x

**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, 2007**                                        |
|   |                                                                                          |   |
| **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.**

(Exactname 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’stelephone number, including area code)

 

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

 

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Indicate by check mark whether theregistrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

 

Indicate by check mark whether theregistrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer (as defined in Rule 12b-2 of the Exchange Act):

Largeaccelerated filer x    Accelerated filer o    Non-acceleratedfiler o

 

Indicate by check mark whether theregistrant is a shell company (as defined in Rule 12b-2 of the ExchangeAct).     Yes o No x

 

As of October 31, 2007, 120,362,832 sharesof common stock, $.01 par value per share, were outstanding.

 

** **

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**EARTHLINK,INC.**

**QuarterlyReport on Form 10-Q**

**For theQuarterly Period Ended September 30, 2007**

** **

**TABLE OFCONTENTS**

 
| **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  |                                                                                        |
|             |                                                                                             |  |  |

 

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** **

**PART I**

 

**Item 1. Financial Statements.**

 

**EARTHLINK, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 

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

 
| ** **                                                                                                                                                                                                                                                            | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                                                                                            | ** ** | **2006**              | ** ** | **2007**               | ** ** |
| ** **                                                                                                                                                                                                                                                            | ** ** | ** **            | ** ** | **(unaudited)**        | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                            | ** ** |
| Current assets:                                                                                                                                                                                                                                                       |       |                  |       |                   |       |
| Cash and cash  equivalents                                                                                                                                                                                                                                            |       | $                     | 158,369    |                   | $          | 95,005 |   |
| Investments in  marketable securities                                                                                                                                                                                                                                 |       | 214,947               |       | 208,572                |       |
| Accounts  receivable, net of allowance of $8,062 and $7,311 as of December 31, 2006 and  September 30, 2007, respectively                                                                                                                                             |       | 51,054                |       | 52,434                 |       |
| Prepaid expenses                                                                                                                                                                                                                                                      |       | 14,831                |       | 10,930                 |       |
| Other current  assets                                                                                                                                                                                                                                                 |       | 17,549                |       | 16,070                 |       |
| Total current  assets                                                                                                                                                                                                                                                 |       | 456,750               |       | 383,011                |       |
| Long-term  investments in marketable securities                                                                                                                                                                                                                       |       | 21,460                |       | 30,272                 |       |
| Property and  equipment, net                                                                                                                                                                                                                                          |       | 96,620                |       | 108,241                |       |
| Investment in  equity affiliate                                                                                                                                                                                                                                       |       | 61,743                |       | —                 |       |
| Investments in  other companies                                                                                                                                                                                                                                       |       | 59,325                |       | 54,351                 |       |
| Purchased  intangible assets, net                                                                                                                                                                                                                                     |       | 59,798                |       | 54,164                 |       |
| Goodwill                                                                                                                                                                                                                                                              |       | 202,277               |       | 202,277                |       |
| Other long-term  assets                                                                                                                                                                                                                                               |       | 10,066                |       | 10,740                 |       |
| Total assets                                                                                                                                                                                                                                                          |       | $                     | 968,039    |                   | $          | 843,056 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                        | ** ** |
| Current  liabilities:                                                                                                                                                                                                                                                 |       |                  |       |                   |       |
| Trade accounts  payable                                                                                                                                                                                                                                               |       | $                     | 41,298     |                   | $          | 36,433 |   |
| Accrued payroll  and related expenses                                                                                                                                                                                                                                 |       | 41,079                |       | 31,337                 |       |
| Other accounts  payable and accrued liabilities                                                                                                                                                                                                                       |       | 94,882                |       | 121,237                |       |
| Deferred revenue                                                                                                                                                                                                                                                      |       | 53,511                |       | 47,332                 |       |
| Total current  liabilities                                                                                                                                                                                                                                            |       | 230,770               |       | 236,339                |       |
|                                                                                                                                                                                                                                                                  |       |                  |       |                   |       |
| Long-term debt                                                                                                                                                                                                                                                        |       | 258,750               |       | 258,750                |       |
| Other long-term  liabilities                                                                                                                                                                                                                                          |       | 19,855                |       | 23,281                 |       |
| Total  liabilities                                                                                                                                                                                                                                                    |       | 509,375               |       | 518,370                |       |
|                                                                                                                                                                                                                                                                  |       |                  |       |                   |       |
| Stockholders’  equity:                                                                                                                                                                                                                                           |       |                  |       |                   |       |
| Convertible  preferred stock, $0.01 par value, 100,000 shares authorized, 0 shares issued  and outstanding as of December 31, 2006 and September 30, 2007                                                                                                             |       | —                |       | —                 |       |
| Common stock,  $0.01 par value, 300,000 shares authorized, 184,545 and 185,892 shares issued  as of December 31, 2006 and September 30, 2007, respectively, and 122,634 and  120,061 shares outstanding as of December 31, 2006 and September 30, 2007,  respectively |       | 1,845                 |       | 1,859                  |       |
| Additional  paid-in capital                                                                                                                                                                                                                                           |       | 2,016,578             |       | 2,038,823              |       |
| Warrants to  purchase common stock                                                                                                                                                                                                                                    |       | 259                   |       | 231                    |       |
| Accumulated  deficit                                                                                                                                                                                                                                                  |       | (1,044,995            | )          | (1,174,656             | )          |
| Treasury stock,  at cost, 61,911 and 65,831 shares as of December 31, 2006 and September 30,  2007, respectively                                                                                                                                                      |       | (508,232              | )          | (533,204               | )          |
| Unrealized  losses on investments                                                                                                                                                                                                                                     |       | (6,791                | )          | (8,367                 | )          |
| Total  stockholders’ equity                                                                                                                                                                                                                                      |       | 458,664               |       | 324,686                |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                                                                                      |       | $                     | 968,039    |                   | $          | 843,056 |   |

 

The accompanyingnotes are an integral part of these financial statements.

 

1

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**EARTHLINK, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS**

 
| ** **                                          | ** ** | **Three Months Ended**                                   | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                          | ** ** | **September 30,**                                             | ** ** | **September 30,**          | ** ** |
| ** **                                          | ** ** | **2006**                                                           | ** ** | **2007**                        | ** ** | **2006** | ** ** | **2007** | ** ** |
| ** **                                          | ** ** | **(in thousands, except per share data)** | ** ** |
| ** **                                          | ** ** | **(unaudited)**                                                    | ** ** |
|                                                |       |                                                               |       |                            |       |   |   |   |   |
| Revenues                                            |       | $                                                                  | 331,309    |                            | $          | 298,764 |   | $ | 973,117 |   | $ | 935,373 |   |
|                                                |       |                                                               |       |                            |       |   |   |   |   |
| Operating costs  and expenses:                      |       |                                                               |       |                            |       |   |   |   |   |
| Service and  equipment costs                        |       | 112,790                                                            |       | 108,974                         |       | 313,163 |   | 330,604 |   |
| Sales incentives                                    |       | 2,644                                                              |       | 3,918                           |       | 7,313 |   | 13,993 |   |
| Total cost of  revenues                             |       | 115,434                                                            |       | 112,892                         |       | 320,476 |   | 344,597 |   |
|                                                |       |                                                               |       |                            |       |   |   |   |   |
| Sales and  marketing                                |       | 95,298                                                             |       | 75,916                          |       | 292,422 |   | 255,132 |   |
| Operations and  customer support                    |       | 64,293                                                             |       | 58,031                          |       | 189,405 |   | 185,578 |   |
| General and  administrative                         |       | 33,286                                                             |       | 29,157                          |       | 95,937 |   | 104,027 |   |
| Amortization of  intangible assets                  |       | 3,372                                                              |       | 3,836                           |       | 8,407 |   | 10,874 |   |
| Facility exit  and restructuring costs              |       | —                                                             |       | 54,820                          |       | (117 | ) | 54,820 |   |
| Total operating  costs and expenses                 |       | 311,683                                                            |       | 334,652                         |       | 906,530 |   | 955,028 |   |
|                                                |       |                                                               |       |                            |       |   |   |   |   |
| Income (loss)  from operations                      |       | 19,626                                                             |       | (35,888                         | )          | 66,587 |   | (19,655 | ) |
| Net losses of  equity affiliate                     |       | (26,174                                                            | )          | (41,895                         | )          | (49,116 | ) | (111,295 | ) |
| Gain (loss) on  investments in other companies, net |       | 25                                                                 |       | (5,810                          | )          | 377 |   | (5,600 | ) |
| Interest income  and other, net                     |       | 3,272                                                              |       | 4,182                           |       | 11,822 |   | 11,282 |   |
| Income (loss)  before income taxes                  |       | (3,251                                                             | )          | (79,411                         | )          | 29,670 |   | (125,268 | ) |
| Provision  (benefit) for income taxes               |       | (69                                                                | )          | (30                             | )          | (69 | ) | 365 |   |
| Net income  (loss)                                  |       | $                                                                  | (3,182     | )                               | $          | (79,381 | ) | $ | 29,739 |   | $ | (125,633 | ) |
|                                                |       |                                                               |       |                            |       |   |   |   |   |
| Basic net income  (loss) per share                  |       | $                                                                  | (0.02      | )                               | $          | (0.65 | ) | $ | 0.23 |   | $ | (1.02 | ) |
| Diluted net  income (loss) per share                |       | $                                                                  | (0.02      | )                               | $          | (0.65 | ) | $ | 0.22 |   | $ | (1.02 | ) |
|                                                |       |                                                               |       |                            |       |   |   |   |   |
| Basic weighted  average common shares outstanding   |       | 128,321                                                            |       | 121,864                         |       | 130,863 |   | 122,772 |   |
| Diluted weighted  average common shares outstanding |       | 128,321                                                            |       | 121,864                         |       | 132,769 |   | 122,772 |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

2

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**EARTHLINK, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                                | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                | ** ** | **September 30,**          | ** ** |
| ** **                                                                                | ** ** | **2006**                        | ** ** | **2007** | ** ** |
| ** **                                                                                | ** ** | **(in thousands)**         | ** ** |
| ** **                                                                                | ** ** | **(unaudited)**                 | ** ** |
| Cash flows from  operating activities:                                                    |       |                            |       |   |   |
| Net income  (loss)                                                                        |       | $                               | 29,739     |   | $ | (125,633 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities: |       |                            |       |   |   |
| Depreciation and  amortization                                                            |       | 33,796                          |       | 40,803 |   |
| Loss on  disposals and impairments of fixed assets                                        |       | 820                             |       | 15,054 |   |
| Net losses of  equity affiliate                                                           |       | 49,116                          |       | 111,295 |   |
| (Gain) loss on  investments in other companies, net                                       |       | (377                            | )          | 5,600 |   |
| Stock-based  compensation                                                                 |       | 10,869                          |       | 15,138 |   |
| Deferred income  taxes                                                                    |       | 221                             |       | 206 |   |
| Decrease  (increase) in accounts receivable, net                                          |       | 1,468                           |       | (1,588 | ) |
| (Increase)  decrease in prepaid expenses and other assets                                 |       | (2,582                          | )          | 442 |   |
| Decrease in  accounts payable and accrued and other liabilities                           |       | (30,344                         | )          | (976 | ) |
| Decrease in  deferred revenue                                                             |       | (3,696                          | )          | (5,797 | ) |
| Other                                                                                     |       | (797                            | )          | (51 | ) |
| Net cash provided  by operating activities                                                |       | 88,233                          |       | 54,493 |   |
|                                                                                      |       |                            |       |   |   |
| Cash flows from  investing activities:                                                    |       |                            |       |   |   |
| Purchases of  property and equipment                                                      |       | (24,395                         | )          | (42,317 | ) |
| Purchases of  subscriber bases                                                            |       | (2,636                          | )          | (6,501 | ) |
| Proceeds from  sales of fixed assets                                                      |       | 8                               |       | 36 |   |
| Investments in  marketable securities                                                     |       |                            |       |   |   |
| Purchases                                                                                 |       | (68,174                         | )          | (337,835 | ) |
| Sales and  maturities                                                                     |       | 192,828                         |       | 335,701 |   |
| Purchase of  business, net                                                                |       | (108,663                        | )          | — |   |
| Investments in  and net advances to/from equity affiliate                                 |       | (78,232                         | )          | (48,913 | ) |
| Investments in  other companies                                                           |       | (60,000                         | )          | — |   |
| Other investing  activities                                                               |       | (426                            | )          | 1,417 |   |
| Net cash used in  investing activities                                                    |       | (149,690                        | )          | (98,412 | ) |
|                                                                                      |       |                            |       |   |   |
| Cash flows from  financing activities:                                                    |       |                            |       |   |   |
| Repayment of  note payable                                                                |       | (2,000                          | )          | — |   |
| Principal  payments under capital lease obligations                                       |       | (26                             | )          | (149 | ) |
| Proceeds from  exercises of stock options and other                                       |       | 3,689                           |       | 5,676 |   |
| Repurchases of  common stock                                                              |       | (79,847                         | )          | (24,972 | ) |
| Net cash used in  financing activities                                                    |       | (78,184                         | )          | (19,445 | ) |
|                                                                                      |       |                            |       |   |   |
| Net decrease in  cash and cash equivalents                                                |       | (139,641                        | )          | (63,364 | ) |
| Cash and cash  equivalents, beginning of period                                           |       | 173,294                         |       | 158,369 |   |
| Cash and cash  equivalents, end of period                                                 |       | $                               | 33,653     |   | $ | 95,005 |   |
|                                                                                      |       |                            |       |   |   |
| Significant  non-cash transactions:                                                       |       |                            |       |   |   |
| Assets acquired  pursuant to capital lease agreement                                      |       | $                               | —     |   | $ | 2,927 |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

3

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**EARTHLINK,INC.**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED**

** **

**1. Organization**

 

EarthLink, Inc. (“EarthLink”or the “Company”) provides integrated communication services and relatedvalue-added services to individual consumers and business customers utilizingInternet Protocol, or IP, based technologies. EarthLink’s core serviceofferings are dial-up and wireline broadband Internet access services andvalue-added services. Additional service offerings include IP-based voiceservices, municipal wireless broadband services and services for businesscustomers.

 

**2. Basis of Presentation**

 

*Basis of Presentation*

 

The condensed consolidatedfinancial statements of EarthLink, which include the accounts of itswholly-owned subsidiaries, for the three and nine months ended September 30,2006 and 2007 and the related footnote information are unaudited and have beenprepared on a basis consistent with the Company’s audited consolidatedfinancial statements as of December 31, 2006 contained in the Company’s AnnualReport on Form 10-K, as amended, as filed with the Securities and ExchangeCommission (the “Annual Report”). All significant intercompany transactionshave been eliminated.

 

These financial statements shouldbe read in conjunction with the audited consolidated financial statements andthe related notes thereto contained in the Company’s Annual Report. In theopinion of management, the accompanying unaudited financial statements containall adjustments (consisting of normal recurring adjustments), which managementconsiders necessary to present fairly the Company’s financial position, resultsof operations and cash flows for the interim periods presented. The results ofoperations for the three and nine months ended September 30, 2007 are notnecessarily indicative of the results anticipated for the entire year endingDecember 31, 2007.

 

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 thoseestimates.

 

*Adoption of Recent AccountingPronouncements*

 

On January 1, 2007, EarthLinkadopted the consensus reached in Emerging Issues Task Force (“EITF”) Issue No.06-2, “Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASBStatement No. 43.” EITF Issue No. 06-2 provides recognition guidance on theaccrual of employees’ rights to compensated absences under a sabbatical orother similar benefit arrangement. The adoption of EITF Issue No. 06-2 resultedin a $4.0 million increase to accumulated deficit and accrued liabilities as ofJanuary 1, 2007.

 

On January 1, 2007, EarthLinkadopted Financial Accounting Standards Board Interpretation (“FIN”)No. 48, “Accounting for Uncertainty in Income Taxes,” which prescribes acomprehensive model for how a company should recognize, measure, present anddisclose in its financial statements uncertain tax positions that a company hastaken or expects to take on a tax return (including a decision whether to fileor not to file a return in a particular jurisdiction). The adoption of FIN No.48 on January 1, 2007 did not result in a material cumulative-effectadjustment.

 

4

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*Reclassifications*

 

Certain amounts in the prior periodfinancial statements have been reclassified to conform to the current periodpresentation.

 

**3. Recent AccountingPronouncements**

 

In September 2006, theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 157, “Fair Value Measurements,” whichestablishes a framework for reporting fair value and expands disclosuresrequired for fair value measurements. SFAS No. 157 is effective forfinancial statements issued for fiscal years beginning after November 15,2007 and interim periods within those fiscal years. The Company is currentlyassessing the impact of the adoption of this standard on its financialstatements.

 

In February 2007, the FASB issuedSFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,”which provides companies with an option to report selected financial assets andliabilities at fair value.  SFAS No. 159 also establishespresentation and disclosure requirements designed to facilitate comparisonsbetween companies that choose different measurement attributes for similartypes of assets and liabilities. SFAS No. 159 is effective as of thebeginning of an entity’s first fiscal year beginning after November 15,2007. The Company is currently assessing the impact of the adoption of thisstandard on its financial statements.

 

**4. Facility Exitand Restructuring****Costs**

 

In August 2007, the Board ofDirectors of EarthLink approved a restructuring plan (the “Plan”). The Plan isintended to reduce costs and improve the efficiency of the Company’soperations. The Plan was the result of a comprehensive review of operationswithin and across the Company’s functions and businesses. Under the Plan, theCompany is reducing its workforce by approximately 900 employees, consolidatingits office facility in Atlanta, Georgia and closing office facilities inOrlando, Florida; Knoxville, Tennessee; Harrisburg, Pennsylvania and SanFrancisco, California. The Plan is being implemented during the third andfourth quarters of 2007. In connection with the Plan, the Company expects torecord total costs of approximately $60.0 to $70.0 million, including $30.0 to$34.0 million for severance and personnel-related costs, $10.0 to $13.0 millionfor lease termination and facilities-related costs, $10.0 to $11.0 million fornon-cash asset impairments and $10.0 to $12.0 million for other associatedcosts. Approximately $59.0 to $69.0 million of total expected facility exit andrestructuring costs relate to the Consumer Services segment and approximately$1.0 million relate to the Business Services segment.

 

The Company accounts for facilityexit and applicable restructuring costs in accordance with SFAS No. 146, “Accountingfor Costs Associated with Exit or Disposal Activities,” which requires that aliability for a cost associated with an exit or disposal activity be recognizedwhen the liability is incurred, and SFAS No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets,” which addresses financialaccounting and reporting for the impairment and disposition of long-livedassets, including property and equipment and purchased intangible assets. TheCompany accounts for post-employment benefits paid under the Company’sseverance plans in accordance with SFAS No. 112, “Employer’s Accounting forPost Employment Benefits.”

 

5

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As a result of the Plan, EarthLinkrecorded facility exit and restructuring costs of $54.8 million during thethree and nine months ended September 30, 2007, including $33.9 millionfor severance and personnel-related costs; $0.7 million for lease terminationand facilities-related costs; $10.4 million for non-cash asset impairments; and$9.8 million for other associated costs. Approximately $54.0 million of totalfacility exit and restructuring costs recorded during the three and nine monthsended September 30, 2007 relate to the Consumer Services segment andapproximately $0.8 million relate to the Business Services segment. Such costshave been classified as facility exit and restructuring costs in the CondensedConsolidated Statements of Operations. The asset impairment charges primarilyrelate to fixed asset write-offs due to facility closings and consolidationsand the termination of certain projects for which costs had been capitalized.These assets were impaired as the carrying values of the assets exceeded theexpected future undiscounted cash flows to the Company. The impairment chargesrecorded during the three and nine months ended September 30, 2007 related tothe Company’s Consumer Services segment and have been classified as facilityexit and restructuring costs in the Condensed Consolidated Statements ofOperations.

 

The following table summarizesactivity for the liability balances associated with the Plan for the period,including changes during the period attributable to costs incurred and chargedto expense and costs paid or otherwise settled:

 
| ** **                        | ** ** | **Severance**           | ** ** | ** **     | ** ** | **Asset**       | ** ** | **Other** | ** ** | ** ** | ** ** |
|-----------------------------------|------------|-------------------------|------------|----------------|------------|-----------------|------------|-----------|------------|------------|------------|
| ** **                        | ** ** | **and Benefits**   | ** ** | **Facilities** | ** ** | **Impairments** | ** ** | **Costs** | ** ** | **Total**  | ** ** |
| ** **                        | ** ** | **(in thousands)** | ** ** |
| Balance as of  December 31, 2006  |       | $                       | —     |           | $          | —          |       | $         | —     |       | $          | — |   | $ | — |   |
| Accruals                          |       | 33,939                  |       | 729            |       | 10,381          |       | 9,771     |       | 54,820     |       |
| Payments                          |       | (1,666                  | )          | —         |       | —          |       | (5,044    | )          | (6,710     | )          |
| Non-cash items                    |       | —                  |       | —         |       | (10,381         | )          | (371      | )          | (10,752    | )          |
| Balance as of  September 30, 2007 |       | $                       | 32,273     |           | $          | 729             |       | $         | —     |       | $          | 4,356 |   | $ | 37,358 |   |

 

Facility exit and restructuringliabilities due within one year of the balance sheet date are classified asother accounts payable and accrued liabilities and facility exit andrestructuring liabilities due after one year are classified as other long-termliabilities in the Condensed Consolidated Balance Sheets. Of the unpaid balanceas of September 30, 2007, approximately $36.8 million associated with the Planwas classified as other accounts payable and accrued liabilities and $0.6million was classified as other long-term liabilities.

 

**5. Earnings per Share**

 

Net income (loss) per share hasbeen computed according to SFAS No. 128, “Earnings per Share,” which requires adual presentation of basic and diluted earnings per share (“EPS”). Basic EPSrepresents net income divided by the weighted average number of common sharesoutstanding during a reported period. Diluted EPS reflects the potentialdilution that could occur if securities or other contracts to issue commonstock, including stock options, warrants, restricted stock units, phantom shareunits, convertible debt and contingently issuable shares (commonly andhereinafter referred to as “Common Stock Equivalents”), were exercised orconverted into common stock. The dilutive effect of outstanding stock options,warrants, convertible debt and restricted stock units is reflected in dilutedearnings per share by application of the treasury stock method. Phantom shareunits and contingently issuable shares are reflected on an if-converted basis.In applying the treasury stock method for stock-based compensationarrangements, the assumed proceeds were computed as the sum of the amount theemployee must pay upon exercise and the amounts of unrecognizedcompensation cost attributed to future services.

 

6

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The following table sets forth thecomputation for basic and diluted net income per share for the nine monthsended September 30, 2006:

 
| ** **                                              | ** ** | **Nine Months Ended**  | ** ** |
|---------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                              | ** ** | **September 30, 2006** | ** ** |
| ** **                                              | ** ** | ** **                       | ** ** |
| Net income (A)                                          |       | $                                | 29,739     |   |
|                                                    |       |                             |       |
| Basic weighted  average common shares outstanding (B)   |       | 130,863                          |       |
| Dilutive effect  of Common Stock Equivalents            |       | 1,906                            |       |
| Diluted weighted  average common shares outstanding (C) |       | 132,769                          |       |
|                                                    |       |                             |       |
| Basic net income  per share (A/B)                       |       | $                                | 0.23       |   |
| Diluted net  income per share (A/C)                     |       | $                                | 0.22       |   |

 

During the nine months endedSeptember 30, 2006, approximately 14.8 million options and warrants wereexcluded from the calculation of diluted EPS because the exercise pricesplus the amount of unrecognized compensation cost attributed to futureservices exceeded the Company’s average stock price during the period.

 

The Company has not included theeffect of Common Stock Equivalents in the calculation of diluted EPS for thethree months ended September 30, 2006 and for the three and nine months endedSeptember 30, 2007 because such inclusion would have an anti-dilutive effect.As of September 30, 2007, the Company had 19.9 million options outstanding,28.5 million warrants outstanding and 2.4 million restricted stock units andphantom share units outstanding. These options, warrants, restricted stockunits and phantom share units could be dilutive in future periods. In addition,approximately 28.4 million shares underlie the Company’s convertible debtinstruments, which could be dilutive in future periods.

 

**6. Investments**

 

*Investments in marketablesecurities*

 

Investments in marketablesecurities are accounted for in accordance with SFAS No. 115, “Accountingfor Certain Investments in Debt and Equity Securities.” All investments withoriginal maturities greater than 90 days are classified as investments inmarketable securities. Investments in marketable securities with maturitiesless than one year from the balance sheet date are considered short-terminvestments in marketable securities. Short-term investments also includeinvestments in asset-backed, auction rate debt securities with interest ratereset periods of 90 days or less but whose underlying agreements have originalmaturities of more than 90 days, based on the provisions of Accounting ResearchBulletin No. 43, Chapter 3A, Working Capital-Current Assets and Liabilities,which allows classification of investments based on management’s view.Investments in marketable securities with maturities greater than one year fromthe balance sheet date, excluding investments in asset-backed, auction ratedebt securities with interest reset periods of 90 days or less, are consideredlong-term investments in marketable securities. The Company has invested ingovernment agency notes, asset-backed debt securities (including auction ratedebt securities), corporate notes and commercial paper, all of which bear aminimum short-term rating of A1/P1 or a minimum long-term rating of A/A2.

 

The Company has classified allshort- and long-term investments in marketable securities asavailable-for-sale. The Company may or may not hold its investments inmarketable securities until maturity. In response to changes in theavailability of and the yield on alternative investments as well as liquidityrequirements, the

 

7

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Company occasionally sells its investments inmarketable securities prior to their stated maturities. Available for salesecurities are carried at fair value, with any unrealized gains and losses, netof tax, included in unrealized gains (losses) on investments as a separatecomponent of stockholders’ equity and in total comprehensive income (loss). Asof December 31, 2006, gross unrealized losses for investments in marketablesecurities were $0.3 million and gross unrealized gains were nominal. As ofSeptember 30, 2007, both gross unrealized losses and gross unrealized gains forinvestments in marketable securities were nominal. The Company believes itsgross unrealized losses are temporary because management has the intent andability to hold these investments until maturity, at which time the Companywould expect to receive the amortized cost basis of these investments based onthe underlying contractual arrangement.

 

Realized gains and losses oninvestments in marketable securities are included in interest income and other,net, in the accompanying Condensed Consolidated Statements of Operations andare determined on a specific identification basis. The Company has not realizedany significant gains or losses on its investments in marketable securitiesduring the periods presented.

 

*Investments in other companies*

 

As of December 31, 2006 andSeptember 30, 2007, minority investments in other companies were $59.3 millionand $54.4 million, respectively, and are classified as investments in othercompanies in the Condensed Consolidated Balance Sheets. The Company accountsfor minority investments in other companies under the cost method of accountingand classifies investments in other companies which are publicly traded asavailable-for-sale securities. Accordingly, the Company adjusts the carryingvalues of those investments to market value through unrealized (losses) gainsincluded in stockholders’ equity and accumulated other comprehensive income(loss). Minority investments in other companies as of December 31, 2006 andSeptember 30, 2007 included $11.0 million and $10.0 million, respectively, ofinvestments carried at cost and $48.3 million and $44.4 million, respectively, ofinvestments recorded at fair value. As of December 31, 2006 and September 30,2007, gross unrealized losses were $6.5 million and $8.4 million, respectively,and there were no gross unrealized gains.

 

Management regularly evaluates therecoverability of its investments in other companies based on the performanceand the financial position of those companies as well as other evidence ofmarket value. Such evaluation includes, but is not limited to, reviewing theinvestee’s cash position, recent financings, projected and historical financialperformance, cash flow forecasts and financing needs. Management also regularlyevaluates whether declines in the fair values of its investments below theircost are other than temporary. This evaluation consists of several qualitativeand quantitative factors regarding the severity and duration of the unrealizedloss as well as the Company’s ability and intent to hold the investment for aperiod of time to recover the cost basis of the investment. During the threeand nine months ended September 30, 2007, the Company recognized $7.0 millionof losses due to declines of the value of investments in other companies thatwere deemed other than temporary. During the three and nine months endedSeptember 30, 2006, the Company did not recognize any losses due toother-than-temporary declines of the value of investments in other companies.

 

During the three and nine monthsended September 30, 2007, the Company received $1.2 million and $1.4 million incash distributions, respectively, from eCompanies Venture Group, L.P. (“EVG”),a limited partnership that has invested in domestic Internet-related companies,which were recorded as gains on investments in other companies 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 EVG distribution.

 

*Investment in equity affiliate*

 

The Company has a joint venturewith SK Telecom Co., Ltd. (“SK Telecom”), HELIO. HELIO is anon-facilities-based mobile virtual network operator (“MVNO”) offering mobilecommunications services and handsets to U.S. consumers. Pursuant to the HELIOContribution and Formation Agreement, the Company has contributed $220.0 millionof cash and non-cash assets to date, including $122.0 million during 2005,$78.5

 

8

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millionduring 2006 and $19.5 million during the nine months ended September 30, 2007.As of December 31, 2006, both EarthLink’s and SK Telecom’s economic ownershipinterest in HELIO was approximately 48 percent and EarthLink’s and SK Telecom’svoting interest was 50 percent. As of September 30, 2007, both EarthLink’s andSK Telecom’s economic ownership interest in HELIO was approximately 47 percentand EarthLink’s and SK Telecom’s voting interest was 50 percent.

 

InJuly 2007, EarthLink and SK Telecom entered into a loan agreement with HELIOpursuant to which EarthLink and SK Telecom could lend up to $200.0 million toHELIO and each made an initial loan to HELIO of $30.0 million. Under the termsof the agreement, EarthLink and SK Telecom may each purchase from HELIO up to$100.0 million of HELIO’s secured promissory notes (the “Promissory Notes”). ThePromissory Notes may be purchased by EarthLink and SK Telecom from time to timeover a one year period commencing on the date of the agreement. The PromissoryNotes bear interest at 10.0% per annum, payable at maturity, and may bepre-paid by HELIO at any time without penalty. The Promissory Notes mature onJuly 23, 2010, unless amounts become due and payable earlier by acceleration orotherwise.

 

TheCompany accounts for its investments in HELIO under the equity method ofaccounting because the Company can exert significant influence over HELIO’soperating and financial policies. As a result, the Company records itsproportionate share of HELIO’s net loss in its Condensed ConsolidatedStatements of Operations. The Company is amortizing the difference between thebook value and fair value of non-cash assets contributed to HELIO over theirestimated useful lives. The amortization increases the carrying value of theCompany’s equity investment and decreases the net losses of equity affiliateincluded in the Condensed Consolidated Statements of Operations. During thethree and nine months ended September 30, 2006, the Company recorded $26.2million and $49.1 million, respectively, of net losses of equity affiliaterelated to its HELIO investment, which is net of amortization of basisdifferences and certain other equity method accounting adjustments. During thethree and nine months ended September 30, 2007, the Company recorded $41.9million and $111.3 million, respectively, of net losses of equity affiliaterelated to its HELIO investments, which is net of amortization of basisdifferences and certain other equity method accounting adjustments.

 

Duringthe three months ended September 30, 2007, EarthLink discontinued recordingadditional net losses of equity affiliate because its investments in HELIO,including the $30.0 million loaned to HELIO in July 2007, were reduced to zero,and EarthLink is not committed to provide further financial support to HELIO.If HELIO subsequently reports net income, EarthLink will resume applying theequity method only after its share of net income exceeds the share of netlosses not recognized since the Company discontinued recording equity methodlosses.

 

Thefollowing table presents summarized statement of operations information ofHELIO for the three and nine months ended September 30, 2006 and 2007:

 
| ** **     | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **     | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **     | ** ** | **2006**                         | ** ** | **2007**                        | ** ** | **2006** | ** ** | **2007** | ** ** |
| ** **     | ** ** | **(in thousands)**          | ** ** |
| ** **     | ** ** | ** **                       | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues       |       | $                                | 12,794     |                            | $          | 51,684 |   | $ | 23,986 |   | $ | 115,228 |   |
| Operating loss |       | (64,886                          | )          | (91,849                         | )          | (124,879 | ) | (241,934 | ) |
| Net loss       |       | (62,321                          | )          | (92,303                         | )          | (117,798 | ) | (239,284 | ) |
|                |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |  |

 

9

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**7. PurchasedIntangible 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, 2006 and September 30, 2007:

 
| ** **                                   | ** ** | **As of December 31, 2006** | ** ** | **As of September 30, 2007** | ** ** |
|----------------------------------------------|------------|-------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                   | ** ** | **Gross**                                       | ** ** | ** **                                       | ** ** | **Net** | ** ** | **Gross** | ** ** | ** ** | ** ** | **Net** | ** ** |
| ** **                                   | ** ** | **Carrying**                                    | ** ** | **Accumulated**                                  | ** ** | **Carrying** | ** ** | **Carrying** | ** ** | **Accumulated** | ** ** | **Carrying** | ** ** |
| ** **                                   | ** ** | **Value**                                       | ** ** | **Amortization**                                 | ** ** | **Value** | ** ** | **Value** | ** ** | **Amortization** | ** ** | **Value** | ** ** |
| ** **                                   | ** ** | **(in thousands)**                         | ** ** |
|                                         |       |                                            |       |                                             |       |   |   |   |   |   |   |   |   |
| Subscriber bases  and customer relationships |       | $                                               | 384,336    |                                             | $          | (337,708 | ) | $ | 46,628 |   | $ | 390,425 |   | $ | (347,909 | ) | $ | 42,516 |   |
| Software,  technology and other              |       | 3,864                                           |       | (1,551                                           | )          | 2,313 |   | 3,892 |   | (3,101 | ) | 791 |   |
| Trade names                                  |       | 10,857                                          |       | —                                           |       | 10,857 |   | 10,857 |   | — |   | 10,857 |   |
|                                         |       |                                            |       |                                             |       |   |   |   |   |   |   |   |   |
| Total                                        |       | $                                               | 399,057    |                                             | $          | (339,259 | ) | $ | 59,798 |   | $ | 405,174 |   | $ | (351,010 | ) | $ | 54,164 |   |

 

Amortization of intangible assetsin the Condensed Consolidated Statements of Operations for the three and ninemonths ended September 30, 2006 and 2007 represents the amortization ofdefinite lived intangible assets. The Company’s definite lived intangibleassets primarily consist of subscriber bases and customer relationships,acquired software and technology and other assets acquired in conjunction withthe purchases of businesses and subscriber bases from other companies that arenot deemed to have indefinite lives. The Company’s identifiable indefinitelived intangible assets consist of trade names. Definite lived intangibleassets are amortized on a straight-line basis over their estimated usefullives, which are generally three to six years for subscriber bases and customerrelationships and one to six years for acquired software and technology. As ofDecember 31, 2006 and September 30, 2007, the weighted average amortizationperiods were 3.3 years for subscriber base assets and customer relationshipsand 4.1 years for software and technology. Based on the current amount ofdefinite lived intangible assets, the Company expects to record amortizationexpense of approximately $5.5 million during the three months ending December31, 2007 and $13.8 million, $10.6 million, $7.2 million, $6.0 million and $0.2million during the years ending December 31, 2008, 2009, 2010, 2011 andthereafter, respectively. Actual amortization expense to be reported in futureperiods could differ materially from these estimates as a result of assetacquisitions, changes in useful lives and other factors.

 

**8. Long-Term Debt**

 

In November2006, the Company issued $258.8 million aggregate principal amount ofConvertible Senior Notes due November 15, 2026 (the “Notes”) in a registeredoffering, which reflects the exercise by the underwriters of their option topurchase an additional $33.8 million of principal to cover over-allotments. TheCompany received net proceeds of $251.6 million after transaction fees of $7.2million. The Notes bear interest at 3.25% per year on the principal amount ofthe Notes until November 15, 2011, and 3.50% interest per year on the principalamount of the Notes thereafter, payable semi-annually in May and November ofeach year. The Notes rank as senior unsecured obligations of the Company.

 

TheNotes are payable with cash and, if applicable, are convertible into shares ofthe Company’s common stock based on an initial conversion rate, subject toadjustment, of 109.6491 shares per $1,000 principal amount of Notes (whichrepresents an initial conversion price of approximately $9.12 per share). Uponconversion, a holder will receive cash up to the principal amount of the Notesand, at the Company’s option, cash, or shares of the Company’s common stock ora combination of cash and shares of common stock for the remainder, if any, ofthe conversion obligation. The conversion obligation is based on the sum of the“daily settlement amounts” for the 20 consecutive trading days that beginon, and include, the second trading day after 

 

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theday the Notes are surrendered for conversion. The Notes will beconvertible only in the following circumstances: (1) during any calendarquarter after the calendar quarter ending December 31, 2006 (and only duringsuch calendar quarter), if the closing sale price of the Company’s common stockfor each of 20 or more trading days in a period of 30 consecutive trading daysending on the last trading day of the immediately preceding calendar quarterexceeds 130% of the conversion price in effect on the last trading day of theimmediately preceding calendar quarter; (2) during the five consecutivebusiness days immediately after any five consecutive trading day period inwhich the average trading price per $1,000 principal amount of Notes was equalto or less than 98% of the average conversion value of the Notes during thenote measurement period; (3) upon the occurrence of specified corporatetransactions; (4) if the Company has called the Notes for redemption; and (5)at any time from, and including, October 15, 2011 to, and including, November15, 2011 and at any time on or after November 15, 2024. The Company has theoption to redeem the Notes, in whole or in part, for cash, on or afterNovember 15, 2011, provided that the Company has made at least tensemi-annual interest payments. In addition, the holders may require theCompany to purchase all or a portion of their notes on each ofNovember 15, 2011, November 15, 2016 and November 15, 2021.

 

As ofDecember 31, 2006 and September 30, 2007, the fair value of the Notes wasapproximately $277.3 million and $287.1 million, respectively, based on quotedmarket prices.

 

Inconnection with the issuance of the Notes, the Company entered into separateconvertible note hedge transactions and separate warrant transactions withrespect to the Company’s common stock to reduce the potential dilution uponconversion of the Notes (collectively referred to as the “Call SpreadTransactions”). The Company purchased call options to cover approximately 28.4million shares of the Company’s common stock, subject to adjustment in certaincircumstances, which is the number of shares underlying the Notes. In addition,the Company sold warrants permitting the purchasers to acquire up toapproximately 28.4 million shares of the Company’s common stock, subject toadjustment in certain circumstances. See Note 9, “Stockholders’ Equity,” formore information on the Call Spread Transactions.

 

**9. Stockholders’ Equity**

 

*Comprehensive Income (Loss)*

 

Comprehensiveincome (loss) includes unrealized gains and losses on certain investmentsclassified as available-for-sale, net of tax, which are excluded from theCondensed Consolidated Statements of Operations in accordance with SFASNo. 130, “Reporting Comprehensive Income.” Comprehensive income (loss) forthe three and nine months ended September 30, 2006 and 2007 was as follows:

 
| ** **                                    | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                    | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                    | ** ** | **2006**                         | ** ** | **2007**                        | ** ** | **2006** | ** ** | **2007** | ** ** |
| ** **                                    | ** ** | **(in thousands)**          | ** ** |
| Net income  (loss)                            |       | $                                | (3,182     | )                               | $          | (79,381 | ) | $ | 29,739 |   | $ | (125,633 | ) |
| Net unrealized  gains (losses) on investments |       | (10,715                          | )          | 452                             |       | (5,331 | ) | (3,235 | ) |
| Total  comprehensive income (loss)            |       | $                                | (13,897    | )                               | $          | (78,929 | ) | $ | 24,408 |   | $ | (128,868 | ) |

 

Thenet change in unrealized gains (losses) on investments for the three and ninemonths ended September 30, 2006 and 2007 was primarily due to the change inestimated fair value of the Company’s investments in other companies as aresult of changes in the closing prices of the common stock of these companiesduring the respective periods.

 

11

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*ShareRepurchases*

 

Sincethe inception of the Company’s share repurchase program, the Board of Directorshas authorized a total of $750.0 million for the repurchase of EarthLink’scommon stock, including $200.0 million that was authorized in August 2007. Asof September 30, 2007, the Company had $270.3 million available under thecurrent authorizations. The Company may repurchase its common stock from timeto time in compliance with Securities and Exchange Commission regulations andother legal requirements, including through the use of derivative transactions,and subject to market conditions and other factors. The share repurchaseprogram does not require the Company to acquire any specific number of sharesand may be terminated by the Board of Directors at any time.

 

Thefollowing table summarizes share purchases during the three and nine monthsended September 30, 2006 and 2007:

 
| ** **                  | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                  | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                  | ** ** | **2006**                         | ** ** | **2007**                        | ** ** | **2006** | ** ** | **2007** | ** ** |
| ** **                  | ** ** | **(in thousands)**          | ** ** |
| Number of shares  purchased |       | 8,049                            |       | 3,920                           |       | 10,539 |   | 3,920 |   |
| Aggregate  purchase price   |       | $                                | 58,705     |                            | $          | 24,972 |   | $ | 79,847 |   | $ | 24,972 |   |
|                             |            |                                  |            |                                 |            |  |  |  |  |  |  |  |  |

 

*Call Spread Transactions*

 

Inconnection with the issuance of the Notes (see Note 8, “Long-Term Debt”), theCompany entered into separate convertible note hedge transactions and separatewarrant transactions with respect to the Company’s common stock to minimize theimpact of the potential dilution upon conversion of the Notes. The Companypurchased call options in private transactions to cover approximately 28.4million shares of the Company’s common stock at a strike price of $9.12 pershare, subject to adjustment in certain circumstances, for $47.2 million. Thecall options generally allow the Company to receive shares of the Company’scommon stock from counterparties equal to the number of shares of common stockpayable to the holders of the Notes upon conversion. These call options willterminate upon the earlier of the maturity dates of the related Notes or thefirst day all of the related Notes are no longer outstanding due to conversionor otherwise. As of December 31, 2006 and September 30, 2007, the estimatedfair value of the call options was $58.4 million and $63.3 million,respectively.

 

TheCompany also sold warrants permitting the purchasers to acquire up toapproximately 28.4 million shares of the Company’s common stock at an exerciseprice of $11.20 per share, subject to adjustments in certain circumstances, inprivate transactions for total proceeds of approximately $32.1 million. Thewarrants expire at various dates from March 2012 through July 2012. Thewarrants provide for net share settlement. In no event shall the Company berequired to deliver a number of shares in connection with the transaction inexcess of twice the aggregate number of warrants. As of December 31, 2006 andSeptember 30, 2007, the estimated fair value of the warrants was $41.0 millionand $43.9 million, respectively.

 

TheCompany has analyzed the Call Spread Transactions under EITF Issue No. 00-19, “Accountingfor Derivative Financial Instruments Indexed to, and Potentially Settled In, aCompany’s Own Stock,” and other relevant literature, and determined that theymeet the criteria for classification as equity transactions. As a result, theCompany recorded the purchase of the call options as a reduction in additionalpaid-in capital and the proceeds from the sale of the warrants as an increaseto additional paid-in capital, and the Company does not recognize subsequentchanges in fair value of the agreements in its financial statements.

 

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**10. Stock-Based Compensation**

 

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

 

Stock-basedcompensation expense under SFAS No. 123(R) was $3.4 million and $10.8 millionduring the three and nine months ended September 30, 2006, respectively, and$4.3 million and $15.1 million during the three and nine months ended September30, 2007, respectively. The Company classifies stock-based compensation expensewithin the same operating expense line items as cash compensation paid toemployees.

 

Includedin stock-based compensation expense for the nine months ended September 30,2007 was $4.9 million of stock-based compensation expense related to Charles G.Betty, EarthLink’s former President and Chief Executive Officer. Mr. Bettypassed away on January 2, 2007. Pursuant to Mr. Betty’s employmentagreement, all unvested stock options and restricted stock units immediatelyvested and became fully exercisable upon death. In addition, the Leadership andCompensation Committee of the Board of Directors extended the exercise periodof Mr. Betty’s stock options until December 31, 2008. This daterepresents the exercise period if Mr. Betty had terminated employment afterserving the full term of his employment agreement, which was set to expire inJuly 2008. During the nine months ended September 30, 2007, EarthLink recordedstock-based compensation of $3.5 million related to the accelerated vesting of1.1 million stock options and 120,000 restricted stock units and recordedstock-based compensation expense of $1.4 million related to the extension ofthe exercise period for Mr. Betty’s stock options.

 

*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 Leadership and Compensation Committee of the Board of Directors, which determinethe terms of the awards granted. Stock options are generally granted with anexercise price equal to the market value of EarthLink common stock on the dateof grant, have a term of ten years or less, and vest over terms of four to sixyears from the date of grant. Restricted stock units generally vest over termsof one and a half years to four 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 

 

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ofvarious events. As of December 31, 2006 and September 30, 2007, approximately29,000 and 40,000 phantom share units, respectively, were outstanding.

 

*Warrants*

 

Priorto December 31, 2000, the Company issued warrants to purchase shares ofthe Company’s common stock to certain members of its Board of Directors,customers, consultants, lessors, creditors and others. As of September 30,2007, warrants to purchase a total of 52,000 shares of common stock wereoutstanding at an exercise price of $5.50. The warrants were exercised inOctober 2007.

 

Duringthe year ended December 31, 2006, the Company sold warrants in connection withthe issuance of Notes permitting the purchasers to acquire up to approximately28.4 million shares of the Company’s common stock. See Note 9, “Stockholders’Equity,” for a description of those warrants.

 

*OptionsOutstanding*

 

                Thefollowing table summarizes information concerning stock option activity as ofand for the nine months ended September 30, 2007: 

 
| ** **                                            | ** ** | ** **                                                | ** ** | ** **   | ** ** | **Weighted**          | ** ** | ** **    | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------------------|------------|--------------|------------|-----------------------|------------|---------------|------------|
| ** **                                            | ** ** | ** **                                                | ** ** | **Weighted** | ** ** | **Average**           | ** ** | ** **    | ** ** |
| ** **                                            | ** ** | ** **                                                | ** ** | **Average**  | ** ** | **Remaining**         | ** ** | **Aggregate** | ** ** |
| ** **                                            | ** ** | ** **                                                | ** ** | **Exercise** | ** ** | **Contractual**       | ** ** | **Intrinsic** | ** ** |
| ** **                                            | ** ** | **Stock Options**                                    | ** ** | **Price**    | ** ** | **Term (Years)** | ** ** | **Value**     | ** ** |
| ** **                                            | ** ** | **(shares and dollars in thousands)** | ** ** |
|                                                  |       |                                                      |       |         |       |                  |       |          |       |
| Outstanding as  of December 31, 2006                  |       | 20,470                                                    |       | $            | 11.27      |                  |       |          |       |   |
| Granted                                               |       | 2,711                                                     |       | 7.28         |       |                  |       |          |       |
| Exercised                                             |       | (923                                                      | )          | 7.22         |       |                  |       |          |       |
| Forfeited and  expired                                |       | (2,343                                                    | )          | 10.82        |       |                  |       |          |       |
| Outstanding as  of September 30, 2007                 |       | 19,915                                                    |       | $            | 10.97      |                  | 6.1        |          | $          | 7,945 |   |
|                                                  |       |                                                      |       |         |       |                  |       |          |       |
| Vested and  expected to vest as of September 30, 2007 |       | 15,935                                                    |       | $            | 11.67      |                  | 5.5        |          | $          | 5,975 |   |
|                                                  |       |                                                      |       |         |       |                  |       |          |       |
| Exercisable as  of September 30, 2007                 |       | 13,148                                                    |       | $            | 12.43      |                  | 4.9        |          | $          | 3,995 |   |

 

The aggregate intrinsic valueamounts in the table above represent the closing price of the Company’s commonstock on September 30, 2007 in excess of the exercise price, multiplied by thenumber of stock options outstanding or exercisable, when the closing price isgreater than the exercise price. The total intrinsic value of stock optionsexercised during the three and nine months ended September 30, 2006 was $0.6million and $2.4 million, respectively. The total intrinsic value of stockoptions exercised during the three and nine months ended September 30, 2007 was$0.5 million and $1.7 million, respectively. The intrinsic value of stockoptions exercised represents the difference between the Company’s common stockat the time of exercise and the exercise price, multiplied by the number of stockoptions exercised.

 

14

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The following table summarizes thestatus of the Company’s stock options as of September 30, 2007:

 
| **Stock Options Outstanding** | ** ** | **Stock Options** | ** ** |
|-----------------------------------------|------------|------------------------|------------|
| ** **                              | ** ** | ** **             | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Exercisable** | ** ** |
| ** **                              | ** ** | ** **             | ** ** | ** ** | ** ** | **Average** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                              | ** ** | ** **             | ** ** | ** ** | ** ** | **Remaining** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **Range of**                       | ** ** | **Number**             | ** ** | **Contractual** | ** ** | **Exercise** | ** ** | **Number** | ** ** | **Exercise** | ** ** |
| **Exercise Prices**                | ** ** | **Outstanding**        | ** ** | **Life** | ** ** | **Price** | ** ** | **Exercisable** | ** ** | **Price** | ** ** |
| ** **                              | ** ** | ** **             | ** ** | **(in thousands)** | ** ** | ** ** | ** ** | ** ** | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| $                                       | 4.85       |                   | $          | 6.13 |   | 1,728 |   | 5.1 |   | $ | 5.58 |   | 1,364 |   | $ | 5.68 |   |
| 6.31                                    |       | 7.02                   |       | 2,198 |   | 8.8 |   | 6.88 |   | 187 |   | 6.51 |   |
| 7.10                                    |       | 7.82                   |       | 2,930 |   | 8.9 |   | 7.37 |   | 1,260 |   | 7.38 |   |
| 7.99                                    |       | 9.24                   |       | 2,261 |   | 6.7 |   | 8.93 |   | 1,618 |   | 8.90 |   |
| 9.25                                    |       | 9.89                   |       | 2,236 |   | 5.9 |   | 9.58 |   | 1,353 |   | 9.63 |   |
| 9.93                                    |       | 10.06                  |       | 2,166 |   | 2.9 |   | 10.06 |   | 2,166 |   | 10.06 |   |
| 10.36                                   |       | 10.51                  |       | 1,981 |   | 7.4 |   | 10.37 |   | 1,129 |   | 10.37 |   |
| 10.56                                   |       | 15.63                  |       | 1,991 |   | 6.5 |   | 11.49 |   | 1,647 |   | 11.55 |   |
| 16.82                                   |       | 51.44                  |       | 2,424 |   | 2.3 |   | 26.91 |   | 2,424 |   | 26.91 |   |
| $                                       | 4.85       |                   | $          | 51.44 |   | 19,915 |   | 6.1 |   | $ | 10.97 |   | 13,148 |   | $ | 12.43 |   |

 

*Valuation Assumptions for Stock Options*

 

The fair value of stock optionsgranted during the nine months ended September 30, 2006 and 2007 was estimatedusing the Black-Scholes option-pricing model with the following assumptions:

 
| ** **               | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------|------------|---------------------------------------------------------|------------|
| ** **               | ** ** | **2006**                                                | ** ** | **2007** | ** ** |
|                     |       |                                                    |       |   |   |
| Dividend yield           |       | 0                                                       | %          | 0 | % |
| Expected  volatility     |       | 44                                                      | %          | 39 | % |
| Risk-free  interest rate |       | 4.90                                                    | %          | 4.81 | % |
| Expected life            |       | 4.4 years                                               |       | 4.3 years |   |

 

Theweighted average grant date fair value of options granted during the nine monthsended September 30, 2006 and 2007 was $3.73 and $2.79, respectively.

 

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 prices for actively traded options on the Company’s stock. Therisk-free interest rate assumption is based upon the U.S. Treasury yield ineffect at the time of grant for periods corresponding with the expected life ofthe option. The expected life of employee stock options represents theweighted-average period stock options expected to vest remain outstanding.

 

15

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*RestrictedStock Units*

 

The following table summarizes theCompany’s restricted stock units as of and for the nine months ended September30, 2007:

 
| ** **                          | ** ** | ** **           | ** ** | **Weighted**        | ** ** |
|-------------------------------------|------------|----------------------|------------|---------------------|------------|
| ** **                          | ** ** | ** **           | ** ** | **Average**         | ** ** |
| ** **                          | ** ** | **Restricted**       | ** ** | **Grant Date** | ** ** |
| ** **                          | ** ** | **Stock Units** | ** ** | **Fair Value** | ** ** |
|                                |       |                 |       |                |       |
| Nonvested as of  December 31, 2006  |       | 1,180,000            |       | $                   | 8.57       |   |
| Granted                             |       | 1,679,000            |       | 6.92                |       |
| Vested                              |       | (330,000             | )          | 5.63                |       |
| Forfeited                           |       | (176,000             | )          | 7.94                |       |
| Nonvested as of  September 30, 2007 |       | 2,353,000            |       | 7.25                |       |
|                                     |            |                      |            |                     |            |  |

 

The fair value of restricted stockunits is determined based on the closing trading price of EarthLink’s commonstock on the grant date. The weighted-average grant date fair value ofrestricted stock units granted during the nine months ended September 30, 2006and 2007 was $9.27 and $6.92, respectively. As of September 30, 2007, there was$13.1 million of total unrecognized compensation cost related to nonvestedrestricted stock units. That cost is expected to be recognized over aweighted-average period of 2.0 years. The total fair value of shares vestedduring the nine months ended September 30, 2006 and 2007 was $1.2 million and$2.5 million, respectively, which represents the closing price of the Company’scommon stock on the vesting date multiplied by the number of restricted stockunits that vested.

 

**11. Income Taxes**

 

EarthLink has recorded income taxes for the three and ninemonths ended September 30, 2007 based on management’s current expectations forthe results of operations for the year ending December 31, 2007 in accordancewith the interim reporting requirements of SFAS No. 109, “Accounting for IncomeTaxes,” and APB Opinion No. 28, “Interim Financial Reporting.”

 

EarthLink continues to maintain afull valuation allowance against its unrealized deferred tax assets, consistingprimarily of net operating loss carryforwards, and EarthLink may recognizedeferred tax assets in future periods when they are estimated to be realizable.To the extent EarthLink may owe income taxes in future periods, EarthLinkintends to use its net operating loss carryforwards to the extent available tooffset taxable income and reduce cash outflows for income taxes.

 

**12. 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 has developed its business, the extent to which HELIO relieson EarthLink 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 were determined based on EarthLink’s coststo provide the services, and management believes 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 HELIOare reflected as reductions to the associated expenses incurred by EarthLink toprovide such services. During the three and nine months ended September 30,2006, fees received for services provided to HELIO were $0.6 million and $1.8million, respectively. During the three and nine months ended September 30,2007, fees received for services provided to HELIO were $0.4 million and $1.3million, respectively.

 

16

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EarthLinkalso markets HELIO’s products and services and purchases wireless Internetaccess devices and services from HELIO. During the three and nine months endedSeptember 30, 2006 and 2007, revenues generated from HELIO and fees paid forproducts and services from HELIO were nominal.

 

InJuly 2007, EarthLink entered into a loan agreement with HELIO pursuant to whichEarthLink could lend up to $100.0 million to HELIO in the form of PromissoryNotes (see Note 6, “Investments”). Also in July 2007, EarthLink purchasedinitial Promissory Notes of $30.0 million.

 

*eCompanies*

 

During the three and nine monthsended September 30, 2007, the Company received $1.2 million and $1.4 million,respectively, in cash distributions as a result of its investment in EVG. SkyDayton, a member of EarthLink’s Board of Directors, is a founding partner inEVG.

 

**13. Segment Information**

 

Inaccordance with SFAS No. 131, “Disclosures about Segments of an Enterprise andRelated Information,” the Company reports segment information along the samelines that its chief executive reviews its operating results in assessingperformance and allocating resources. Effective March 2007, the Companyoperates two reportable segments, Consumer Services and Business Services,which are described below in more detail.

 

TheCompany’s segments are strategic business units that are managed based upondifferences in customers, services and marketing channels. The Company’sConsumer Services segment provides integrated communications services and relatedvalue-added services to individual customers. These services include dial-upand high-speed Internet access, municipal wireless broadband and voiceservices, among others. The Company’s Business Services segment providesintegrated communications services and related value-added services tobusinesses and communications carriers. These services include managed datanetworks, dedicated Internet access and web hosting, among others.

 

TheCompany evaluates performance of its segments based on segment income fromoperations. Segment income from operations includes revenues from externalcustomers, related cost of revenues and operating expenses directlyattributable to the segment, which include costs over which segment managershave direct discretionary control, such as advertising and marketing programs,customer support expenses, site operations expenses, product developmentexpenses, certain technology and facilities expenses, billing operations andprovisions for doubtful accounts. Segment income from operations excludes otherincome and expense items and certain expenses over which segment managers donot have discretionary control. Costs excluded from segment income fromoperations include various corporate expenses (consisting of certain costs suchas corporate management, human resources, finance and legal), amortization ofintangible assets, facility exit and restructuring costs, and stock-basedcompensation expense under SFAS No. 123(R), as they are not considered in themeasurement of segment performance.

 

17

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Information on reportable segments and a reconciliation to consolidatedincome (loss) from operations for the three and nine months ended September 30,2006 and 2007 is as follows:

 
| ** **                             | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|----------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                                 | ** ** | **2007**                                                | ** ** | **2006** | ** ** | **2007** | ** ** |
| ** **                             | ** ** | **(in thousands)**                                  | ** ** |
| **Consumer  Services**                 |       |                                                     |       |                                                    |       |   |   |   |   |
| Revenues                               |       | $                                                        | 282,259    |                                                    | $          | 251,293 |   | $ | 860,443 |   | $ | 792,060 |   |
| Cost of revenues                       |       | 86,117                                                   |       | 83,531                                                  |       | 262,328 |   | 255,761 |   |
| Gross margin                           |       | 196,142                                                  |       | 167,762                                                 |       | 598,115 |   | 536,299 |   |
| Direct segment  operating expenses     |       | 158,791                                                  |       | 135,936                                                 |       | 490,239 |   | 442,919 |   |
| Segment  operating income              |       | $                                                        | 37,351     |                                                    | $          | 31,826 |   | $ | 107,876 |   | $ | 93,380 |   |
|                                   |       |                                                     |       |                                                    |       |   |   |   |   |
| **Business  Services**                 |       |                                                     |       |                                                    |       |   |   |   |   |
| Revenues                               |       | $                                                        | 49,050     |                                                    | $          | 47,471 |   | $ | 112,674 |   | $ | 143,313 |   |
| Cost of revenues                       |       | 29,317                                                   |       | 29,361                                                  |       | 58,148 |   | 88,836 |   |
| Gross margin                           |       | 19,733                                                   |       | 18,110                                                  |       | 54,526 |   | 54,477 |   |
| Direct segment  operating expenses     |       | 17,724                                                   |       | 12,257                                                  |       | 35,145 |   | 45,044 |   |
| Segment  operating income              |       | $                                                        | 2,009      |                                                    | $          | 5,853 |   | $ | 19,381 |   | $ | 9,433 |   |
|                                   |       |                                                     |       |                                                    |       |   |   |   |   |
| **Consolidated**                       |       |                                                     |       |                                                    |       |   |   |   |   |
| Revenues                               |       | $                                                        | 331,309    |                                                    | $          | 298,764 |   | $ | 973,117 |   | $ | 935,373 |   |
| Cost of revenues                       |       | 115,434                                                  |       | 112,892                                                 |       | 320,476 |   | 344,597 |   |
| Gross margin                           |       | 215,875                                                  |       | 185,872                                                 |       | 652,641 |   | 590,776 |   |
| Direct segment  operating expenses     |       | 176,515                                                  |       | 148,193                                                 |       | 525,384 |   | 487,963 |   |
| Segment  operating income              |       | 39,360                                                   |       | 37,679                                                  |       | 127,257 |   | 102,813 |   |
| Stock-based  compensation expense      |       | 3,424                                                    |       | 4,303                                                   |       | 10,826 |   | 15,081 |   |
| Amortization of  intangible assets     |       | 3,372                                                    |       | 3,836                                                   |       | 8,407 |   | 10,874 |   |
| Facility exit  and restructuring costs |       | —                                                   |       | 54,820                                                  |       | (117 | ) | 54,820 |   |
| Other operating  expenses              |       | 12,938                                                   |       | 10,608                                                  |       | 41,554 |   | 41,693 |   |
| Income (loss)  from operations         |       | $                                                        | 19,626     |                                                    | $          | (35,888 | ) | $ | 66,587 |   | $ | (19,655 | ) |

 

Theprimary component of the Company’s revenues is access and service revenues,which consist of narrowband access services (including traditional,fully-featured narrowband access and value-priced narrowband access); broadbandaccess services (including high-speed access via DSL, cable and wirelesstechnologies, IP-based voice and fees charged for high-speed data networks tosmall and medium-sized businesses); and web hosting services. The Company alsoearns revenues from value-added services, which include ancillary services soldas add-on features to the Company’s access services, search and advertisingrevenues.

 

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

 

Businessaccess and service revenues consist of retail and wholesale fees charged forhigh-speed, high-capacity access services including DSL, cable, satellite anddedicated circuit services; fees charged for high-speed data networks for smalland medium-sized businesses; installation fees; termination fees; fees forequipment; regulatory surcharges billed to customers; and web hosting.

 

18

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Informationon revenues by groups of similar services and by segment for the three and ninemonths ended September 30, 2006 and 2007 is as follows:

 
| ** **             | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **             | ** ** | **2006**                                             | ** ** | **2007**                                            | ** ** | **2006** | ** ** | **2007** | ** ** |
| ** **             | ** ** | **(in thousands)**                              | ** ** |
| **Consumer  Services** |       |                                                 |       |                                                |       |   |   |   |   |
| Access and  service    |       | $                                                    | 252,390    |                                                | $          | 219,381 |   | $ | 774,808 |   | $ | 694,169 |   |
| Value-added  services  |       | 29,869                                               |       | 31,912                                              |       | 85,635 |   | 97,891 |   |
| Total revenues         |       | $                                                    | 282,259    |                                                | $          | 251,293 |   | $ | 860,443 |   | $ | 792,060 |   |
|                   |       |                                                 |       |                                                |       |   |   |   |   |
| **Business  Services** |       |                                                 |       |                                                |       |   |   |   |   |
| Access and  service    |       | $                                                    | 48,223     |                                                | $          | 46,833 |   | $ | 110,070 |   | $ | 141,115 |   |
| Value-added  services  |       | 827                                                  |       | 638                                                 |       | 2,604 |   | 2,198 |   |
| Total revenues         |       | $                                                    | 49,050     |                                                | $          | 47,471 |   | $ | 112,674 |   | $ | 143,313 |   |
|                   |       |                                                 |       |                                                |       |   |   |   |   |
| **Consolidated**       |       |                                                 |       |                                                |       |   |   |   |   |
| Access and  service    |       | $                                                    | 300,613    |                                                | $          | 266,214 |   | $ | 884,878 |   | $ | 835,284 |   |
| Value-added  services  |       | 30,696                                               |       | 32,550                                              |       | 88,239 |   | 100,089 |   |
| Total revenues         |       | $                                                    | 331,309    |                                                | $          | 298,764 |   | $ | 973,117 |   | $ | 935,373 |   |

 

TheCompany manages its working capital on a consolidated basis and does notallocate long-lived assets to segments. In addition, segment assets are notreported to, or used by, the chief operating decision maker and therefore,pursuant to SFAS No. 131, total segment assets have not been disclosed.

 

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

 

19

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

 

Certain statements in this Quarterly Report onForm 10-Q are forward-looking statements within the meaning of the PrivateSecurities Litigation Reform Act of 1995, Section 27A of the SecuritiesAct of 1933, and Section 21E of the Securities Exchange Act of 1934. Thewords “estimate,” “plan,” “intend,” “expect,” “anticipate,” “believe” andsimilar expressions are intended to identify forward-looking statements. Theseforward-looking statements are found at various places throughout this report.EarthLink disclaims any intention or obligation to update or revise anyforward-looking statements, whether as a result of new information, futureevents or otherwise. Although EarthLink believes that its expectations arebased on reasonable assumptions, it can give no assurance that its goals willbe achieved. Important factors that could cause actual results to differ fromestimates or projections contained in the forward-looking statements are describedunder “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 FinancialCondition and Results of Operations” and the audited Consolidated FinancialStatements and the Notes thereto contained in the Annual Report on Form 10-Kfor the year ended December 31, 2006, as amended.*

 

**Overview**

 

EarthLink,Inc. provides integrated communication services and related value-addedservices to individual consumers and business customers utilizing InternetProtocol, or IP, based technologies. Our core service offerings are dial-up andwireline broadband Internet access services and value-added services.Additional services offerings include IP-based voice services, municipalwireless broadband services and our services for business customers.

 

EffectiveMarch 2007, we operate as two reportable segments, Consumer Services andBusiness Services. Our Consumer Services segment provides integratedcommunications services and related value-added services to individualcustomers. These services include narrowband Internet access, wireline andwireless broadband Internet access and IP-based voice services. Our BusinessServices segment provides integrated communications services and relatedvalue-added services to businesses and communications carriers. These servicesinclude managed data networks, dedicated Internet access and web hosting.

 

Wealso have a joint venture with SK Telecom Co., Ltd. (“SK Telecom”), HELIO. HELIOis a non-facilities-based mobile virtual network operator (MVNO) offeringmobile communications services and handsets to consumers in the U.S. HELIO wasformed in March 2005 and began offering its products and services during April2006.

 

*IndustryBackground*

 

Weoperate in the Internet access market, which is characterized by rapidlychanging technology, evolving industry standards, changes in customer needs,new service and product introductions and intense competition. The Internetaccess market has reached a mature stage of growth; however, growth is expectedto continue at a slow rate as more services become available online, Internetaccess prices remain low, computer prices continue to decline and consumersincreasingly gain access at places outside the home.

 

In thelast few years, the composition of the Internet access market has changed andthe number of households with broadband access surpassed the number ofhouseholds with dial-up access. Consumers continue to migrate to broadband dueto the faster connection and download speeds provided by broadband access, theability to free up their phone lines and the more reliable and “always on”connection. The pricing for broadband services, particularly for introductorypromotional periods, services bundled with video and telephone services, andservices with slower speeds, has been declining and is approaching prices fortraditional dial-up services, making it a more viable option for consumers thatcontinue to rely on dial-up connections for Internet access. In 

 

20

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addition, advanced applications such as onlinegaming, music downloads and photo sharing require greater bandwidth for optimalperformance, which adds to the demand for broadband access.

 

Currently,most residential broadband consumers access the Internet via DSL or cable. Anincreasing array of alternative broadband access technologies, such as wirelessbroadband and broadband over power lines, are now available. The availabilityof these alternatives may further encourage future broadband deployment andmarket penetration. However, there is uncertainty regarding mass consumeradoption. The growth of mobile devices that support email and sales of laptopcomputers and other mobile devices create an increasing need for portable andmobile Internet access. In addition, one of the outgrowths from the rapiddeployment of broadband connectivity has been the adoption of Voice overInternet Protocol (“VoIP”). VoIP is a technology that enables voicecommunications over the Internet through the conversion of voice signals intodata packets. VoIP technology presents several advantages over the technologyused in traditional wireline telephone networks and enables VoIP providers tooperate with lower capital expenditures and operating costs while offering bothtraditional and innovative service features.

 

*RevenueSources*

 

Weprovide access services (including traditional, fully-featured narrowbandaccess and value-priced narrowband access; high-speed access via DSL, cable andwireless technologies; and IP-based voice) and value-added services (includingancillary services sold as add-on feature to our services, search and advertising).We earn revenues primarily from monthly fees charged to customers for services.We also earn revenues from usage fees; installation fees; termination fees; andfees for equipment used to access our services. Total revenues decreased from$331.3 million during the three months ended September 30, 2006 to $298.8million during the three months ended September 30, 2007, and decreased from$973.1 million during the nine months ended September 30, 2006 to $935.4million during the nine months ended September 30, 2007. The decreases in totalrevenues were primarily due to decreases in narrowband access revenues, offsetby increases in IP-based voice services revenues and value-added servicesrevenues. Our traditional, premium-priced narrowband revenues have beendeclining due to the maturity of this service. In addition, the mix of ournarrowband customers continues to shift towards value-priced narrowband access.The decrease in revenues during the nine month period was also offset by anincrease in revenues due to our acquisition of New Edge Networks in April 2006.

 

*BusinessStrategy and Risks*

 

Ourrecent business strategy has been to generate profits from our existing coreaccess services and to reinvest the cash generated from these services intovarious growth initiatives with the objective of generating a return on ourinvestments. These growth initiatives include VoIP services, municipal wirelessbroadband services and business services. VoIP and municipal wireless broadbandservices are still in their early stages and continue to experience operationaland competitive challenges. Our ability to succeed in providing these newservices will depend on whether we have a competitively-priced offering,improve the quality of these services and develop a reasonable cost structureto ensure an acceptable return on our investment.

 

Inresponse to declining revenues, changes in our industry and changes in consumerbehavior, we have just completed a comprehensive review of our core accessservices. We have also reviewed each of our growth initiatives to evaluatewhether these initiatives are complementary to our long-term strategy and allowus to maximize shareholder value. As a result of these reviews, we implementeda corporate restructuring plan (“the Plan”) to reduce operating costs andimprove the efficiency of our organization. Under the Plan, we willsignificantly reduce employees, close or consolidate certain facilities,discontinue certain projects and reduce sales and marketing efforts. For ourcore access services, we plan to reduce the back-office cost structure andreduce sales and marketing efforts aimed at customers that have highacquisition costs and early life churn. For our growth initiatives, we havesignificantly reduced the cost structure. Additionally, for our IP-based voiceand municipal wireless initiatives we do not expect to expand our existing footprintto additional markets at this time. We continue to evaluate all of our growthinitiatives.

 

21

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Webelieve the most important factors for us to be successful are the following:

 

•                  improving the cost structure of our business andaligning our cost structure with trends in our revenue;

•                  implementing plans to reduce our cost structurewithout impacting the quality of services we provide;

•                  reducing our subscriber acquisition costs,increasing the number of subscribers we add through partnerships andacquisitions from other ISPs and retaining existing tenured customers;

•                  renewing, extending or otherwise entering intowholesale broadband access agreements with telecommunications providers atcompetitive and improved wholesale broadband access prices and, in the eventthere are adverse changes in the retail pricing environment for broadbandaccess services, at wholesale broadband access prices that decreasesufficiently to at least coincide with declines in retail prices;

•                  monitoring the operations of our current growthinitiatives to maximize the value to our shareholders and mitigate the risk ofour investments;

•                  exploring, identifying and investing in additionalgrowth opportunities and successfully implementing strategies to costeffectively execute on the opportunities;

•                  differentiating our products and services to enableus to deliver high quality services that improve customers’ Internetexperiences, including bundling our various communications services; and

•                  exploring and evaluating potential strategictransactions that we believe may complement our current and future businessactivities, and successfully integrating any acquisitions and investments intoour business.

 

Theprimary challenges we face in executing our business strategy are maintainingprofitability in our existing services, competition, reducing churn andpurchasing cost-effective wholesale broadband access.

 

*Third Quarter2007 Highlights*

 

Asdiscussed above, total revenues decreased during the three months endedSeptember 30, 2007 compared to the prior year period. In addition, oursubscriber base decreased from approximately 5.3 million paying subscribers asof September 30, 2006 to approximately 4.2 million paying subscribers as ofSeptember 30, 2007. The decrease in paying subscribers was primarily due to theremoval of approximately 753,000 wholesale broadband subscribers that wereunder our marketing relationship with Embarq Corporation (“Embarq”) and adecrease in premium narrowband subscribers. Overall operating expensesincreased during the three months ended September 30, 2007 compared to theprior period primarily due to facility exit and restructuring costs resultingfrom our restructuring plan. However, these costs were offset by a decrease insales and marketing expenses for our core access services and a decrease incosts related to our growth initiatives. Additionally, our net losses of equityaffiliate related to our HELIO joint venture increased as HELIO incurred lossesdue to the start-up nature of their business. The decrease in total revenues,increase in total operating costs and expenses and net losses of HELIO causedour net loss to increase from $3.2 million during the three months endedSeptember 30, 2006 to $79.4 million during the three months ended September 30,2007.

 

22

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** **

**GrowthInitiatives**

 

Ourgrowth initiatives have recently included IP-based voice services, municipalwireless broadband services and services for business customers. We areimplementing plans to change the underlying business models and coststructures, in light of our evaluation of these initiatives.

 

*IP-based voice.*InOctober 2005, we began offering the next generation of our VoIP services,EarthLink trueVoiceSM. EarthLink trueVoice is a competitivealternative to traditional telephone service and is available to EarthLink andnon-EarthLink high-speed Internet access subscribers. In late 2005 and 2006, welaunched DSL and Home Phone Service, a new DSL and VoIP service, which usesCovad Communications Group, Inc.’s (“Covad”) line-powered voice access thatallows us to offer consumers low-cost phone services bundled with high-speedInternet access. In March 2006, we invested $50.0 million in Covad to fund thenetwork build-out for this service. DSL and Home Phone Service is now availablein 12 markets in the U.S. covering approximately 12.5 million households.

 

*Municipal wireless broadband*. We have invested in wireless, or Wi-Fi, broadbandaccess to deploy a competitive alternative to DSL and cable for deliveringbroadband Internet access services. During 2006 and early 2007, we beganoffering our municipal wireless broadband services in the cities ofPhiladelphia, Pennsylvania and Anaheim, California. In March 2007, we purchaseda municipal wireless network from the city of Corpus Christi, Texas that hadalready been deployed by the city. In June 2007, we transitioned the existingnetwork to our wireless network and began offering wireless Internet access toresidents and businesses of Corpus Christi. We currently have approximately 150square miles of wireless broadband networks covering approximately 0.6 millionhouseholds.

 

*Business services*. In April 2006, we acquired New Edge Networks (“NewEdge”), a single-source national provider of secure multi-site managed datanetworks and dedicated Internet access for businesses and communicationscarriers. The acquisition of New Edge expanded our service offerings to smalland medium-sized enterprises and our distribution channels.

 

**Joint Venture**

 

Wehave a joint venture with SK Telecom, HELIO. HELIO is a non-facilities-basedmobile virtual network operator (MVNO) offering mobile communications servicesand handsets to consumers in the U.S. HELIO launched its first wireless voiceand data service devices in 2006, and launched its fifth exclusive device inthe second quarter of 2007. From its formation in March 2005 though September2007, EarthLink and SK Telecom invested an aggregate of $440.0 million of cashand non-cash assets in HELIO pursuant to the Contribution and FormationAgreement, including an aggregate of $39.0 million that was invested during thenine months ended September 30, 2007. As of September 30, 2007, EarthLink andSK Telecom each had an approximate 47% economic ownership interest and a 50%voting interest in HELIO.

 

InJuly 2007, we and SK Telecom entered into a lending agreement with HELIOpursuant to which we and SK Telecom could lend up to $200.0 million to HELIOand made an initial loan of $30.0 million each. Under the terms of theagreement, we and SK Telecom may each lend HELIO up to $100.0 million in theform of promissory notes. In August 2007, SK Telecom preliminarily agreed toinvest up to $270.0 million in HELIO, while we retain a significant ownershipposition in HELIO. We and SK Telecom are currently renegotiating the HELIOjoint venture agreements.

 

23

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**Acquisition**

 

In April 2006, we acquired NewEdge. The acquisition of New Edge expands our service offerings for businessesand communications carriers. Under the terms of the merger agreement, weacquired 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. InJuly 2007, approximately 0.8 million shares of EarthLink, Inc. common stockthat had been held in escrow were returned to us.

 

**MarketingAlliances**

 

We have an agreement with TimeWarner Cable and Bright House Networks, companies whose networks pass more than30 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, 2007, more than 40%of our consumer broadband subscribers were serviced via either the Time WarnerCable or Bright House Networks network.

 

We had a marketing relationshipwith Embarq, a spin-off of Sprint Nextel Corporation’s local communicationsbusiness. The relationship provided that EarthLink was the wholesale high-speedISP for Embarq’s local residential and small business customers. The contractsassociated with these arrangements expired in April 2007, and we and Embarq didnot renew the wholesale broadband contract. Effective April 2007, we removedapproximately 753,000 wholesale broadband subscribers under the marketingrelationship from our broadband subscriber count and total subscriber count.

 

24

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**Key OperatingMetrics**

 

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

 
| ** **                                   | ** ** | **September 30,   2006** | ** ** | **December 31, 2006** | ** ** | **June 30,  2007** | ** ** | **September 30,  2007** | ** ** |
|----------------------------------------------|------------|-------------------------------|------------|----------------------------|------------|-------------------------|------------|-----------------------------------|------------|
| **Subscriber  Data (a)**                     |       |                          |       |                       |       |                    |       |                              |       |
| **Consumer  Services**                       |       |                          |       |                       |       |                    |       |                              |       |
| Narrowband  access subscribers               |       | 3,285,000                     |       | 3,261,000                  |       | 3,042,000               |       | 2,856,000                         |       |
| Broadband access  subscribers                |       | 1,797,000                     |       | 1,831,000                  |       | 1,092,000               |       | 1,093,000                         |       |
| Total consumer  services subscribers         |       | 5,082,000                     |       | 5,092,000                  |       | 4,134,000               |       | 3,949,000                         |       |
| **Business  Services**                       |       |                          |       |                       |       |                    |       |                              |       |
| Narrowband  access subscribers               |       | 43,000                        |       | 40,000                     |       | 31,000                  |       | 30,000                            |       |
| Broadband access  subscribers                |       | 69,000                        |       | 69,000                     |       | 70,000                  |       | 68,000                            |       |
| Web hosting  accounts                        |       | 116,000                       |       | 112,000                    |       | 106,000                 |       | 104,000                           |       |
| Total business  services subscribers         |       | 228,000                       |       | 221,000                    |       | 207,000                 |       | 202,000                           |       |
| **Total  subscriber count at end of period** |       | 5,310,000                     |       | 5,313,000                  |       | 4,341,000               |       | 4,151,000                         |       |
|                                         |       |                          |       |                       |       |                    |       |                              |       |

 
| ** **                          | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                          | ** ** | **2006**                                   | ** ** | **2007**                                  | ** ** | **2006** | ** ** | **2007** | ** ** |
| **Subscriber  Activity**            |       |                                       |       |                                      |       |   |   |   |   |
| Subscribers at  beginning of period |       | 5,344,000                                  |       | 4,341,000                                 |       | 5,315,000 |   | 5,313,000 |   |
| Gross organic  subscriber additions |       | 683,000                                    |       | 504,000                                   |       | 2,097,000 |   | 1,645,000 |   |
| Acquired  subscribers               |       | 5,000                                      |       | 32,000                                    |       | 76,000 |   | 65,000 |   |
| Adjustment (b)                      |       | —                                     |       | —                                    |       | — |   | (753,000 | ) |
| Churn                               |       | (722,000                                   | )          | (726,000                                  | )          | (2,178,000 | ) | (2,119,000 | ) |
| Subscribers at  end of period       |       | 5,310,000                                  |       | 4,151,000                                 |       | 5,310,000 |   | 4,151,000 |   |
|                                |       |                                       |       |                                      |       |   |   |   |   |
| **Churn  rate (c)**                 |       | 4.5                                        | %          | 5.7                                       | %          | 4.5 | % | 5.0 | % |
|                                |       |                                       |       |                                      |       |   |   |   |   |
| **Consumer  Services Data**         |       |                                       |       |                                      |       |   |   |   |   |
| Average  subscribers (d)            |       | 5,099,000                                  |       | 4,031,000                                 |       | 5,132,000 |   | 4,489,000 |   |
| ARPU (e)                            |       | $                                          | 18.45      |                                      | $          | 20.78 |   | $ | 18.63 |   | $ | 19.60 |   |
| Churn rate (c)                      |       | 4.6                                        | %          | 5.9                                       | %          | 4.6 | % | 5.1 | % |
|                                |       |                                       |       |                                      |       |   |   |   |   |
| **Business  Services Data**         |       |                                       |       |                                      |       |   |   |   |   |
| Average  subscribers (d)            |       | 231,000                                    |       | 204,000                                   |       | 209,000 |   | 211,000 |   |
| ARPU (e)                            |       | $                                          | 70.68      |                                      | $          | 77.56 |   | $ | 59.84 |   | $ | 75.58 |   |
| Churn rate (c)                      |       | 2.6                                        | %          | 2.4                                       | %          | 2.8 | % | 2.6 | % |

 

----

(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)  InApril 2007, our wholesale contract with Embarq expired. As a result, we removed753,000 wholesale broadband EarthLink-supported Embarq customers from ourbroadband subscriber count and total subscriber count.

 

25

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(c)  Churnrate is used to measure the rate at which subscribers discontinue service on avoluntary 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. Churn rate for the nine months endedSeptember 30, 2007 excludes the impact of the Embarq adjustment.

 

(d)  Average subscribersor accounts for the three month periods is calculated by averaging the endingmonthly subscribers or accounts for the four months preceding and including theend of the quarterly period. Average subscribers or accounts for the nine monthperiods is calculated by averaging the ending monthly subscribers or accountsfor the ten months preceding and including the end of the period.

 

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

 

**Results ofOperations**

 

***Consolidated Results of Operations***

 

Thefollowing table sets forth statement of operations data for the periodsindicated:

 
| ** **                                          | ** ** | **Three Months Ended  September 30,** | ** ** | ** ** | ** ** | ** **        | ** ** | **Nine Months Ended  September 30,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------------------------------------|------------|------------------------------------------------------|------------|------------|------------|-------------------|------------|-----------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                          | ** ** | **2006**                                             | ** ** | **2007**   | ** ** | **$ Change** | ** ** | **% Change**                                   | ** ** | **2006**   | ** ** | **2007**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                          | ** ** | **(dollars in thousands)**                 | ** ** |
|                                                |       |                                                 |       |       |       |              |       |                                                |       |       |       |       |       |   |   |   |   |
| Revenues                                            |       | $                                                    | 331,309    |       | $          | 298,764           |       | $                                                   | (32,545    | )          | -10%       |       | $          | 973,117 |   | $ | 935,373 |   | $ | (37,744 | ) | -4% |   |
|                                                |       |                                                 |       |       |       |              |       |                                                |       |       |       |       |       |   |   |   |   |
| Operating costs  and expenses:                      |       |                                                 |       |       |       |              |       |                                                |       |       |       |       |       |   |   |   |   |
| Service and  equipment costs                        |       | 112,790                                              |       | 108,974    |       | (3,816            | )          | -3%                                                 |       | 313,163    |       | 330,604    |       | 17,441 |   | 6% |   |
| Sales incentives                                    |       | 2,644                                                |       | 3,918      |       | 1,274             |       | 48%                                                 |       | 7,313      |       | 13,993     |       | 6,680 |   | 91% |   |
| Total cost of  revenues                             |       | 115,434                                              |       | 112,892    |       | (2,542            | )          | -2%                                                 |       | 320,476    |       | 344,597    |       | 24,121 |   | 8% |   |
|                                                |       |                                                 |       |       |       |              |       |                                                |       |       |       |       |       |   |   |   |   |
| Sales and  marketing                                |       | 95,298                                               |       | 75,916     |       | (19,382           | )          | -20%                                                |       | 292,422    |       | 255,132    |       | (37,290 | ) | -13% |   |
| Operations and  customer support                    |       | 64,293                                               |       | 58,031     |       | (6,262            | )          | -10%                                                |       | 189,405    |       | 185,578    |       | (3,827 | ) | -2% |   |
| General and  administrative                         |       | 33,286                                               |       | 29,157     |       | (4,129            | )          | -12%                                                |       | 95,937     |       | 104,027    |       | 8,090 |   | 8% |   |
| Amortization of  intangible assets                  |       | 3,372                                                |       | 3,836      |       | 464               |       | 14%                                                 |       | 8,407      |       | 10,874     |       | 2,467 |   | 29% |   |
| Facility exit and  restructuring costs              |       | —                                               |       | 54,820     |       | 54,820            |       | *                                                   |       | (117       | )          | 54,820     |       | 54,937 |   | * |   |
| Total operating  costs and expenses                 |       | 311,683                                              |       | 334,652    |       | 22,969            |       | 7%                                                  |       | 906,530    |       | 955,028    |       | 48,498 |   | 5% |   |
|                                                |       |                                                 |       |       |       |              |       |                                                |       |       |       |       |       |   |   |   |   |
| Income (loss)  from operations                      |       | 19,626                                               |       | (35,888    | )          | (55,514           | )          | *                                                   |       | 66,587     |       | (19,655    | )          | (86,242 | ) | -130% |   |
| Net losses of  equity affiliate                     |       | (26,174                                              | )          | (41,895    | )          | (15,721           | )          | 60%                                                 |       | (49,116    | )          | (111,295   | )          | (62,179 | ) | 127% |   |
| Gain (loss) on  investments in other companies, net |       | 25                                                   |       | (5,810     | )          | (5,835            | )          | *                                                   |       | 377        |       | (5,600     | )          | (5,977 | ) | * |   |
| Interest income  and other, net                     |       | 3,272                                                |       | 4,182      |       | 910               |       | 28%                                                 |       | 11,822     |       | 11,282     |       | (540 | ) | -5% |   |
| Income (loss)  before income taxes                  |       | (3,251                                               | )          | (79,411    | )          | (76,160           | )          | *                                                   |       | 29,670     |       | (125,268   | )          | (154,938 | ) | * |   |
| Provision  (benefit) for income taxes               |       | (69                                                  | )          | (30        | )          | 39                |       | -57%                                                |       | (69        | )          | 365        |       | 434 |   | * |   |
| Net income (loss)                                   |       | $                                                    | (3,182     | )          | $          | (79,381           | )          | $                                                   | (76,199    | )          | *          |       | $          | 29,739 |   | $ | (125,633 | ) | $ | (155,372 | ) | * |   |

 

----

*denotes percentage is not meaningful

 

26

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***Segment Results of Operations***

 

Ourbusiness segments are strategic business units that are managed based upondifferences in customers, services and marketing channels. Our ConsumerServices segment provides dial-up Internet access, high-speed Internet access,municipal wireless broadband and voice services, among others, to individualcustomers. Our Business Services segment provides managed data networks,dedicated Internet access and web hosting, among others, to businesses andcommunications carriers.

 

Weevaluate the performance of our operating segments based on segment income fromoperations. Segment income from operations includes revenues from externalcustomers, related cost of revenues and operating expenses directlyattributable to the segment, which include expenses over which segment managershave direct discretionary control, such as advertising and marketing programs,customer support expenses, site operations expenses, product developmentexpenses, certain technology and facilities expenses, billing operations andprovisions for doubtful accounts. Segment income from operations excludes otherincome and expense items and certain expenses over which segment managers donot have discretionary control. Costs excluded from segment income fromoperations include various corporate expenses (consisting of certain costs suchas corporate management, human resources, finance and legal), amortization ofintangible assets, facility exit and restructuring costs and stock-basedcompensation expense under Statement of Financial Accounting Standards (“SFAS”)No. 123(R), as they are not considered in the measurement of segmentperformance.

 

Thefollowing tables set forth segment data for the periods indicated:

 
| ** **                             | ** ** | **Three Months Ended September 30,** | ** ** | ** ** | ** ** | ** **              | ** ** |
|----------------------------------------|------------|----------------------------------------------------------|------------|------------|------------|-------------------------|------------|
| ** **                             | ** ** | **2006**                                                 | ** ** | **2007**   | ** ** | **$  Change** | ** ** | **% Change** | ** ** |
| ** **                             | ** ** | **(dollars in thousands)**                     | ** ** |
| **Consumer  Services**                 |       |                                                     |       |       |       |                    |       |   |   |
| Revenues                               |       | $                                                        | 282,259    |       | $          | 251,293                 |       | $ | (30,966 | ) | -11 | % |
| Cost of revenues                       |       | 86,117                                                   |       | 83,531     |       | (2,586                  | )          | -3 | % |
| Gross margin                           |       | 196,142                                                  |       | 167,762    |       | (28,380                 | )          | -14 | % |
| Direct segment  operating expenses     |       | 158,791                                                  |       | 135,936    |       | (22,855                 | )          | -14 | % |
| Segment income  from operations        |       | $                                                        | 37,351     |       | $          | 31,826                  |       | $ | (5,525 | ) | -15 | % |
|                                   |       |                                                     |       |       |       |                    |       |   |   |
| **Business  Services**                 |       |                                                     |       |       |       |                    |       |   |   |
| Revenues                               |       | $                                                        | 49,050     |       | $          | 47,471                  |       | $ | (1,579 | ) | -3 | % |
| Cost of revenues                       |       | 29,317                                                   |       | 29,361     |       | 44                      |       | 0 | % |
| Gross margin                           |       | 19,733                                                   |       | 18,110     |       | (1,623                  | )          | -8 | % |
| Direct segment  operating expenses     |       | 17,724                                                   |       | 12,257     |       | (5,467                  | )          | -31 | % |
| Segment income  from operations        |       | $                                                        | 2,009      |       | $          | 5,853                   |       | $ | 3,844 |   | * |   |
|                                   |       |                                                     |       |       |       |                    |       |   |   |
| **Consolidated**                       |       |                                                     |       |       |       |                    |       |   |   |
| Revenues                               |       | $                                                        | 331,309    |       | $          | 298,764                 |       | $ | (32,545 | ) | -10 | % |
| Cost of revenues                       |       | 115,434                                                  |       | 112,892    |       | (2,542                  | )          | -2 | % |
| Gross margin                           |       | 215,875                                                  |       | 185,872    |       | (30,003                 | )          | -14 | % |
| Direct segment  operating expenses     |       | 176,515                                                  |       | 148,193    |       | (28,322                 | )          | -16 | % |
| Segment income  from operations        |       | 39,360                                                   |       | 37,679     |       | (1,681                  | )          | -4 | % |
| Stock-based  compensation expense      |       | 3,424                                                    |       | 4,303      |       | 879                     |       | 26 | % |
| Amortization of  intangible assets     |       | 3,372                                                    |       | 3,836      |       | 464                     |       | 14 | % |
| Facility exit  and restructuring costs |       | —                                                   |       | 54,820     |       | 54,820                  |       | * |   |
| Other operating  expenses              |       | 12,938                                                   |       | 10,608     |       | (2,330                  | )          | -18 | % |
| Income (loss)  from operations         |       | $                                                        | 19,626     |       | $          | (35,888                 | )          | $ | (55,514 | ) | * |   |

 

27

----

 
| ** **                             | ** ** | **Nine Months Ended September 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|----------------------------------------|------------|---------------------------------------------------------|------------|------------|------------|-------------------|------------|
| ** **                             | ** ** | **2006**                                                | ** ** | **2007**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                             | ** ** | **(dollars in thousands)**                    | ** ** |
| **Consumer  Services**                 |       |                                                    |       |       |       |              |       |   |   |
| Revenues                               |       | $                                                       | 860,443    |       | $          | 792,060           |       | $ | (68,383 | ) | -8 | % |
| Cost of revenues                       |       | 262,328                                                 |       | 255,761    |       | (6,567            | )          | -3 | % |
| Gross margin                           |       | 598,115                                                 |       | 536,299    |       | (61,816           | )          | -10 | % |
| Direct segment  operating expenses     |       | 490,239                                                 |       | 442,919    |       | (47,320           | )          | -10 | % |
| Segment income  from operations        |       | $                                                       | 107,876    |       | $          | 93,380            |       | $ | (14,496 | ) | -13 | % |
|                                   |       |                                                    |       |       |       |              |       |   |   |
| **Business  Services**                 |       |                                                    |       |       |       |              |       |   |   |
| Revenues                               |       | $                                                       | 112,674    |       | $          | 143,313           |       | $ | 30,639 |   | 27 | % |
| Cost of revenues                       |       | 58,148                                                  |       | 88,836     |       | 30,688            |       | 53 | % |
| Gross margin                           |       | 54,526                                                  |       | 54,477     |       | (49               | )          | 0 | % |
| Direct segment  operating expenses     |       | 35,145                                                  |       | 45,044     |       | 9,899             |       | 28 | % |
| Segment income  from operations        |       | $                                                       | 19,381     |       | $          | 9,433             |       | $ | (9,948 | ) | -51 | % |
|                                   |       |                                                    |       |       |       |              |       |   |   |
| **Consolidated**                       |       |                                                    |       |       |       |              |       |   |   |
| Revenues                               |       | $                                                       | 973,117    |       | $          | 935,373           |       | $ | (37,744 | ) | -4 | % |
| Cost of revenues                       |       | 320,476                                                 |       | 344,597    |       | 24,121            |       | 8 | % |
| Gross margin                           |       | 652,641                                                 |       | 590,776    |       | (61,865           | )          | -9 | % |
| Direct segment  operating expenses     |       | 525,384                                                 |       | 487,963    |       | (37,421           | )          | -7 | % |
| Segment income  from operations        |       | 127,257                                                 |       | 102,813    |       | (24,444           | )          | -19 | % |
| Stock-based  compensation expense      |       | 10,826                                                  |       | 15,081     |       | 4,255             |       | 39 | % |
| Amortization of  intangible assets     |       | 8,407                                                   |       | 10,874     |       | 2,467             |       | 29 | % |
| Facility exit  and restructuring costs |       | (117                                                    | )          | 54,820     |       | 54,937            |       | * |   |
| Other operating  expenses              |       | 41,554                                                  |       | 41,693     |       | 139               |       | 0 | % |
| Income (loss)  from operations         |       | $                                                       | 66,587     |       | $          | (19,655           | )          | $ | (86,242 | ) | -130 | % |

 

----

*denotes percentage is not meaningful

 

28

----

 

***Revenues***

 

Thefollowing table presents revenues by groups of similar services and by segmentfor the three and nine months ended September 30, 2006 and 2007:

 
| ** **             | ** ** | **Three Months Ended  September 30,** | ** ** | ** ** | ** ** | ** **              | ** ** | **Nine Months Ended  September 30,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------|------------|------------------------------------------------------|------------|------------|------------|-------------------------|------------|-----------------------------------------------------|------------|------------|------------|------------|------------|
| ** **             | ** ** | **2006**                                             | ** ** | **2007**   | ** ** | **$  Change** | ** ** | **% Change**                                   | ** ** | **2006**   | ** ** | **2007**   | ** ** | **$  Change** | ** ** | **% Change** | ** ** |
| ** **             | ** ** | **(dollars in thousands)**                 | ** ** |
| **Consumer  Services** |       |                                                 |       |       |       |                    |       |                                                |       |       |       |       |       |   |   |   |   |
| Access and  service    |       | $                                                    | 252,390    |       | $          | 219,381                 |       | $                                                   | (33,009    | )          | -13%       |       | $          | 774,808 |   | $ | 694,169 |   | $ | (80,639 | ) | -10% |   |
| Value-added  services  |       | 29,869                                               |       | 31,912     |       | 2,043                   |       | 7%                                                  |       | 85,635     |       | 97,891     |       | 12,256 |   | 14% |   |
| Total revenues         |       | $                                                    | 282,259    |       | $          | 251,293                 |       | $                                                   | (30,966    | )          | -11%       |       | $          | 860,443 |   | $ | 792,060 |   | $ | (68,383 | ) | -8% |   |
|                   |       |                                                 |       |       |       |                    |       |                                                |       |       |       |       |       |   |   |   |   |
| **Business  Services** |       |                                                 |       |       |       |                    |       |                                                |       |       |       |       |       |   |   |   |   |
| Access and  service    |       | $                                                    | 48,223     |       | $          | 46,833                  |       | $                                                   | (1,390     | )          | -3%        |       | $          | 110,070 |   | $ | 141,115 |   | $ | 31,045 |   | 28% |   |
| Value-added  services  |       | 827                                                  |       | 638        |       | (189                    | )          | -23%                                                |       | 2,604      |       | 2,198      |       | (406 | ) | -16% |   |
| Total revenues         |       | $                                                    | 49,050     |       | $          | 47,471                  |       | $                                                   | (1,579     | )          | -3%        |       | $          | 112,674 |   | $ | 143,313 |   | $ | 30,639 |   | 27% |   |
|                   |       |                                                 |       |       |       |                    |       |                                                |       |       |       |       |       |   |   |   |   |
| **Consolidated**       |       |                                                 |       |       |       |                    |       |                                                |       |       |       |       |       |   |   |   |   |
| Access and  service    |       | $                                                    | 300,613    |       | $          | 266,214                 |       | $                                                   | (34,399    | )          | -11%       |       | $          | 884,878 |   | $ | 835,284 |   | $ | (49,594 | ) | -6% |   |
| Value-added  services  |       | 30,696                                               |       | 32,550     |       | 1,854                   |       | 6%                                                  |       | 88,239     |       | 100,089    |       | 11,850 |   | 13% |   |
| Total revenues         |       | $                                                    | 331,309    |       | $          | 298,764                 |       | $                                                   | (32,545    | )          | -10%       |       | $          | 973,117 |   | $ | 935,373 |   | $ | (37,744 | ) | -4% |   |

 

*Consolidatedrevenues*

 

Theprimary component of our revenues is access and service revenues, which consistof narrowband access services (including traditional, fully-featured narrowbandaccess and value-priced narrowband access); broadband access services(including high-speed access via DSL, cable and wireless technologies; IP-basedvoice; and fees charged for high-speed data networks to small and medium-sizedbusinesses and communications carriers); and web hosting services. We also earnrevenues from value-added services, which include ancillary services sold asadd-on features to our access services and search and advertising services.Total revenues decreased from $331.3 million during the three months endedSeptember 30, 2006 to $298.8 million during the three months ended September30, 2007, which was comprised of decreases of $31.0 million and $1.6 million inconsumer services revenue and business services revenue, respectively. Totalrevenues decreased from $973.1 million during the nine months ended September30, 2006 to $935.4 million during the nine months ended September 30, 2007,which was comprised of a $68.4 million decrease in consumer services revenue offsetby a $30.6 million increase in business services revenue.

 

Thedecreases in consumer services revenue were primarily attributable to decreasesin average consumer subscribers, from approximately 5.1 million during thethree and nine months ended September 30, 2006 to approximately 4.0 million and4.5 million during the three and nine months ended September 30, 2007,respectively. The decrease in business services revenue during the three monthsended September 30, 2007 compared to the prior year period was primarilyattributable to a decrease in average business subscribers offset by anincrease in business services ARPU. The increase in business services revenueduring the nine months ended September 30, 2007 compared to the prior yearperiod was primarily attributable to increases in ARPU, primarily driven by ouracquisition of New Edge in April 2006.

 

*Consumerservices revenue*

 

*Access and service*. Consumer access and service revenues consist ofnarrowband access, broadband access and voice services. These revenues arederived from monthly fees charged to customers for dial-up Internet access;monthly retail and wholesale fees charged for high-speed, high-capacity accessservices including DSL, cable, satellite and wireless services; fees chargedfor IP-based voice services; usage fees;

 

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installation fees; termination fees; and fees for equipment. Consumeraccess and service revenues decreased 13% to $219.4 million and 10% to $694.2million during the three and nine months ended September 30, 2007 compared tothe prior year periods. The decreases in consumer access and service revenuesduring the three and nine months ended September 30, 2007 were primarily due todecreases in average subscribers, offset by increases in consumer access andservice ARPU.

 

Average consumer access and servicesubscribers decreased due to the removal of 753,000 Embarq subscribers from oursubscriber count effective April 2007 and due to a decrease in premiumnarrowband subscribers resulting from the continued maturing and ongoingcompetitiveness of the market for narrowband Internet access. These decreaseswere offset by an increase in average PeoplePC subscribers; an increase inaverage retail broadband subscribers due to the continued growth in the marketfor broadband access and our efforts and our partners’ efforts to promotebroadband services; and an increase in average voice subscribers due to thelaunch of EarthLink DSL and Home Phone Service in eight additional marketsduring the end of 2006. We expect our consumer access and service subscriberbase to continue to decrease due to the continued maturation of the market forpremium narrowband access. In addition, during the three months ended September30, 2007, in response to changing industry trends we refocused our businessstrategy to reduce sales and marketing efforts. We are focusing effortsprimarily on the retention of tenured customers and on acquiring customersthrough partnerships and acquisitions from other ISPs. This may negativelyimpact the number of subscribers we are able to add and our revenues.

 

ARPUdepends on a variety of factors, including changes in the mix of customers andtheir related pricing plans; the use of promotions and discounted pricing plansto obtain or retain subscribers; increases or decreases in the prices of ourexisting services; and the addition of new services. We currently offer severalconsumer access services at different price plans, and we provide servicesthrough retail and wholesale relationships. All of these have an effect on ouroverall ARPU. Consumer access and service ARPU increased during the three andnine months ended September 30, 2007 compared to the prior year periods due toan increases in broadband access and service ARPU. Offsetting this increase forthe nine month period was a decrease in narrowband access and service ARPU.

 

The increases in broadband accessand service ARPU during the three and nine months periods was primarily due toa shift in the mix of our broadband customer base from wholesale DSLsubscribers to retail DSL subscribers and to retail cable subscribers due tothe removal of Embarq wholesale subscribers; an increase in our voicesubscribers; and certain revenues received pursuant to the Embarq transitionagreement. Offsetting these increases were general declines in retail DSLprices introduced as a result of declines in costs from our DSL serviceproviders and the increased use of promotional pricing for our serviceofferings.

 

The decrease in narrowband accessand service ARPU during the nine months ended September 30, 2007 compared tothe prior year period was due to the shift in the mix of our narrowbandsubscriber base from premium narrowband access services, which are typicallypriced at $21.95 per month, to our PeoplePC value-priced narrowband accessservices, which are generally priced at $10.95 per month. During the ninemonths ended September 30, 2006, average PeoplePC access subscribersrepresented approximately 41% of our average consumer narrowband customer base,and during the nine months ended September 30, 2007, average PeoplePC accesssubscribers represented approximately 50% of our average consumer narrowbandcustomer base.

 

*Value-added services revenues.*Value-added services revenues consist of searchrevenues; advertising revenues; revenues from ancillary services sold as add-onfeatures to our Internet access services, such as security products, email byphone, Internet call waiting and email storage; and revenues from home networkingproducts and services. We derive these revenues by paid placements forsearches; delivering traffic to our partners in the form of subscribers, pageviews or e-commerce transaction; advertising our partners’ products andservices in our various online properties and electronic publications,including the Personal Start PageTM; referring our customers to ourpartners’ products and services; and monthly fees charged for ancillaryservices.

 

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Value-addedservices revenues increased 7% to $31.9 million and 14% to $97.9 million duringthe three and nine months ended September 30, 2007, respectively, compared tothe prior year periods due primarily to increases in sales of securityproducts. Also contributing to the increase for the nine months ended September30, 2007 compared to the prior year period was increased search advertisingrevenues and partnership advertising revenues.

 

*Businessservices revenue*

 

Business access and servicerevenues consist of retail and wholesale fees charged for high-speed,high-capacity access services including DSL, cable, satellite and dedicatedcircuit services; fees charged for high-speed data networks for small andmedium-sized businesses; installation fees; termination fees; fees forequipment; regulatory surcharges billed to customers; and web hosting. We earnweb hosting revenues by leasing server space and providing web services toindividuals and businesses wishing to present a web or e-commerce presence onthe Internet.

 

Business access and servicerevenues decreased from $48.2 million during the three months ended September30, 2006 to $46.8 million during the three months ended September 30, 2007.This decrease was primarily due to a decrease in average business accesssubscribers and average web hosting accounts. Business access and servicerevenues increased from $110.1 million during the nine months ended September30, 2006 to $141.1 million during the nine months ended September 30, 2007.This increase was due to increases in both ARPU and average subscribers, whichwere attributable to the acquisition of New Edge in April 2006. Offsettingthese increases was a decrease in web hosting revenues primarily due to adecrease in average web hosting accounts.

 

Our business broadband subscriberbase consists of customers which are added through retail and wholesalerelationships. Retail business services generally have an ARPU between $110 and$130 for 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 of broadband services for small and medium-sized businessesdepends upon customer requirements for different service delivery methods,amounts of bandwidth, quality of service and distance from the points ofpresence, and may vary widely from these ranges. The number of customers beingadded or served at any point in time through our wholesale efforts is subjectto the business and marketing circumstances of our telecommunications partners.

 

***Cost of revenues***

 

Serviceand equipment costs are the primary component of our cost of revenues andconsist 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. Service and equipmentcosts also include the cost of Internet appliances. Our principal provider fornarrowband telecommunications services is Level 3 Communications, Inc.,and our largest providers of broadband connectivity are Covad and Time WarnerCable. We also do lesser amounts of business with a wide variety of local,regional and other national providers. We purchase broadband access fromIncumbent Local Exchange Carriers, Competitive Local Exchange Carriers andcable providers. Cost of revenues also includes sales incentives. We offersales incentives such as free modems and Internet access on a trial basis.

 

Totalcost of revenues decreased 2% from $115.4 million during the three months endedSeptember 30, 2006 to $112.9 million during the three months ended September30, 2007, and increased 8% from $320.5 million during the nine months endedSeptember 30, 2006 to $344.6 million during the nine months ended September 30,2007. The decrease during the three months ended September 30, 2007 compared tothe prior year period was due to a $2.6 million decrease in consumer servicecost of revenues, which was due to the decrease in average subscribers. Thisdecrease in consumer service cost of revenues was offset by an increase insales incentives due to an increase in modems and other equipment provided tocustomers for IP-based voice services. The increase during the nine monthsended September 30, 2007 compared to the prior year period was due to a $30.7million increase in business services cost of revenues offset by a $6.6 milliondecrease in consumer service cost of revenues. Business services cost ofrevenues increased during the nine months ended 

 

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September 30, 2007 due to increases in averagemonthly costs per subscriber, primarily as a result of New Edge subscribers andtheir associated cost. Offsetting the increase in business services cost ofrevenues was a decrease in consumer services cost of revenues primarily due tothe decrease in average subscribers.

 

***Sales and marketing***

 

Sales and marketing expensesinclude advertising and promotion expenses, fees paid to distribution partnersto acquire new paying subscribers, personnel-related expenses and telemarketingcosts incurred to acquire and retain subscribers. Sales and marketing expensesdecreased from $95.3 million during the three months ended September 30,2006 to $75.9 million during the three months ended September 30, 2007, anddecreased from $292.4 million during the nine months ended September 30,2006 to $255.1 million during the nine months ended September 30, 2007. Thedecrease during the three month period consisted of decreases in consumerservices sales and marketing expenses and business services sales and marketingexpenses. The decreases in sales and marketing expenses for both segments wasattributable to decreased spending for our core access services and decreasedspending related to our IP-based voice growth initiative, offset by an increasedue to the launch of municipal wireless broadband services during 2007.

 

The decrease during the nine monthperiod primarily consisted of a decrease in consumer services sales andmarketing expenses, offset by an increase in business services sales andmarketing expenses. The decrease in consumer services sales and marketingexpenses was primarily attributable to decreased spending for our core accessservices, offset by an increase due to the launch of municipal wirelessbroadband services. The increases in business services sales and marketingexpenses were primarily due to the inclusion of New Edge sales and marketingexpenses. We expect sales and marketing expenses to continue to decrease as wescale back sales and marketing efforts in connection with our refocusedstrategy and as a result of our corporate restructuring plan announced inAugust 2007.

 

***Operations and customer support***

 

Operations and customer supportexpenses consist of costs associated with technical support and customerservice, providing our subscribers with toll-free access to our technicalsupport and customer service centers, maintenance of customer informationsystems, software development and network operations. Operations and customersupport expenses decreased 10% from $64.3 million during the three months endedSeptember 30, 2006 to $58.0 million during the three months ended September 30,2007, and decreased 2% from $189.4 million during the nine months endedSeptember 30, 2006 to $185.6 million during the nine months ended September 30,2007. The decreases primarily consisted of declines in consumer servicesoperations and customer support expenses attributable to decreased spending forour core access services and a decrease in spending related to our IP-basedvoice growth initiative. The decreased spending related to personnel-relatedcosts, outsourced labor and professional fees. Offsetting the decreases for thenine months ended September 30, 2007 compared to the prior year period was anincrease in business services operations and customer support expenses due tothe inclusion of New Edge expenses and an increase in expenses associated withour municipal wireless broadband initiative. We expect operations and customersupport expenses to continue to decrease as a result of our corporaterestructuring plan announced in August 2007.

 

***General and administrative***

 

Generaland administrative expenses consist of fully burdened costs associated with theexecutive, finance, legal and human resources departments; outside professionalservices; payment processing; credit card fees; collections and bad debt.General and administrative expenses decreased 12% from $33.3 millionduring the three months ended September 30, 2006 to $29.2 million duringthe three months ended September 30, 2007, but increased 8% from$95.9 million during the nine months ended September 30, 2006 to$104.0 million during the nine months ended September 30, 2007. Thedecrease during the three months ended September 30, 2007 compared to the prioryear period was attributable to a decrease in corporate general andadministrative expenses, primarily personnel-related costs, as we began toimplement plans to reduce our cost structure. The increase during the ninemonths ended September 30, 2007 compared to the prior year period was due to anincrease in corporate general and administrative expenses and an increase inbusiness services general and administrative 

 

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expenses. Corporate general and administrativeexpenses increased primarily due to $6.4 million of cash and non-cashcompensation expense related to the death of Mr. Betty, as more fully describedbelow, and an increase in legal fees. Business services general and administrativeexpenses increased due to the acquisition of New Edge.

 

Mr.Betty passed away on January 2, 2007. Pursuant to Mr. Betty’s employmentagreement, all unvested stock options and restricted stock units immediatelyvested and became fully exercisable upon death. In addition, the Leadership andCompensation Committee of the Board of Directors extended the exercise periodof Mr. Betty’s stock options until December 31, 2008. This daterepresents the exercise period if Mr. Betty had terminated employment afterserving the full term of his employment agreement, which was set to expire inJuly 2008. During the nine months ended September 30, 2007, we recordedstock-based compensation expense of $3.5 million related to the acceleratedvesting of 1.1 million stock options and 0.1 million restricted stock units andrecorded stock-based compensation expense of $1.4 million related to theextension of the exercise period for Mr. Betty’s stock options. We alsorecorded $1.5 million of compensation expense for a payment to Mr. Betty’sestate in accordance with his employment agreement.

 

We expect general andadministrative expenses to decrease as a result of our corporate restructuringplan announced in August 2007.

 

***Stock-based compensation expense***

 

Stock-basedcompensation expense in accordance with SFAS No. 123(R) was allocated asfollows for the three and nine months ended September 30, 2006 and 2007:

 
| ** **                       | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                       | ** ** | **2006**                                             | ** ** | **2007**                                            | ** ** | **2006** | ** ** | **2007** | ** ** |
| ** **                       | ** ** | **(in thousands)**                                   | ** ** |
| Sales and  marketing             |       | $                                                    | 791        |                                                | $          | 1,186 |   | $ | 2,494 |   | $ | 2,590 |   |
| Operations and  customer support |       | 1,583                                                |       | 2,080                                               |       | 4,942 |   | 4,839 |   |
| General and  administrative      |       | 1,050                                                |       | 1,037                                               |       | 3,390 |   | 7,652 |   |
|                             |       | $                                                    | 3,424      |                                                | $          | 4,303 |   | $ | 10,826 |   | $ | 15,081 |   |

 

***Amortization of intangible assets***

 

Amortizationof intangible assets represents the amortization of definite lived intangibleassets acquired in purchases of businesses and purchases of customer bases fromother companies. Definite lived intangible assets, which primarily consist ofsubscriber bases and customer relationships, acquired software and technologyand other assets, are amortized on a straight-line basis over their estimateduseful lives, which range from one to six years. Amortization of intangibleassets was $3.4 million and $3.8 million during the three months endedSeptember 30, 2006 and 2007, respectively, and $8.4 million and $10.9 millionduring the nine months ended September 30, 2006 and 2007, respectively. Theincrease in amortization of intangible assets during the three month period wasprimarily due to amortization resulting from acquisitions of subscriber basesfrom ISPs over the past year. The increase in amortization of intangible assetsduring the nine month period was due to the amortization of identifiabledefinite lived intangible assets resulting from the acquisition of New Edge inApril 2006, as well as acquisitions of subscriber bases from ISPs over the pastyear.

 

***Facility exitand restructuring******costs***

 

InAugust 2007, our Board of Directors approved a corporate restructuring plan.The Plan is intended to reduce costs and improve the efficiency of ouroperations. The Plan was the result of a comprehensive review of operationswithin and across our functions and businesses. Under the Plan, we are reducingour workforce by approximately 900 employees, consolidating our office facilityin Atlanta, Georgia and closing office facilities in Orlando, Florida;Knoxville, Tennessee; Harrisburg, Pennsylvania and San Francisco, California.The Plan is being implemented during the third and fourth quarters of 2007. Asa result of the Plan, we recorded facility exit 

 

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and restructuring costs of $54.8 million during thethree and nine months ended September 30, 2007, including $33.9 millionfor severance and personnel-related costs; $0.7 million for lease terminationand facilities-related costs; $10.4 million for non-cash asset impairments; and$9.8 million for other associated costs.

 

***Net losses of equity affiliate***

 

We account for our investment inHELIO 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 areoffset by increases in the carrying value of our investment associated withamortizing the difference between the book value of non-cash assets contributedto HELIO and their fair value. These increases, which result in decreases inthe net losses of equity affiliate in our statements of operations, are beingrecorded over the estimated useful lives of the non-cash assets contributed.

 

Net losses of equity affiliate forthe three and nine months ended September 30, 2006 of $26.2 million and $49.1million, respectively, included our proportionate share of HELIO’s net lossesoffset by amortization associated with recognizing the difference between thecarrying value and fair value of non-cash assets contributed. Net losses ofequity affiliate for the three and nine months ended September 30, 2007 of$41.9 million and $111.3 million, respectively, included our proportionateshare of HELIO’s net losses offset by amortization associated with recognizingthe difference between the carrying value and fair value of non-cash assetscontributed. HELIO’s net loss has increased due to the start-up nature of HELIO’soperations and HELIO’s recent product launches. During the three months endedSeptember 30, 2007, we discontinued recording additional net losses of equityaffiliate because our investments in HELIO, including the $30.0 million loanedto HELIO in July 2007, were reduced to zero, and we are not committed toprovide further financial support. As a result, we do not expect to record netlosses of equity affiliate for the foreseeable future.

 

***Gain (loss) on investments in other companies***

 

Duringthe three and nine months ended September 30, 2007, we recognized $7.0 millionof impairment losses due to declines of the value of certain of our investmentsin other companies that were deemed other than temporary. During the three andnine months ended September 30, 2006, we did not recognize any losses due toother-than-temporary declines of the value of investments.

 

Duringthe three and nine months ended September 30, 2007, we received $1.2 millionand $1.4 million in cash distributions, respectively, from eCompanies VentureGroup, L.P. (“EVG”), a limited partnership that has invested in domesticemerging Internet-related companies, which were recorded as a gain oninvestments in other companies. During the nine months ended September 30,2006, we recorded a $0.4 million gain on investments in other companiesresulting from an EVG distribution.

 

***Interest income and other, net***

 

Interest income and other, net, isprimarily comprised of interest earned on our cash, cash equivalents andmarketable securities; interest earned on our Covad investment; interestexpense incurred on our Convertible Senior Notes due November 15, 2026 (“Notes”);and other miscellaneous income and expense items. Interest income and other,net, increased from $3.3 million during the three months ended September 30,2006 to $4.2 million during the three months ended September 30, 2007. This wasprimarily due to an increase in interest earned on our cash, cash equivalentsand marketable securities due to higher investment yields on our cash andmarketable securities and an increase in our average cash and marketablesecurities balance. This was offset by interest expense incurred on our Notes,which were issued in November 2006 in a registered offering and bear interestat 3.25% per year on the principal amount of the Notes until November 15, 2011,and 3.50% interest per year on the principal amount of the Notes thereafter.

 

Interest income and other, net,remained relatively constant at $11.8 million and $11.3 million during the ninemonths ended September 30, 2006 and 2007, respectively. This was primarily dueto an increase in interest earned on our cash, cash equivalents and marketablesecurities due to higher investment yields on our cash and marketablesecurities and an increase in our average cash and marketable securitiesbalance and an 

 

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increase due to interest earned on our Covad investment, as we beganearning interest on our investment in March 2006. These increases were offsetby interest expense incurred on the Notes.

 

***Provision for income taxes***

 

We have recorded income taxes during the three and ninemonths ended September 30, 2007 based on management’s current expectations inaccordance with the interim reporting requirements of SFAS No. 109, “Accountingfor Income Taxes,” and Accounting Principles Board Opinion No. 28, “InterimFinancial Reporting.”

 

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

 

**Facility Exit andRestructuring****Costs**

 

As previouslydiscussed, we began implementing a corporate restructuring plan in August 2007.The following table summarizes activity for the liability balances associatedwith the Plan for the period, including changes during the period attributableto costs incurred and charged to expense and costs paid or otherwise settled:

 
| ** **                        | ** ** | **Severance**           | ** ** | ** **     | ** ** | **Asset**       | ** ** | **Other** | ** ** | ** ** | ** ** |
|-----------------------------------|------------|-------------------------|------------|----------------|------------|-----------------|------------|-----------|------------|------------|------------|
| ** **                        | ** ** | **and Benefits**   | ** ** | **Facilities** | ** ** | **Impairments** | ** ** | **Costs** | ** ** | **Total**  | ** ** |
| ** **                        | ** ** | **(in thousands)** | ** ** |
| Balance as of  December 31, 2006  |       | $                       | —     |           | $          | —          |       | $         | —     |       | $          | — |   | $ | — |   |
| Accruals                          |       | 33,939                  |       | 729            |       | 10,381          |       | 9,771     |       | 54,820     |       |
| Payments                          |       | (1,666                  | )          | —         |       | —          |       | (5,044    | )          | (6,710     | )          |
| Non-cash items                    |       | —                  |       | —         |       | (10,381         | )          | (371      | )     | (10,752    | )          |
| Balance as of  September 30, 2007 |       | $                       | 32,273     |           | $          | 729             |       | $         | —     |       | $          | 4,356 |   | $ | 37,358 |   |

 

In connection with the Plan, weexpect to record total facility exit and restructuring costs of approximately$60.0 to $70.0 million, including $30.0 to $34.0 million for severance andpersonnel-related costs, $10.0 to $13.0 million for lease termination andfacilities-related costs, $10.0 to $11.0 million for non-cash asset impairmentsand $10.0 to $12.0 million for other associated costs. We expect to incurfuture cash outflows for severance and personnel-related costs during theremainder of 2007 and during the first quarter of 2008. We expect to incurfuture cash outflows for real estate obligations through 2014. Please see ‘‘Liquidityand Capital Resources’’ below for a discussion of our plans for fundingexpected future cash payments. We realized limited cost savings during thethree months ended September 30, 2007 as a result of completing the Plan, butwe expect to realize future cost savings, including a reduction in personnelcosts, occupancy costs, depreciation expense and other support costs. However,we may not experience the level of benefits and related cost savings we havehistorically realized with facility exit and restructuring plans or expect torealize in connection with our Plan or any of our other cost reduction efforts.In addition, we may incur additional facility exit and restructuring costs, includingfacility exit and restructuring costs that may result from our continuingreview of our growth initiatives.

 

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**Liquidity andCapital Resources**

 

The following table sets forthsummarized cash flow data for the nine months ended September 30,

 

2006 and 2007:

 
| ** **                                 | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                 | ** ** | **2006**                                                | ** ** | **2007** | ** ** |
| ** **                                 | ** ** | **(in thousands)**                                 | ** ** |
|                                       |       |                                                    |       |   |   |
| Net income  (loss)                         |       | $                                                       | 29,739     |   | $ | (125,633 | ) |
| Non-cash items                             |       | 93,648                                                  |       | 187,839 |   |
| Changes in working  capital                |       | (35,154                                                 | )          | (7,713 | ) |
| Net cash  provided by operating activities |       | $                                                       | 88,233     |   | $ | 54,493 |   |
|                                       |       |                                                    |       |   |   |
| Net cash used in  investing activities     |       | $                                                       | (149,690   | ) | $ | (98,412 | ) |
|                                       |       |                                                    |       |   |   |
| Net cash used in  financing activities     |       | $                                                       | (78,184    | ) | $ | (19,445 | ) |

 

*Operating activities*

 

Netcash provided by operating activities decreased during the nine months endedSeptember 30, 2007 compared to the prior year period. This was primarily due toa decrease in revenues. Additionally, cash flows from operating activities havebeen adversely affected in 2007 due to funding of our growth initiatives in theform of increased operating and sales and marketing expenses; however, we havebegun to reduce costs associated with our growth initiatives and our coreaccess services in response to industry developments and competition. We expectthe result of these cost savings will be to generate increased cash fromoperating activities.

 

Non-cashitems include items that are not expected to generate or require the use ofcash, such as depreciation and amortization relating to our network, facilitiesand intangible assets, net losses of equity affiliate, deferred income taxes,stock-based compensation and non-cash disposals and impairments of fixedassets. Non-cash items increased during the nine months ended September 30,2007 compared to the prior year period due to an increase in net losses ofequity affiliate, impairments of fixed assets resulting from our restructuringplan, an increase in gain (loss) on investments in other companies, net, anincrease in depreciation and amortization expense and an increase instock-based compensation expense.

 

Changesin working capital requirements include changes in accounts receivable, prepaidand other assets, accounts payable, accrued and other liabilities and deferredrevenue. Cash used for working capital requirements decreased from $35.2million during the nine months ended September 30, 2006 to $7.7 million duringthe nine months ended September 30, 2007.

 

*Investing activities*

 

Cash used for investing activitiesdecreased during the nine months ended September 30, 2007 compared to the prioryear period, which was due to decreases in cash used for investments in othercompanies, investments in HELIO and cash used for our acquisition of New Edge in2006, offset by a decrease in net sales of investments in marketable securitiesand an increase in capital expenditures. Our investing activities used cash of$149.7 million during the nine months ended September 30, 2006. This consistedprimarily of $108.7 million net cash paid to acquire New Edge, our $50.0million investment in Covad, our $10.0 million investment in CurrentCommunications, Group LLC and $78.2 million of investments in and net advancesto (from) 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. Offsetting theseinvesting outlays were proceeds of $124.7 million from sales and maturities ofinvestments in marketable securities, net of purchases.

 

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Our investing activities used cashof $98.4 million during the nine months ended September 30, 2007. Thisconsisted primarily of $42.3 million of capital expenditures, primarilyassociated with network and technology center related projects, $30.0 millionloaned to HELIO, $19.5 million of contributions to HELIO, $2.1 million ofpurchases of investments in marketable securities, net of sales and maturities,and $6.5 million to purchase subscriber bases from other ISPs. We have investedsignificantly in our network and technology center infrastructure, and weexpect to continue to invest capital to enhance the reliability and capacity ofour network as well as to improve the efficiency of our technical and customersupport services. In addition, management continuously reviews industry andeconomic conditions to identify opportunities to pursue acquisitions ofsubscriber bases, and we may invest in or acquire other companies.

 

*Financing activities*

 

Our financing activities used cashof $78.2 million during the nine months ended September 30, 2006. Thisconsisted primarily of $79.8 million used to purchase 10.5 million shares ofour 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. Our financing activities used cash of $19.4 million during the ninemonths ended September 30, 2007, which primarily consisted of $25.0 millionused to purchase 3.9 million shares of our common stock, offset by proceedsfrom the exercise of stock options of $5.7 million. The decrease in net cashused in financing activities from the prior year period was primarily due to adecrease in purchases of our common stock.

 

**Off-BalanceSheet Arrangements**

 

As of September 30, 2007, we didnot have any off-balance sheet arrangements that have or are reasonably likelyto have a current or future effect on our financial condition, changes infinancial condition, revenues or expenses, results of operations, liquidity,capital expenditures or capital resources that are material to investors.

 

**Share RepurchaseProgram**

 

The Board of Directors hasauthorized a total of $750.0 million to repurchase our common stock under ourshare repurchase program, including $200.0 million that was authorized inAugust 2007. As of October 31, 2007, we had utilized approximately $479.7 millionpursuant to the authorizations and had $270.3 million available under thecurrent authorization. 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 by the Board of Directors at any time.

 

**Income Taxes**

 

We continue to maintain a full valuationallowance against our deferred tax assets of approximately $393.4 million,consisting primarily of net operating loss carryforwards. We may recognizedeferred tax assets in future periods when they are determined to berealizable. To the extent we may owe income taxes in future periods, we intendto use our net operating loss carryforwards to the extent available to reducecash outflows for income taxes.

 

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**Future Uses ofCash and Funding Sources**

 

We willbe using cash to pay severance and related benefits to employees terminated inconnection with our restructuring plan and to pay real estate obligationsassociated with facilities exited in our restructuring plan. Historically, wehave expended significant resources enhancing our existing services anddeveloping, acquiring, implementing and launching new services. These uses ofcash have been in the form of initial product development and infrastructurecosts, followed by sales and marketing costs to add customers that willgenerate recurring revenues. However, we are implementing plans to scale ourgrowth initiatives and our core access services more economically in order toimprove the returns on our investments. We also expect to incur capital expendituresto maintain and upgrade our network and technology infrastructure and to buildwireless broadband networks in our existing municipalities. The actual amountof capital expenditures in 2007 as well as in future periods may fluctuate dueto a number of factors which are difficult to predict and could changesignificantly over time. Additionally, technological advances may require us tomake capital expenditures to develop or acquire new equipment or technology inorder to replace aging or technologically obsolete equipment. We also expect tocontinue to use cash to acquire and retain new and existing subscribers for ourcore access services, including purchases of subscriber bases from other ISPs.

 

Ourcash requirements depend on numerous factors, including the rate of marketacceptance of our services, our ability to successfully develop new revenuesources, our ability to maintain and expand our customer base, the rate ofexpansion of our network infrastructure, the size and types of acquisitions inwhich we may engage and the level of resources required to expand our sales andmarketing programs. We also may use cash to repurchase common stock under ourexisting share repurchase program.

 

Ourprincipal sources of liquidity are our cash, cash equivalents and investmentsin marketable securities, as well as the cash flow we generate from our coreaccess operations. As of September 30, 2007, we had $95.0 million in cash andcash equivalents. In addition, we held short- and long-term investments inmarketable securities valued at $208.6 million and $30.3 million, respectively.Short-term investments in marketable securities consist of investments thathave maturity dates of up to one year from the balance sheet date andasset-backed, auction rate securities that have interest rate reset periods ofup to one year from the balance sheet date, and long-term investments inmarketable securities consist of investments that have maturity dates of morethan one year from the balance sheet date.

 

DuringNovember 2006, we issued $258.8 million aggregate principal amount ofConvertible Senior Notes due November 15, 2026 in a registered offering. Wereceived net proceeds of $251.6 million after transaction fees of $7.2 million.We used $15.1 million of the proceeds for hedge transactions to reduce thepotential dilution that could result upon conversion of the Convertible SeniorNotes. The remaining proceeds are being used for general corporate purposes.

 

Wehave a financing lease agreement with General Electric Capital Corporation tolease certain equipment necessary to build our municipal broadband wirelessinfrastructure in selected markets. Under the agreement, we can lease up to$75.0 million of assets. As of September 30, 2007, we had acquiredapproximately $2.9 million of equipment pursuant to the financing agreement.

 

Ouravailable cash and marketable securities, together with our results ofoperations, are expected to be sufficient to meet our operating expenses,capital requirements and investment and other obligations for the next 12months. However, as a result of other investment activities and possibleacquisition opportunities, we may seek additional financing in the future.Except for our financing lease agreement discussed above, we have nocommitments for any additional financing and have no lines of credit or similarsources of financing. We cannot be sure that we can obtain additional financingon favorable terms, if at all, through the issuance of equity securities or theincurrence of additional debt. Additional equity financing may dilute ourstockholders, and debt financing, if available, may restrict our ability torepurchase common stock, declare and pay dividends and raise future capital. Ifwe are unable to obtain additional needed financing, we may be required toreduce our planned capital expenditures and/or suspend or reduce our investmentactivities, which could materially and adversely affect our prospects forlong-term growth.

 

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**Related Party Transactions**

 

*HELIO*

 

We andHELIO have entered into a services agreement pursuant to which we provide HELIOfacilities, accounting, tax, billing, procurement, risk management, payroll,human resource, employee benefit administration and other support services inexchange for management fees. However, as HELIO has developed its business, theextent to which HELIO relies on us to provide these services has decreased. Webelieve that providing these services to HELIO enabled HELIO to more quicklyand cost effectively launch its business than if it were to purchase theseservices from third parties. The management fees were determined based on ourcosts to provide the services, and management believes such fees are reasonable.The total amount of fees that HELIO pays to us depends on the extent to whichHELIO utilizes our services. Fees for services provided to HELIO are reflectedas reductions to the associated expenses incurred by us to provide suchservices. During the three and nine months ended September 30, 2006, feesreceived for services provided to HELIO were $0.6 million and $1.8 million,respectively. During the three and nine months ended September 30, 2007, feesreceived for services provided to HELIO were $0.4 million and $1.3 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, 2006 and 2007, revenues generated from HELIO and fees paid forproducts and services from HELIO were nominal.

 

InJuly 2007, we entered into a loan agreement with HELIO pursuant to which wecould lend up to $100.0 million to HELIO in the form of Promissory Notes. Alsoin July 2007, EarthLink purchased initial Promissory Notes of $30.0 million.

 

*eCompanies*

 

During the three and nine monthsended September 30, 2007, we received $1.2 million and $1.4 million,respectively, of cash distributions as a result of our investment in eCompaniesVenture Group, L.P. (“EVG”). Sky Dayton, a member of our Board of Directors, isa founding partner in EVG.

 

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**Recent Accounting Pronouncements**

 

InSeptember 2006, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 157, “Fair Value Measurements,” which establishes a framework forreporting 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. We are currently assessing the impact of the adoption of this standardon our financial statements.

 

InFebruary 2007, the FASB issued SFAS No. 159, “The Fair Value Option forFinancial Assets and Financial Liabilities,” which provides companies with anoption to report selected financial assets and liabilities at fair value. SFAS No. 159 also establishes presentation and disclosure requirementsdesigned to facilitate comparisons between companies that choose differentmeasurement attributes for similar types of assets and liabilities. SFASNo. 159 is effective as of the beginning of an entity’s first fiscal yearbeginning after November 15, 2007. We are currently assessing the impactof the adoption of this standard on our financial statements.

 

**Safe Harbor Statement**

 

TheManagement’s Discussion and Analysis and other portions of this QuarterlyReport on Form   10-Q include “forward-looking”statements (rather than historical facts) that are subject to risks anduncertainties that could cause actual results to differ materially from thosedescribed. Although we believe that the expectations expressed in theseforward-looking statements are reasonable, we cannot promise that ourexpectations will turn out to be correct. Our actual results could be materiallydifferent 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 might not realize the benefits we are seeking from thecorporate restructuring plan announced on August 28, 2007 and that ourcorporate restructuring plan might have a negative effect on our efforts tomaintain our subscribers and our relationships with our business partners;(2)  that we may have to undertakefurther restructuring plans that would entail additional charges and cause usto take additional actions, including incurring facility exit and restructuringcharges that may result from our continuing review of our growth initiatives;(3) that we may not successfully enhance existing or develop new products andservices in a cost-effective manner to meet customer demand in the rapidlyevolving market for Internet, wireless and IP-based voice communications services,including new products and services offered in connection with our voice andmunicipal broadband network growth initiatives, which we do not expect to beprofitable in their early stages; (4) that our service offerings may fail to becompetitive with existing and new competitors; (5) that competitive product,price or marketing pressures could cause us to lose existing customers tocompetitors (churn), or may cause us to reduce prices for our services whichcould adversely impact average revenue per user; (6) that we may beunsuccessful in making and integrating acquisitions into our business, whichcould result in operating difficulties, losses and other adverse consequences;(7) that the continued decline of our narrowband revenues could adversely affectour profitability and adversely impact our ability to invest in otherinitiatives; (8) that we may not be able to successfully manage the costsassociated with delivering our wireline broadband services, which couldadversely affect our ability to grow or sustain revenues and our profitability;(9) that companies may not provide last mile broadband access to us on awholesale basis or on terms or at prices that allow us to grow and beprofitable; (10) that our commercial and alliance arrangements may beterminated or may not be as beneficial as anticipated, which could adverselyaffect our ability to increase our subscriber base; (11) that our business maysuffer if our third-parties for technical and customer support and certainbilling services are unable to provide these services, cannot expand to meetour needs or terminate their relationships with us; (12) that serviceinterruptions or impediments could harm our business; (13) that governmentregulations could force us to change our business practices; (14) that changesin, or interpretations of, laws regarding consumer protection could subject usto liability or cause us to change our practices; (15) that we may not be ableto protect our proprietary technologies or successfully defend infringement claimsand may be required to enter licensing arrangements on unfavorable terms; (16)that we may be accused of infringing upon the intellectual property rights ofthird parties, which is costly to defend and could limit our ability to usecertain technologies in the future; (17) that we could face substantialliabilities if we are unable to successfully defend against legal actions; (18)that our business depends on the continued development 

 

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of effective business support systems, processes andpersonnel; (19) that we may be unable to hire and retain sufficient qualifiedpersonnel, and the loss of any of our key executive officers could adverselyaffect us; (20) that we may not obtain a sufficient number of wirelessbroadband customers in a municipality to generate a sufficient return on ourinvestment in a wireless broadband network in that municipality; (21) thatcertain aspects of our VoIP service are not the same as traditional telephoneservice, which may limit the acceptance of our services by mainstream consumersand our potential for growth; (22) that our E911 emergency services aredifferent from those offered by traditional wireline telephone companies andmay expose us to significant liability; (23) that our ability to provide ourVoIP service is dependent upon third-party facilities and equipment, thefailure of which could cause delays or interruptions of our service, damage ourreputation, cause us to lose customers and limit our growth; (24) that we maynot realize the benefits we are seeking from our investments in the HELIO jointventure or other investment activities as a result of lower than predictedrevenues or subscriber levels of the companies in which we invest, largerfunding requirements for those companies or otherwise; (25) that our stockprice has been volatile historically and may continue to be volatile; (26) thatour indebtedness could adversely affect our financial health and limit ourability to react to changes in our industry or to implement our strategicinitiatives; (27) that we may be unable to repurchase our convertible seniornotes for cash when required by the holders, including following a fundamentalchange, or to pay the cash portion of the conversion value upon conversion ofany notes by the holders; (28) that the convertible note hedge and warranttransactions may affect the value of our common stock; and (29) that someprovisions of Delaware law, our second restated certificate of incorporationand amended and restated bylaws may be deemed to have an anti-takeover effectand may delay or prevent a tender offer or takeover attempt that a stockholdermight consider in its best interest. These risks and uncertainties, as well asother risks and uncertainties that could cause our actual results to differsignificantly from management’s expectations, are not intended to represent acomplete list of all risks and uncertainties inherent in our business, andshould be read in conjunction with the more detailed cautionary statements andrisk factors included in our Annual Report on Form 10-K for the year endedDecember 31, 2006, as amended.

 

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

 

*Interest Rate Risk*

 

We are exposed to interest raterisk with respect to our investments in marketable securities. A change inprevailing interest rates may cause the fair value of our investments tofluctuate. For example, if we hold a security that was issued with a fixedinterest rate at the then-prevailing rate and the prevailing interest ratelater rises, the fair value of the investment may decline. To minimize thisrisk, we have historically held investments until maturity, and as a result, wereceive interest and principal amounts pursuant to the underlying agreements.To further mitigate risk, we maintain a portfolio of investments in a varietyof securities, including government agency notes, asset-backed debt securities(including auction rate debt securities), corporate notes and commercial paper,all of which bear a minimum short-term rating of A1/P1 or a minimum long-termrating of A/A2. As of December 31, 2006 and September 30, 2007, net unrealizedlosses in these investments were not material. 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.

 

Thefollowing table presents the amounts of our cash equivalents and short- andlong-term investments that are subject to interest rate risk by range ofexpected maturity and weighted-average interest rates as of December 31,2006 and September 30, 2007. This table does not include money market fundsbecause those funds are not subject to interest rate risk.

 
| ** **                                    | ** ** | **As of December 31, 2006** | ** ** | **As of September 30, 2007** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                    | ** ** | **Amortized**                                   | ** ** | **Estimated  Fair**                              | ** ** | **Amortized** | ** ** | **Estimated  Fair** | ** ** |
| ** **                                    | ** ** | **Cost**                                        | ** ** | **Value**                                        | ** ** | **Cost** | ** ** | **Value** | ** ** |
| ** **                                    | ** ** | **(dollars in thousands)**            | ** ** |
| Included in cash  and cash equivalents        |       | $                                               | 46,289     |                                             | $          | 46,289 |   | $ | 7,742 |   | $ | 7,742 |   |
| Weighted average  interest rate               |       | 5.3                                             | %          |                                             |       | 5.2 | % |   |   |
| Weighted average  maturity (mos.)             |       | 1.0                                             |       |                                             |       | 1.8 |   |   |   |
|                                          |       |                                            |       |                                             |       |   |   |   |   |
| Included in  marketable securities-short-term |       | $                                               | 215,181    |                                             | $          | 214,947 |   | $ | 208,570 |   | $ | 208,572 |   |
| Weighted average  interest rate               |       | 5.2                                             | %          |                                             |       | 5.5 | % |   |   |
| Weighted average  maturity (mos.)*            |       | 2.7                                             |       |                                             |       | 1.8 |   |   |   |
|                                          |       |                                            |       |                                             |       |   |   |   |   |
| Included in marketable  securities-long-term  |       | $                                               | 21,497     |                                             | $          | 21,460 |   | $ | 30,242 |   | $ | 30,272 |   |
| Weighted average  interest rate               |       | 5.2                                             | %          |                                             |       | 5.2 | % |   |   |
| Weighted average  maturity (mos.)             |       | 19.3                                            |       |                                             |       | 17.6 |   |   |   |

 

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* The maturity of asset-backed,auction rate securities for purposes of this calculation is consistent withmanagement’s view as to the availability of such securities to fund currentoperating activities.

 

We are also exposed to interestrate risk with respect to our convertible senior notes due November 15, 2026.The fair value of our convertible senior notes may be adversely impacted due toa rise in interest rates. In general, securities with longer maturities aresubject to greater interest rate risk than those with shorter maturities. Ourconvertible senior notes bear interest at a fixed rate of 3.25% per year untilNovember 15, 2011, and 3.50% per year thereafter. As of December 31, 2006 andSeptember 30, 2007, the carrying value of our convertible senior notes was$258.8 million, and the fair value was approximately $277.3 million and $287.1million, respectively, which was based on quoted market prices.

 

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*Equity Risk*

 

We areexposed to equity price risk as it relates to changes in the market value ofour equity investments and call options. We invest in equity instruments ofpublic and private companies for operational and strategic purposes. Inconnection with the issuance of our convertible senior notes, we purchased calloptions to cover approximately 28.4 million shares of our common stock, subjectto adjustment in certain circumstances, which is the number of sharesunderlying the notes. These securities are subject to significant fluctuationsin fair market value due to volatility of the stock market and the industriesin which the companies operate. We typically do not attempt to reduce oreliminate our market exposure in these equity instruments.

 

The following table presents thecarrying value and fair value of our financial instruments subject to equityrisk as of December 31, 2006 and September 30, 2007:

 
| ** **                                       | ** ** | **As of December 31, 2006** | ** ** | **As of September 30, 2007** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                       | ** ** | **Carrying**                                    | ** ** | **Estimated  Fair**                              | ** ** | **Carrying** | ** ** | **Estimated  Fair** | ** ** |
| ** **                                       | ** ** | **Amount**                                      | ** ** | **Value**                                        | ** ** | **Amount** | ** ** | **Value** | ** ** |
| ** **                                       | ** ** | **(in thousands)**                         | ** ** |
| Investments in  other companies for which it is: |       |                                            |       |                                             |       |   |   |   |   |
| Practicable to  estimate fair value              |       | $                                               | 48,325     |                                             | $          | 48,325 |   | $ | 44,351 |   | $ | 44,351 |   |
| Not practicable  to estimate fair value          |       | 11,000                                          |       | N/A                                              |       | 10,000 |   | N/A |   |
| Call options                                     |       | 47,162                                          |       | 58,361                                           |       | 47,162 |   | 63,346 |   |
|                                                  |            |                                                 |            |                                                  |            |  |  |  |  |  |  |  |  |

 

**Item 4. Controls and Procedures.**

 

**Evaluation ofDisclosure Controls and 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.

 

**Changes inInternal Control over Financial Reporting**

 

Therewere no changes in our internal control over financial reporting during thethree months ended September 30, 2007 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

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**Part II**

 

**Item 1.  Legal Proceedings.**

 

EarthLink is a party to various legal proceedings that areordinary and incidental to its business. Management does not expect that anycurrently pending legal proceedings will have a material adverse effect onEarthLink’s results of operations or financial position.

 

**Item 1A.  Risk Factors.**

 

Setforth below are material updates to the risk factors discussed in our AnnualReport on Form 10-K for the year ended December 31, 2006, as amended.

 

***We might not realize the benefits we are seeking from the corporaterestructuring plan announced on August 28, 2007 and our corporate restructuringplan might have a negative effect on our efforts to maintain our subscribersand our relationships with our business partners.***

 

In August 2007, we implemented a corporate restructuring plan intended toreduce costs and improve the efficiency of our operations. There are severalrisks inherent in our efforts, including the risk that cost-cutting plans willimpair our ability to effectively develop new products, to remain competitiveand to operate effectively, which could have a negative effect on our effortsto maintain our subscribers and our relationships with our business partners.There is also the risk that we will not be able to reduce expenditures quicklyenough and maintain them at a level necessary to increase profitability. Eachof the above measures could have long-term effects on our business, decreasingor slowing product development, making it more difficult for us to respond tocustomers and maintain the quality of services we provide, and limiting ourability to hire and retain key personnel. These circumstances could adverselyaffect our business, financial position, results of operations and cash flows.

 

***We may have to undertake further restructuring plans that would entailadditional charges and cause us to take additional actions, including incurringfacility exit and restructuring charges that may result from our continuingreview of our growth initiatives.***

 

Ourcorporate restructuring plan announced in August 2007 was, in part, the resultof a review of each of our growth initiatives to evaluate whether theseinitiatives are complementary to our long-term strategy and allow us tomaximize shareholder value. We continue to evaluate all of our growthinitiatives, and these reviews may result in additional restructuring activities.Engaging in further restructuring activities could result in additionalfacility exit and restructuring costs, and could adversely affect our business,financial position, results of operations and cash flows.

 

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**Item 2.  ****Unregistered Sales of EquitySecurities and Use of Proceeds****.**

 

The number of shares repurchasedand the average price paid per share for each month in the three months endedSeptember 30, 2007 are as follows:

 
| **2007**                          | ** ** | **Total Number  of Shares  Repurchased**                                         | ** ** | **Average  Price Paid  per Share** | ** ** | **Total Number of  Shares Repurchased  as Part of Publicly  Announced Program (1)** | ** ** | **Maximum Dollar  Value that May  Yet be Purchased  Under the Program** | ** ** |
|-----------------------------------|------------|--------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------|------------|
| ** **                        | ** ** | **(in thousands, except average price paid per share)** | ** ** |
| July 1 through  July 31           |       | —                                                                                     |       | $                                            | —     |                                                                                                                        | —     |                                                                                                       | $          | 95,295 |   |
| August 1 through  August 31       |       | 3,920                                                                                      |       | 6.37                                         |       | 3,920                                                                                                                       |       | 270,323                                                                                                    |       |
| September 1  through September 30 |       | —                                                                                     |       | —                                       |       | —                                                                                                                      |       | 270,323                                                                                                    |       |
| Total                             |       | 3,920                                                                                      |       |                                         |       | 3,920                                                                                                                       |       |                                                                                                       |       |
|                                   |            |                                                                                            |            |                                              |            |                                                                                                                             |            |                                                                                                            |            |  |  |

 

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(1)          Since the inception of the share repurchase program(“Repurchase Program”), the Board of Directors has authorized a total of $750.0million for the repurchase of our common stock, including $200.0 million thatwas authorized in August 2007. The Board of Directors has also approvedrepurchasing common stock pursuant to plans under Rule 10b5-1 of the SecuritiesExchange Act of 1934, as amended. We may repurchase our common stock from timeto time in compliance with the Securities and Exchange Commission’s regulationsand other legal requirements, including through the use of derivative transactions,and subject to market conditions and other factors. The Repurchase Program doesnot require us to acquire any specific number of shares and may be terminatedat any time.

 

**Item 5.  Other Information.**

 

None.

 

**Item 6.  Exhibits.**

 

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

 
| 31.1   |   | Certification of Chief Executive Officer pursuant to Securities Exchange  Act Rules 13a-14 and 15d-14, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                          |
| 31.2   |   | Certification of Chief Financial Officer pursuant to Securities Exchange  Act Rules 13a-14 and 15d-14, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|   |   |                                                                                                                                                                          |
| 32.1   |   | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section  1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                           |
|   |   |                                                                                                                                                                          |
| 32.2   |   | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section  1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                           |

 

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#### **SIGNATURES**

#### ** **

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|   |                                      | EARTHLINK,  INC.                              |
|--------|-------------------------------------------|-----------------------------------------------|
|   |                                      |                                          |
|   |                                      |                                          |
| Date:  |     November  2, 2007 |                                          |   | /s/  ROLLA P. HUFF |
|   |                                      | Rolla P. Huff, Chief  Executive Officer       |
|   |                                      |                                          |
|   |                                      |                                          |
| Date:  |     November  2, 2007 |                                          |   | /s/  KEVIN M. DOTTS |
|   |                                      | Kevin M. Dotts, Chief  Financial Officer      |
|   |                                      | (principal financial  and accounting officer) |

 

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