Tableof Contents

 

 

 

**UNITED STATES SECURITIES ANDEXCHANGE 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 June 30, 2008**                                                                                                                                                             |
| ** ** | ** **                                                                                                                                                                                                         |
| **OR**     |
| ** ** | ** **                                                                                                                                                                                                         |
| **o**      | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**                                                                                                            |
| ** ** | ** **                                                                                                                                                                                                         |
| ** ** | **For the transition period from                  to               .** |

 

**Commission File Number: 001-15605**

 

**EARTHLINK, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

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

 

**(404) 815-0770**

(Registrant’s telephone number, including area code)

 

----

 

 

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

 

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Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes x No o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer or a smaller reporting company (asdefined in Rule 12b-2 of the Exchange Act):

 

Seethe definitions of “large accelerated filer,” “accelerated filer” and “smallerreporting company” in Rule 12b-2 of the Exchange Act.

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

 

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

 

As of July 31,2008, 110,599,309 shares of common stock, $.01 par value per share, wereoutstanding.

 

 

** **

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Table of Contents

 

**EARTHLINK, INC.**

**Quarterly Report on Form 10-Q**

**For the Quarterly Period Ended June 30,2008**

** **

**TABLE OF CONTENTS**

 
| **Part I**                                                                                     |       |
|-----------------------------------------------------------------------------------------------------|------------|
|                                                                                                |       |
| Item 1. Financial  Statements                                                                       | 1          |
|                                                                                                |       |
| Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations | 24         |
|                                                                                                |       |
| Item 3. Quantitative and Qualitative Disclosures About  Market Risk                                 | 44         |
|                                                                                                |       |
| Item 4. Controls and Procedures                                                                     | 44         |
|                                                                                                |       |
| **Part II**                                                                                    | ** ** |
| ** **                                                                                          | ** ** |
| Item  1. Legal Proceedings                                                                          | 45         |
|                                                                                                |       |
| Item  1A. Risk Factors                                                                              | 45         |
|                                                                                                |       |
| Item 2. Unregistered Sales of Equity Securities and  Use of Proceeds                                | 45         |
|                                                                                                |       |
| Item 4. Submission of Matters to a Vote of Security  Holders                                        | 45         |
|                                                                                                |       |
| Item  5. Other Information                                                                          | 46         |
|                                                                                                |       |
| Item  6. Exhibits                                                                                   | 46         |
|                                                                                                |       |
| Signatures                                                                                          | 47         |

 

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Tableof Contents

 

**PART I**

 

**Item 1.  Financial Statements.**

 

**EARTHLINK, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

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

 
| ** **                                                                                                                                                                                                                                                                      | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------|------------|
| ** **                                                                                                                                                                                                                                                                      | ** ** | **2007**              | ** ** | **2008**          | ** ** |
| ** **                                                                                                                                                                                                                                                                      | ** ** | ** **            | ** ** | **(unaudited)**   | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                      |
| Current assets:                                                                                                                                                                                                                                                                 |       |                  |       |              |       |
| Cash and cash  equivalents                                                                                                                                                                                                                                                      |       | $                     | 173,827    |              | $          | 374,850 |   |
| Investments in  marketable securities                                                                                                                                                                                                                                           |       | 93,204                |       | 3,983             |       |
| Accounts  receivable, net of allowance of $6,422 and $4,993 as of December 31,  2007 and June 30, 2008, respectively                                                                                                                                                  |       | 41,483                |       | 32,647            |       |
| Prepaid expenses                                                                                                                                                                                                                                                                |       | 7,747                 |       | 8,644             |       |
| Current assets  of discontinued operations                                                                                                                                                                                                                                      |       | 6,744                 |       | 2,346             |       |
| Other current  assets                                                                                                                                                                                                                                                           |       | 12,999                |       | 13,881            |       |
| Total current  assets                                                                                                                                                                                                                                                           |       | 336,004               |       | 436,351           |       |
| Long-term  investments in marketable securities                                                                                                                                                                                                                                 |       | 21,564                |       | 62,756            |       |
| Property and  equipment, net                                                                                                                                                                                                                                                    |       | 57,300                |       | 46,915            |       |
| Investments in  other companies                                                                                                                                                                                                                                                 |       | 62,923                |       | 9,425             |       |
| Purchased  intangible assets, net                                                                                                                                                                                                                                               |       | 46,276                |       | 38,172            |       |
| Goodwill                                                                                                                                                                                                                                                                        |       | 202,277               |       | 189,497           |       |
| Other long-term  assets                                                                                                                                                                                                                                                         |       | 8,149                 |       | 6,997             |       |
| Total assets                                                                                                                                                                                                                                                                    |       | $                     | 734,493    |              | $          | 790,113 |   |
|                                                                                                                                                                                                                                                                            |       |                  |       |              |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                                  |
| Current  liabilities:                                                                                                                                                                                                                                                           |       |                  |       |              |       |
| Trade accounts  payable                                                                                                                                                                                                                                                         |       | $                     | 28,808     |              | $          | 18,789 |   |
| Accrued payroll  and related expenses                                                                                                                                                                                                                                           |       | 32,055                |       | 26,315            |       |
| Other accounts  payable and accrued liabilities                                                                                                                                                                                                                                 |       | 66,930                |       | 50,159            |       |
| Current  liabilities of discontinued operations                                                                                                                                                                                                                                 |       | 15,930                |       | 5,312             |       |
| Deferred revenue                                                                                                                                                                                                                                                                |       | 44,626                |       | 38,766            |       |
| Total current  liabilities                                                                                                                                                                                                                                                      |       | 188,349               |       | 139,341           |       |
|                                                                                                                                                                                                                                                                            |       |                  |       |              |       |
| Long-term debt                                                                                                                                                                                                                                                                  |       | 258,750               |       | 258,750           |       |
| Other long-term  liabilities                                                                                                                                                                                                                                                    |       | 25,921                |       | 20,945            |       |
| Total  liabilities                                                                                                                                                                                                                                                              |       | 473,020               |       | 419,036           |       |
|                                                                                                                                                                                                                                                                            |       |                  |       |              |       |
| Stockholders’  equity:                                                                                                                                                                                                                                                     |       |                  |       |              |       |
| Convertible  preferred stock, $0.01 par value, 100,000 shares authorized, 0 shares issued  and outstanding as of December 31, 2007 and June 30, 2008                                                                                                                  |       | —                |       | —            |       |
| Common stock,  $0.01 par value, 300,000 shares authorized, 186,490 and 187,729 shares issued  as of December 31, 2007 and June 30, 2008, respectively, and  110,547 and 110,501 shares outstanding as of December 31, 2007 and June 30,  2008, respectively |       | 1,865                 |       | 1,877             |       |
| Additional  paid-in capital                                                                                                                                                                                                                                                     |       | 2,047,268             |       | 2,061,098         |       |
| Accumulated  deficit                                                                                                                                                                                                                                                            |       | (1,184,119            | )          | (1,076,429        | )          |
| Treasury stock,  at cost, 75,943 and 77,228 shares as of December 31, 2007 and  June 30, 2008, respectively                                                                                                                                                           |       | (602,564              | )          | (611,689          | )          |
| Unrealized  losses on investments                                                                                                                                                                                                                                               |       | (977                  | )          | (3,780            | )          |
| Total  stockholders’ equity                                                                                                                                                                                                                                                |       | 261,473               |       | 371,077           |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                                                                                                |       | $                     | 734,493    |              | $          | 790,113 |   |

 

The accompanying notesare an integral part of these financial statements.

 

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**EARTHLINK, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

 
| ** **                                                    | ** ** | **Three Months Ended**                                   | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                    | ** ** | **June 30,**                                                  | ** ** | **June 30,**              | ** ** |
| ** **                                                    | ** ** | **2007**                                                           | ** ** | **2008**                       | ** ** | **2007** | ** ** | **2008** | ** ** |
| ** **                                                    | ** ** | **(in thousands, except per share data)** | ** ** |
| ** **                                                    |       | **(unaudited)**                                                    |       |
|                                                          |       |                                                               |       |                           |       |   |   |   |   |
| Revenues                                                      |       | $                                                                  | 311,866    |                           | $          | 245,603 |   | $ | 636,013 |   | $ | 508,677 |   |
|                                                          |       |                                                               |       |                           |       |   |   |   |   |
| Operating costs  and expenses:                                |       |                                                               |       |                           |       |   |   |   |   |
| Service and  equipment costs                                  |       | 108,599                                                            |       | 91,917                         |       | 218,390 |   | 188,709 |   |
| Sales incentives                                              |       | 5,110                                                              |       | 571                            |       | 9,714 |   | 1,330 |   |
| Total cost of  revenues                                       |       | 113,709                                                            |       | 92,488                         |       | 228,104 |   | 190,039 |   |
|                                                          |       |                                                               |       |                           |       |   |   |   |   |
| Sales and  marketing                                          |       | 75,800                                                             |       | 25,806                         |       | 175,069 |   | 56,722 |   |
| Operations and  customer support                              |       | 59,892                                                             |       | 33,642                         |       | 119,964 |   | 72,866 |   |
| General and  administrative                                   |       | 29,431                                                             |       | 23,768                         |       | 72,692 |   | 48,694 |   |
| Amortization of  intangible assets                            |       | 3,542                                                              |       | 3,987                          |       | 7,038 |   | 8,000 |   |
| Facility exit,  restructuring and other costs                 |       | —                                                             |       | 2,061                          |       | — |   | 3,091 |   |
| Total operating  costs and expenses                           |       | 282,374                                                            |       | 181,752                        |       | 602,867 |   | 379,412 |   |
|                                                          |       |                                                               |       |                           |       |   |   |   |   |
| Income from  operations                                       |       | 29,492                                                             |       | 63,851                         |       | 33,146 |   | 129,265 |   |
| Net losses of  equity affiliate                               |       | (40,054                                                            | )          | —                         |       | (69,400 | ) | — |   |
| Gain on  investments in other companies, net                  |       | 210                                                                |       | 1,325                          |       | 210 |   | 1,325 |   |
| Interest income  (expense) and other, net                     |       | 3,597                                                              |       | (760                           | )          | 7,100 |   | 856 |   |
| Income (loss)  from continuing operations before income taxes |       | (6,755                                                             | )          | 64,416                         |       | (28,944 | ) | 131,446 |   |
| Income tax  provision                                         |       | (226                                                               | )          | (6,725                         | )          | (395 | ) | (15,999 | ) |
| Income (loss)  from continuing operations                     |       | (6,981                                                             | )          | 57,691                         |       | (29,339 | ) | 115,447 |   |
| Loss from  discontinued operations, net of tax                |       | (9,309                                                             | )          | (4,365                         | )          | (16,913 | ) | (7,757 | ) |
| Net income  (loss)                                            |       | $                                                                  | (16,290    | )                              | $          | 53,326 |   | $ | (46,252 | ) | $ | 107,690 |   |
|                                                          |       |                                                               |       |                           |       |   |   |   |   |
| Basic net income  (loss) per share                            |       |                                                               |       |                           |       |   |   |   |   |
| Continuing  operations                                        |       | $                                                                  | (0.06      | )                              | $          | 0.52 |   | $ | (0.24 | ) | $ | 1.05 |   |
| Discontinued  operations                                      |       | (0.08                                                              | )          | (0.04                          | )          | (0.14 | ) | (0.07 | ) |
| Basic net income  (loss) per share                            |       | $                                                                  | (0.13      | )                              | $          | 0.48 |   | $ | (0.38 | ) | $ | 0.98 |   |
| Basic weighted  average common shares outstanding             |       | 123,257                                                            |       | 110,033                        |       | 123,159 |   | 109,762 |   |
|                                                          |       |                                                               |       |                           |       |   |   |   |   |
| Diluted net  income (loss) per share                          |       |                                                               |       |                           |       |   |   |   |   |
| Continuing  operations                                        |       | $                                                                  | (0.06      | )                              | $          | 0.51 |   | $ | (0.24 | ) | $ | 1.04 |   |
| Discontinued  operations                                      |       | (0.08                                                              | )          | (0.04                          | )          | (0.14 | ) | (0.07 | ) |
| Diluted net  income (loss) per share                          |       | $                                                                  | (0.13      | )                              | $          | 0.48 |   | $ | (0.38 | ) | $ | 0.97 |   |
| Diluted weighted  average common shares outstanding           |       | 123,257                                                            |       | 112,256                        |       | 123,159 |   | 111,277 |   |

 

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

 

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**EARTHLINK, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                                | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                | ** ** | **June 30,**              | ** ** |
| ** **                                                                                | ** ** | **2007**                       | ** ** | **2008** | ** ** |
| ** **                                                                                | ** ** | **(in thousands)**        | ** ** |
| ** **                                                                                | ** ** | **(unaudited)**                | ** ** |
| Cash flows from  operating activities:                                                    |       |                           |       |   |   |
| Net income  (loss)                                                                        |       | $                              | (46,252    | ) | $ | 107,690 |   |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities: |       |                           |       |   |   |
| Depreciation and  amortization                                                            |       | 26,118                         |       | 20,507 |   |
| Loss on  disposals and impairments of fixed assets                                        |       | 7                              |       | 3,665 |   |
| Net losses of  equity affiliate                                                           |       | 69,400                         |       | — |   |
| Gain on  investments in other companies, net                                              |       | (210                           | )          | (1,325 | ) |
| Stock-based  compensation                                                                 |       | 10,813                         |       | 9,722 |   |
| Deferred income  taxes                                                                    |       | —                         |       | 12,194 |   |
| Other  adjustments                                                                        |       | (43                            | )          | — |   |
| Decrease in  accounts receivable, net                                                     |       | 39                             |       | 8,825 |   |
| Decrease  (increase) in prepaid expenses and other assets                                 |       | 1,275                          |       | (7,128 | ) |
| Decrease in  accounts payable and accrued and other liabilities                           |       | (24,709                        | )          | (39,659 | ) |
| Decrease in  deferred revenue                                                             |       | (3,277                         | )          | (6,380 | ) |
| Net cash  provided by operating activities                                                |       | 33,161                         |       | 108,111 |   |
|                                                                                      |       |                           |       |   |   |
| Cash flows from  investing activities:                                                    |       |                           |       |   |   |
| Purchases of  property and equipment                                                      |       | (26,828                        | )          | (2,258 | ) |
| Purchases of  subscriber bases                                                            |       | (2,949                         | )          | (127 | ) |
| Proceeds from  sales of fixed assets                                                      |       | 36                             |       | — |   |
| Investments in  marketable securities:                                                    |       |                           |       |   |   |
| Purchases                                                                                 |       | (232,536                       | )          | (53,027 | ) |
| Sales and  maturities                                                                     |       | 213,202                        |       | 97,160 |   |
| Investments in  and net advances to/from equity affiliate                                 |       | (19,474                        | )          | 8 |   |
| Proceeds  received from investments in other companies                                    |       | 210                            |       | 57,070 |   |
| Net cash (used  in) provided by investing activities                                      |       | (68,339                        | )          | 98,826 |   |
|                                                                                      |       |                           |       |   |   |
| Cash flows from  financing activities:                                                    |       |                           |       |   |   |
| Principal  payments under capital lease obligations                                       |       | (15                            | )          | (2,687 | ) |
| Proceeds from  exercises of stock options and other                                       |       | 4,447                          |       | 5,899 |   |
| Repurchases of  common stock                                                              |       | —                         |       | (9,126 | ) |
| Net cash  provided by (used in) financing activities                                      |       | 4,432                          |       | (5,914 | ) |
|                                                                                      |       |                           |       |   |   |
| Net (decrease)  increase in cash and cash equivalents                                     |       | (30,746                        | )          | 201,023 |   |
| Cash and cash  equivalents, beginning of period                                           |       | 158,369                        |       | 173,827 |   |
| Cash and cash  equivalents, end of period                                                 |       | $                              | 127,623    |   | $ | 374,850 |   |

 

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

 

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**EARTHLINK,INC.**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED**

 

**1.  Organization**

 

EarthLink, Inc.(“EarthLink” or the “Company”) is an Internet service provider (“ISP”),providing nationwide Internet access and related value-added services toindividual and business customers. The Company’s primary service offeringsinclude dial-up Internet access, high-speed Internet access and web hostingservices. The Company also provides value-added services, such as search,advertising and ancillary services sold as add-on features to the Company’sInternet access services. In addition, through the Company’s wholly-ownedsubsidiary, New Edge Networks, the Company provides secure multi-site manageddata networks and dedicated Internet access for businesses and communicationscarriers.

 

TheCompany operates two reportable segments, Consumer Services and BusinessServices. The Company’s Consumer Services segment provides Internet access andrelated value-added services to individual customers. These services includedial-up and high-speed Internet access and voice services, among others. TheCompany’s Business Services segment provides Internet access and relatedvalue-added services to businesses and communications carriers. These servicesinclude managed data networks, dedicated Internet access and web hosting, amongothers. For further information concerning the Company’s business segments, seeNote 14, “Segment Information.”

 

**2.  Basis of Presentation**

 

*Basis ofPresentation*

 

Thecondensed consolidated financial statements of EarthLink, which include theaccounts of its wholly-owned subsidiaries, for the three and six months ended June 30,2007 and 2008 and the related footnote information are unaudited and have beenprepared on a basis consistent with the Company’s audited consolidatedfinancial statements as of December 31, 2007 contained in the Company’sAnnual Report on Form 10-K as filed with the Securities and ExchangeCommission (the “Annual Report”).  Allsignificant intercompany transactions have been eliminated.

 

Thesefinancial statements should be read in conjunction with the auditedconsolidated financial statements and the related notes thereto contained inthe Company’s Annual Report.  In theopinion of management, the accompanying unaudited financial statements containall adjustments (consisting of normal recurring adjustments), which managementconsiders necessary to present fairly the Company’s financial position, resultsof operations and cash flows for the interim periods presented.  The results of operations for the three andsix months ended June 30, 2008 are not necessarily indicative of theresults anticipated for the entire year ending December 31, 2008.

 

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

 

*Discontinued Operations*

 

Inaccordance with Statement of Financial Accounting Standards (“SFAS”) No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets,” the Companyhas reflected its municipal wireless broadband results of operations asdiscontinued operations for all periods presented.  See Note 5, “Discontinued Operations,” forfurther discussion.

 

*Reclassifications*

 

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

 

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**EARTHLINK,INC.**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED- (Continued)**

 

*Recently Issued AccountingPronouncements*

 

In May 2008,Financial Accounting Standards Board (“FASB”) issued Staff Position No. APB14-1, “Accounting for Convertible Debt Instruments that May be Settled inCash Upon Conversion” (“FSP APB 14-1”). FSP APB 14-1 requires that theliability and equity components of convertible debt instruments that may besettled in cash upon conversion (including partial cash settlement) beseparately accounted for in a manner that reflects an issuer’s nonconvertibledebt borrowing rate. The resulting debt discount is amortized over the periodthe convertible debt is expected to be outstanding as additional non-cashinterest expense. FSP APB 14-1 is effective for financial statements issued forfiscal years beginning after December 15, 2008, and interim periods withinthose fiscal years. Retrospective application to all periods presented isrequired except for instruments that were not outstanding during any of theperiods that will be presented in the annual financial statements for theperiod of adoption but were outstanding during an earlier period. The adoptionof FSP APB 14-1 will affect the accounting for the Company’s Convertible SeniorNotes due November 15, 2026, which were issued in November 2006, andwill result in increased non-cash interest expense. The Company is currentlyassessing the impact of the adoption of this standard on its financialstatements.

 

Also in May 2008, the FASBissued Statement of Financial Accounting Standards (“SFAS”) No. 162, “TheHierarchy of Generally Accepted Accounting Principles.” SFAS No. 162identifies the sources of accounting principles and the framework for selectingthe principles to be used in the preparation of financial statements ofnongovernmental entities that are presented in conformity with generallyaccepted accounting principles (GAAP) in the United States (the GAAPhierarchy). SFAS No. 162 is effective 60 days following the SEC’s approvalof the Public Company Accounting Oversight Board amendments to AU Section 411,“The Meaning of Present Fairlyin Conformity With Generally Accepted Accounting Principles.” The Company doesnot expect the adoption of SFAS No. 162 to have a material impact on its financialstatements.

 

**3.  Earnings per Share**

 

Netincome (loss) per share has been computed according to SFAS No. 128, “Earningsper Share,” which requires a dual presentation of basic and diluted earningsper share (“EPS”). Basic EPS represents net income (loss) divided by theweighted average number of common shares outstanding during a reported period.Diluted EPS reflects the potential dilution that could occur if securities orother contracts to issue common stock, including stock options, warrants,restricted stock units, phantom share units and convertible debt (collectively “CommonStock Equivalents”), were exercised or converted into common stock. Thedilutive effect of outstanding stock options, warrants, restricted stock unitsand convertible debt is reflected in diluted earnings per share by applicationof the treasury stock method. Phantom share units are reflected on anif-converted basis. In applying the treasury stock method for stock-basedcompensation arrangements, the assumed proceeds are computed as the sum of theamount the employee must pay upon exercise and the amounts of averageunrecognized compensation cost attributed to future services.

 

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**EARTHLINK,INC.**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED- (Continued)**

 

Thefollowing table sets forth the computation for basic and diluted net income pershare for the three and six months ended June 30, 2008:

 

| ** **                                          | ** ** | **Three Months Ended**                                   | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                          | ** ** | **June 30, 2008**                                        | ** ** | **June 30, 2008**    | ** ** |
| ** **                                          | ** ** | **(in thousands, except per share data)** | ** ** |
|                                                |       |                                                               |       |                           |       |
| **Numerator**                                       |       |                                                               |       |                           |       |
| Income from  continuing operations                  |       | $                                                                  | 57,691     |                           | $          | 115,447 |   |
| Loss from  discontinued operations                  |       | (4,365                                                             | )          | (7,757                         | )          |
| Net income                                          |       | $                                                                  | 53,326     |                           | $          | 107,690 |   |
|                                                |       |                                                               |       |                           |       |
| **Denominator**                                     |       |                                                               |       |                           |       |
| Basic weighted  average common shares outstanding   |       | 110,033                                                            |       | 109,762                        |       |
| Dilutive effect  of Common Stock Equivalents        |       | 2,223                                                              |       | 1,515                          |       |
| Diluted weighted  average common shares outstanding |       | 112,256                                                            |       | 111,277                        |       |
|                                                |       |                                                               |       |                           |       |
| **Basic  net income per share**                     |       |                                                               |       |                           |       |
| Continuing  operations                              |       | $                                                                  | 0.52       |                           | $          | 1.05 |   |
| Discontinued  operations                            |       | (0.04                                                              | )          | (0.07                          | )          |
| Basic net income  per share                         |       | $                                                                  | 0.48       |                           | $          | 0.98 |   |
|                                                |       |                                                               |       |                           |       |
| **Diluted  net income per share**                   |       |                                                               |       |                           |       |
| Continuing operations                               |       | $                                                                  | 0.51       |                           | $          | 1.04 |   |
| Discontinued  operations                            |       | (0.04                                                              | )          | (0.07                          | )          |
| Diluted net  income per share                       |       | $                                                                  | 0.48       |                           | $          | 0.97 |   |

 

Duringthe three and six months ended June 30, 2008, approximately 8.0 millionand 9.3 million, respectively, options and restricted stock units were excludedfrom the calculation of diluted EPS because the exercise prices plus theamount of unrecognized compensation cost attributed to future services exceededthe Company’s average stock price during the period. Approximately 28.4 millionshares that underlie the Company’s convertible debt instruments and 28.4million warrants were also excluded from the calculation of diluted EPS becausethe exercise prices exceeded the Company’s average stock price during theperiod. These securities could be dilutive in future periods.

 

TheCompany has not included the effect of Common Stock Equivalents in thecalculation of diluted EPS for the three and six months ended June 30,2007 because such inclusion would have an anti-dilutive effect due to the Company’snet loss. As of June 30, 2007, the Company had 20.6 million optionsoutstanding, 1.1 million restricted stock units outstanding and 28.5 millionwarrants outstanding.

 

6

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

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

 

Facility exit, restructuring andother costs consisted of the following during the three and six months ended June 30,2008:

 

| ** **                  | ** ** | **Three Months**       | ** ** | **Six Months**         | ** ** |
|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                  | ** ** | **Ended**                   | ** ** | **Ended**                   | ** ** |
| ** **                  | ** ** | **June 30, 2008** | ** ** | **June 30, 2008** | ** ** |
| ** **                  | ** ** | **(in thousands)**     | ** ** |
| ** **                  | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| 2007  Restructuring Plan    |       | $                           | 2,169      |                        | $          | 3,262 |   |
| Legacy  Restructuring Plans |       | (108                        | )          | (171                        | )          |
|                        |       | $                           | 2,061      |                        | $          | 3,091 |   |

 

*2007 Restructuring Plan*

 

In August 2007,EarthLink adopted a restructuring plan (the “2007 Plan”) to reduce costs andimprove the efficiency of the Company’s operations. The 2007 Plan was theresult of a comprehensive review of operations within and across the Company’sfunctions and businesses. Under the 2007 Plan, the Company reduced itsworkforce by approximately 900 employees, closed office facilities in Orlando,Florida; Knoxville, Tennessee; Harrisburg, Pennsylvania and San Francisco,California and is consolidating its office facilities in Atlanta, Georgia andPasadena, California. The 2007 Plan was primarily implemented during the latterhalf of 2007 and is expected to be completed during 2008. In connection withthe 2007 Plan, the Company expects to record total costs of approximately $75.0to $85.0 million, including $30.0 to $32.0 million for severance andpersonnel-related costs, $17.0 to $22.0 million for lease termination andfacilities-related costs, $26.0 to $28.0 million for non-cash asset impairmentsand $2.0 to $3.0 million for other associated costs.

 

Thefollowing table summarizes facility exit and restructuring costs during thethree and six months ended June 30, 2008 and the cumulative costs incurredto date as a result of the 2007 Plan. Such costs have been classified asfacility exit, restructuring and other costs in the Condensed ConsolidatedStatement of Operations.

 

| ** **                                      | ** ** | ** **                  | ** ** | ** **                  | ** ** | **Cumulative**   | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|------------------|------------|
| ** **                                      | ** ** | **Three Months**       | ** ** | **Six Months**         | ** ** | **Costs**        | ** ** |
| ** **                                      | ** ** | **Ended**                   | ** ** | **Ended**                   | ** ** | **Incurred**     | ** ** |
| ** **                                      | ** ** | **June 30, 2008** | ** ** | **June 30, 2008** | ** ** | **To Date** | ** ** |
| ** **                                      | ** ** | **(in thousands)**     | ** ** |
|                                            |       |                        |       |                        |       |             |       |
| Severance and  personnel-related costs          |       | $                           | 108        |                        | $          | 474              |       | $ | 30,777 |   |
| Lease  termination and facilities-related costs |       | 2,005                       |       | 2,005                       |       | 14,221           |       |
| Non-cash asset  impairments                     |       | 27                          |       | 313                         |       | 20,934           |       |
| Other associated  costs                         |       | 29                          |       | 470                         |       | 1,601            |       |
|                                            |       | $                           | 2,169      |                        | $          | 3,262            |       | $ | 67,533 |   |

 

Management continues to evaluateEarthLink’s business and, therefore, may have supplemental provisions for newplan initiatives as well as changes in estimates to amounts previouslyrecorded, as payments are made or actions are completed.

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

Thefollowing table summarizes activity for the liability balances associated withthe 2007 Plan for the six months ended June 30, 2008, including changesduring the period attributable to costs incurred and charged to expense andcosts paid or otherwise settled:

 

| ** **                            | ** ** | **Severance**           | ** ** | ** **     | ** ** | **Asset**       | ** ** | **Other** | ** ** | ** ** | ** ** |
|---------------------------------------|------------|-------------------------|------------|----------------|------------|-----------------|------------|-----------|------------|------------|------------|
| ** **                            | ** ** | **and Benefits**   | ** ** | **Facilities** | ** ** | **Impairments** | ** ** | **Costs** | ** ** | **Total**  | ** ** |
| ** **                            | ** ** | **(in thousands)** | ** ** |
| Balance as of  December 31, 2007 |       | $                       | 12,041     |           | $          | 16,124          |       | $         | —     |       | $          | — |   | $ | 28,165 |   |
| Accruals                              |       | 474                     |       | 2,005          |       | 313             |       | 470       |       | 3,262      |       |
| Payments                              |       | (12,502                 | )          | (2,433         | )          | —          |       | (470      | )          | (15,405    | )          |
| Non-cash charges                      |       | —                  |       | 548            |       | (313            | )          | —    |       | 235        |       |
| Balance as of  June 30, 2008     |       | $                       | 13         |           | $          | 16,244          |       | $         | —     |       | $          | — |   | $ | 16,257 |   |

 

Facilityexit and restructuring liabilities due within one year of the balance sheetdate are classified as other accounts payable and accrued liabilities andfacility exit and restructuring liabilities due after one year are classifiedas other long-term liabilities in the Condensed Consolidated Balance Sheets. Ofthe unpaid balance as of June 30, 2008, approximately $5.7 millionassociated with the 2007 Plan was classified as other accounts payable andaccrued liabilities and $10.6 million was classified as other long-termliabilities.

 

*Legacy Restructuring Plans*

 

EarthLinkperiodically evaluates and adjusts its estimates for facility exit andrestructuring costs for legacy restructuring plans based on currently-availableinformation. Such adjustments are included as facility exit, restructuring andother costs in the Condensed Consolidated Statements of Operations. During thethree and six months ended June 30, 2008, EarthLink recorded $0.1 millionand $0.2 million, respectively, in reductions to facility exit, restructuringand other costs as a result of changes in estimates for legacy restructuringplans.

 

**5.  Discontinued Operations**

 

In November 2007,management concluded that its municipal wireless broadband operations were nolonger consistent with the Company’s strategic direction and the Company’sBoard of Directors authorized management to pursue the divestiture of theCompany’s municipal wireless broadband assets. During the six months ended June 30,2008, the Company transferred its municipal wireless broadband networks to thecities of Corpus Christi, TX and Milpitas, CA in exchange for releasing theCompany from its existing network agreements. The Company also transferred itsmunicipal wireless broadband networks in the city of Philadelphia, PA to alocal Philadelphia company. Additionally, the Company terminated its municipalwireless broadband service in New Orleans, LA and Anaheim, CA and is removingits network equipment from those cities. The Company expects to complete thedivestiture of its remaining municipal wireless broadband assets during 2008.

 

TheCompany classified its municipal wireless broadband assets as held for sale inthe Condensed Consolidated Balance Sheets and presented the municipal wirelessbroadband results of operations as discontinued operations for all periodspresented. The municipal wireless broadband results of operations werepreviously included in the Consumer Services segment.

 

TheCompany recorded impairment and other costs of $5.9 million during the sixmonths ended June 30, 2008 related to the municipal wireless broadbandoperations, including $2.8 million for non-cash asset impairments andother non-cash charges; $0.2 million for severance and personnel-relatedcosts; and $2.9 million for other associated costs. These charges arereflected within discontinued operations in the Condensed ConsolidatedStatements of Operations.

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

Thefollowing table presents summarized results of operations related to theCompany’s discontinued operations for the three and six months ended June 30,2007 and 2008:

 

| ** **                                     | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                     | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                     | ** ** | **2007**                         | ** ** | **2008**                       | ** ** | **2007** | ** ** | **2008** | ** ** |
| ** **                                     | ** ** | **(in thousands)**          | ** ** |
| ** **                                     | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                       |       | $                                | 338        |                           | $          | 551 |   | $ | 597 |   | $ | 1,288 |   |
| Loss from  discontinued operations, net of tax |       | (9,309                           | )          | (4,365                         | )          | (16,913 | ) | (7,757 | ) |
|                                                |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |

 

Theassets of discontinued operations as of December 31, 2007 and June 30,2008 consisted primarily of property and equipment and the liabilities ofdiscontinued operations as of December 31, 2007 and June 30, 2008consisted primarily of accruals for purchases of property and equipment.Pursuant to SFAS No. 144, as of December 31, 2007 and June 30,2008, the assets were reported at their estimated fair value less costs to selland are no longer being depreciated.

 

**6.  Investments**

 

*Investments inmarketable securities*

 

Investmentsin marketable securities are accounted for in accordance with SFAS No. 115,“Accounting for Certain Investments in Debt and Equity Securities.” The Companyhas invested in government agency notes, asset-backed debt securities (includingauction rate securities), corporate notes and commercial paper, all of whichbear a minimum short-term rating of A1/P1 or a minimum long-term rating ofA/A2. All investments with original maturities greater than 90 days areclassified as investments in marketable securities. Investments in marketablesecurities with maturities less than one year from the balance sheet date areconsidered short-term investments in marketable securities. Investments inmarketable securities with maturities greater than one year from the balancesheet date are considered long-term investments in marketable securities.Long-term investments in marketable securities as of June 30, 2008 alsoinclude investments in asset-backed, auction rate securities with interest ratereset periods of 90 days or less but whose underlying agreements have originalmaturities of more than 90 days. These investments were included in short-terminvestments in marketable securities as of December 31, 2007.

 

As of June 30,2008, the Company’s long-term investments in marketable securities includedauction rate securities with a par value of $57.8 million and a fair value of$54.0 million. During the six months ended June 30, 2008, auctions forthese securities failed to attract sufficient buyers, resulting in the Companycontinuing to hold such securities. These securities are variable-rate debtinstruments whose underlying agreements have contractual maturities of up to 40years, but have interest rate reset periods at pre-determined intervals, usuallyevery 28 days. These securities are predominantly secured by student loansguaranteed by state related higher education agencies and reinsured by theUnited States Department of Education. The Company may not be able to accessthese funds until a successful auction occurs or until the underlying notesmature. Due to uncertainty surrounding the timing of a market recovery, theCompany has classified its auction rate securities as long-term investments inmarketable securities in the Condensed Consolidated Balance Sheet as of June 30,2008. As a result of temporary declines in the fair value of the Company’sauction rate securities, which the Company attributes to liquidity issuesrather than credit issues, it has recorded an unrealized loss of $3.8 millionas of June 30, 2008. The Company will continue to evaluate the fair valueof its investments in auction rate securities each reporting period for apotential other-than-temporary impairment.

 

TheCompany has classified all short- and long-term investments in marketablesecurities as available-for-sale. The Company may or may not hold itsinvestments in marketable securities until maturity. In response to changes inthe availability of and the yield on alternative investments as well asliquidity requirements, the Company occasionally sells its investments inmarketable securities prior to their stated maturities. Available for 

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

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, 2007, gross unrealized gains were $0.1 million and grossunrealized losses were nominal. As of June 30, 2008, gross unrealizedlosses were $3.8 million and gross unrealized gains were nominal. The Companybelieves its gross unrealized losses are temporary impairments as managementhas the intent and ability to hold these investments until maturity or untilthe market price fully recovers, at which time the Company would expect toreceive the amortized cost basis of the investments based on the underlyingcontractual arrangement.

 

*Investments inother companies*

 

Investmentsin other companies consisted of the following as of December 31, 2007 and June 30,2008:

 

| ** **                            | ** ** | **As of**          | ** ** | **As of**    | ** ** |
|---------------------------------------|------------|-------------------------|------------|-------------------|------------|
| ** **                            | ** ** | **December 31,**   | ** ** | **June 30,** | ** ** |
| ** **                            | ** ** | **2007**                | ** ** | **2008**          | ** ** |
| ** **                            | ** ** | **(in thousands)** | ** ** |
| Investments  stated at fair value     |       | $                       | 52,923     |              | $          | 125 |   |
| Investments  stated at cost           |       | 10,000                  |       | 9,300             |       |
| Total  investments in other companies |       | $                       | 62,923     |              | $          | 9,425 |   |

 

TheCompany accounts for minority investments in other companies under the costmethod of accounting and classifies investments in other companies which arepublicly traded as available-for-sale securities. Accordingly, the Companyadjusts the carrying values of those investments to market value throughunrealized gains (losses) included in stockholders’ equity and accumulatedother comprehensive income (loss). As of December 31, 2007, grossunrealized losses were $1.1 million and there were no gross unrealized gains.As of June 30, 2008, there were no gross unrealized losses or grossunrealized gains.

 

The Company’s investments in othercompanies as of December 31, 2007 included $5.3 million for 6.1 millionshares of Covad Communications Group, LLC (“Covad”) common stock and $47.5million aggregate principal amount of 12% Senior Secured Convertible Notes due2011 (the “Covad Notes”), including accrued and unpaid interest. In April 2008,Platinum Equity, LLC acquired all outstanding shares of Covad. Upon closing ofthe transaction, a change of control of Covad occurred, resulting in Covad’srepurchase of all Covad Notes held by EarthLink at a purchase price equal to100% of the principal amount thereof plus accrued and unpaid interest. As aresult, during the three months ended June 30, 2008, the Company receivedcash of $50.8 million for the aggregate principal amount of the Covad Notesplus accrued interest and received cash of $6.3 million for the 6.1 millionshares of common stock. The Company recognized a gain of $2.0 million based onits cost basis of the Covad common stock, which was classified as gain oninvestments in other companies, net, in the Condensed Consolidated Statementsof Operations.

 

Duringthe three months ended June 30, 2007, the Company received a $0.2 millioncash distribution from eCompanies Venture Group, L.P. (“EVG”), a limitedpartnership that has invested in domestic emerging Internet-related companies,which was recorded as gain on investments in other companies, net, in theCondensed Consolidated Statements of Operations.

 

Managementregularly evaluates the recoverability of its investments in other companiesbased on the performance and the financial position of those companies as wellas other evidence of market value. Such evaluation includes, but is not limitedto, reviewing the investee’s cash position, recent financings, projected andhistorical financial performance, cash flow forecasts and financing needs.During the three months ended June 30, 2008, the Company recognized animpairment loss of $0.7 million due to other-than-temporary declines of thevalue of its investments in other companies. This loss was classified withingain on investments in other companies, net, in the Condensed ConsolidatedStatements of Operations. During the three months ended June 

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

30,2007, the Company did not recognize any losses due to other-than-temporarydeclines of the value of its investments in other companies.

 

*Investment inequity affiliate*

 

TheCompany has a joint venture with SK Telecom Co., Ltd. (“SK Telecom”), HELIO.HELIO is a non-facilities-based mobile virtual network operator (“MVNO”)offering mobile communications services and handsets to U.S. consumers.  HELIO was formed in March 2005 and beganoffering its products and services in April 2006. As of June 30,2008, EarthLink had an approximate 32% economic ownership interest and 12%voting interest in HELIO, while SK Telecom had an approximate 67% economicownership interest and 88% voting interest in HELIO.

 

TheCompany accounts for its investment in HELIO under the equity method ofaccounting because the Company can exert significant influence over HELIO’soperating and financial policies.  TheCompany had been recording its proportionate share of HELIO’s net loss in its CondensedConsolidated Statements of Operations and amortizing the difference between thebook value and fair value of non-cash assets contributed to HELIO over theirestimated useful lives. The amortization increased the carrying value of theCompany’s investment and decreased the net losses of equity affiliate includedin the Condensed Consolidated Statements of Operations. During the three andsix months ended June 30, 2007, the Company recorded $40.1 million and$69.4 million, respectively, of net losses of equity affiliate related to itsHELIO investment, which is net of amortization of basis differences and certainother equity method accounting adjustments. During 2007, EarthLink discontinuedrecording additional net losses of equity affiliate because the carrying valueof its investments in HELIO were reduced to zero, and EarthLink is notcommitted to provide further financial support to HELIO.

 

In June 2008,Virgin Mobile USA, Inc. (“Virgin Mobile”) entered into an agreement toacquire HELIO in exchange for limited partnership units equivalent to 13million shares of Virgin Mobile common stock. EarthLink’s equity and debtinvestments in HELIO will be exchanged for limited partnership units equivalentto approximately 1.8 million shares of Virgin Mobile common stock, subject toadjustment upon closing in accordance with the terms of the transactionagreement. Following the transaction, EarthLink will have an approximate 2%ownership interest in Virgin Mobile. The transaction is expected to closeduring the third quarter of 2008.

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

**7.  Purchased Intangible Assets and Goodwill**

 

*Goodwill*

 

Duringthe six months ended June 30, 2008, the carrying amount of goodwilldecreased $12.8 million due to the utilization of net operating losscarryforwards acquired from OneMain.com, Inc., Cidco Incorporated,PeoplePC Inc. and New Edge Networks.

 

*Purchased Intangible Assets*

 

Thefollowing table presents the components of the Company’s acquired identifiableintangible assets included in the accompanying Condensed Consolidated BalanceSheets as of December 31, 2007 and June 30, 2008:

 
| ** **                                      | ** ** | **As of December 31, 2007** | ** ** | **As of June 30, 2008** | ** ** |
|-------------------------------------------------|------------|-------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                      | ** ** | **Gross**                                       | ** ** | ** **                                  | ** ** | **Net** | ** ** | **Gross** | ** ** | ** ** | ** ** | **Net** | ** ** |
| ** **                                      | ** ** | **Carrying**                                    | ** ** | **Accumulated**                             | ** ** | **Carrying** | ** ** | **Carrying** | ** ** | **Accumulated** | ** ** | **Carrying** | ** ** |
| ** **                                      | ** ** | **Value**                                       | ** ** | **Amortization**                            | ** ** | **Value** | ** ** | **Value** | ** ** | **Amortization** | ** ** | **Value** | ** ** |
| ** **                                      | ** ** | **(in thousands)**                         | ** ** |
| Intangible  assets subject to amortization:     |       |                                            |       |                                        |       |   |   |   |   |   |   |   |   |
| Subscriber bases  and customer relationships    |       | $                                               | 118,702    |                                        | $          | (79,763 | ) | $ | 38,939 |   | $ | 118,598 |   | $ | (87,090 | ) | $ | 31,508 |   |
| Software,  technology and other                 |       | 3,892                                           |       | (3,161                                      | )          | 731 |   | 739 |   | (529 | ) | 210 |   |
| Trade names                                     |       | —                                          |       | —                                      |       | — |   | 1,521 |   | (152 | ) | 1,369 |   |
|                                            |       | 122,594                                         |       | (82,924                                     | )          | 39,670 |   | 120,858 |   | (87,771 | ) | 33,087 |   |
| Intangible  assets not subject to amortization: |       |                                            |       |                                        |       |   |   |   |   |   |   |   |   |
| Trade names                                     |       | 6,606                                           |       | —                                      |       | 6,606 |   | 5,085 |   | — |   | 5,085 |   |
|                                            |       | $                                               | 129,200    |                                        | $          | (82,924 | ) | $ | 46,276 |   | $ | 125,943 |   | $ | (87,771 | ) | $ | 38,172 |   |

 

Amortizationof intangible assets in the Condensed Consolidated Statements of Operations forthe three and six months ended June 30, 2007 and 2008 represents theamortization of definite lived intangible assets.  The Company’s definite lived intangibleassets primarily consist of subscriber bases and customer relationships,acquired software and technology, certain trade names and other assets acquiredin conjunction with the purchases of businesses and subscriber bases from othercompanies that are not deemed to have indefinite lives. The Company’sidentifiable indefinite lived intangible assets consist of certain trade names.Definite lived intangible assets are amortized on a straight-line basis overtheir estimated useful lives, which are generally three to six years forsubscriber bases and customer relationships and three years for acquiredsoftware and technology.  As of June 30,2008, the weighted average amortization periods were 3.9 years for subscriberbase assets and customer relationships, 3.3 years for software and technologyand 5.0 years for trade names. Based on the current amount of definite livedintangible assets, the Company expects to record amortization expense ofapproximately $6.3 million during the remaining six months in the year ending December 31,2008 and $11.0 million, $7.5 million, $6.3 million and $2.0 million during theyears ending December 31, 2009, 2010, 2011 and 2012, respectively. Actualamortization expense to be reported in future periods could differ materiallyfrom these estimates as a result of asset acquisitions, changes in useful livesand other relevant factors.

 

Duringthe six months ended June 30, 2008, the Company wrote-off fully amortizeddefinite lived intangible assets, consisting of software and technology, with agross carrying value and accumulated amortization of $3.2 million.

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

**8.  Long-Term Debt**

 

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

 

TheNotes are payable with cash and, if applicable, convertible into shares of theCompany’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 the day the Notes are surrenderedfor conversion. The Notes will be convertible only in the followingcircumstances: (1) during any calendar quarter after the calendar quarterending December 31, 2006 (and only during such calendar quarter), if theclosing sale price of the Company’s common stock for each of 20 or more tradingdays in a period of 30 consecutive trading days ending on the last trading dayof the immediately preceding calendar quarter exceeds 130% of the conversionprice in effect on the last trading day of the immediately preceding calendarquarter; (2) during the five consecutive business days immediately afterany five consecutive trading day period in which the average trading price per$1,000 principal amount of Notes was equal to or less than 98% of the averageconversion value of the Notes during the note measurement period; (3) uponthe occurrence of specified corporate transactions; (4) if the Company hascalled the Notes for redemption; and (5) at any time from, and including, October 15,2011 to, and including, November 15, 2011 and at any time on or after November 15,2024.  The Company has the option toredeem the Notes, in whole or in part, for cash, on or after November 15,2011, provided that the Company had made at least ten semi-annual interestpayments. In addition, the holders may require the Company to purchase all or aportion of their notes on each of November 15, 2011, November 15,2016 and November 15, 2021.

 

As of December 31, 2007 and June 30,2008, the fair value of the Notes was approximately $262.0 million and $300.0million, respectively, based on the quoted market prices.

 

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

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

**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 SFAS No. 130,“Reporting Comprehensive Income.” Comprehensive income (loss) for the three andsix months ended June 30, 2007 and 2008 was as follows:

 

| ** **                                                             | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                             | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                             | ** ** | **2007**                         | ** ** | **2008**                       | ** ** | **2007** | ** ** | **2008** | ** ** |
| ** **                                                             | ** ** | **(in thousands)**          | ** ** |
| Net income  (loss)                                                     |       | $                                | (16,290    | )                              | $          | 53,326 |   | $ | (46,252 | ) | $ | 107,690 |   |
| Net unrealized holding  losses on investments                          |       | (2,255                           | )          | (767                           | )          | (6,798 | ) | (1,024 | ) |
| Reclassification  adjustment for realized gains on certain investments |       | —                           |       | (1,779                         | )          | — |   | (1,779 | ) |
| Total  comprehensive income (loss)                                     |       | $                                | (18,545    | )                              | $          | 50,780 |   | $ | (53,050 | ) | $ | 104,887 |   |

 

*ShareRepurchases*

 

Sincethe inception of the Company’s share repurchase program, the Board of Directorshas authorized a total of $750.0 million for the repurchase of EarthLink’scommon stock. As of June 30, 2008, the Company had $191.8 millionavailable under the current authorizations. The Company may repurchase itscommon stock from time to time in compliance with Securities and ExchangeCommission regulations and other legal requirements, including through the useof derivative transactions, and subject to market conditions and other factors.The share repurchase program does not require the Company to acquire anyspecific number of shares and may be terminated by the Board of Directors atany time.

 

TheCompany repurchased 1.3 million shares of its common stock for $9.1 millionduring the six months ended June 30, 2008. The Company did not repurchaseany shares of its common stock during the three months ended June 30, 2008 orduring the three and six months ended June 30, 2007.

 

*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 Company purchased call options in privatetransactions to cover approximately 28.4 million shares of the Company’s commonstock at a strike price of $9.12 per share, subject to adjustment in certaincircumstances, for $47.2 million. The call options generally allow the Companyto receive shares of the Company’s common stock from counterparties equal tothe number of shares of common stock payable to the holders of the Notes uponconversion. These call options will terminate at the earlier of the maturitydates of the related senior convertible notes or the first day all of therelated senior convertible notes are no longer outstanding due to conversion orotherwise.  As of December 31, 2007and June 30, 2008, the estimated fair value of the call options was $43.8million and $69.6 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 in March 2012 through July 2012.  The warrants provide for net sharesettlement. In no event shall the Company be required to deliver a number ofshares in connection with the transaction in excess of twice the aggregatenumber of warrants. As of December 31, 2007 and June 30, 2008, theestimated fair value of the warrants was $28.0 million and $57.1 million,respectively.

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

TheCompany has analyzed the Call Spread Transactions under Emerging Issues TaskForce Issue No. 00-19, “Accounting for Derivative Financial InstrumentsIndexed to, and Potentially Settled In, a Company’s Own Stock,” and otherrelevant literature, and determined that they meet the criteria forclassification as equity transactions. As a result, the Company recorded thepurchase of the call options as a reduction in additional paid-in capital andthe proceeds of the warrants as an addition to paid-in capital, and the Companywill not recognize subsequent changes in fair value of the agreements.

 

**10.  Stock-Based Compensation**

 

TheCompany accounts for stock-based compensation pursuant to SFAS No. 123(R),“Share-Based Payment,” which requires measurement of compensation cost for allstock awards at fair value on the date of grant and recognition of compensationexpense over the requisite service period for awards expected to vest. The Companyestimates the fair value of stock options using the Black-Scholes valuationmodel, and determines the fair value of restricted stock units based on thenumber of shares granted and the quoted price of EarthLink’s common stock onthe date of grant*.* Such value isrecognized as expense over the requisite service period, net of estimatedforfeitures, using the straight-line attribution method. The estimate of awardsthat will ultimately vest requires significant judgment, and to the extentactual results or updated estimates differ from the Company’s currentestimates, such amounts will be recorded as a cumulative adjustment in theperiod estimates are revised. The Company considers many factors whenestimating expected forfeitures, including types of awards, employee class andhistorical employee attrition rates. Actual results, and future changes inestimates, may differ substantially from the Company’s current estimates.

 

Stock-basedcompensation expense under SFAS No. 123(R) was $2.9 million and $4.5million during the three months ended June 30, 2007 and 2008,respectively, and $10.8 million and $9.7 million during the six months ended June 30,2007 and 2008, respectively.  Inaccordance with Staff Accounting Bulletin No. 107, the Company hasclassified stock-based compensation expense during the three and six monthsended June 30, 2007 and 2008 within the same operating expense line itemsas cash compensation paid to employees.

 

*StockIncentive Plans*

 

TheCompany has granted options to employees and directors to purchase the Company’scommon stock under various stock incentive plans. The Company has also grantedrestricted stock units to employees and directors under various stock incentiveplans. Under the plans, employees and non-employee directors are eligible toreceive awards of various forms of equity-based incentive compensation,including stock options, restricted stock, restricted stock units, phantomshare units and performance awards, among others. The plans are administered bythe Board of Directors or the Leadership and Compensation Committee of theBoard of Directors, which determine the terms of the awards granted. Stockoptions are generally granted with an exercise price equal to the market valueof EarthLink, Inc. common stock on the date of grant, have a term of tenyears or less and vest over terms of four to six years from the date of grant.Restricted stock units are granted with various vesting terms that range fromone to six years from the date of grant.

 

*Deferred Compensation Plan*

 

TheCompany’s Second Deferred Compensation Plan for Directors and Certain KeyEmployees permits members of the Board of Directors and eligible employees toelect to defer receipt of shares of common stock pursuant to vested restrictedstock units and various cash consideration, such as directors’ fees andbonuses. The cash consideration is converted into phantom share units at theclosing price on the date the consideration would otherwise be paid, and vestedrestricted stock units are converted into phantom share units on a one-for-onebasis. Phantom share units are fully vested at the date of grant and areconverted to common stock upon the occurrence of various events. As of December 31,2007 and June 30, 2008, approximately 43,000 and 17,000 phantom shareunits were outstanding, respectively.

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

*OptionsOutstanding*

 

Thefollowing table summarizes information concerning stock option activity as ofand for the six months ended June 30, 2008:

 

| ** **                                            | ** ** | ** **                                                | ** ** | ** **   | ** ** | **Weighted**          | ** ** | ** **    | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------------------|------------|--------------|------------|-----------------------|------------|---------------|------------|
| ** **                                            | ** ** | ** **                                                | ** ** | **Weighted** | ** ** | **Average**           | ** ** | ** **    | ** ** |
| ** **                                            | ** ** | ** **                                                | ** ** | **Average**  | ** ** | **Remaining**         | ** ** | **Aggregate** | ** ** |
| ** **                                            | ** ** | ** **                                                | ** ** | **Exercise** | ** ** | **Contractual**       | ** ** | **Intrinsic** | ** ** |
| ** **                                            | ** ** | **Stock Options**                                    | ** ** | **Price**    | ** ** | **Term (Years)** | ** ** | **Value**     | ** ** |
| ** **                                            | ** ** | **(shares and dollars in thousands)** | ** ** |
|                                                  |       |                                                      |       |         |       |                  |       |          |       |
| Outstanding as  of December 31, 2007             |       | 13,427                                                    |       | $            | 10.69      |                  |       |          |       |   |
| Granted                                               |       | 164                                                       |       | 7.73         |       |                  |       |          |       |
| Exercised                                             |       | (854                                                      | )          | 6.89         |       |                  |       |          |       |
| Forfeited and  expired                                |       | (2,397                                                    | )          | 12.63        |       |                  |       |          |       |
| Outstanding as  of June 30, 2008                 |       | 10,340                                                    |       | $            | 10.51      |                  | 6.0        |          | $          | 7,061 |   |
|                                                  |       |                                                      |       |         |       |                  |       |          |       |
| Vested and  expected to vest as of June 30, 2008 |       | 9,513                                                     |       | $            | 10.75      |                  | 5.7        |          | $          | 6,061 |   |
|                                                  |       |                                                      |       |         |       |                  |       |          |       |
| Exercisable as  of June 30, 2008                 |       | 7,207                                                     |       | $            | 11.67      |                  | 5.0        |          | $          | 3,473 |   |

 

The aggregate intrinsic valueamounts in the table above represent the closing price of the Company’s commonstock on June 30, 2008 in excess of the exercise price, multiplied by thenumber of stock options outstanding or exercisable, when the closing price isgreater than the exercise price. This represents the amount that would havebeen received by the stock option holders if they had all exercised their stockoptions on June 30, 2008. The total intrinsic value of options exercisedduring the three and six months ended June 30, 2007 was $0.4 million and$1.2 million, respectively. The total intrinsic value of options exercisedduring the three and six months ended June 30, 2008 was $1.0 million and$1.5 million, respectively. The intrinsic value of stock options exercisedrepresents the difference between the price of the Company’s common stock atthe time of exercise and the exercise price, multiplied by the number of stockoptions exercised. To the extent the forfeiture rate is different than what theCompany has anticipated, stock-based compensation related to these awards willbe different from the Company’s expectations.

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

Thefollowing table summarizes the status of the Company’s stock options as of June 30,2008:

 
| ** **                              | ** ** | ** **      | ** ** | ** **            | ** ** | ** **              | ** ** | ** **      | ** ** | ** **   | ** ** | **Stock Options**  | ** ** |
|-----------------------------------------|------------|-----------------|------------|-----------------------|------------|-------------------------|------------|-----------------|------------|--------------|------------|-------------------------|------------|
| **Stock Options Outstanding** | ** ** | **Exercisable** | ** ** |
| ** **                              | ** ** | ** **      | ** ** | ** **            | ** ** | ** **              | ** ** | **Weighted**    | ** ** | ** **   | ** ** | ** **              | ** ** | ** ** | ** ** |
| ** **                              | ** ** | ** **      | ** ** | ** **            | ** ** | ** **              | ** ** | **Average**     | ** ** | **Weighted** | ** ** | ** **              | ** ** | **Weighted** | ** ** |
| ** **                              | ** ** | ** **      | ** ** | ** **            | ** ** | ** **              | ** ** | **Remaining**   | ** ** | **Average**  | ** ** | ** **              | ** ** | **Average** | ** ** |
| **Range of**                       | ** ** | **Number**      | ** ** | **Contractual**       | ** ** | **Exercise**            | ** ** | **Number**      | ** ** | **Exercise** | ** ** |
| **Exercise Prices**                | ** ** | **Outstanding** | ** ** | **Life (Years)** | ** ** | **Price**               | ** ** | **Exercisable** | ** ** | **Price**    | ** ** |
| ** **                              | ** ** | ** **      | ** ** | ** **            | ** ** | **(in thousands)** | ** ** | ** **      | ** ** | ** **   | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| $                                       | 5.10       |            | to         |                  | $          | 6.86                    |       | 1,015           |       | 5.5          |       | $                       | 5.91       |   | 625 |   | $ | 5.71 |   |
| 6.86                                    |       | to              |       | 7.25                  |       | 1,082                   |       | 8.5             |       | 6.97         |       | 307                     |       | 6.95 |   |
| 7.25                                    |       | to              |       | 7.31                  |       | 1,500                   |       | 9.0             |       | 7.31         |       | 700                     |       | 7.31 |   |
| 7.31                                    |       | to              |       | 9.01                  |       | 1,398                   |       | 6.6             |       | 8.54         |       | 1,004                   |       | 8.73 |   |
| 9.01                                    |       | to              |       | 9.64                  |       | 1,114                   |       | 5.7             |       | 9.52         |       | 655                     |       | 9.56 |   |
| 9.64                                    |       | to              |       | 10.06                 |       | 987                     |       | 2.2             |       | 10.06        |       | 987                     |       | 10.06 |   |
| 10.06                                   |       | to              |       | 11.38                 |       | 1,699                   |       | 6.8             |       | 10.57        |       | 1,404                   |       | 10.58 |   |
| 11.38                                   |       | to              |       | 48.61                 |       | 1,545                   |       | 2.7             |       | 21.81        |       | 1,525                   |       | 21.94 |   |
| $                                       | 5.10       |            | to         |                  | $          | 48.61                   |       | 10,340          |       | 6.0          |       | $                       | 10.51      |   | 7,207 |   | $ | 11.67 |   |

 

*Valuation Assumptions for Stock Options*

 

Thefair value of stock options granted during the six months ended June 30,2007 and 2008 was estimated using the Black-Scholes option-pricing model withthe following assumptions:

 

| ** **               | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------|------------|---------------------------------------------------|------------|
| ** **               | ** ** | **2007**                                          | ** ** | **2008** | ** ** |
|                     |       |                                              |       |   |   |
| Dividend yield           |       | 0                                                 | %          | 0 | % |
| Expected  volatility     |       | 39                                                | %          | 39 | % |
| Risk-free  interest rate |       | 4.88                                              | %          | 3.00 | % |
| Expected life            |       | 4.3 years                                         |       | 4.2 years |   |

 

The weightedaverage grant date fair value of options granted during the six months ended June 30,2007 and 2008 was $2.83 and $2.71, 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 curvein effect at the time of grant for periods corresponding with the expected lifeof the option. The expected life of employee stock options represents theweighted-average period the stock options are expected to remain outstanding.

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

*RestrictedStock Units*

 

The following table summarizes theCompany’s restricted stock units as of and for the six months ended June 30,2008:

 

| ** **                              | ** ** | ** **           | ** ** | **Weighted**        | ** ** |
|-----------------------------------------|------------|----------------------|------------|---------------------|------------|
| ** **                              | ** ** | ** **           | ** ** | **Average**         | ** ** |
| ** **                              | ** ** | **Restricted**       | ** ** | **Grant Date** | ** ** |
| ** **                              | ** ** | **Stock Units** | ** ** | **Fair Value** | ** ** |
|                                    |       |                 |       |                |       |
| Nonvested as of  December 31, 2007 |       | 2,061,000            |       | $                   | 7.17       |   |
| Granted                                 |       | 3,540,000            |       | 7.19                |       |
| Vested                                  |       | (531,000             | )          | 7.08                |       |
| Forfeited                               |       | (312,000             | )          | 7.08                |       |
| Nonvested as of  June 30, 2008     |       | 4,758,000            |       | 7.20                |       |
|                                         |            |                      |            |                     |            |  |

 

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 six months ended June 30, 2007and 2008 was $7.40 and $7.19, respectively. As June 30, 2008, there was$23.6 million of total unrecognized compensation cost related to nonvestedrestricted stock units. That cost is expected to be recognized over aweighted-average period of 2.4 years. The total fair value of shares vestedduring the six months ended June 30, 2007 and 2008 was $1.3 million and$4.9 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**

 

EarthLinkrecorded an income tax provision from continuing operations of $6.7 million and$16.0 million during the three and six months ended June 30, 2008,respectively. The income tax provision is based on management’s currentexpectations for the results of operations for the year ending December 31,2008 in accordance with the interim reporting requirements of SFAS No. 109,“Accounting for Income Taxes,” Accounting Principles Board (“APB”) Opinion No. 28,“Interim Financial Reporting,” and FASB Interpretation No. 18 “Accountingfor Income Taxes in Interim Periods — an interpretation of APB Opinion No. 28.”

 

Themajor components of the income tax provision for the three and six months endedJune 30, 2007 and 2008 are as follows:

 

| ** **                       | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                       | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                       | ** ** | **2007**                         | ** ** | **2008**                       | ** ** | **2007** | ** ** | **2008** | ** ** |
| ** **                       | ** ** | **(in millions)**           | ** ** |
|                             |       |                             |       |                           |       |   |   |   |   |
| Federal  alternative minumum tax |       | $                                | —     |                           | $          | 1.2 |   | $ | — |   | $ | 2.4 |   |
| State income tax                 |       | 0.1                              |       | 0.5                            |       | 0.3 |   | 1.3 |   |
| Other                            |       | —                           |       | —                         |       | — |   | (0.5 | ) |
| Current  provision               |       | 0.1                              |       | 1.7                            |       | 0.3 |   | 3.2 |   |
|                             |       |                             |       |                           |       |   |   |   |   |
| Deferred  provision              |       | 0.1                              |       | 5.0                            |       | 0.1 |   | 12.8 |   |
|                             |       |                             |       |                           |       |   |   |   |   |
| Total                            |       | $                                | 0.2        |                           | $          | 6.7 |   | $ | 0.4 |   | $ | 16.0 |   |

 

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** **

**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

Adiscrete item has been recorded during the six months ended June 30, 2008for a change in valuation allowance resulting from a change in classificationof an indefinite lived intangible asset to a definite lived intangible asset,corresponding to a decrease in the valuation allowance which resulted in a taxbenefit of $0.5 million. The non-cash deferred tax provision has been recordedfor estimated utilization of federal and state net operating loss carryforwardsacquired from OneMain.com, Inc., Cidco Incorporated, PeoplePC Inc., andNew Edge Networks.  The associated reduction in the valuation allowance dueto the expected utilization of these acquired federal and state net operatinglosses has been recorded as a reduction to goodwill and not as a benefit toincome taxes.  The current AMT liability is payable as a result of netoperating loss carryforward limitations associated with the AMT calculation.

 

EarthLinkcontinues to maintain a full valuation allowance against its unrealizeddeferred tax assets, which include net operating loss carryforwards. EarthLink may recognize deferred tax assets in future periods when they aredetermined to be more likely than not realizable.  To the extent EarthLinkreports income in future periods, EarthLink intends to use its net operatingloss carryforwards to the extent available to offset taxable income and reducecash outflows for income taxes.  The Company’s ability to use its federaland state net operating loss carryforwards and federal and state tax creditcarryforwards may be subject to restrictions attributable to equitytransactions in the future resulting from changes in ownership as defined underthe Internal Revenue Code.

 

On January 1,2007, EarthLink adopted Financial Interpretation (“FIN”) No. 48.  TheCompany has identified its federal tax return and its state tax returns inCalifornia, Florida, Georgia and Illinois as “major” tax jurisdictions, asdefined in FIN No. 48.  Periods extending back to 1994 are stillsubject to examination for all “major” jurisdictions. The adoption of FIN No. 48on January 1, 2007 did not result in a material cumulative-effect adjustment.The Company believes that its income tax filing positions and deductions willbe sustained on audit and does not anticipate any adjustments that will resultin material adverse effect on the Company’s financial condition, results ofoperations or cash flows.  The Company’s policy for recording interest andpenalties associated with audits is to record such items as a component ofincome taxes.  No adjustments were madeto the FIN 48 liability during the quarter.

 

**12. Related Party Transactions**

 

EarthLinkand HELIO have entered into a services agreement pursuant to which EarthLinkprovides HELIO billing and other support services in exchange for managementfees. The management fees were determined based on EarthLink’s costs to providethe services, and management believes such fees are reasonable.  The total amount of fees that HELIO pays toEarthLink depends on the extent to which HELIO utilizes EarthLink’sservices.  Fees for services provided toHELIO are reflected as reductions to the associated expenses incurred byEarthLink to provide such services. During the three months ended June 30,2007 and 2008, fees received for services provided to HELIO were $0.5 millionand $0.3 million, respectively. During the six months ended June 30, 2007and 2008, fees received for services provided to HELIO were $0.9 million and$0.7 million, respectively.

 

EarthLinkpurchases wireless Internet access devices and services from HELIO. During thethree months ended June 30, 2007 fees paid for products and servicesreceived from HELIO were $0.2 and during the three months ended June 30,2008 fees paid for products and services received from HELIO were nominal.During the six months ended June 30, 2007 and 2008, fees paid for productsand services received from HELIO were $0.3 million and $0.1 million,respectively.

 

As of December 31,2007 and June 30, 2008, the Company had accounts receivable from HELIO ofapproximately $0.2 million and $0.2 million, respectively.

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

**13.  Fair Value Measurements**

 

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

 

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

 

As of June 30,2008, the Company held certain assets that are required to be measured at fairvalue on a recurring basis.  These included the Company’s investmentsin marketable securities, including auction rate securities and investments inother companies.

 

Thefollowing table presents the Company’s assets measured at fair value on arecurring basis subject to the disclosure requirements of SFAS No. 157 asof June 30, 2008:

 
| ** **                                  | ** ** | ** **                  | ** ** | **Fair Value Measurements as of June 30, 2008 Using** | ** ** |
|---------------------------------------------|------------|-----------------------------|------------|-----------------------------------------------------------------------------------------------|------------|
| ** **                                  | ** ** | ** **                  | ** ** | **Quoted Prices in**                                                                | ** ** | **Significant Other** | ** ** | **Significant** | ** ** |
| ** **                                  | ** ** | ** **                  | ** ** | **Active Markets for**                                                              | ** ** | **Observable** | ** ** | **Unobservable** | ** ** |
| ** **                                  | ** ** | **Balance as of** | ** ** | **Identical Assets**                                                                     | ** ** | **Inputs** | ** ** | **Inputs** | ** ** |
| **Description**                             | ** ** | **June 30, 2008** | ** ** | **(Level 1)**                                                                            | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| ** **                                  | ** ** | **(in thousands)**     | ** ** |
| Auction rate  securities                    |       | $                           | 53,952     |                                                                                          | $          | — |   | $ | — |   | $ | 53,952 |   |
| Other  investments in marketable securities |       | 12,787                      |       | 12,787                                                                                        |       | — |   | — |   |
| Investments in  other companies             |       | 125                         |       | 125                                                                                           |       | — |   | — |   |
| Total                                       |       | $                           | 66,864     |                                                                                          | $          | 12,912 |   | $ | — |   | $ | 53,952 |   |

 

Investmentsin marketable securities, other than auction rate securities, and equityinvestments in other companies are measured at fair value using quoted marketprices and are classified within Level 1 of the valuation hierarchy. TheCompany has consistently applied these valuation techniques in all periodspresented.

 

TheCompany has invested in auction rate securities, which are more fully describedin Note 6, “Investments.”  Due to recent events in the creditmarkets, these instruments held by the Company failed to attract sufficientbuyers during the six months ended June 30, 2008.  Due to thelack of availability of observable market quotes, the fair values of theCompany’s auction rate securities were estimated utilizing a discounted cashflow analysis as of June 30, 2008.  These analyses consider,among other items, the collateralization underlying the security investments,the creditworthiness of the counterparty, and the timing and value of expectedfuture cash flows.  These securities were also compared, whenpossible, to other observable market data with similar characteristics to thesecurities held by the Company.

 

Basedon market conditions, the Company changed its valuation methodology for auctionrate securities to a discounted cash flow analysis during the six months ended June 30,2008.  Accordingly, these securities changed from Level 1 to Level 3within SFAS No. 157’s hierarchy since the Company’s initial adoption ofSFAS No. 157 on January 1, 2008.

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

Thefollowing table presents the Company’s assets measured at fair value on arecurring basis using significant unobservable inputs (Level 3) as defined inSFAS No. 157 as of June 30, 2008:

 

| ** **                                | ** ** | **Auction**             | ** ** |
|-------------------------------------------|------------|-------------------------|------------|
| ** **                                | ** ** | **Rate**                | ** ** |
| ** **                                | ** ** | **Securities**          | ** ** |
| ** **                                | ** ** | **(in thousands)** | ** ** |
| **Balance  as of December 31, 2007** |       | $                       | —     |   |
| Transfers to  Level 3                     |       | 38,900                  |       |
| Total unrealized  losses                  |       | (3,798                  | )          |
| Purchases and  settlements (net)          |       | 18,850                  |       |
| **Balance  as of June 30, 2008**     |       | $                       | 53,952     |   |

 

The $3.8 million of unrealizedlosses are included in unrealized losses on investments as a separate componentof stockholders’ equity and in total comprehensive income (loss) and relate toassets held as of June 30, 2008.

 

**14.  Segment Information**

 

Inaccordance with SFAS No. 131, “Disclosures about Segments of an Enterpriseand Related Information,” the Company reports segment information along thesame lines that its chief executive reviews its operating results in assessingperformance and allocating resources. The Company operates two reportablesegments, Consumer Services and Business Services, which are described below inmore 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 Internet access services and relatedvalue-added services to individual customers. These services include dial-upand high-speed Internet access and voice services, among others. The Company’sBusiness Services segment provides Internet access services and relatedvalue-added services to businesses and communications carriers. These servicesinclude managed data networks, dedicated Internet access and web hosting, amongothers.

 

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 inthe measurement of segment performance.

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

Information on reportable segments and a reconciliation to consolidatedincome from operations for the three and six months ended June 30, 2007and 2008 is as follows:

 
| ** **                                    | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                    | ** ** | **2007**                                            | ** ** | **2008**                                          | ** ** | **2007** | ** ** | **2008** | ** ** |
| ** **                                    | ** ** | **(in thousands)**                             | ** ** |
| **Consumer  Services**                        |       |                                                |       |                                              |       |   |   |   |   |
| Revenues                                      |       | $                                                   | 263,778    |                                              | $          | 201,197 |   | $ | 540,171 |   | $ | 417,541 |   |
| Cost of revenues                              |       | 84,276                                              |       | 67,331                                            |       | 168,629 |   | 138,503 |   |
| Gross margin                                  |       | 179,502                                             |       | 133,866                                           |       | 371,542 |   | 279,038 |   |
| Direct segment  operating expenses            |       | 133,742                                             |       | 53,692                                            |       | 293,074 |   | 114,693 |   |
| Segment  operating income                     |       | $                                                   | 45,760     |                                              | $          | 80,174 |   | $ | 78,468 |   | $ | 164,345 |   |
|                                          |       |                                                |       |                                              |       |   |   |   |   |
| **Business  Services**                        |       |                                                |       |                                              |       |   |   |   |   |
| Revenues                                      |       | $                                                   | 48,088     |                                              | $          | 44,406 |   | $ | 95,842 |   | $ | 91,136 |   |
| Cost of revenues                              |       | 29,433                                              |       | 25,157                                            |       | 59,475 |   | 51,536 |   |
| Gross margin                                  |       | 18,655                                              |       | 19,249                                            |       | 36,367 |   | 39,600 |   |
| Direct segment  operating expenses            |       | 16,118                                              |       | 11,957                                            |       | 32,787 |   | 26,827 |   |
| Segment  operating income                     |       | $                                                   | 2,537      |                                              | $          | 7,292 |   | $ | 3,580 |   | $ | 12,773 |   |
|                                          |       |                                                |       |                                              |       |   |   |   |   |
| **Consolidated**                              |       |                                                |       |                                              |       |   |   |   |   |
| Revenues                                      |       | $                                                   | 311,866    |                                              | $          | 245,603 |   | $ | 636,013 |   | $ | 508,677 |   |
| Cost of revenues                              |       | 113,709                                             |       | 92,488                                            |       | 228,104 |   | 190,039 |   |
| Gross margin                                  |       | 198,157                                             |       | 153,115                                           |       | 407,909 |   | 318,638 |   |
| Direct segment  operating expenses            |       | 149,860                                             |       | 65,649                                            |       | 325,861 |   | 141,520 |   |
| Segment  operating income                     |       | 48,297                                              |       | 87,466                                            |       | 82,048 |   | 177,118 |   |
| Stock-based  compensation expense             |       | 2,898                                               |       | 4,569                                             |       | 10,778 |   | 9,722 |   |
| Amortization of  intangible assets            |       | 3,542                                               |       | 3,987                                             |       | 7,038 |   | 8,000 |   |
| Facility exit,  restructuring and other costs |       | —                                              |       | 2,061                                             |       | — |   | 3,091 |   |
| Other operating  expenses                     |       | 12,365                                              |       | 12,998                                            |       | 31,086 |   | 27,040 |   |
| Income from  operations                       |       | $                                                   | 29,492     |                                              | $          | 63,851 |   | $ | 33,146 |   | $ | 129,265 |   |

 

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

 

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 

 

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**EARTHLINK, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**UNAUDITED - (Continued)**

 

datanetworks for small and medium-sized businesses; installation fees; terminationfees; fees for equipment; regulatory surcharges billed to customers; and webhosting.

 

Informationon revenues by groups of similar services and by segment for the three and sixmonths ended June 30, 2007 and 2008 is as follows:

 

| ** **             | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **             | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **             | ** ** | **2007**                         | ** ** | **2008**                       | ** ** | **2007** | ** ** | **2008** | ** ** |
| ** **             | ** ** | **(in thousands)**          | ** ** |
| **Consumer  Services** |       |                             |       |                           |       |   |   |   |   |
| Access and  service    |       | $                                | 231,392    |                           | $          | 176,280 |   | $ | 474,192 |   | $ | 365,251 |   |
| Value-added  services  |       | 32,386                           |       | 24,917                         |       | 65,979 |   | 52,290 |   |
| Total revenues         |       | $                                | 263,778    |                           | $          | 201,197 |   | $ | 540,171 |   | $ | 417,541 |   |
|                   |       |                             |       |                           |       |   |   |   |   |
| **Business  Services** |       |                             |       |                           |       |   |   |   |   |
| Access and  service    |       | $                                | 47,327     |                           | $          | 43,761 |   | $ | 94,282 |   | $ | 89,639 |   |
| Value-added  services  |       | 761                              |       | 645                            |       | 1,560 |   | 1,497 |   |
| Total revenues         |       | $                                | 48,088     |                           | $          | 44,406 |   | $ | 95,842 |   | $ | 91,136 |   |
|                   |       |                             |       |                           |       |   |   |   |   |
| **Consolidated**       |       |                             |       |                           |       |   |   |   |   |
| Access and  service    |       | $                                | 278,719    |                           | $          | 220,041 |   | $ | 568,474 |   | $ | 454,890 |   |
| Value-added  services  |       | 33,147                           |       | 25,562                         |       | 67,539 |   | 53,787 |   |
| Total revenues         |       | $                                | 311,866    |                           | $          | 245,603 |   | $ | 636,013 |   | $ | 508,677 |   |

 

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.

 

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

 

Certain statements in this Quarterly Report on Form 10-Qare forward-looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995, Section 27A of the Securities Act of 1933,and Section 21E of the Securities Exchange Act of 1934. The words “estimate,”“plan,” “intend,” “expect,” “anticipate,” “believe” and similar expressions areintended to identify forward-looking statements. These forward-lookingstatements are found at various places throughout this report. EarthLinkdisclaims any intention or obligation to update or revise any forward-lookingstatements, whether as a result of new information, future events or otherwise.Although EarthLink believes that its expectations are based on reasonableassumptions, it can give no assurance that its goals will be achieved.Important factors that could cause actual results to differ from estimates orprojections contained in the forward-looking statements are described under “SafeHarbor Statement” in this Item 2.

* *

***The following discussion should be read inconjunction with the accompanying unaudited Condensed Consolidated FinancialStatements and related Notes thereto and with “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” and the auditedConsolidated Financial Statements and the Notes thereto contained in the AnnualReport on Form 10-K for the year ended December 31, 2007.*

* *

**Overview**

 

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

 

Weoperate two reportable segments, Consumer Services and Business Services. OurConsumer Services segment provides Internet access and related value-addedservices to individual customers. These services include dial-up and high-speedInternet access and voice services, among others. Our Business Services segmentprovides Internet access and related value-added services to businesses andcommunications carriers. These services include managed data networks,dedicated Internet access and web hosting, among others.

 

*IndustryBackground*

* *

Weoperate in the Internet access market, which is characterized by intensecompetition, changing technology, evolving industry standards, changes incustomer needs and new service and product introductions. The Internet accessmarket has reached a mature stage of growth; however, growth is expected tocontinue 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 addition,advanced applications such as online gaming, music downloads and photo sharingrequire greater bandwidth for optimal performance, which adds to the demand forbroadband access. However, analysts predict a continuing market for dial-upcustomers.

 

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*RevenueSources*

* *

Weprovide access services (including traditional, fully-featured narrowbandaccess and value-priced narrowband access; high-speed access via DSL, cable andsatellite; IP-based voice; and high-speed data networks for small andmedium-sized businesses and communications carriers) and value-added services(including ancillary services sold as an add-on feature to our services, searchand advertising). We earn revenues primarily from monthly fees charged tocustomers for services. We also earn revenues from usage fees; installationfees; termination fees; and fees for equipment used to access our services.Total revenues were $311.9 million and $245.6 million during the three monthsended June 30, 2007 and 2008, respectively. Our traditional,premium-priced narrowband revenues have been declining due to the maturity ofthis service. Our revenues also declined over the past year due to a change inour business strategy to reduce sales and marketing activities which resultedin adding customers that did not provide an acceptable rate of return or thathad a pattern of early life churn.

 

*BusinessStrategy and Risks*

* *

Inresponse to declining revenues, changes in our industry and changes in consumerbehavior, we completed a comprehensive review of our core access servicesduring the latter half of 2007. We also reviewed each of our prior growthinitiatives to evaluate whether these initiatives were complementary to ourlong-term strategy and allowed us to maximize shareholder value. As a result ofthese reviews, we implemented a restructuring plan (“the 2007 Plan”) to reduceoperating costs and improve the efficiency of our organization. Under the 2007Plan, we significantly reduced employees, closed or consolidated certainfacilities, discontinued certain projects and reduced sales and marketingefforts. For our core access services, we reduced the back-office coststructure and reduced sales and marketing efforts aimed at customers that hadhigh acquisition costs and early life churn. For our IP-based voice andbusiness services, we significantly reduced the cost structure. For ourmunicipal wireless broadband operations, we concluded that the operations wereno longer consistent with our strategic direction and have finalized plans todivest our municipal wireless broadband assets. Finally, we discontinuedfurther investments in HELIO, our joint venture with SK Telecom Co., Ltd. (“SKTelecom”).

 

Ourcurrent business focus is the following:

 

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

 

·                  *Customer Retention*. We are focused on retaining our existing tenuredcustomers. We continue to focus on offering reasonably priced access withhigh-quality customer service and technical support. We believe focusing on thecustomer relationship will increase loyalty and reduce churn.  We also believe that these tenured customersprovide cost benefits, including reduced call center support costs and reducedbad debt expense.

 

·                  *Opportunities for growth*.  In responseto changes in our business, we have significantly reduced our sales andmarketing spending. However, we are focused on continuing to add customers thatgenerate an acceptable rate of return and increasing the number of subscriberswe add through partnerships and acquisitions from other ISPs.  We will evaluate potential strategictransactions that could complement our business. We are also focused on addingcustomers organically by growing our services to business customers through NewEdge, our wholly-owned subsidiary. We believe this is a potential growth marketand we will continue to differentiate ourselves by providing customers withchoices for our business services.

 

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Theprimary challenges we face in executing our business strategy are managing therate of decline in our revenues, responding to competition, reducing churn,maintaining profitability in our access services, purchasing cost-effective wholesalebroadband access and adding customers that generate an acceptable rate ofreturn. The factors we believe are instrumental to the achievement of our goalsand targets, including the factors identified above, may be subject tocompetitive, regulatory and other events and circumstances that are beyond ourcontrol. Further, we can provide no assurance that we will be successful inachieving any or all of the factors identified above, that the achievement orexistence of such factors will favorably impact profitability, or that otherfactors will not arise that would adversely affect future profitability.

 

*Second Quarter2008 Highlights*

* *

Totalrevenues decreased during the three months ended June 30, 2008 compared tothe prior year period. In addition, our subscriber base decreased fromapproximately 4.3 million paying subscribers as of June 30, 2007 toapproximately 3.3 million paying subscribers as of June 30, 2008. Thedecrease in subscribers consisted primarily of decreases in premium narrowbandand PeoplePC value-priced narrowband subscribers, which were attributable tothe decrease in our sales and marketing activities. Overall operating expensesdecreased during the three months ended June 30, 2008 compared to theprior year period primarily due to cost savings realized from our 2007corporate restructuring plan, a reduction in costs to acquire new subscribersand a decrease in support costs due to a more tenured subscriber base. Ourcommunications costs to provide our services also decreased due to the decreasein subscribers. We recognized net income of $53.3 million during the threemonths ended June 30, 2008 compared to a net loss of $16.3 million duringthe three months ended June 30, 2007. This was due to the decrease intotal operating costs and expenses and a decrease in net losses of HELIO, as wediscontinued recording equity method losses during 2007. These improvementswere partially offset by the decrease in revenues and an increase in our incometax provision.

 

*Looking Ahead*

* *

Weexpect total revenues to continue to decrease during the remainder of 2008 aswe reduce sales and marketing efforts aimed at customers that have a highacquisition cost and early life churn. We also expect cost savings associatedwith our decreased sales and marketing activities, decreased support costs froma more tenured customer base and benefits realized from our corporaterestructuring plan to offset some of the decline in our revenues. However,although we expect operating costs and expenses to decrease compared to 2007,we do not anticipate the large-scale cost reduction opportunities that we have experiencedduring the three and six months ended June 30, 2008.

 

**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 was formed in March 2005 andbegan offering its products and services in April 2006. As of June 30,2008, we had an approximate 32% economic ownership interest and 12% votinginterest in HELIO, while SK Telecom had an approximate 67% economic ownershipinterest and 88% voting interest in HELIO.  In June 2008, VirginMobile USA, Inc. (“Virgin Mobile”) entered into an agreement to acquireHELIO in exchange for limited partnership units equivalent to 13 million sharesof Virgin Mobile common stock. Our equity and debt investments in HELIOwill be exchanged for limited partnership units equivalent to approximately 1.8million shares of Virgin Mobile common stock, subject to adjustment uponclosing in accordance with the terms of the transaction agreement. Followingthe transaction, we will have an approximate 2% ownership interest in VirginMobile. The transaction is expected toclose during the third quarter of 2008.

 

**MarketingAlliance**

 

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 over theirsystems.  In connection with theagreement, Time Warner Cable and Bright House Networks receive considerationfrom EarthLink for carrying the EarthLink service and related Internet traffic.As of June 30, 2008, more than 40% of our consumer broadband subscriberswere serviced via either the Time Warner Cable or Bright House Networksnetwork.

 

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**Key OperatingMetrics**

 

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

 
| ** **                                   | ** ** | **June 30,** | ** ** | **December 31,** | ** ** | **March 31,** | ** ** | **June 30,** | ** ** |
|----------------------------------------------|------------|-------------------|------------|-----------------------|------------|--------------------|------------|-------------------|------------|
| ** **                                   | ** ** | **2007**          | ** ** | **2007**              | ** ** | **2008**           | ** ** | **2008**          | ** ** |
| **Subscriber Data (a)**                      |       |              |       |                  |       |               |       |              |       |
| **Consumer Services**                        |       |              |       |                  |       |               |       |              |       |
| Narrowband access subscribers                |       | 3,039,000         |       | 2,624,000             |       | 2,368,000          |       | 2,130,000         |       |
| Broadband access subscribers (b)             |       | 1,091,000         |       | 1,059,000             |       | 1,026,000          |       | 988,000           |       |
| Total consumer services                      |       | 4,130,000         |       | 3,683,000             |       | 3,394,000          |       | 3,118,000         |       |
| **Business Services**                        |       |              |       |                  |       |               |       |              |       |
| Narrowband access subscribers                |       | 31,000            |       | 27,000                |       | 25,000             |       | 24,000            |       |
| Broadband access subscribers                 |       | 70,000            |       | 66,000                |       | 65,000             |       | 63,000            |       |
| Web hosting accounts                         |       | 106,000           |       | 100,000               |       | 97,000             |       | 94,000            |       |
| Total business services                      |       | 207,000           |       | 193,000               |       | 187,000            |       | 181,000           |       |
| **Total subscriber count at end  of period** |       | 4,337,000         |       | 3,876,000             |       | 3,581,000          |       | 3,299,000         |       |

 
| ** **                         | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                         | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                         | ** ** | **2007**                         | ** ** | **2008**                       | ** ** | **2007** | ** ** | **2008** | ** ** |
| **Subscriber Activity**            |       |                             |       |                           |       |   |   |   |   |
| Subscribers at beginning of period |       | 5,269,000                        |       | 3,581,000                      |       | 5,313,000 |   | 3,876,000 |   |
| Gross organic subscriber additions |       | 467,000                          |       | 162,000                        |       | 1,135,000 |   | 415,000 |   |
| Acquired subscribers               |       | 34,000                           |       | —                         |       | 34,000 |   | — |   |
| Adjustment (c)                     |       | (753,000                         | )          | —                         |       | (753,000 | ) | — |   |
| Churn                              |       | (680,000                         | )          | (444,000                       | )          | (1,392,000 | ) | (992,000 | ) |
| Subscribers at end of period       |       | 4,337,000                        |       | 3,299,000                      |       | 4,337,000 |   | 3,299,000 |   |
|                               |       |                             |       |                           |       |   |   |   |   |
| **Churn rate (d)**                 |       | 4.9                              | %          | 4.3                            | %          | 4.7 | % | 4.6 | % |
|                               |       |                             |       |                           |       |   |   |   |   |
| **Consumer Services Data**         |       |                             |       |                           |       |   |   |   |   |
| Average subscribers (e)            |       | 4,401,000                        |       | 3,250,000                      |       | 4,699,000 |   | 3,394,000 |   |
| ARPU (f)                           |       | $                                | 19.98      |                           | $          | 20.64 |   | $ | 19.16 |   | $ | 20.50 |   |
| Churn rate (d)                     |       | 5.0                              | %          | 4.4                            | %          | 4.8 | % | 4.7 | % |
|                               |       |                             |       |                           |       |   |   |   |   |
| **Business Services Data**         |       |                             |       |                           |       |   |   |   |   |
| Average subscribers (e)            |       | 211,000                          |       | 184,000                        |       | 214,000 |   | 187,000 |   |
| ARPU (f)                           |       | $                                | 76.04      |                           | $          | 80.37 |   | $ | 74.67 |   | $ | 81.14 |   |
| Churn rate (d)                     |       | 2.7                              | %          | 2.5                            | %          | 2.7 | % | 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) Customerswho subscribe to our EarthLink DSL and Home Phone service are counted as both abroadband subscriber and a voice subscriber.

 

(c) Wehad a marketing relationship with Embarq, a spin-off of Sprint NextelCorporation’s local communications business. The relationship provided thatEarthLink was the wholesale high-speed ISP for 

 

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Embarq’slocal residential and small business customers. The contracts associated withthese arrangements expired in April 2007. As a result, we removed 753,000wholesale broadband EarthLink-supported Embarq subscribers from our broadbandsubscriber count and total subscriber count.

 

(d) Churn rate is used to measure the rate at which subscribers discontinue serviceon a voluntary or involuntary basis. Churn rate is computed by dividing the average monthly number ofsubscribers that discontinued service during the period by the averagesubscribers for the period.

 

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

 

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

 

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**Results ofOperations**

 

***Consolidated Results of Operations***

 

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

 
| ** **                                                    | ** ** | **Three Months Ended**     | ** ** | ** ** | ** ** | ** **  | ** ** | **Six Months Ended** | ** ** | ** ** | ** ** | ** **  | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------|------------|------------|------------|-------------|------------|--------------------------------|------------|------------|------------|-------------|------------|
| ** **                                                    | ** ** | **June 30,**                    | ** ** | **Dollar** | ** ** | **Percent** | ** ** | **June 30,**              | ** ** | **Dollar** | ** ** | **Percent** | ** ** |
| ** **                                                    | ** ** | **2007**                             | ** ** | **2008**   | ** ** | **Change**  | ** ** | **Change**                     | ** ** | **2007**   | ** ** | **2008**    | ** ** | **Change** | ** ** | **Change** | ** ** |
| ** **                                                    | ** ** | **(dollars in thousands)** | ** ** |
|                                                          |       |                                 |       |       |       |        |       |                           |       |       |       |        |       |   |   |   |   |
| Revenues                                                      |       | $                                    | 311,866    |       | $          | 245,603     |       | $                              | (66,263    | )          | -21%       |        | $          | 636,013 |   | $ | 508,677 |   | $ | (127,336 | ) | -20 | % |
|                                                          |       |                                 |       |       |       |        |       |                           |       |       |       |        |       |   |   |   |   |
| Operating costs and expenses:                                 |       |                                 |       |       |       |        |       |                           |       |       |       |        |       |   |   |   |   |
| Service and equipment costs                                   |       | 108,599                              |       | 91,917     |       | (16,682     | )          | -15%                           |       | 218,390    |       | 188,709     |       | (29,681 | ) | -14 | % |
| Sales incentives                                              |       | 5,110                                |       | 571        |       | (4,539      | )          | -89%                           |       | 9,714      |       | 1,330       |       | (8,384 | ) | -86 | % |
| Total cost of revenues                                        |       | 113,709                              |       | 92,488     |       | (21,221     | )          | -19%                           |       | 228,104    |       | 190,039     |       | (38,065 | ) | -17 | % |
|                                                          |       |                                 |       |       |       |        |       |                           |       |       |       |        |       |   |   |   |   |
| Sales and marketing                                           |       | 75,800                               |       | 25,806     |       | (49,994     | )          | -66%                           |       | 175,069    |       | 56,722      |       | (118,347 | ) | -68 | % |
| Operations and customer support                               |       | 59,892                               |       | 33,642     |       | (26,250     | )          | -44%                           |       | 119,964    |       | 72,866      |       | (47,098 | ) | -39 | % |
| General and administrative                                    |       | 29,431                               |       | 23,768     |       | (5,663      | )          | -19%                           |       | 72,692     |       | 48,694      |       | (23,998 | ) | -33 | % |
| Amortization of intangible assets                             |       | 3,542                                |       | 3,987      |       | 445         |       | 13%                            |       | 7,038      |       | 8,000       |       | 962 |   | 14 | % |
| Facility exit, restructuring and other costs                  |       | —                               |       | 2,061      |       | 2,061       |       | *                              |       | —     |       | 3,091       |       | 3,091 |   |   | * |
| Total operating costs and expenses                            |       | 282,374                              |       | 181,752    |       | (100,622    | )          | -36%                           |       | 602,867    |       | 379,412     |       | (223,455 | ) | -37 | % |
|                                                          |       |                                 |       |       |       |        |       |                           |       |       |       |        |       |   |   |   |   |
| Income from operations                                        |       | 29,492                               |       | 63,851     |       | 34,359      |       | 117%                           |       | 33,146     |       | 129,265     |       | 96,119 |   | 290 | % |
| Net losses of equity affiliate                                |       | (40,054                              | )          | —     |       | 40,054      |       | -100%                          |       | (69,400    | )          | —      |       | 69,400 |   | -100 | % |
| Gain on investments in other companies                        |       | 210                                  |       | 1,325      |       | 1,115       |       | *                              |       | 210        |       | 1,325       |       | 1,115 |   |   | * |
| Interest income (expense) and other, net                      |       | 3,597                                |       | (760       | )          | (4,357      | )          | -121%                          |       | 7,100      |       | 856         |       | (6,244 | ) | -88 | % |
| Income (loss) from continuing operations before income  taxes |       | (6,755                               | )          | 64,416     |       | 71,171      |       | *                              |       | (28,944    | )          | 131,446     |       | 160,390 |   |   | * |
| Income tax provision                                          |       | (226                                 | )          | (6,725     | )          | (6,499      | )          | *                              |       | (395       | )          | (15,999     | )          | (15,604 | ) |   | * |
| Income (loss) from continuing operations                      |       | (6,981                               | )          | 57,691     |       | 64,672      |       | *                              |       | (29,339    | )          | 115,447     |       | 144,786 |   |   | * |
| Loss from discontinued operations, net of tax                 |       | (9,309                               | )          | (4,365     | )          | 4,944       |       | -53%                           |       | (16,913    | )          | (7,757      | )          | 9,156 |   | -54 | % |
| Net income (loss)                                             |       | $                                    | (16,290    | )          | $          | 53,326      |       | $                              | 69,616     |       | *          |        | $          | (46,252 | ) | $ | 107,690 |   | $ | 153,942 |   |   | * |

 

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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 accessand voice services, among others, to individual customers. Our BusinessServices segment provides managed data networks, dedicated Internet access andweb hosting, among others, to businesses and communications 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 three months ended June 30,2007 and 2008:

 
| ** **                                   | ** ** | **Three Months Ended June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|----------------------------------------------|------------|-----------------------------------------------------|------------|------------|------------|-------------------|------------|
| ** **                                   | ** ** | **2007**                                            | ** ** | **2008**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                   | ** ** | **(dollars in thousands)**                | ** ** |
| **Consumer Services**                        |       |                                                |       |       |       |              |       |   |   |
| Revenues                                     |       | $                                                   | 263,778    |       | $          | 201,197           |       | $ | (62,581 | ) | -24% |   |
| Cost of revenues                             |       | 84,276                                              |       | 67,331     |       | (16,945           | )          | -20% |   |
| Gross margin                                 |       | 179,502                                             |       | 133,866    |       | (45,636           | )          | -25% |   |
| Direct segment operating expenses            |       | 133,742                                             |       | 53,692     |       | (80,050           | )          | -60% |   |
| Segment operating income                     |       | $                                                   | 45,760     |       | $          | 80,174            |       | $ | 34,414 |   | 75% |   |
|                                         |       |                                                |       |       |       |              |       |   |   |
| **Business Services**                        |       |                                                |       |       |       |              |       |   |   |
| Revenues                                     |       | $                                                   | 48,088     |       | $          | 44,406            |       | $ | (3,682 | ) | -8% |   |
| Cost of revenues                             |       | 29,433                                              |       | 25,157     |       | (4,276            | )          | -15% |   |
| Gross margin                                 |       | 18,655                                              |       | 19,249     |       | 594               |       | 3% |   |
| Direct segment operating expenses            |       | 16,118                                              |       | 11,957     |       | (4,161            | )          | -26% |   |
| Segment operating income                     |       | $                                                   | 2,537      |       | $          | 7,292             |       | $ | 4,755 |   | 187% |   |
|                                         |       |                                                |       |       |       |              |       |   |   |
| **Consolidated**                             |       |                                                |       |       |       |              |       |   |   |
| Revenues                                     |       | $                                                   | 311,866    |       | $          | 245,603           |       | $ | (66,263 | ) | -21% |   |
| Cost of revenues                             |       | 113,709                                             |       | 92,488     |       | (21,221           | )          | -19% |   |
| Gross margin                                 |       | 198,157                                             |       | 153,115    |       | (45,042           | )          | -23% |   |
| Direct segment operating expenses            |       | 149,860                                             |       | 65,649     |       | (84,211           | )          | -56% |   |
| Segment operating income                     |       | 48,297                                              |       | 87,466     |       | 39,169            |       | 81% |   |
| Stock-based compensation expense             |       | 2,898                                               |       | 4,569      |       | 1,671             |       | 58% |   |
| Amortization of intangible assets            |       | 3,542                                               |       | 3,987      |       | 445               |       | 13% |   |
| Facility exit, restructuring and other costs |       | —                                              |       | 2,061      |       | 2,061             |       | * |   |
| Other operating expenses                     |       | 12,365                                              |       | 12,998     |       | 633               |       | 5% |   |
| Income from operations                       |       | $                                                   | 29,492     |       | $          | 63,851            |       | $ | 34,359 |   | 117% |   |

 

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Thefollowing tables set forth segment data for the six months ended June 30,2007 and 2008:

 
| ** **                                   | ** ** | **Six Months Ended June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|----------------------------------------------|------------|---------------------------------------------------|------------|------------|------------|-------------------|------------|
| ** **                                   | ** ** | **2007**                                          | ** ** | **2008**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                   | ** ** | **(dollars in thousands)**              | ** ** |
| **Consumer Services**                        |       |                                              |       |       |       |              |       |   |   |
| Revenues                                     |       | $                                                 | 540,171    |       | $          | 417,541           |       | $ | (122,630 | ) | -23% |   |
| Cost of revenues                             |       | 168,629                                           |       | 138,503    |       | (30,126           | )          | -18% |   |
| Gross margin                                 |       | 371,542                                           |       | 279,038    |       | (92,504           | )          | -25% |   |
| Direct segment operating expenses            |       | 293,074                                           |       | 114,693    |       | (178,381          | )          | -61% |   |
| Segment operating income                     |       | $                                                 | 78,468     |       | $          | 164,345           |       | $ | 85,877 |   | 109% |   |
|                                         |       |                                              |       |       |       |              |       |   |   |
| **Business Services**                        |       |                                              |       |       |       |              |       |   |   |
| Revenues                                     |       | $                                                 | 95,842     |       | $          | 91,136            |       | $ | (4,706 | ) | -5% |   |
| Cost of revenues                             |       | 59,475                                            |       | 51,536     |       | (7,939            | )          | -13% |   |
| Gross margin                                 |       | 36,367                                            |       | 39,600     |       | 3,233             |       | 9% |   |
| Direct segment operating expenses            |       | 32,787                                            |       | 26,827     |       | (5,960            | )          | -18% |   |
| Segment operating income                     |       | $                                                 | 3,580      |       | $          | 12,773            |       | $ | 9,193 |   | 257% |   |
|                                         |       |                                              |       |       |       |              |       |   |   |
| **Consolidated**                             |       |                                              |       |       |       |              |       |   |   |
| Revenues                                     |       | $                                                 | 636,013    |       | $          | 508,677           |       | $ | (127,336 | ) | -20% |   |
| Cost of revenues                             |       | 228,104                                           |       | 190,039    |       | (38,065           | )          | -17% |   |
| Gross margin                                 |       | 407,909                                           |       | 318,638    |       | (89,271           | )          | -22% |   |
| Direct segment operating expenses            |       | 325,861                                           |       | 141,520    |       | (184,341          | )          | -57% |   |
| Segment operating income                     |       | 82,048                                            |       | 177,118    |       | 95,070            |       | 116% |   |
| Stock-based compensation expense             |       | 10,778                                            |       | 9,722      |       | (1,056            | )          | -10% |   |
| Amortization of intangible assets            |       | 7,038                                             |       | 8,000      |       | 962               |       | 14% |   |
| Facility exit, restructuring and other costs |       | —                                            |       | 3,091      |       | 3,091             |       | * |   |
| Other operating expenses                     |       | 31,086                                            |       | 27,040     |       | (4,046            | )          | -13% |   |
| Income from operations                       |       | $                                                 | 33,146     |       | $          | 129,265           |       | $ | 96,119 |   | 290% |   |

 

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***Revenues***

 

The following table presentsrevenues by groups of similar services and by segment for the three and sixmonths ended June 30, 2007 and 2008:

 
| ** **            | ** ** | **Three Months Ended**     | ** ** | ** ** | ** ** | ** **        | ** ** | **Six Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------|------------|--------------------------------------|------------|------------|------------|-------------------|------------|--------------------------------|------------|------------|------------|------------|------------|
| ** **            | ** ** | **June 30,**                    | ** ** | ** ** | ** ** | ** **        | ** ** | **June 30,**              | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **            | ** ** | **2007**                             | ** ** | **2008**   | ** ** | **$ Change** | ** ** | **% Change**              | ** ** | **2007**   | ** ** | **2008**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **(dollars in thousands)** | ** ** |
| **Consumer Services** |       |                                 |       |       |       |              |       |                           |       |       |       |       |       |   |   |   |   |
| Access and service    |       | $                                    | 231,392    |       | $          | 176,280           |       | $                              | (55,112    | )          | -24%       |       | $          | 474,192 |   | $ | 365,251 |   | $ | (108,941 | ) | -23% |   |
| Value-added services  |       | 32,386                               |       | 24,917     |       | (7,469            | )          | -23%                           |       | 65,979     |       | 52,290     |       | (13,689 | ) | -21% |   |
| Total revenues        |       | $                                    | 263,778    |       | $          | 201,197           |       | $                              | (62,581    | )          | -24%       |       | $          | 540,171 |   | $ | 417,541 |   | $ | (122,630 | ) | -23% |   |
|                  |       |                                 |       |       |       |              |       |                           |       |       |       |       |       |   |   |   |   |
| **Business Services** |       |                                 |       |       |       |              |       |                           |       |       |       |       |       |   |   |   |   |
| Access and service    |       | $                                    | 47,327     |       | $          | 43,761            |       | $                              | (3,566     | )          | -8%        |       | $          | 94,282 |   | $ | 89,639 |   | $ | (4,643 | ) | -5% |   |
| Value-added services  |       | 761                                  |       | 645        |       | (116              | )          | -15%                           |       | 1,560      |       | 1,497      |       | (63 | ) | -4% |   |
| Total revenues        |       | $                                    | 48,088     |       | $          | 44,406            |       | $                              | (3,682     | )          | -8%        |       | $          | 95,842 |   | $ | 91,136 |   | $ | (4,706 | ) | -5% |   |
|                  |       |                                 |       |       |       |              |       |                           |       |       |       |       |       |   |   |   |   |
| **Consolidated**      |       |                                 |       |       |       |              |       |                           |       |       |       |       |       |   |   |   |   |
| Access and service    |       | $                                    | 278,719    |       | $          | 220,041           |       | $                              | (58,678    | )          | -21%       |       | $          | 568,474 |   | $ | 454,890 |   | $ | (113,584 | ) | -20% |   |
| Value-added services  |       | 33,147                               |       | 25,562     |       | (7,585            | )          | -23%                           |       | 67,539     |       | 53,787     |       | (13,752 | ) | -20% |   |
| Total revenues        |       | $                                    | 311,866    |       | $          | 245,603           |       | $                              | (66,263    | )          | -21%       |       | $          | 636,013 |   | $ | 508,677 |   | $ | (127,336 | ) | -20% |   |

 

*Consolidatedrevenues*

 

 The primary component of our revenues isaccess and service revenues, which consist of narrowband access services(including traditional, fully-featured narrowband access and value-pricednarrowband access); broadband access services (including high-speed access viaDSL, cable and satellite; IP-based voice; and fees charged for high-speed datanetworks to small and medium-sized businesses and communications carriers); andweb hosting services. We also earn revenues from value-added services, whichinclude search, advertising and ancillary services sold as add-on features toour access services. Total revenues decreased from $311.9 million during thethree months ended June 30, 2007 to $245.6 million during the three monthsended June 30, 2008, and decreased from $636.0 million during the sixmonths ended June 30, 2007 to $508.7 million during the six months ended June 30,2008.  These were comprised of decreasesof $62.6 million and $122.6 million in consumer services revenue during thethree and six months ended June 30, 2008, respectively, and decreases of$3.7 million and $4.7 million in business services revenues during the threeand six months ended June 30, 2008, respectively.

 

Thedecreases in consumer services revenue were primarily attributable to decreasesin average consumer subscribers, which were approximately 4.4 million and 4.7million during the three and six months ended June 30, 2007, respectively,and approximately 3.3 million and 3.4 million during the three and six monthsended June 30, 2008, respectively. The decreases were driven primarily byaverage premium and value-priced narrowband subscribers and the removal of753,000 Embarq subscribers in April 2007. Consumer service ARPU increased from$19.98 and $19.16 during the three and six months ended June 30, 2007,respectively, to $20.64 and $20.50 during the three and six months ended June 30,2008, respectively. The increases in consumer service ARPU were primarily dueto a shift in the mix of our consumer broadband base from wholesale DSLsubscribers to retail DSL subscribers and to retail cable subscribers due tothe removal of Embarq wholesale subscribers.

 

The decreases in business servicesrevenue were attributable to decreases in average business subscribers, whichconsisted of decreases in average web hosting accounts, average New Edge customersand average business narrowband customers. These decreases were offset byincreases in business services ARPU.  Theincreases in business services ARPU were attributable to increases in New EdgeARPU and increases in the mix of subscribers from lower ARPU businessnarrowband subscribers to higher ARPU New Edge subscribers.

 

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*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 and satellite; fees charged for IP-based voiceservices; usage fees; installation fees; termination fees; and fees forequipment. Consumer access and service revenues decreased from $231.4 millionduring the three months ended June 30, 2007 to $176.3 million during thethree months ended June 30, 2008, and decreased from $474.2 million duringthe six months ended June 30, 2007 to $365.3 million during the six monthsended June 30, 2008.  The decreasesin consumer access and service revenues were primarily due to decreases innarrowband access and broadband access revenues.

 

Narrowband access revenuesdecreased due to a decrease in both premium narrowband and value-pricednarrowband subscribers resulting from the continued maturing and ongoingcompetitiveness of the market for narrowband Internet access and from thechange in our business strategy. During 2008, we reduced sales and marketingefforts that resulted in adding customers that did not provide an acceptablerate of return or that had a pattern of early life churn. We are focusingefforts primarily on the retention of tenured customers and adding customersthat have similar characteristics of our tenured customer base and are more likelyto produce an acceptable rate of return. We expect our consumer access andservice subscriber base to continue to decrease due to the change in ourbusiness strategy and due to the continued maturation of the market for premiumnarrowband access. However, as our customers become more tenured, we expect ourchurn rates to decline.

 

Broadband revenues decreased due toa decrease in average broadband access subscribers, offset by an increase inbroadband ARPU. Average broadband access subscribers decreased largely due tothe removal of 753,000 Embarq subscribers from our subscriber count effective April 2007.We had a marketing relationship with Embarq, a spin-off of Sprint NextelCorporation’s local communications business, which provided that EarthLink wasthe wholesale high-speed ISP for Embarq’s local residential and small businesscustomers. The contracts associated with these arrangements expired in April 2007,and we and Embarq did not renew the wholesale broadband contract. Effective April 2007,we removed approximately 753,000 wholesale broadband subscribers under themarketing relationship from our broadband subscriber count and total subscribercount. Also contributing to the decrease in average broadband accesssubscribers were decreases in retail DSL and retail cable subscribers.

 

The increases in broadband accessARPU during the three and six months ended June 30, 2008 compared to theprior year periods were primarily due a shift in the mix of our broadbandcustomer base from wholesale DSL subscribers to retail DSL subscribers and toretail cable subscribers due to the removal of Embarq wholesale subscribers.Offsetting these increases were general declines in retail DSL pricesintroduced as a result of declines in costs from our DSL service providers.

 

ARPU depends on a variety offactors, including changes in the mix of customers and their related pricingplans; the use of promotions and discounted pricing plans to obtain or retainsubscribers; increases or decreases in the prices of our existing services; andthe addition of new services. We currently offer several consumer accessservices at different price plans, and we provide services through retail andwholesale relationships. All of these have an effect on our overall ARPU.

 

*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 homenetworking products and services.* *We derive these revenues by paidplacements for searches; delivering traffic to our partners in the form ofsubscribers, page views or e-commerce transactions; advertising ourpartners’ products and services in our various online properties and electronicpublications, including the Personal Start PageTM; referring ourcustomers to our partners’ products and services; and monthly fees charged forancillary services.

 

Value-addedservices revenues decreased 23% from $32.4 million during the three monthsended June 30, 2007 to $24.9 million during the three months ended June 30,2008, and decreased 21% from $66.0 million 

 

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during the six months ended June 30, 2007 to$52.3 million during the six months ended June 30, 2008. The decreasesover the prior year periods were due primarily to decreases in searchadvertising revenues resulting from the decline in average consumer servicessubscribers and decreases in partnership advertising revenues.  Contributing to the decrease during the threemonth period was a decrease in sales of security products to our value-pricednarrowband customers, resulting from the decrease in average value-pricednarrowband customers.

 

*Businessservices revenue*

 

The primary component of businessservices revenues is access and service revenues. 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 have a web or e-commerce presence on theInternet.

 

Business access and servicerevenues decreased from $47.3 million during the three months ended June 30,2007 to $43.8 million during the three months ended June 30, 2008, anddecreased from $94.3 million during the six months ended June 30, 2007 to$89.6 million during the six months ended June 30, 2008. The decreaseswere primarily due to decreases in average business access and servicesubscribers, which were due to decreases in average in web hosting accounts,average New Edge customers and average business narrowband customers. Thesedecreases were offset by increases in business access and service ARPU, whichwere driven by increases in New Edge ARPU and increases in the mix ofsubscribers from lower ARPU business narrowband subscribers to higher ARPU NewEdge subscribers.

 

Our business broadband subscriberbase consists of customers which are added through retail and wholesalerelationships. Retail business services generally have an ARPU between $100 and$130 for non-networked solutions and an ARPU between $175 and $225 fornetworked solutions. Wholesale business services generally have an ARPU between$75 and $95. The pricing of broadband services for small and medium-sizedbusinesses depends upon customer requirements for different service deliverymethods, amounts of bandwidth, quality of service and distance from the pointsof presence, and may vary widely from these ranges. The number of customersbeing added or served at any point in time through our wholesale efforts issubject to the business and marketing circumstances of our telecommunicationspartners.

 

***Cost of revenues***

 

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

 

Totalcost of revenues decreased 19% from $113.7 million during the three monthsended June 30, 2007 to $92.5 million during the three months ended June 30,2008, and decreased 17% from $228.1 million during the six months ended June 30,2007 to $190.0 million during the six months ended June 30, 2008. Thedecrease during the three months ended June 30, 2008 compared to the prioryear period was comprised of a $16.9 million decrease in consumer services costof revenues and a $4.3 million decrease in business services cost of revenues.The decrease during the six months ended June 30, 2008 compared to theprior year period was comprised of a $30.1 million decrease in consumerservices cost of revenues and a $7.9 million decrease in business services costof revenues. Consumer services cost of revenues decreased due to the decline inaverage consumer services subscribers. Consumer services cost of revenues alsodeclined as a result of a decrease in sales incentives resulting from fewergross subscriber additions during the three and six months ended June 30,2008 as we 

 

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reduced our sales and marketing activities. Businessservices cost of revenues decreased due to the decreases in average businessservices subscribers and decreases in average monthly costs per subscriber,primarily as a result of a decrease in New Edge cost of revenues due to morefavorable agreements with telecommunications service providers.

 

***Sales and marketing***

 

Salesand marketing expenses include advertising and promotion expenses, fees paid todistribution partners to acquire new paying subscribers, personnel-relatedexpenses and telemarketing costs incurred to acquire subscribers. Sales andmarketing expenses decreased 66% from $75.8 million during the three monthsended June 30, 2007 to $25.8 million during the three months ended June 30,2008, and decreased 68% from $175.1 million during the six months ended June 30,2007 to $56.7 million during the six months ended June 30, 2008. Thesedecreases consisted primarily of decreases in consumer services sales andmarketing expenses as we decreased spending aimed at customers that had highacquisition costs and early life churn and as we realized benefits from the2007 Plan. Although we expect to continue to realize benefits during theremainder of 2008 compared to 2007 as we scale back sales and marketing effortsin connection with our refocused strategy, we do not anticipate the type oflarge-scale cost reduction opportunities that we have experienced during thethree and six months ended June 30, 2008.

 

***Operations and customer support***

 

Operationsand customer support expenses consist of costs associated with technicalsupport and customer service, providing our subscribers with toll-free accessto our technical support and customer service centers, maintenance of customerinformation systems, software development and network operations. Operationsand customer support expenses decreased 44% from $59.9 million during the threemonths ended June 30, 2007 to $33.6 million during the three months ended June 30,2008, and decreased 39% from $120.0 million during the six months ended June 30,2007 to $72.9 million during the six months ended June 30, 2008. Thedecreases in operations and customer support expenses consisted of decreases inpersonnel-related costs, outsourced labor, professional fees and occupancycosts. These decreases were primarily attributable to benefits realized as aresult of our corporate restructuring plan and our efforts to reduce ourback-office cost structure. In addition, we experienced a decrease in callvolumes for customer service and technical support as our overall subscriberbase has decreased and the composition of our subscriber base has become moretenured. Although we expect operations and customer support expenses tocontinue to decrease in 2008 compared to 2007 as a result of the 2007 Plan andour refocused strategy, we do not anticipate the type of large-scale costreduction opportunities that we have experienced during the three and sixmonths ended June 30, 2008.

 

***General and administrative***

 

General and administrative expensesconsist of fully burdened costs associated with the executive, finance, legaland human resources departments; outside professional services; paymentprocessing; credit card fees; collections; and bad debt. General andadministrative expenses decreased 19% from $29.4 million during the threemonths ended June 30, 2007 to $23.8 million during the three months ended June 30,2008, and decreased 33% from $72.7 million during the six months ended June 30,2007 to $48.7 million during the six months ended June 30, 2008.  The decreases in general and administrativeexpenses consisted of decreases in bad debt and payment processing fees,personnel-related costs and professional and legal fees. Bad debt and paymentprocessing fees decreased due to the decrease in our overall subscriber baseand due to our subscriber base consisting of more tenured customers, who have alower frequency of non-payment. The decreases in other costs were attributableto benefits realized as a result of our corporate restructuring plan and ourefforts to reduce our back-office cost structure. Although we expectgeneral and administrative expenses to continue to decrease in 2008 compared to2007 as a result of the 2007 Plan and our refocused strategy, we do notanticipate the type of large-scale cost reduction opportunities that we have experiencedduring the three and six months ended June 30, 2008.

 

Also contributing to the decreasein general and administrative expenses during the six month period was adecrease in stock-based compensation expense due to the inclusion of $6.4million of cash and non-cash compensation expense during the six months ended June 30,2007 related to the death of our former Chief Executive Officer, Charles G.Betty, on January 2, 2007. This compensation expense included $3.5 millionof stock-based compensation expense related to the accelerated vesting of 1.1million stock options and 0.1 million 

 

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restricted stock units, $1.4 million of stock-based compensation expenserelated to the extension of the exercise period for Mr. Betty’s stockoptions and $1.5 million of compensation expense for a payment to Mr. Betty’sestate in accordance with his employment agreement.

 

***Stock-based compensation expense***

 

Stock-basedcompensation expense in accordance with SFAS No. 123(R) was allocatedas follows for the three and six months ended June 30, 2007 and 2008:

 
| ** **                      | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                      | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                      | ** ** | **2007**                         | ** ** | **2008**                       | ** ** | **2007** | ** ** | **2008** | ** ** |
| ** **                      | ** ** | **(in thousands)**          | ** ** |
| Sales and marketing             |       | $                                | 694        |                           | $          | 1,290 |   | $ | 1,405 |   | $ | 2,824 |   |
| Operations and customer support |       | 1,362                            |       | 2,251                          |       | 2,758 |   | 4,788 |   |
| General and administrative      |       | 842                              |       | 1,028                          |       | 6,615 |   | 2,110 |   |
|                            |       | $                                | 2,898      |                           | $          | 4,569 |   | $ | 10,778 |   | $ | 9,722 |   |

 

***Amortization of intangible assets***

 

Amortizationof intangible assets represents the amortization of definite lived intangibleassets acquired in purchases of businesses and purchases of customer bases fromother companies. Definite lived intangible assets, which primarily consist ofsubscriber bases and customer relationships, acquired software and technology,trade names and other assets, are amortized on a straight-line basis over theirestimated useful lives, which range from three to six years. Amortization ofintangible assets was $3.5 million and $4.0 million during the three monthsended June 30, 2007 and 2008, respectively, and $7.0 million and $8.0million during the six months ended June 30, 2007 and 2008, respectively.The increases in amortization of intangible assets during the three and sixmonths ended June 30, 2008 compared to the prior year periods wereprimarily due to amortization of identifiable definite lived intangible assetsresulting from acquisitions of subscriber bases from ISPs over the past yearand changes in the estimated useful lives of certain of our identifiabledefinite lived intangible assets.

 

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***Facility exit, restructuring and other costs***

 

Facility exit, restructuring andother costs consisted of the following for the periods presented:

 
| ** **                                     | ** ** | **Three Months**       | ** ** | **Six Months**         | ** ** |
|------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                     | ** ** | **Ended**                   | ** ** | **Ended**                   | ** ** |
| ** **                                     | ** ** | **June 30, 2008** | ** ** | **June 30, 2008** | ** ** |
| ** **                                     | ** ** | **(in thousands)**     | ** ** |
| ** **                                     | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| 2007 Restructuring Plan                        |       |                        |       |                        |       |
| Severance and personnel-related costs          |       | $                           | 108        |                        | $          | 474 |   |
| Lease termination and facilities-related costs |       | 2,005                       |       | 2,005                       |       |
| Non-cash asset impairments                     |       | 27                          |       | 313                         |       |
| Other associated costs                         |       | 29                          |       | 470                         |       |
|                                           |       | 2,169                       |       | 3,262                       |       |
| Legacy Restructuring Plans                     |       | (108                        | )          | (171                        | )          |
| Total facility exit, restucturing and other    |       | $                           | 2,061      |                        | $          | 3,091 |   |

 

In August 2007, we adopted arestructuring plan to reduce costs and improve the efficiency of our operations.The 2007 Plan was the result of a comprehensive review of operations within andacross our functions and businesses. Under the 2007 Plan, we reduced ourworkforce by approximately 900 employees, closed office facilities in Orlando,Florida; Knoxville, Tennessee; Harrisburg, Pennsylvania and San Francisco,California and are consolidating our office facilities in Atlanta, Georgia andPasadena, California. The Plan was primarily implemented during the latter halfof 2007 and is expected to be completed during 2008. Management continues toevaluate our business and, therefore, may have supplemental provisions for newplan initiatives as well as changes in estimates to amounts previouslyrecorded, as payments are made or actions are completed.

 

We periodically evaluate and adjustour estimates for facility exit and restructuring costs for legacyrestructuring plans implemented during the years ended December 31, 2003and 2004 (“Legacy Plans”) based on currently-available information and recordsuch adjustments as facility exit, restructuring and other costs. Facilityexit, restructuring and other costs during the three and six months ended June 30,2008 also included $0.1 million and $0.2 million, respectively, in reductionsto facility exit, restructuring and other costs as a result of changes inestimates for Legacy Plans.

 

***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 havebeen offset by increases in the carrying value of our investment associatedwith amortizing the difference between the book value of non-cash assetscontributed to HELIO and their fair value.

 

Netlosses of equity affiliate for the three and six months ended June 30,2007 of $40.1 million and $69.4 million, respectively, included ourproportionate share of HELIO’s net losses offset by amortization associatedwith recognizing the difference between the carrying value and fair value ofnon-cash assets contributed. During the year ended December 31, 2007, westopped recording additional net losses of equity affiliate because thecarrying value of our investments in HELIO were reduced to zero, and we are notcommitted to provide further financial support. As a result, we did not recordany net losses of equity affiliate during the three and six months ended June 30,2008. In June 2008, Virgin Mobile entered into an agreement to acquireHELIO. The transaction is expected to close during the third quarter of 2008.

 

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***Interest income (expense) and other, net***

 

Interest income (expense) andother, net, is primarily comprised of interest earned on our cash, cashequivalents and marketable securities; interest earned on our Covad debtinvestment; interest expense incurred on our Convertible Senior Notes due November 15,2026; and other miscellaneous income and expense items. Interest income(expense) and other, net, decreased $4.4 million during the three months ended June 30,2008 compared to the prior year period primarily due to a decrease in interestearned on our cash, cash equivalents and marketable securities due to lowerinvestment yields. Interest income (expense) and other, net, decreased $6.2million during the six months ended June 30, 2008 compared to the prioryear period. This was primarily due to a decrease in interest earned on ourcash, cash equivalents and marketable securities due to lower investment yieldsand a decrease in our average cash and marketable securities balance. Ouraverage cash and marketable securities balance decreased during the six monthsended June 30, 2008 compared to the prior year period primarily due tocash payments resulting from the 2007 Plan. Also contributing to the decrease ininterest income (expense) and other, net, was the liquidation of our Covad debtinvestment, which was repurchased by Platinum Equity, LLC in April 2008.

 

***Provision for income taxes***

 

Wehave recorded income taxes during the three and six months ended June 30,2008 based on management’s current annual operating expectations in accordancewith the interim reporting requirements of SFAS No. 109, “Accounting forIncome Taxes,” and Accounting Principles Board Opinion No. 28, “InterimFinancial Reporting.”

 

Wecontinue to maintain a full valuation allowance against our unrealized deferredtax assets, which include net operating loss carryforwards.  We may recognize deferred tax assets infuture periods when they are determined to be more likely than not realizable.To the extent we report income in future periods, we intend to use our netoperating loss carryforwards to the extent available to offset taxable incomeand reduce cash outflows for income taxes. Our ability to use our federal and state net operating loss carryforwardsand federal and state tax credit carryforwards may be subject to restrictionsattributable to equity transactions in the future resulting from changes inownership as defined under the Internal Revenue Code.

 

***Loss from discontinued operations, net of tax***

 

Loss from discontinued operations,net of tax, for the three and six months ended June 30, 2007 and 2008reflects our municipal wireless broadband operations. In November 2007,management concluded that our municipal wireless broadband operations were nolonger consistent with our strategic direction and our Board of Directorsauthorized management to pursue the sale of our municipal wireless broadbandassets. The municipal wireless results of operations were previously includedin our Consumer Services segment.

 

Duringthe six months ended June 30, 2008, we transferred our municipal wirelessbroadband networks to the cities of Corpus Christi, TX and Milpitas, CA inexchange for releasing us from our existing network agreements. We alsotransferred our municipal wireless broadband networks in the city ofPhiladelphia, PA to a local Philadelphia company. Additionally, we terminatedour municipal wireless broadband service in New Orleans, LA and Anaheim, CA andare removing our network equipment from those cities. We expect to complete thedivestiture of our remaining municipal wireless broadband assets during 2008.

 

Werecorded impairment and other costs of $4.0 million during the three monthsended June 30, 2008 related to our municipal wireless broadbandoperations, including $0.9 million for non-cash asset impairments and othernon-cash charges; $0.2 million for severance and personnel-related costs;and $2.9 million for other associated costs. We recorded impairment andother costs of $5.9 million during the six months ended June 30, 2008,including $2.8 million for non-cash asset impairments; $0.2 millionfor severance and personnel-related costs; and $2.9 million for otherassociated costs. These charges are reflected within discontinued operations inthe Condensed Consolidated Statements of Operations.

 

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Thefollowing table presents summarized results of operations related to ourdiscontinued operations for the three and six months ended June 30, 2007and 2008:

 
| ** **                                    | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                    | ** ** | **2007**                                            | ** ** | **2008**                                          | ** ** | **2007** | ** ** | **2008** | ** ** |
| ** **                                    | ** ** | **(in thousands)**                             | ** ** |
| ** **                                    | ** ** | ** **                                          | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                      |       | $                                                   | 338        |                                              | $          | 551 |   | $ | 597 |   | $ | 1,288 |   |
| Operating costs and expenses                  |       | (9,647                                              | )          | (1,513                                            | )          | (17,510 | ) | (3,693 | ) |
| Impairment and other costs                    |       | —                                              |       | (4,004                                            | )          | — |   | (5,953 | ) |
| Income tax benefit                            |       | —                                              |       | 601                                               |       | — |   | 601 |   |
| Loss from discontinued operations, net of tax |       | $                                                   | (9,309     | )                                                 | $          | (4,365 | ) | $ | (16,913 | ) | $ | (7,757 | ) |

 

**Facility Exitand Restructuring Costs**

 

*2007 Plan*. * *We expect to incurfuture cash outflows for real estate obligations through 2014 related to the2007 Plan. The following table summarizes activity for the liability balancesassociated with the 2007 Plan for the six months ended June 30, 2008,including changes during the year attributable to costs incurred and charged toexpense and costs paid or otherwise settled:

 
| ** **                           | ** ** | **Severance**           | ** ** | ** **     | ** ** | **Asset**       | ** ** | **Other** | ** ** | ** ** | ** ** |
|--------------------------------------|------------|-------------------------|------------|----------------|------------|-----------------|------------|-----------|------------|------------|------------|
| ** **                           | ** ** | **and Benefits**   | ** ** | **Facilities** | ** ** | **Impairments** | ** ** | **Costs** | ** ** | **Total**  | ** ** |
| ** **                           | ** ** | **(in thousands)** | ** ** |
| ** **                           | ** ** | ** **              | ** ** |
| Balance as of December 31, 2007 |       | $                       | 12,041     |           | $          | 16,124          |       | $         | —     |       | $          | — |   | $ | 28,165 |   |
| Accruals                             |       | 474                     |       | 2,005          |       | 313             |       | 470       |       | 3,262      |       |
| Payments                             |       | (12,502                 | )          | (2,433         | )          | —          |       | (470      | )          | (15,405    | )          |
| Non-cash charges                     |       | —                  |       | 548            |       | (313            | )          | —    |       | 235        |       |
| Balance as of June 30, 2008     |       | $                       | 13         |           | $          | 16,244          |       | $         | —     |       | $          | — |   | $ | 16,257 |   |

 

*Legacy Plans*. As of June 30,2008, we had $2.0 million remaining for real estate commitments associated withthe Legacy Plans. All other costs have been paid or otherwise settled. Weexpect to incur future cash outflows for real estate obligations through 2010related to the Legacy Plans.

 

**Liquidity andCapital Resources**

 

The following table sets forthsummarized cash flow data for the six months ended June 30, 2007 and 2008:

 
| ** **                                          | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                          | ** ** | **2007**                                          | ** ** | **2008** | ** ** |
| ** **                                          | ** ** | **(in thousands)**                           | ** ** |
|                                                |       |                                              |       |   |   |
| Net income (loss)                                   |       | $                                                 | (46,252    | ) | $ | 107,690 |   |
| Non-cash items                                      |       | 106,086                                           |       | 44,763 |   |
| Changes in working capital                          |       | (26,673                                           | )          | (44,342 | ) |
| Net cash provided by operating activities           |       | $                                                 | 33,161     |   | $ | 108,111 |   |
|                                                |       |                                              |       |   |   |
| Net cash (used in) provided by investing activities |       | $                                                 | (68,339    | ) | $ | 98,826 |   |
|                                                |       |                                              |       |   |   |
| Net cash provided by (used in) financing activities |       | $                                                 | 4,432      |   | $ | (5,914 | ) |

 

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*Operatingactivities*

 

Netcash provided by operating activities increased during the six months ended June 30,2008 compared to the prior year period primarily due to a decrease in operatingcosts and expenses as we realized benefits from the 2007 Plan and as wedecreased costs to acquire and support new customers. In addition, cashprovided by operating activities was negatively impacted during the six monthsended June 30, 2007 due to spending for our prior growth initiatives.

 

Non-cash items include items thatare not expected to generate or require the use of cash, such as depreciationand amortization relating to our network, facilities and intangible assets, netlosses of equity affiliate, deferred income taxes, stock-based compensation,non-cash disposals and impairments of fixed assets and gain on investments inother companies, net. Non-cash items decreased during the six months ended June 30,2008 compared to the prior year period due to decreases in net losses of equityaffiliate and depreciation expense. These decreases were offset by an increasein deferred income taxes.

 

Changesin working capital requirements include changes in accounts receivable, prepaidand other assets, accounts payable, accrued and other liabilities and deferredrevenue. Cash used for working capital requirements increased during the sixmonths ended June 30, 2008 compared to the prior year period primarily dueto cash payments resulting of our 2007 corporate restructuring plan.

 

*Investingactivities*

 

Our investing activities used cashof $68.3 million during the six months ended June 30, 2007. This consistedprimarily of $26.8 million of capital expenditures, primarily associated withnetwork and technology center related projects; $19.5 million of contributionsto HELIO; $19.3 million of purchases of investments in marketable securities,net of sales and maturities; and $2.9 million to purchase subscriber bases fromother ISPs. Our investing activities provided cash of $98.8 million during the sixmonths ended June 30, 2008. This consisted of $44.1 million of sales andmaturities of investments in marketable securities, net of sales, and $57.1million received for our Covad investment, offset by $2.3 million of capitalexpenditures.

 

*Financing activities*

 

Our financing activities providedcash of $4.4 million during the six months ended June 30, 2007, whichprimarily consisted of proceeds from the exercise of stock options. Ourfinancing activities used cash of $6.0 million during the six months ended June 30,2008. This consisted of $9.1 million used to repurchase 1.3 million shares ofour common stock and $2.7 million for principal payments under capital leaseobligations, which was primarily due to $2.5 million used to repay our GeneralElectric Capital Corporation lease obligation. This was offset by $5.8 millionof proceeds from the exercise of stock options

 

**Off-BalanceSheet Arrangements**

 

As of June 30, 2008, we didnot have any off-balance sheet arrangements that have or are reasonably likelyto have a current or future effect on our financial condition, changes infinancial condition, revenues or expenses, results of operations, liquidity,capital expenditures or capital resources that are material to investors.

 

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**Share RepurchaseProgram**

 

TheBoard of Directors has authorized a total of $750.0 million to repurchase ourcommon stock under our share repurchase program. We did not repurchase anyshares of our common stock during the three months ended June 30, 2008. As of June 30,2008, we had utilized approximately $558.2 million pursuant to theauthorizations and had $191.8 million available under the currentauthorization. We may repurchase our common stock from time to time incompliance with the Securities and Exchange Commission’s regulations and otherlegal requirements, and subject to market conditions and other factors. Theshare repurchase program does not require us to acquire any specific number ofshares and may be terminated by the Board of Directors at any time.

 

**Income Taxes**

 

We continue to maintain a fullvaluation allowance against our deferred tax assets of approximately $385.0million, consisting primarily of net operating loss carryforwards. We mayrecognize deferred tax assets in future periods when they are determined to berealizable. To the extent we may owe income taxes in future periods, we intendto use our net operating loss carryforwards to the extent available to reducecash outflows for income taxes.

 

**Future Uses ofCash and Funding Sources**

 

Weexpect to use and invest cash during the year ending December 31, 2008 fora number of reasons. We expect to continue to use cash to acquire and retainnew and existing subscribers for our services, including purchases ofsubscriber bases from other ISPs. We will also use cash to pay real estateobligations associated with facilities exited in our restructuring plan. We mayalso incur additional costs to exit our municipal wireless broadbandoperations. We also expect to incur capital expenditures to maintain andupgrade our network and technology infrastructure. The actual amount of capitalexpenditures may fluctuate due to a number of factors which are difficult topredict and could change significantly over time. Additionally, technologicaladvances may require us to make capital expenditures to develop or acquire newequipment or technology in order to replace aging or technologically obsoleteequipment. Finally, we may also use cash to repurchase common stock under ourexisting share repurchase program.

 

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

 

Ourprincipal sources of liquidity are our cash, cash equivalents and investmentsin marketable securities, as well as the cash flow we generate from ouroperations. As of June 30, 2008, we had $374.9 million in cash and cashequivalents. In addition, we held short- and long-term investments inmarketable securities valued at $4.0 million and $62.8 million, respectively.Short-term investments in marketable securities consist of investments thathave maturity dates of up to one year from the balance sheet date, andlong-term investments in marketable securities consist of investments that havematurity dates of more than one year from the balance sheet date.

 

As of June 30,2008, $54.0 million of our long-term investments in marketable securities wereauction rate securities. These securities are variable-rate debt instrumentswhose underlying agreements have contractual maturities of up to 40 years. Thesecurities are issued by various state related higher education agencies. Thehigher education securities are primarily secured by student loans guaranteedby the agencies and reinsured by the United States Department of Education.Liquidity for these auction rate securities is typically provided by an auctionprocess that resets the applicable interest rate at pre-determined intervals,usually every 28 days. During 2008, all of our auction rate securities failedto attract sufficient buyers, resulting in our continuing to hold suchsecurities. We may not be able to access these funds until a successful auctionoccurs or until the final maturity of the underlying notes. In addition, whileall of our auction rate securities are currently rated AAA, if the auctionscontinue to fail or if the credit ratings on the securities deteriorate, we mayin the future be required to record an other-than-temporary impairment chargeon these investments. Based on our remaining cash and marketable 

 

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securitiesand operating cash flows, we do not anticipate the current lack of liquidity onthese investments will affect our ability to operate our business as usual.

 

In April 2008, PlatinumEquity, LLC acquired all outstanding shares of Covad. As a result, we receivedcash of $50.8 million for the aggregate principal amount of the 12% SeniorSecured Convertible Notes due 2011 held by us plus accrued interest in April 2008and we received cash of $6.3 million for our 6.1 million shares of Covad commonstock in May 2008.

 

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. Wehave no commitments for any additional financing and have no lines of credit orsimilar sources of financing. We cannot be sure that we can obtain additionalfinancing on favorable terms, if at all, through the issuance of equitysecurities or the incurrence of additional debt. Additional equity financingmay dilute our stockholders, and debt financing, if available, may restrict ourability to repurchase common stock, declare and pay dividends and raise futurecapital. If we are unable to obtain additional needed financing, it mayprohibit us from making acquisitions, capital expenditures and/or investments,which could materially and adversely affect our prospects for long-term growth.

 

**Related Party Transactions**

 

*HELIO*

 

EarthLinkand HELIO have entered into a services agreement pursuant to which we provideHELIO billing and other support services in exchange for management fees. Themanagement fees were determined based on our costs to provide the services, andmanagement believes such fees are reasonable. The total amount of fees that HELIO pays to us depends on the extent towhich HELIO utilizes our services.  Feesfor services provided to HELIO are reflected as reductions to the associatedexpenses incurred by us to provide such services. During the three months endedJune 30, 2007 and 2008, fees received for services provided to HELIO were$0.5 million and $0.3 million, respectively. During the six months ended June 30,2007 and 2008, fees received for services provided to HELIO were $0.9 millionand $0.7 million, respectively.

 

Wepurchase wireless Internet access devices and services from HELIO. During thethree months ended June 30, 2007 fees paid for products and servicesreceived from HELIO were $0.2 and during the three months ended June 30,2008 fees paid for products and services received from HELIO were nominal.During the six months ended June 30, 2007 and 2008, fees paid for productsand services received from HELIO were $0.3 million and $0.1 million,respectively.

 

As of December 31,2007 and June 30, 2008, we had accounts receivable from HELIO ofapproximately $0.2 million and $0.2 million, respectively.

 

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**Safe Harbor Statement**

 

TheManagement’s Discussion and Analysis and other portions of this QuarterlyReport on Form 10-Q include “forward-looking” statements (rather thanhistorical facts) that are subject to risks and uncertainties that could causeactual results to differ materially from those described. Although we believethat the expectations expressed in these forward-looking statements arereasonable, we cannot promise that our expectations will turn out to becorrect. Our actual results could be materially different from and worse thanour expectations. With respect to such forward-looking statements, we seek theprotections afforded by the Private Securities Litigation Reform Act of 1995.These risks include, without limitation, (1) that changes to our businessstrategy will reduce our revenues; (2) that the continued decline of ourconsumer access services revenues could adversely affect our profitability; (3) thatprices for certain of our consumer access services have been decreasing, whichcould adversely affect our revenues and profitability; (4) that ourcorporate restructuring plan announced in August 2007 might have anegative effect on our efforts to maintain our subscribers and ourrelationships with our business partners; (5) that as a result of ourcontinuing review of our business, we may have to undertake furtherrestructuring plans that would require additional charges including incurringfacility exit and restructuring charges; (6) that we face significantcompetition which could reduce our market share and reduce our profitability; (7) thatwe may be unsuccessful in making and integrating acquisitions and investmentsinto our business, which could result in operating difficulties, losses andother adverse consequences; (8) that we may not be able to successfullymanage the costs associated with delivering our broadband services, which couldadversely affect our results of operations; (9) that companies may notprovide access to us on a wholesale basis or on reasonable terms or prices,which could cause our operating results to suffer; (10) that if we do notcontinue to innovate and provide products and services that are useful tosubscribers, we may not remain competitive, and our revenues and operatingresults could suffer; (11) that our commercial and alliance arrangements may beterminated or may not be as beneficial as anticipated, which could adverselyaffect our ability to retain or increase our subscriber base; (12) that ourbusiness may suffer if third parties used for technical and customer supportand certain billing services are unable to provide these services, cannotexpand to meet our needs or terminate their relationships with us; (13) thatservice interruptions or impediments could harm our business; (14) thatgovernment regulations could adversely affect our business or force us tochange our business practices; (15) that we may not be able to protect ourproprietary technologies; (16) that we may be accused of infringing upon theintellectual property rights of third parties, which is costly to defend andcould limit our ability to use certain technologies in the future; (17) that wecould face substantial liabilities if we are unable to successfully defendagainst legal actions; (18) that our business depends on the continueddevelopment of effective business support systems, processes and personnel;(19) that we may be unable to hire and retain sufficient qualified personnel,and the loss of any of our key executive officers could adversely affect us;(20) that our VoIP business exposes us to certain risks that could cause us tolose customers, expose us to significant liability or otherwise harm ourbusiness; (21) that the use of our net operating losses and certain other taxattributes could be limited in the future; (22) that our stock price has beenvolatile historically and may continue to be volatile; (23) that ourindebtedness could adversely affect our financial health and limit our abilityto react to changes in our industry; (24) that the convertible notes hedge andwarrant transactions may affect the value of our common stock; and (25) thatprovisions of our second restated certificate of incorporation, amended andrestated bylaws and other elements of our capital structure could limit ourshare price and delay a change of management. These risks and uncertainties, aswell as other risks and uncertainties that could cause our actual results todiffer significantly from management’s expectations, are not intended torepresent a complete list of all risks and uncertainties inherent in ourbusiness, and should be read in conjunction with the more detailed cautionarystatements and risk factors included in our Annual Report on Form 10-K forthe year ended December 31, 2007.

 

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

 

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

 

*Auction Rate Securities*

 

TheCompany is exposed to risk with respect to its auction rate securities. Thesesecurities are variable-rate debt instruments whose underlying agreements havecontractual maturities of up to 40 years. These securities are issued byvarious state regulated higher education agencies. The securities arepredominantly secured by student loans guaranteed by the agencies and reinsuredby the United States Department of Education. Liquidity for these auction ratesecurities is typically provided by an auction process that resets theapplicable interest rate at pre-determined intervals, usually every 28 days.During the six months ended June 30, 2008, the Company’s auction ratesecurities failed to attract sufficient buyers, resulting in our continuing tohold such securities. The Company may not be able to access these funds until asuccessful auction occurs or until the final maturity of the underlying notes.

 

Due tothe lack of availability of observable market quotes, the fair values of theCompany’s auction rate securities were estimated utilizing a discounted cashflow analysis as of June 30, 2008.  These analyses consider,among other items, the collateralization underlying the security investments,the creditworthiness of the counterparty and the timing and value of expectedfuture cash flows.  As a result of temporary declines in the fair value ofthe Company’s auction rate securities, which the Company attributes toliquidity issues rather than credit issues, it has recorded an unrealized lossof $3.8 million as of June 30, 2008 to reduce the cost basis of $57.8million to the estimated fair value of $54.0 million. The Company will continueto evaluate the fair value of its investments in auction rate securities eachreporting period for a potential other-than-temporary impairment. While all ofthe Company’s auction rate securities are currently rated AAA, if the marketdoes not recover or if the credit ratings on the securities deteriorate, it mayin the future be required to record an other-than-temporary impairment chargeon these investments.

 

**Item 4. Controls and Procedures.**

 

**Evaluation ofDisclosure Controls and Procedures**

 

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

 

**Changes inInternal Control over Financial Reporting**

 

Therewere no changes in our internal control over financial reporting during thethree months ended June 30, 2008 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.**

 

EarthLinkis a party to various legal proceedings that are ordinary and incidental to itsbusiness. Management does not expect that any currently pending legalproceedings will have a material adverse effect on EarthLink’s results ofoperations or financial position.

 

**Item 1A.  Risk Factors.**

 

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

 

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

 

None.

 

**Item 4.  Submission of Matters to a Vote of Security Holders.**

 

EarthLinkheld its 2008 annual meeting of stockholders on May 8, 2008. The followingsummarizes the voting results for the two proposals submitted for a vote of thestockholders at that meeting:

 

Proposal1.  To elect Sky D. Dayton, William H. Harris, Jr. and Rolla P.Huff to EarthLink’s Board of Directors as Class II directors for athree-year term.

 
| ** **      | ** ** | **Sky D. Dayton** | ** ** | **William H. Harris, Jr.** | ** ** | **Rolla P. Huff** | ** ** |
|-----------------|------------|-----------------------------|------------|-------------------------------------------|------------|-----------------------------|------------|
| Votes For       |       | 99,968,650 shares           |       | 98,984,165 shares                         |       | 99,470,118 shares           |       |
| Votes Abstained |       | 1,068,728 shares            |       | 1,773,213 shares                          |       | 1,287,260 shares            |       |

 

Proposal2. To ratify the appointment of Ernst & Young LLP by the AuditCommittee of the Board of Directors to serve as EarthLink’s independentregistered public accounting firm for the fiscal year ending December 31,2008.

 

VotesFor—100,231,865 shares

VotesAgainst—442,210 shares

VotesAbstained—83,302 shares

 

Bothof these proposals were approved by the EarthLink stockholders at the annualmeeting.

 

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**Item 5.  Other Information.**

 

None.

 

**Item 6.   Exhibits.**

 

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

 
| 10.1   |   | Change-in-Control  Accelerated Vesting and Severance Plan, amended effective as of  October 19, 2005 and amended and restated effective as of  February 17, 2006 and as of May 8, 2008. |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                   |
| 10.2   |   | EarthLink, Inc. Board of Directors Compensation  Plan, dated July 2008.                                                                                                                      |
|   |   |                                                                                                                                                                                                   |
| 10.3   |   | Form of  Restricted Stock Unit Agreement for Nonemployee Directors.                                                                                                                               |
|   |   |                                                                                                                                                                                                   |
| 10.4   |   | Restricted  Stock Unit Agreement dated as of February 8, 2008 for Rolla P. Huff  under the EarthLink, Inc. 2006 Equity and Cash Incentive Plan.                                              |
|   |   |                                                                                                                                                                                                   |
| 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:  | August 1, 2008 |             | /s/  ROLLA P. HUFF |
|   |                |             | Rolla P. Huff, Chairman  of the Board and Chief  Executive Officer (principal executive officer) |
|   |                |             |   |
|   |                |             |   |
| Date:  | August 1, 2008 |             | /s/  KEVIN M. DOTTS |
|   |                |             | Kevin M. Dotts, Chief  Financial Officer |
|   |                |             | (principal financial  officer) |
|   |                |             |   |
|   |                |             |   |
| Date:  | August 1, 2008 |             | /s/  BRADLEY A. FERGUSON |
|   |                |             | Bradley A. Ferguson,  Vice President and  Corporate Controller |
|   |                |             | (principal accounting  officer) |

 

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