 25         |       | 25                |       | *                               |       | 2,437      |       | 377        |       | (2,060 | ) | -85 | % |
| Net losses of equity affiliate                 |       | (4,592                           | )          | (26,174    | )          | (21,582           | )          | *                               |       | (6,934     | )          | (49,116    | )          | (42,182 | ) | * |   |
| Interest income and other, net                 |       | 3,400                            |       | 3,272      |       | (128              | )          | -4%                             |       | 9,211      |       | 11,822     |       | 2,611 |   | 28 | % |
| Income (loss) before income taxes              |       | 41,836                           |       | (3,251     | )          | (45,087           | )          | -108%                           |       | 132,395    |       | 29,670     |       | (102,725 | ) | -78 | % |
| Provision (benefit) for income taxes           |       | 5,401                            |       | (69        | )          | (5,470            | )          | -101%                           |       | 18,765     |       | (69        | )          | (18,834 | ) | -100 | % |
| Net income  (loss)                             |       | $                                | 36,435     |       | $          | (3,182            | )          | $                               | (39,617    | )          | -109%      |       | $          | 113,630 |   | $ | 29,739 |   | $ | (83,891 | ) | -74 | % |

 

----

* denotes percentage isnot meaningful

23

----

 

*Narrowbandaccess revenues*

Narrowband accessrevenues primarily consist of monthly fees charged to customers for dial-upInternet access and usage fees. Narrowband revenues decreased 17% to $150.8 million and 17% to $472.8million during the three and nine months ended September 30, 2006,respectively, compared to the prior year periods.  The decreases in narrowband revenues were dueto decreases in narrowband ARPU and average narrowband subscribers.Contributing to the decrease during the nine months ended September 30, 2006was the transfer of wireless operations to HELIO effective March 24, 2005,which caused narrowband access revenues to decrease by $4.6 million during thenine months ended September 30, 2006 compared to the prior year period.

Narrowband ARPU decreasedfrom $16.33 during the three months ended September 30, 2005 to $14.90 duringthe three months ended September 30, 2006, and decreased from $16.84 during thenine months ended September 30, 2005 to $15.16 during the nine months endedSeptember 30, 2006. These decreases were due to the shift in the mix of ournarrowband subscriber base from premium narrowband access services, which aretypically priced at $21.95 per month, to our PeoplePC value-priced narrowbandaccess services, which are generally priced at $10.95 per month. During thethree and nine months ended September 30, 2005, average PeoplePC accesssubscribers were 1.1 million and 1.0 million, respectively, representing 30%and 27%, respectively, of our average narrowband customer base. During thethree and nine months ended September 30, 2006, average PeoplePC accesssubscribers were 1.5 million and 1.4 million, respectively, representing 43%and 40%, respectively, of our average narrowband customer base. Alsocontributing to the decreases in narrowband ARPU, although to a lesser extent,was the increased use of promotional pricing for our service offerings.

The following table summarizesnarrowband subscriber activity during the three and nine months ended September30, 2005 and 2006:

|                                                                  | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                       | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                       | ** ** | **2005**                         | ** ** | **2006**                        | ** ** | **2005** | ** ** | **2006** | ** ** |
|                                                             |       |                             |       |                            |       |   |   |   |   |
| Subscribers at  beginning of period                              |       | 3,753,000                        |       | 3,411,000                       |       | 3,880,000 |   | 3,580,000 |   |
| Gross organic  subscriber additions                              |       | 540,000                          |       | 491,000                         |       | 1,632,000 |   | 1,540,000 |   |
| Acquired  subscribers                                            |       | 6,000                            |       | 6,000                           |       | 101,000 |   | 18,000 |   |
| Narrowband  subscribers converted to our broadband services, net |       | (23,000                          | )          | (7,000                          | )          | (66,000 | ) | (34,000 | ) |
| Adjustment (a)                                                   |       | —                           |       | —                          |       | (27,000 | ) | — |   |
| Churn                                                            |       | (626,000                         | )          | (571,000                        | )          | (1,870,000 | ) | (1,774,000 | ) |
| Subscribers at end of  period                                    |       | 3,650,000                        |       | 3,330,000                       |       | 3,650,000 |   | 3,330,000 |   |

 

----

(a)  Effective March24, 2005, we transferred approximately 27,000 wireless subscribers to HELIO inconnection with completing the formation of HELIO.

Average narrowbandsubscribers decreased from 3.7 million and 3.8 million during the three andnine months ended September 30, 2005, respectively, to 3.4 million and 3.5million during the three and nine months ended September 30, 2006,respectively. In addition, the mix of customers shifted from premium narrowbandsubscribers to PeoplePC narrowband subscribers because the growth in ouraverage PeoplePC narrowband subscribers was offset by a decline in our averagepremium narrowband customers, the combination of which resulted in a change inthe composition of our narrowband customer base. Average premium narrowbandsubscribers decreased by 0.7 million, while average PeoplePC subscribersincreased 0.4 million during the three and nine months ended September 30, 2006compared to the prior year periods. The decreases in premium narrowbandsubscribers resulted from the migration of subscribers to broadband servicesand the continued maturing and ongoing competitiveness of the market fornarrowband Internet access. We expect the

24

----

 

mix of our narrowband subscriber base to continue toshift from premium narrowband access services to PeoplePC access services forthe foreseeable future.

Our results of operationsare significantly affected by subscriber cancellations, or “churn.”  Our average monthly churn rates fornarrowband subscribers were 5.6% during the three months ended September 30,2005 and 2006 and 5.5% and 5.7% during the nine months ended September 30, 2005and 2006, respectively.  If churn ratescontinue to be at or above the rate experienced during the three and ninemonths ended September 30, 2006, our narrowband subscriber base may decrease atan accelerated rate which would adversely affect our business. We continue toimplement plans to address churn, which focus on improving the customer’sInternet experience and enhancing service offerings.  However, we can provide no assurance that ourplans will be successful in mitigating the adverse impact increased churn ratesmay have on our subscriber base and operating results. In addition, competitivefactors outside of our control may also adversely affect future rates ofcustomer churn.

*Broadbandaccess revenues*

Broadbandaccess revenues consist of retail and wholesale fees charged for high-speed,high-capacity access services including DSL, cable, satellite and dedicatedcircuit services; fees charged for high-speed data networks to small andmedium-sized businesses; fees charged for IP-based voice services; installationfees; termination fees; fees for equipment; and regulatory surcharges billed tocustomers. Broadband revenues increased 37% to $149.4 million and 24% to $409.4million during the three and nine months ended September 30, 2006,respectively, compared to the prior year periods. The increases were primarilydue to increases in average broadband subscribers. Also contributing to theincreases were increases in broadband ARPU of 13% and 4%, respectively, duringthe three and nine months ended September 30, 2006 compared to the prior yearperiods. Additionally, broadband access revenue included $3.0 million and $5.7million of IP-based voice revenue, respectively, during the three and ninemonths ended September 30, 2006.

Theaverage number of broadband subscribers increased from 1.5 million during thethree and nine months ended September 30, 2005 to 1.8 million during the threeand nine months ended September 30, 2006. The increases in average subscriberswere primarily due to the continued growth in the market for broadband access,our and our partners’ efforts to promote broadband services, the addition ofNew Edge customers and an increase in IP-based voice subscribers due to thelaunch of new voice services.

Thefollowing table summarizes broadband subscriber activity during the three and ninemonths ended September 30, 2005 and 2006:

|                                                                  | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                       | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                       | ** ** | **2005**                         | ** ** | **2006**                        | ** ** | **2005** | ** ** | **2006** | ** ** |
|                                                             |       |                             |       |                            |       |   |   |   |   |
| Subscribers at  beginning of period                              |       | 1,495,000                        |       | 1,810,000                       |       | 1,364,000 |   | 1,608,000 |   |
| Gross organic  subscriber additions                              |       | 153,000                          |       | 183,000                         |       | 466,000 |   | 536,000 |   |
| Acquired  subscribers (a)                                        |       | —                           |       | —                          |       | — |   | 58,000 |   |
| Narrowband  subscribers converted to our broadband services, net |       | 23,000                           |       | 7,000                           |       | 66,000 |   | 34,000 |   |
| Churn                                                            |       | (127,000                         | )          | (143,000                        | )          | (352,000 | ) | (379,000 | ) |
| Subscribers at end of  period                                    |       | 1,544,000                        |       | 1,857,000                       |       | 1,544,000 |   | 1,857,000 |   |

 

----

(a)  Acquiredsubscribers for the nine months ended September 30, 2006 represents broadbandsubscribers acquired in the New Edge merger transaction.

25

----

 

Our broadband subscriberbase consists of consumers and small and medium enterprises which are addedthrough retail and wholesale relationships. In a retail relationship, we marketthe service directly to consumers and businesses under an EarthLink brand, havelatitude in establishing price, and are responsible for most aspects ofproviding the service, including first tier customer support. In a wholesalerelationship, a telecommunications partner markets the service, has latitude inestablishing price and pays us to provide underlying broadband access orInternet services such as authentication, email, web space, news and varyingdegrees of customer support. In a retail relationship, EarthLink generallyrecognizes the amount the subscriber is billed as revenue, but in a wholesalerelationship, EarthLink recognizes the amount due from the wholesale partner asrevenue. Consumer retail services are generally priced above $35 per month persubscriber to cover all of the costs of the service; however, certain retail relationships,such as those with EarthLink Experience and certain cable customers, generateper month revenues that are less than $20 and have negligibletelecommunications service and equipment costs. Consumer wholesalerelationships are priced between $3 and $6 per month recognizing the limitedset of activities performed by EarthLink. Retail business services generally have an ARPU between $110 and $130for non-networked solutions and an ARPU between $175 and $225 for networkedsolutions. Wholesale business services generally have an ARPU between $60 and$80. The pricing for small and medium enterprises depends upon customerrequirements for different service delivery methods, amounts of bandwidth,quality of service and distance from the points of presence, and may varywidely from these ranges. The number of customers being added or served at anypoint in time through our wholesale efforts is subject to the business andmarketing circumstances of our telecommunications partners.

BroadbandARPU increased 13% and 4% during the three and nine months ended September 30,2006, respectively, compared to the prior year periods due primarily to theaddition of higher ARPU New Edge subscribers. Partially offsetting theseincreases was lower retail DSL ARPU resulting from the increased use ofpromotional pricing; general declines in retail DSL prices introduced as aresult of declines in costs from our DSL service providers; and a shift in themix of our broadband subscriber base from retail services to wholesale servicesand, within our retail broadband customer base, from retail DSL subscribers toretail cable subscribers.

The pricing of our retailbroadband access services is subject to competitive pressures that are beyondour control. Incumbent local exchange carriers (“ILECs”) have generally reducedretail prices for their broadband service offerings. Such competitive pressuresmay cause us to decrease the price of our retail broadband access serviceswhich may cause our service offerings to be uneconomical in certain markets andmay result in a decrease in overall broadband ARPU and/or a reduction in grossmargin dollars per subscriber. Any of these could materially adversely affectour business.

*Advertisingand other value-added services revenues*

Advertising and othervalue-added services revenues consist of revenues from our partnerships, whichare promotional arrangements with advertisers, retailers, service providers andcontent providers. We earn these revenues by paid placements for searches;delivering traffic to our partners in the form of subscribers, page views ore-commerce revenues; advertising our partners’ products and services in ourvarious online properties and electronic publications, including the PersonalStart PageTM; andreferring our customers to our partners’ products and services. Advertising andother value-added services revenues also include certain ancillary servicessold as add-on features to our Internet services, such as security products,email by phone, Internet call waiting and email storage.

Advertising and othervalue-added services revenues increased 36% to $22.4 million and 40% to $63.9million during the three and nine months ended September 30, 2006,respectively, compared to the prior year periods due primarily to increased searchadvertising revenues as a result of the increased use of the Internet as anadvertising medium. Also contributing to the increases was a $1.5 million and$5.0 million increase in ancillary services revenues during the three and ninemonths ended September 30, 2006, respectively, compared to the prior yearperiods, respectively.

26

----

 

*Web hosting revenues*

We earn web hostingrevenues by leasing server space and providing web services to individuals andbusinesses wishing to present a web or e-commerce presence on the Internet. Webhosting revenues decreased 13% to $8.7 million and 13% to $27.0 millionduring the three and nine months ended September 30, 2006, respectively,compared to the prior year periods. These decreases were primarily due to decreasesin average web hosting accounts, which declined 12% from 133,000 during thethree months ended September 30, 2005 to 118,000 during the three months endedSeptember 30, 2006 and declined 14% from 138,000 during the nine months endedSeptember 30, 2005 to 121,000 during the nine months ended September 30, 2006.

*Cost of revenues*

Telecommunicationsservice and equipment costs are the primary component of our cost of revenuesand consist of telecommunications fees, set-up fees, network equipment costsincurred to provide our Internet access services, depreciation of our networkequipment and surcharges due to regulatory agencies. Telecommunications serviceand equipment costs also include the cost of Internet appliances sold.Telecommunications service and equipment costs increased 25% from $90.2 millionduring the three months ended September 30, 2005 to $112.8 million during thethree months ended September 30, 2006. Telecommunications service and equipmentcosts increased 12% from $279.0 million during the nine months ended September30, 2005 to $313.2 million during the nine months ended September 30, 2006. Theincreases in telecommunications service and equipment costs were primarily dueto 26% and 13% increases in average monthly telecommunications service andequipment cost per subscriber. The increases in average monthly costs persubscriber were primarily a result of acquired New Edge subscribers who have ahigher average cost per subscriber as New Edge provides high-speed datanetworks to small and medium-sized businesses. Partially offsetting theseincreases was reduced costs resulting from more favorable agreements withtelecommunications service providers as well as optimizing network capacity toreduce costs. Partially offsetting the increase during the three and ninemonths ended September 30, 2006 compared to the prior year periods was a 1%decrease in average subscribers.

Our retail broadbandaccess and managed data networks services have a higher telecommunications costof revenue per subscriber than our other principal forms of Internet access andrelated services. As a result, we expect telecommunications service andequipment costs per subscriber to increase for the remainder of 2006. We expectthat there may be additional, although limited, opportunities to reduce suchcosts by continuing to eliminate higher cost providers, reducing costs from theremaining vendors, and achieving higher utilization of existingtelecommunications capacity. These initiatives may partially offset thenegative effect expected to result from the increase in telecommunicationsservice and equipment costs per subscriber.

EarthLink’s principalproviders for narrowband telecommunications services are Level 3Communications, Inc. and Qwest Corporation, and our largest providers ofbroadband connectivity are Covad and Time Warner Cable. We also do lesseramounts of business with a wide variety of local, regional and other nationalproviders. EarthLink purchases broadband access from ILECs, competitive localexchange carriers (“CLECs”) and cable providers.

Cost of revenues alsoincludes sales incentives. We frequently offer sales incentives such as modemsand free Internet access on a trial basis. Sales incentives decreased from $2.2million during the three months ended September 30, 2005 to $1.6 million duringthe three months ended September 30, 2006, and decreased from $6.7 millionduring the nine months ended September 30, 2005 to $4.5 million during the ninemonths ended September 30, 2006. The decreases were due to a decline in modemprices and a decrease in the number of modems provided to customers as a resultof a decrease in retail DSL gross adds.

*Sales andmarketing*

Sales and marketingexpenses include advertising and promotion expenses, fees paid to distributionpartners to acquire new paying subscribers, personnel-related expenses andtelemarketing costs incurred to acquire and retain subscribers. Sales andmarketing expenses increased from $92.7 million during the three

27

----

 

months ended September 30, 2005 to $93.9 millionduring the three months ended September 30, 2006. This was primarily due to theinclusion of New Edge sales and marketing expenses, an increase in sales andmarketing expenses to launch our voice products and an increase in spending forour value added services, partially offset by a decrease in sales and marketingfor our premium narrowband services. Sales and marketing expenses decreased slightly from $291.2 millionduring the nine months ended September 30, 2005 to $290.7 million during thenine months ended September 30, 2006. This decrease was comprised of a decrease in sales and marketing for ourpremium narrowband services, substantially offset by increases in sales andmarketing expenses to launch our voice products, the inclusion of New Edge salesand marketing expenses, increases in PeoplePC sales and marketing expenses andincreases due to the launch of municipal broadband services. Sales andmarketing expenses for the three and nine months ended September 30, 2006 alsoincluded $0.8 million and $2.5 million, respectively, of stock-basedcompensation expense from the adoption of Statement of Financial AccountingStandards (“SFAS”) No. 123(R), “Share-Based Payment,” on January 1, 2006. Salesand marketing expenses may increase for the remainder of 2006 due to the launchof new products and services associated with implementing our strategic growthinitiatives, including additional markets for IP-based voice services andmunicipal wireless broadband services.

*Operationsand customer support*

Operations and customersupport expenses consist of costs associated with technical support andcustomer service, providing our subscribers with toll-free access to ourtechnical support and customer service centers, maintenance of customerinformation systems, software development and network operations.  Operations and customer support expensesincreased 15% from $57.8 million during the three months ended September 30,2005 to $66.7 million during the three months ended September 30, 2006, andincreased 8% from $178.7 million during the nine months ended September 30,2005 to $193.9 million during the nine months ended September 30, 2006. Theincreases were primarily the result of the inclusion of New Edge operations andcustomer support expenses, expenses associated with our voice and municipalwireless broadband strategic growth initiatives, and an increase due tostock-based compensation expense from the adoption of SFAS No. 123(R) onJanuary 1, 2006. Operations and customer support expenses for the three andnine months ended September 30, 2006 included $1.5 million and $4.9 million,respectively, of stock-based compensation expense.

*Generaland administrative*

General andadministrative expenses consist of fully burdened costs associated with theexecutive, finance, legal and human resource departments; outside professionalservices; payment processing; credit card fees; collections and bad debt.General and administrative expenses increased 24% from $26.9 millionduring the three months ended September 30, 2005 to $33.3 million duringthe three months ended September 30, 2006, and increased 17% from $82.3 millionduring the nine months ended September 30, 2005 to $95.9 million during thenine months ended September 30, 2006. The increase during the three month period was primarily due to theinclusion of New Edge general and administrative expenses; increases inpersonnel and travel costs resulting from the implementation of our strategicgrowth initiatives; and an increase due to stock-based compensation expensefrom the adoption of SFAS No. 123(R) on January 1, 2006. The increase duringthe nine month period was primarily due to the inclusion of New Edge generaland administrative expenses; increases in personnel costs, travel costs andprofessional fees resulting from the implementation of our strategic growthinitiatives; and an increase due to stock-based compensation expense from theadoption of SFAS No. 123(R) on January 1, 2006. These increases were partiallyoffset by decreases in bad debt and payment processing resulting primarily frombetter collection efforts. General and administrative expenses for the threeand nine months ended September 30, 2006 included $1.1 million and $3.4million, respectively, of stock-based compensation expense.

*Acquisition-related amortization*

Acquisition-relatedamortization represents the amortization of definite life intangible assetsacquired in conjunction with the purchases of businesses and customer basesfrom other ISPs. Definite life intangible assets, which primarily consist ofsubscriber bases and customer relationships, software and technology and otherassets, are amortized on a straight-line basis over their estimated usefullives, which range from one to six years. Acquisition-related amortizationincreased 19% from $2.8 million during the three months ended September 30,2005 to $3.4 million during the three months ended September 30, 2006 primarilydue to amortization of identifiable definite life intangible assets resultingfrom the acquisition of New Edge in April 2006. Acquisition-relatedamortization decreased 13% from $9.7 million during the nine months ended

28

----

September 30, 2005 to $8.4 million during the ninemonths ended September 30, 2006 primarily as a result of several subscriberbase assets becoming fully amortized over the past year and a decrease insubscriber base acquisitions in recent years. Partially offsetting the decreaseduring the nine months ended September 30, 2006 compared to the prior yearperiod was an increase due to amortization of New Edge identifiable definitelife intangible assets.

*Net losses of equity affiliate*

We account for our investmentin HELIO under the equity method of accounting because we can exert significantinfluence over HELIO’s operating and financial policies. Accordingly, we recordour proportionate share of HELIO’s net losses. These equity method losses arepartially offset by increases in the carrying value of our investmentassociated with amortizing the difference between the book value of non-cashassets contributed to HELIO and their fair value. These increases, which resultin decreases in the net losses of equity affiliate in our statements ofoperations, are being recorded over the estimated useful lives of the non-cashassets contributed. Net losses of equity affiliate for the three months endedSeptember 30, 2005 and 2006 included $6.2 million and $28.0 million,respectively, for our proportionate share of HELIO’s net losses. Net losses ofequity affiliate for the nine months ended September 30, 2005 and 2006 included$10.3 million and $54.8 million, respectively, for our proportionate share ofHELIO’s net losses. During the three months ended September 30, 2005 and 2006,our net losses of equity affiliate were offset by $1.6 million and $1.8million, respectively, of amortization associated with recognizing thedifference between the carrying value and fair value of assets contributed.During the nine months ended September 30, 2005 and 2006, our net losses ofequity affiliate were offset by $3.3 million and $5.7 million, respectively, ofamortization associated with recognizing the difference between the carryingvalue and fair value of assets contributed. Due to the start-up nature of HELIO’soperations and HELIO’s product launches in 2006, we expect HELIO’s net loss tocontinue to increase, and, as a result, we expect our net losses of equityaffiliate to increase as we record our proportionate share of HELIO’s netlosses.

*Gain on investments in othercompanies, net*

During the nine monthsended September 30, 2005, we received a $4.0 million cash distribution fromeCompanies Venture Group, L.P. (“EVG”). In applying the cost method, we recorded $0.7 million as a return of ourinvestment based on the carrying value of the investment, and the remaining$3.3 million was recorded as gain on investments in other companies, net. Gainon investments in other companies, net, of $2.4 million during the nine monthsended September 30, 2005 also included an impairment loss of $0.9 million oncertain of our investments in other companies as a result of declines in fairvalue that were considered to be other-than- temporary. During the nine monthsended September 30, 2006, we recorded a $0.4 million gain on investments due toan additional EVG distribution. 

Except with respect toHELIO, we do not exercise significant influence or control over the operatingand financial policies of the companies in which we have invested. We are notthe primary beneficiary for any of the companies in which we have invested.Accordingly, we use the cost method to account for our investments in othercompanies and use the equity method to account for our investment in HELIO.

*Interest income and other, net*

Interest income andother, net, decreased from $3.4 million during the three months ended September30, 2005 to $3.3 million during the three months ended September 30, 2006primarily due to a decrease in our average cash and marketable securitiesbalance, partially offset by higher investment yields on our cash andmarketable securities and interest income earned on our Covad SeniorConvertible Notes.  Interest income andother, net, increased from $9.2 million during the nine months ended September30, 2005 to $11.8 million during the nine months ended September 30, 2006. Theincrease was due to higher investment yields and interest income earned on ourCovad Senior Convertible Notes, partially offset by a decrease in our averagecash and marketable

29

----

securities balance. Our weighted average investmentyields have increased from approximately 3.3% and 2.8% during the three andnine months ended September 30, 2005, respectively, to approximately 4.8% and4.7% during the three and nine months ended September 30, 2006, respectively,as the U.S. Federal Reserve Bank has increased interest rates.  Our average cash and marketable securitiesbalance decreased from $415.3 million during the three months ended September30, 2005 to $203.0 million during the three months ended September 30, 2006,and decreased from $455.9 million during the nine months ended September 30,2005 to $290.5 million during the nine months ended September 30, 2006.  Our cash and investment balances decreasedprimarily as a result of the acquisition of New Edge, our investment in Covad,our scheduled contributions to HELIO and capital expenditures, partially offsetby cash provided by operations.

*Provisionfor income taxes*

The provision for incometaxes during the three and nine months ended September 30, 2005 consisted of$1.0 million and $2.2 million, respectively, of state income taxes due and avaluation allowance of $0.7 million and $2.2 million, respectively, establishedfor federal and state alternative minimum tax (“AMT”) amounts due which may beused to offset tax due in future periods. The provision for income taxes duringthe three and nine months ended September 30, 2005 also included non-cash,deferred tax provisions of $3.7 million and $14.4 million, respectively,associated with the utilization of net operating loss carryforwards which wereacquired in connection with the acquisitions of OneMain.com, Inc., PeoplePCInc. and Cidco Incorporated.

Based on management’s currentexpectations, we have recorded income taxes at an effective tax rate of 0%during the three and nine months ended September 30, 2006 in accordance withinterim reporting requirements of SFAS No. 109, “Accounting for Income Taxes,”and Accounting Principles Board Opinion No. 28, “Interim Financial Reporting.” 

Wecontinue to maintain a valuation allowance against our unrealized deferred taxassets, consisting primarily of net operating loss carryforwards, and we mayrecognize deferred tax assets in future periods when they are determined to berealizable.  

**Stock-Based Compensation**

Priorto January 1, 2006, we accounted for stock-based compensation issued toemployees using the intrinsic value method. Generally, no stock-based employee compensation cost related to stockoptions was reflected in net income, as all options granted under stock-basedcompensation plans had an exercise price equal to the market value of theunderlying common stock on the grant date. Compensation cost related torestricted stock units granted to non-employee directors and certain keyemployees was reflected in net income as services were rendered. 

OnJanuary 1, 2006, we adopted SFAS No. 123(R), which requires measurement ofcompensation cost for all stock awards at fair value on the date of grant andrecognition of compensation over the requisite service period for awardsexpected to vest. The fair value of stock options is estimated using theBlack-Scholes valuation model, and the fair value of restricted stock units isdetermined based on the number of shares granted and the quoted price of ourcommon 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. The estimateof awards that will ultimately vest requires significant judgment, and to theextent actual results or updated estimates differ from the Company’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. 

Weadopted SFAS 123(R) using the modified prospective method which requiresthe application of the accounting standard as of January 1, 2006. Ourconsolidated financial statements as of and for the three and nine months endedSeptember 30, 2006 reflect the impact of SFAS 123(R). In accordance withthe modified prospective method, the consolidated financial statements for theprior period have not been restated to reflect, and do not include, the impactof SFAS 123(R). The cumulative effect of adoption of SFAS No. 123(R) was

30

----

not material.Stock-based compensation expense under SFAS No. 123(R) was $3.4 million and$10.8 million, respectively, during the three and nine months ended September30, 2006, of which $3.0 million and $9.4 million, respectively, related tostock options.  Stock-based compensationduring the three and nine months ended September 30, 2006 is classified withinthe same operating expense line items as cash compensation paid to employees.Stock-based compensation expense was $0.3 million and $1.2 million during thethree and nine months ended September 30, 2005, which related to restrictedstock units and modifications of stock options.

**Liquidity and Capital Resources**

The following table setsforth summarized cash flow data for the nine months ended September 30, 2005and 2006:

|                                                      | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                           | ** ** | **2005**                                                | ** ** | **2006** | ** ** |
| ** **                                           | ** ** | **(in thousands)**                                 | ** ** |
|                                                 |       |                                                    |       |   |   |
| Net income                                           |       | $                                                       | 113,630    |   | $ | 29,739 |   |
| Non-cash items                                       |       | 56,530                                                  |       | 93,648 |   |
| Changes in  working capital                          |       | (9,442                                                  | )          | (35,154 | ) |
| Net cash  provided by operating activities           |       | $                                                       | 160,718    |   | $ | 88,233 |   |
|                                                 |       |                                                    |       |   |   |
| Net cash  provided by (used in) investing activities |       | $                                                       | 8,577      |   | $ | (149,690 | ) |
|                                                 |       |                                                    |       |   |   |
| Net cash used in  financing activities               |       | $                                                       | (171,796   | ) | $ | (78,184 | ) |

 

*Operating activities*

Net cash provided byoperating activities decreased during the nine months ended September 30, 2006compared to the prior year period, primarily due to the increase in operatingexpenses discussed elsewhere in this Management’s Discussion and Analysis ofFinancial Condition and Results of Operation. Cash flows from operatingactivities are expected to be adversely affected during the remainder of 2006because of operating expenses we expect to incur to fund our strategic growthinitiatives; however, we will seek to effectively manage expenses associatedwith our core access services and our working capital to mitigate the adverseimpact our growth initiatives are expected to have on our operating cash flows.

Non-cash items includeitems that are not expected to generate or require the use of cash, such asdepreciation and amortization relating to our network, facilities andintangible assets, net losses of equity affiliate, deferred income taxes,stock-based compensation, non-cash disposals and impairments of fixed assetsand gain on investments in other companies, net. Non-cash items increasedduring the nine months ended September 30, 2006 compared to the prior yearperiod primarily due to an increase in net losses of equity affiliate relatedto our investment in HELIO and an increase in stock-based compensationresulting from the adoption of SFAS No. 123(R) on January 1, 2006. Theseincreases were partially offset by a decrease in deferred income taxes and adecrease in depreciation and amortization expense.

Changes in workingcapital requirements include changes in accounts receivable, prepaid and otherassets, accounts payable, accrued and other liabilities and deferred revenue.Cash used for working capital requirements increased during the nine monthsended September 30, 2006 compared to the prior year period primarily due to adecline in accounts payable and accrued and other expenses.

31

----

*Investing activities*

Our investing activitiesused cash of $149.7 million during the nine months ended September 30, 2006.This consisted primarily of $108.7 million net cash paid to acquire New Edge, a$50.0 million investment in Covad in March 2006, a $10.0 million investment inCurrent Communications Group, LLC and $78.5 million of scheduled contributionsto HELIO. In addition, we used $24.4 million for capital expenditures,primarily associated with network and technology center related projects, and$2.6 million to purchase subscriber bases from other ISPs. Partially offsettingthese investing outlays were proceeds of $124.7 million from sales andmaturities of investments in marketable securities, net of purchases. We haveinvested significantly in our network and technology center infrastructure, andwe expect to continue to invest capital to enhance the reliability and capacityof our network as well as to improve the efficiency of our technical andcustomer support services. In addition, management continuously reviewsindustry and economic conditions to identify opportunities to pursueacquisitions of subscriber bases, and we may invest in or acquire othercompanies. 

*Financing activities*

Our financing activitiesused cash of $78.2 million during the nine months ended September 30, 2006.This consisted primarily of $79.8 million used to purchase 10.5 million sharesof our common stock and $2.0 million used to repay a note payable. Partiallyoffsetting cash used for financing activities were proceeds from the exerciseof stock options of $3.7 million during the nine months ended September 30,2006. The decrease in net cash used in financing activities from the prior yearperiod was primarily due to a decrease in purchases of treasury stock.

**Off-BalanceSheet Arrangements**

As of September 30, 2006,we did not have any off-balance sheet arrangements that have or are reasonablylikely to have a current or future effect on our financial condition, changesin financial condition, revenues or expenses, results of operations, liquidity,capital expenditures or capital resources that are material to investors.

**Share Repurchase Program**

In May 2006, our Board ofDirectors authorized the resumption of purchases under our existing sharerepurchase program, which was suspended during the first quarter of 2006. As ofOctober 31, 2006, we have utilized approximately $454.7 million pursuant to theshare repurchase program and have $95.3 million available under the currentauthorization. We may repurchase our common stock from time to time incompliance with the Securities and Exchange Commission’s regulations and otherlegal requirements, and subject to market conditions and other factors. Theshare repurchase program does not require us to acquire any specific number ofshares and may be terminated at any time.

**Income Taxes**

We continue to maintain afull valuation allowance against our deferred tax assets of approximately$375.4 million, consisting primarily of net operating loss carryforwards.Included in that amount are our estimates of deferred tax assets resulting fromour acquisition of New Edge, which are preliminary and subject to adjustment. Wemay recognize deferred tax assets in future periods if they are determined tobe realizable. To the extent we may owe income taxes in future periods, weintend to use our net operating loss carryforwards to the extent available toreduce cash outflows for income taxes.

32

----

**Future Uses of Cash and FundingSources**

We expect to use andinvest cash for a number of reasons, including expected cash outlays to expandour municipal wireless broadband footprint, to increase marketing efforts forour VoIP services and to expand New Edge’s distribution and marketing efforts.We also expect to use cash for cash commitments pursuant to the Contributionand Formation Agreement for our HELIO joint venture, including cashcontributions in February and August 2007 totalling $19.5 million. 

We have expended and willcontinue to expend significant resources enhancing our existing services anddeveloping, acquiring, implementing and launching new services, such as VoIPservices and wireless broadband services. We believe wireless and IP-basedvoice services and wireless broadband services represent significant growthopportunities and may require significant cash outlays. These uses of cash willbe in the form of initial product development and infrastructure costs inaddition to the sales and marketing costs to add customers that will generaterecurring revenues. We expect to use additional cash in the future to furtherexpand our footprint in the markets we offer our IP-based voice services,including our EarthLink DSL and Home Phone Services. Additionally, we alsoexpect to continue to use cash to acquire and retain new and existingsubscribers. Capital expenditures are expected to increase in the remainder of2006 as we invest in wireless broadband services and IP-based voice services.These initiatives may result in significant capital expenditures to develop,implement and build wireless broadband networks in various municipalities. Wealso expect to incur capital expenditures to maintain and upgrade our networkand technology infrastructure. The actual amount of capital expenditures infuture periods may fluctuate due to a number of factors which are difficult topredict and could change significantly over time, including, withoutlimitation, the timing and extent of municipal wireless network build-outs andadditional awards to build out networks. Additionally, technological advancesmay require us to make capital expenditures to develop or acquire new equipmentor technology in order to replace aging or technologically obsolete equipment.

Our cash requirementsdepend on numerous factors, including the rate of market acceptance of our andHELIO’s services, our ability to successfully develop new revenue sources, ourability to maintain and expand our customer base, the rate of expansion of ournetwork infrastructure, the size and types of acquisitions in which we mayengage, the level of resources required to expand our sales and marketingprograms, and general economic developments.

Our principal sources ofliquidity are our cash, cash equivalents and investments in marketablesecurities, as well as the cash flow we generate from operations. As ofSeptember 30, 2006, we had $33.7 million in cash and cash equivalents. Inaddition, we held short- and long-term investments in marketable securitiesvalued at $104.9 million and $19.7 million, respectively. Short-terminvestments in marketable securities consist of investments that have maturitydates of less than one year from the balance sheet date and asset-backed, auctionrate securities that have interest rate reset periods of up to one year fromthe balance sheet date, and long-term investments in marketable securitiesconsist of investments that have maturity dates of more than one year from thebalance sheet date.

Our available cash andmarketable securities, together with our results of operations, are expected tobe sufficient to meet our operating expenses, capital requirements andinvestment and other obligations for the next twelve months. We have no commitmentsfor any financing and have no lines of credit or similar sources of financing.However, as a result of our growth initiatives and other investment activities,we may seek additional financing in the future. Additional equity financing maydilute our stockholders, and debt financing, if available, may restrict ourability to repurchase common stock, pay dividends and raise future capital. Wecannot be sure that we can obtain additional financing on favorable terms, ifat all, through the issuance of equity securities or the incurrence of debt. Ifwe are unable to obtain additional needed financing, we may be required toreduce our planned capital expenditures, suspend or reduce our investmentactivities and/or reduce any of our planned growth initiatives, which couldmaterially and adversely affect our prospects for long-term growth.

33

----

**Related Party Transactions**

*HELIO*

UponHELIO’s formation, EarthLink and HELIO entered into a services agreementpursuant to which we provide HELIO facilities, accounting, tax, billing,procurement, risk management, payroll, human resource, employee benefitadministration and other support services in exchange for management fees.However, as HELIO develops it business, the extent to which HELIO relies on usto provide these services has decreased. We believe that providing theseservices to HELIO enabled HELIO to more quickly and cost effectively launch itsbusiness than if it were to purchase these services from third parties. Themanagement fees were determined based on our costs to provide the services, andmanagement believes such fees are reasonable. The total amount of fees thatHELIO pays to us depends on the extent to which HELIO utilizes our services.Fees for services provided to HELIO are reflected as reductions to theassociated expenses incurred by us to provide such services. During the threeand nine months ended September 30, 2005, fees received for services providedto HELIO were $1.0 million and $2.4 million, respectively. During the three andnine months ended September 30, 2006, fees received for services provided toHELIO were $0.6 million and $1.8 million, respectively. 

Wealso market HELIO’s products and services and purchase wireless Internet accessdevices and services from HELIO. During the three and nine months endedSeptember 30, 2005 and 2006, revenues generated from HELIO and fees paid forproducts and services from HELIO were minimal. 

*eCompanies*

During the nine monthsended September 30, 2005, we received a $4.0 million cash distribution from ourinvestment in EVG. Sky Dayton, a member of EarthLink’s Board of Directors, is afounding partner in EVG.

**Recent Accounting Pronouncements**

In June 2006, theFinancial Accounting Standards Board (“FASB”) ratified the consensus reached inEmerging Issues Task Force (“EITF”) Issue No. 06-2, “Accounting for SabbaticalLeave and Other Similar Benefits Pursuant to FASB Statement No. 43.” EITF IssueNo. 06-2 provides recognition guidance on the accrual of employees’ rights tocompensated absences under a sabbatical or other similar benefit arrangement.EITF Issue No. 06-2 is effective for EarthLink for all financial statementsafter December 31, 2006. We are currently assessing the impact of the adoptionof EITF Issue No. 06-2.

In July 2006, theFASB issued FASB Interpretation (“FIN”) No. 48, “Accounting forUncertainty in Income Taxes,” which prescribes a comprehensive model for how acompany should recognize, measure, present and disclose in its financialstatements uncertain tax positions that a company has taken or expects to takeon a tax return (including a decision whether to file or not to file a returnin a particular jurisdiction). The accounting provisions of FIN No. 48 areeffective for fiscal yearsbeginning after December 15, 2006. We are in the process of determiningthe effect, if any, the adoption of FIN No. 48 will have on our financialstatements.

InSeptember 2006, the FASB issued Statement of Financial AccountingStandards (“SFAS”) No. 157, “Fair Value Measurements”, which establishes aframework for reporting fair value and expands disclosures about fair valuemeasurements. SFAS No. 157 is effective for financial statements issuedfor fiscal years beginning after November 15, 2007 and interim periodswithin those fiscal years. We are currently assessing the impact of theadoption of this standard on our financial statements. 

34

----

**Safe Harbor Statement**

The Management’sDiscussion and Analysis and other portions of this Quarterly Report onForm   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 we may be unable to successfully enhance existing ordevelop or offer new products and services in a cost-effective or timely mannerto meet customer demand in the rapidly evolving market for Internet, wirelessand IP-based communications services, including new products and servicesoffered in connection with our voice and municipal broadband networkinitiatives; (2) that we may not realize the benefits we are seeking from ourinvestments in the HELIO joint venture or our other investment activities, as aresult of lower than predicted revenues or subscriber levels of the companiesin which we invest, larger funding requirements for those companies orotherwise; (3) that our service offerings may fail to be competitive withexisting and new competitors; (4) that competitive product, price or marketingpressures could cause us to lose existing customers to competitors, or maycause us to reduce prices for our services which would adversely impact averagerevenue per user; (5) that we may experience significant fluctuations in ouroperating results and rate of growth and may not be profitable in the future;(6) that we may not be successful in making and integrating acquisitions andinvestments into our business, which could result in operating difficulties;(7) that the continued decline of our narrowband revenues would adverselyaffect us; (8) that we may not be able to successfully execute our broadbandstrategy which could materially and adversely affect our subscriber growthrates, future overall revenues and profitability; (9) that we may be unable tomaintain or increase our customer levels if ILECs and cable companies do notprovide last mile broadband access to us on a wholesale basis or on terms or atprices that allow us to grow and be profitable in the broadband market,especially as a result of the U.S. Supreme Court ruling and FCC orderconcerning wholesale broadband access; (10) that our commercial and alliancearrangements may not be renewed, may be terminated, or may not be as beneficialto us as we anticipate; (11) that the market for VoIP services may not developas anticipated; (12) that we may not generate the returns anticipated on ourinvestments to construct and deploy municipal wireless broadband networks; (13)that our third-party network providers may be unwilling or unable to provideInternet, wireline and wireless telecommunications access; (14) that ourthird-party providers for technical and customer support and billing servicesmay be unable to provide these services on an economical basis or at all; (15)that service interruptions or impediments could harm our business; (16) thatbusiness failures and mergers in the telecommunications industry may inhibitour ability to manage our costs; (17) that government regulations couldforce us to change our business practices; (18) that we may be unable toprotect our proprietary technologies or successfully defend infringement claimsand that we may be required to enter licensing arrangements on unfavorableterms; (19) that we may be accused of infringing upon the intellectual propertyrights of third parties, which is costly to defend and could limit our abilityto use certain technologies in the future; (20) that we could face substantialliabilities if we are unable to successfully defend against legal actions; (21)that we may not be able to continually develop effective business systems,processes and personnel to support our business; (22) that we may be unable tohire and retain qualified personnel, including our key executive officers; (23)that our stock price has been volatile and may continue to be volatile; (24)that provisions in our certificate of incorporation, bylaws and shareholderrights plan could limit our share price and delay a change of management; and(25) that some other unforeseen difficulties may occur. These risks anduncertainties, as well as other risks and uncertainties that could cause ouractual results to differ significantly from management’s expectations, are notintended to represent a complete list of all risks and uncertainties inherentin our business, and should be read in conjunction with the more detailedcautionary statements and risk factors included in our Annual Report on Form 10-K for the year ended December 31, 2005.

35

----

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

Market risk is thepotential loss arising from adverse changes in market rates and prices, such asinterest rates, foreign currency exchange rates and changes in the market valueof financial instruments.   The primaryobjective of our investment activities is to preserve principal while at thesame time maximizing the income we receive from our investments withoutsignificantly increasing risk. We are exposed to market risk as a result ofchanges in the market value of our investments. 

*Interest Rate Risk*

A change in prevailinginterest rates may cause the fair value of our investments to fluctuate. Forexample, if we hold a security that was issued with a fixed interest rate atthe then-prevailing rate and the prevailing interest rate later rises, the fairvalue of our investment may decline. To minimize this risk, we havehistorically held many investments until maturity, and as a result, we receive interestand principal amounts pursuant to the underlying agreements. To furthermitigate risk, we maintain our portfolio of investments in a variety ofsecurities.  As of December 31, 2005 andSeptember 30, 2006, net unrealized gains in these investments were notmaterial.  In general, money market fundsare not subject to market risk because the interest paid on such fundsfluctuates with the prevailing interest rate. In addition, we invest inrelatively short-term securities and, therefore, changes in short-term interestrates impact the amount of interest income included in the statements ofoperations. The effect of a hypothetical one percentage point increase ininterest rates would decrease the value of our investments by less than 1% oftheir fair value as of September 30, 2006. The following table summarizes our investments by security type as ofDecember 31, 2005 and September 30, 2006:

|                                                   | ** ** | **As of December 31, 2005** | ** ** | **As of September 30, 2006** | ** ** |
|---------------------------------------------------|------------|-------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                        | ** ** | ** **                                      | ** ** | **Estimated**                                    | ** ** | ** ** | ** ** | **Estimated** | ** ** |
| ** **                                        | ** ** | **Amortized**                                   | ** ** | **Fair**                                         | ** ** | **Amortized** | ** ** | **Fair** | ** ** |
| ** **                                        | ** ** | **Cost**                                        | ** ** | **Value**                                        | ** ** | **Cost** | ** ** | **Value** | ** ** |
| ** **                                        | ** ** | **(in thousands)**                         | ** ** |
|                                              |       |                                            |       |                                             |       |   |   |   |   |
| Government  agency notes                          |       | $                                               | 148,084    |                                             | $          | 147,575 |   | $ | 80,573 |   | $ | 80,387 |   |
| Asset-backed  (including auction rate) securities |       | 90,058                                          |       | 90,045                                           |       | 27,471 |   | 27,471 |   |
| Corporate notes                                   |       | 28,514                                          |       | 28,489                                           |       | 13,575 |   | 13,566 |   |
| Commercial paper                                  |       | 48,807                                          |       | 48,784                                           |       | 25,376 |   | 25,365 |   |
|                                              |       | $                                               | 315,463    |                                             | $          | 314,893 |   | $ | 146,995 |   | $ | 146,789 |   |

 

36

----

The following table presents the amounts of our cashequivalents and short- and long-term investments that are subject to marketrisk by range of expected maturity and weighted-average interest rates as ofDecember 31, 2005 and September 30, 2006. This table does not include moneymarket funds because those funds are not subject to market risk.

 
| ** **                                    | ** ** | **As of December 31, 2005** | ** ** | **As of September 30, 2006** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                    | ** ** | ** **                                      | ** ** | **Estimated**                                    | ** ** | ** ** | ** ** | **Estimated** | ** ** |
| ** **                                    | ** ** | **Amortized**                                   | ** ** | **Fair**                                         | ** ** | **Amortized** | ** ** | **Fair** | ** ** |
| ** **                                    | ** ** | **Cost**                                        | ** ** | **Value**                                        | ** ** | **Cost** | ** ** | **Value** | ** ** |
| ** **                                    | ** ** | **(dollars in thousands)**            | ** ** |
| Included in cash  and cash equivalents        |       | $                                               | 66,068     |                                             | $          | 66,068 |   | $ | 22,256 |   | $ | 22,256 |   |
| Weighted average  interest rate               |       | 4.3                                             | %          |                                             |       | 5.4 | % |   |   |
| Weighted average  maturity (mos.)             |       | 1.2                                             |       |                                             |       | 1.2 |   |   |   |
|                                          |       |                                            |       |                                             |       |   |   |   |   |
| Included in  marketable securities-short-term |       | $                                               | 208,265    |                                             | $          | 207,845 |   | $ | 104,990 |   | $ | 104,870 |   |
| Weighted average  interest rate               |       | 4.0                                             | %          |                                             |       | 4.8 | % |   |   |
| Weighted average  maturity (mos.)*            |       | 3.9                                             |       |                                             |       | 2.1 |   |   |   |
|                                          |       |                                            |       |                                             |       |   |   |   |   |
| Included in  marketable securities-long-term  |       | $                                               | 41,130     |                                             | $          | 40,980 |   | $ | 19,750 |   | $ | 19,664 |   |
| Weighted average  interest rate               |       | 4.2                                             | %          |                                             |       | 4.8 | % |   |   |
| Weighted average  maturity (mos.)             |       | 22.1                                            |       |                                             |       | 14.5 |   |   |   |

 

----

* The maturity of asset-backed, auction ratesecurities for purposes of this calculation is consistent with management’sview as to the availability of such securities to fund operating activities.

*EquityRisk*

Weare exposed to market risk as it relates to changes in the market value of ourequity investments. We invest in equity instruments of public and privatecompanies for operational and strategic purposes. These securities are subjectto significant fluctuations in fair market value due to volatility of the stockmarket and the industries in which the companies operate. These securitiesinclude an equity method investment classified as investment in equityaffiliate in the Condensed Consolidated Balance Sheets, and investments inprivately-held securities, publicly-traded securities and convertiblesecurities classified as investments in other companies in the CondensedConsolidated Balance Sheets. As of September 30, 2006, we had$97.3 million of investments accounted for using the equity method ofaccounting, $47.8 million of fair value investments and $11.0 millionof cost-method investments.  Using ahypothetical reduction of 10% in the underlying stock price of thesesecurities, the fair value of our investments would decrease by approximately$4.0 million as of September 30, 2006.

**Item4. Controls and Procedures.**

**Evaluation of Disclosure Controlsand Procedures**

Pursuantto Rule 13a-15(b) under the Securities Exchange Act of 1934 (the “ExchangeAct”), EarthLink’s management, including EarthLink’s Chief Executive Officerand Chief Financial Officer, evaluated the effectiveness of EarthLink’sdisclosure controls and procedures (as defined underRule 13a-15(e) under the Exchange Act) as of the end of the periodcovered by this report. Based upon that evaluation, EarthLink’s Chief ExecutiveOfficer and Chief Financial Officer concluded that EarthLink’s 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 EarthLink’sChief Executive Officer and Chief Financial Officer, to allow timely decisionsregarding required disclosure.

37

----

**Changesin Internal Control over Financial Reporting**

InApril 2006, we acquired New Edge Holding Company (“New Edge”, awholly-owned subsidiary of EarthLink) and we have subsequently undertaken areview of New Edge’s internal controls. We will make appropriate changes tothose internal controls as we integrate its business with ours. As we furtherintegrate New Edge’s business, we will continue to review its internal controlsand may take further steps to ensure that its internal controls are effective.

Exceptfor changes that result from the acquisition of New Edge, there has been nochange in EarthLink’s internal control over financial reporting during thethree months ended September 30, 2006 that has materially affected or isreasonably likely to materially affect, EarthLink’s internal control overfinancial reporting.

38

----

**Part II**

**Item 1.    Legal Proceedings.**

EarthLink is aparty to various legal proceedings that are ordinary and incidental to itsbusiness. Management does not expect that any currently pending legalproceedings will have a material adverse effect on EarthLink’s results ofoperations 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, 2005.

**Item 2.  UnregisteredSales of Equity Securities and Use of Proceeds.**

The number of sharesrepurchased and the average price paid per share for each month in the threemonths ended September 30, 2006 are as follows:
| ** **                             | ** ** | ** **                                                                                 | ** ** | ** **          | ** ** | **Total Number of**          | ** ** | **Maximum Dollar**         | ** ** |
|----------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|---------------------|------------|----------------------------------------|------------|---------------------------------|------------|
| ** **                             | ** ** | **Total Number**                                                                      | ** ** | **Average**         | ** ** | **Shares Repurchased**            | ** ** | **Value that May**    | ** ** |
| ** **                             | ** ** | **of Shares**                                                                         | ** ** | **Price Paid** | ** ** | **as Part of Publicly** | ** ** | **Yet be Purchased**  | ** ** |
| **2006**                               | ** ** | **Repurchased**                                                                            | ** ** | **per Share**  | ** ** | **Announced Program (1)**    | ** ** | **Under the Program** | ** ** |
| ** **                             | ** ** | **(in thousands, except average price paid per share)** | ** ** |
| July 1 through July 31                 |       | 530                                                                                        |       | $                   | 8.05       |                                   | 530        |                            | $          | 155,497 |   |
| August 1 through August  31            |       | 4,023                                                                                      |       | 7.28                |       | 4,023                                  |       | 126,221                         |       |
| September 1 through  September 30 |       | 3,496                                                                                      |       | 7.20                |       | 3,496                                  |       | 101,061                         |       |
| Total                                  |       | 8,049                                                                                      |       |                |       | 8,049                                  |       |                            |       |
|                                        |            |                                                                                            |            |                     |            |                                        |            |                                 |            |  |  |

 

----

(1)          Since the inception ofthe share repurchase program (“Repurchase Program”), the Board of Directors hasauthorized a total of $550.0 million for the repurchase of our common stock.The Board of Directors has also approved repurchasing common stock pursuant toplans under Rule 10b5-1 of the Securities Exchange Act of 1934, as amended.During the first quarter of 2006, we suspended repurchases of common stock,including termination of our 10b5-1 plan. During the second quarter of 2006, weresumed repurchases of common stock. We may repurchase our common stock fromtime to time in compliance with the SEC’s regulations and other legalrequirements, including through the use of derivative transactions, and subjectto market conditions and other factors. The Repurchase Program does not requireus to acquire any specific number of shares and may be terminated at any time.

39

----

**Item 5.  Other Information.**

None.

**Item 6.   Exhibits.**

(a)        Exhibits.   The followingexhibits are filed as part of this report**:**

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

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

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

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

40

----

#### **SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.
|        | EARTHLINK, INC.                              |
|--------|----------------------------------------------|
|   |                                         |
|   |                                         |
| Date:  |     November  6, 2006    |   | /s/ CHARLES G. BETTY |   |
|   |                                         |   | Charles G. Betty, Chief Executive Officer |
|   |                                         |   |   |
|   |                                         |   |   |
| Date:  |     November  6, 2006    |   | /s/ KEVIN M. DOTTS |   |
|   |                                         |   | Kevin M. Dotts, Chief Financial Officer |
|   | (principal financial and accounting officer) |

 

41

----