**UNITED STATES SECURITIES AND EXCHANGE COMMISSIONWashington, 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, 2007**                                                                        |
| ** ** | ** **                                                                                                              |
| **OR**     |
| ** ** |                                                                                                                    |
| **o**      | **TRANSITION REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                           |
| ** ** | ** **                                                                                                              |
| ** ** | **For the transition period from          to        ** |

 

**CommissionFile Number: 001-15605**

**EARTHLINK,INC.**

(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)

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

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Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.  Yes xNo o

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

Large acceleratedfiler x     Accelerated filer o      Non-accelerated filer o

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

As of July 31, 2007, 123,663,623 shares of commonstock, $.01 par value per share, were outstanding.

 

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**EARTHLINK, INC.Quarterly Report on Form 10-QFor the Quarterly Period Ended June 30, 2007**

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

 

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**PART I**

**Item 1.  FinancialStatements.**

**EARTHLINK,INC.CONDENSED CONSOLIDATED BALANCE SHEETS(in thousands, except per share data)**
| ** **                                                                                                                                                                                                                                                 | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------|------------|
| ** **                                                                                                                                                                                                                                                 | ** ** | **2006**              | ** ** | **2007**          | ** ** |
| ** **                                                                                                                                                                                                                                                 | ** ** | ** **            | ** ** | **(unaudited)**   | ** ** |
| ** **                                                                                                                                                                                                                                                 | ** ** | ** **            | ** ** | ** **        | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                 | ** ** | ** **            | ** ** | ** **        | ** ** |
| Current assets:                                                                                                                                                                                                                                            |       |                  |       |              |       |
| Cash and cash equivalents                                                                                                                                                                                                                                  |       | $                     | 158,369    |              | $          | 127,623 |   |
| Investments in marketable securities                                                                                                                                                                                                                       |       | 214,947               |       | 229,546           |       |
| Accounts receivable, net of allowance of  $8,062 and $9,810 as of December 31, 2006 and June 30, 2007, respectively                                                                                                                                        |       | 51,054                |       | 50,989            |       |
| Prepaid expenses                                                                                                                                                                                                                                           |       | 14,831                |       | 11,498            |       |
| Other current assets                                                                                                                                                                                                                                       |       | 17,549                |       | 16,073            |       |
| Total current assets                                                                                                                                                                                                                                       |       | 456,750               |       | 435,729           |       |
| Long-term investments in marketable  securities                                                                                                                                                                                                            |       | 21,460                |       | 26,198            |       |
| Property and equipment, net                                                                                                                                                                                                                                |       | 96,620                |       | 113,623           |       |
| Investment in equity affiliate                                                                                                                                                                                                                             |       | 61,743                |       | 11,887            |       |
| Investments in other companies                                                                                                                                                                                                                             |       | 59,325                |       | 55,123            |       |
| Purchased intangible assets, net                                                                                                                                                                                                                           |       | 59,798                |       | 56,083            |       |
| Goodwill                                                                                                                                                                                                                                                   |       | 202,277               |       | 202,277           |       |
| Other long-term assets                                                                                                                                                                                                                                     |       | 10,066                |       | 10,888            |       |
| Total assets                                                                                                                                                                                                                                               |       | $                     | 968,039    |              | $          | 911,808 |   |
|                                                                                                                                                                                                                                                       |       |                  |       |              |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                              | ** ** | ** **            | ** ** | ** **        | ** ** |
| Current liabilities:                                                                                                                                                                                                                                       |       |                  |       |              |       |
| Trade accounts payable                                                                                                                                                                                                                                     |       | $                     | 41,298     |              | $          | 31,882 |   |
| Accrued payroll and related expenses                                                                                                                                                                                                                       |       | 41,079                |       | 35,239            |       |
| Other accounts payable and accrued  liabilities                                                                                                                                                                                                            |       | 94,882                |       | 91,040            |       |
| Deferred revenue                                                                                                                                                                                                                                           |       | 53,511                |       | 49,958            |       |
| Total current liabilities                                                                                                                                                                                                                                  |       | 230,770               |       | 208,119           |       |
|                                                                                                                                                                                                                                                       |       |                  |       |              |       |
| Long-term debt                                                                                                                                                                                                                                             |       | 258,750               |       | 258,750           |       |
| Other long-term liabilities                                                                                                                                                                                                                                |       | 19,855                |       | 26,730            |       |
| Total liabilities                                                                                                                                                                                                                                          |       | 509,375               |       | 493,599           |       |
|                                                                                                                                                                                                                                                       |       |                  |       |              |       |
| Stockholders’ equity:                                                                                                                                                                                                                                 |       |                  |       |              |       |
| Convertible preferred stock, $0.01 par  value, 100,000 shares authorized, 0 shares issued and outstanding as of  December 31, 2006 and June 30, 2007                                                                                                       |       | —                |       | —            |       |
| Common stock, $0.01 par value, 300,000  shares authorized, 184,545 and 185,477 shares issued as of December 31, 2006  and June 30, 2007, respectively, and 122,634 and 123,566 shares outstanding  as of December 31, 2006 and June 30, 2007, respectively |       | 1,845                 |       | 1,855             |       |
| Additional paid-in capital                                                                                                                                                                                                                                 |       | 2,016,578             |       | 2,033,219         |       |
| Warrants to purchase common stock                                                                                                                                                                                                                          |       | 259                   |       | 231               |       |
| Accumulated deficit                                                                                                                                                                                                                                        |       | (1,044,995            | )          | (1,095,275        | )          |
| Treasury stock, at cost, 61,911 shares  as of December 31, 2006 and June 30, 2007                                                                                                                                                                          |       | (508,232              | )          | (508,232          | )          |
| Unrealized losses on investments                                                                                                                                                                                                                           |       | (6,791                | )          | (13,589           | )          |
| Total stockholders’ equity                                                                                                                                                                                                                            |       | 458,664               |       | 418,209           |       |
| Total liabilities and stockholders’  equity                                                                                                                                                                                                           |       | $                     | 968,039    |              | $          | 911,808 |   |

 

The accompanying notes are an integralpart of these financial statements.

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**EARTHLINK, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**
| ** **                                          | ** ** | **Three Months Ended**                                   | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                          | ** ** | **June 30,**                                                  | ** ** | **June 30,**              | ** ** |
| ** **                                          | ** ** | **2006**                                                           | ** ** | **2007**                       | ** ** | **2006** | ** ** | **2007** | ** ** |
| ** **                                          | ** ** | **(in thousands, except per share data)** | ** ** |
| ** **                                          | ** ** | **(unaudited)**                                                    | ** ** |
|                                                |       |                                                               |       |                           |       |   |   |   |   |
| Revenues                                            |       | $                                                                  | 332,096    |                           | $          | 312,203 |   | $ | 641,808 |   | $ | 636,609 |   |
|                                                |       |                                                               |       |                           |       |   |   |   |   |
| Operating costs and expenses:                       |       |                                                               |       |                           |       |   |   |   |   |
| Service and equipment costs                         |       | 110,301                                                            |       | 110,472                        |       | 200,373 |   | 221,630 |   |
| Sales incentives                                    |       | 2,392                                                              |       | 5,367                          |       | 4,669 |   | 10,075 |   |
| Total cost of revenues                              |       | 112,693                                                            |       | 115,839                        |       | 205,042 |   | 231,705 |   |
|                                                |       |                                                               |       |                           |       |   |   |   |   |
| Sales and marketing                                 |       | 91,172                                                             |       | 76,186                         |       | 195,015 |   | 174,817 |   |
| Operations and customer support                     |       | 66,553                                                             |       | 65,936                         |       | 127,221 |   | 131,946 |   |
| General and administrative                          |       | 31,441                                                             |       | 30,517                         |       | 62,651 |   | 74,870 |   |
| Amortization of intangible assets                   |       | 3,122                                                              |       | 3,542                          |       | 5,035 |   | 7,038 |   |
| Facility exit and restructuring costs               |       | (117                                                               | )          | —                         |       | (117 | ) | — |   |
| Total operating costs and expenses                  |       | 304,864                                                            |       | 292,020                        |       | 594,847 |   | 620,376 |   |
|                                                |       |                                                               |       |                           |       |   |   |   |   |
| Income from operations                              |       | 27,232                                                             |       | 20,183                         |       | 46,961 |   | 16,233 |   |
| Net losses of equity affiliate                      |       | (15,351                                                            | )          | (40,054                        | )          | (22,942 | ) | (69,400 | ) |
| Gain on investments in other companies              |       | 352                                                                |       | 210                            |       | 352 |   | 210 |   |
| Interest income and other, net                      |       | 4,334                                                              |       | 3,597                          |       | 8,550 |   | 7,100 |   |
| Income (loss) before income taxes                   |       | 16,567                                                             |       | (16,064                        | )          | 32,921 |   | (45,857 | ) |
| Provision for income taxes                          |       | —                                                             |       | 226                            |       | — |   | 395 |   |
| Net income (loss)                                   |       | $                                                                  | 16,567     |                           | $          | (16,290 | ) | $ | 32,921 |   | $ | (46,252 | ) |
|                                                |       |                                                               |       |                           |       |   |   |   |   |
| Basic net income (loss) per share                   |       | $                                                                  | 0.12       |                           | $          | (0.13 | ) | $ | 0.25 |   | $ | (0.38 | ) |
| Diluted net income (loss) per share                 |       | $                                                                  | 0.12       |                           | $          | (0.13 | ) | $ | 0.24 |   | $ | (0.38 | ) |
| Basic weighted average common shares  outstanding   |       | 132,779                                                            |       | 123,257                        |       | 132,147 |   | 123,159 |   |
| Diluted weighted average common shares  outstanding |       | 134,897                                                            |       | 123,257                        |       | 134,718 |   | 123,159 |   |

 

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,**              | ** ** |
| ** **                                                                                | ** ** | **2006**                       | ** ** | **2007** | ** ** |
| ** **                                                                                | ** ** | **(in thousands)**        | ** ** |
| ** **                                                                                | ** ** | **(unaudited)**                | ** ** |
| Cash flows from operating activities:                                                     |       |                           |       |   |   |
| Net income (loss)                                                                         |       | $                              | 32,921     |   | $ | (46,252 | ) |
| Adjustments to reconcile net income (loss) to net cash provided by  operating activities: |       |                           |       |   |   |
| Depreciation and amortization                                                             |       | 21,810                         |       | 26,118 |   |
| Loss on disposals of fixed assets                                                         |       | 809                            |       | 7 |   |
| Net losses of equity affiliate                                                            |       | 22,942                         |       | 69,400 |   |
| Gain on investments in other companies                                                    |       | (352                           | )          | (210 | ) |
| Stock-based compensation                                                                  |       | 7,427                          |       | 10,813 |   |
| Decrease in accounts receivable, net                                                      |       | 5,048                          |       | 39 |   |
| Decrease in prepaid expenses and other assets                                             |       | 837                            |       | 1,275 |   |
| Decrease in accounts payable and accrued and other liabilities                            |       | (30,686                        | )          | (24,709 | ) |
| Decrease in deferred revenue                                                              |       | (1,622                         | )          | (3,277 | ) |
| Other                                                                                     |       | (514                           | )          | (43 | ) |
| Net cash provided by operating activities                                                 |       | 58,620                         |       | 33,161 |   |
|                                                                                      |       |                           |       |   |   |
| Cash flows from investing activities:                                                     |       |                           |       |   |   |
| Purchases of property and equipment                                                       |       | (13,857                        | )          | (26,828 | ) |
| Purchases of subscriber bases                                                             |       | (1,795                         | )          | (2,949 | ) |
| Proceeds from sales of fixed assets                                                       |       | 8                              |       | 36 |   |
| Investments in marketable securities                                                      |       |                           |       |   |   |
| Purchases                                                                                 |       | (60,387                        | )          | (232,536 | ) |
| Sales and maturities                                                                      |       | 162,060                        |       | 213,202 |   |
| Purchase of business, net                                                                 |       | (108,663                       | )          | — |   |
| Investments in and net advances to equity affiliate                                       |       | (39,433                        | )          | (19,474 | ) |
| Investments in other companies                                                            |       | (60,000                        | )          | — |   |
| Other investing activities                                                                |       | (803                           | )          | 210 |   |
| Net cash used in investing activities                                                     |       | (122,870                       | )          | (68,339 | ) |
|                                                                                      |       |                           |       |   |   |
| Cash flows from financing activities:                                                     |       |                           |       |   |   |
| Repayment of note payable                                                                 |       | (2,000                         | )          | — |   |
| Principal payments under capital lease obligations                                        |       | (14                            | )          | (15 | ) |
| Proceeds from exercises of stock options and other                                        |       | 3,198                          |       | 4,447 |   |
| Repurchases of common stock                                                               |       | (21,142                        | )          | — |   |
| Net cash (used in) provided by financing activities                                       |       | (19,958                        | )          | 4,432 |   |
|                                                                                      |       |                           |       |   |   |
| Net decrease in cash and cash  equivalents                                                |       | (84,208                        | )          | (30,746 | ) |
| Cash and cash equivalents, beginning of  period                                           |       | 173,294                        |       | 158,369 |   |
| Cash and cash equivalents, end of period                                                  |       | $                              | 89,086     |   | $ | 127,623 |   |
|                                                                                      |       |                           |       |   |   |
| Significant non-cash transactions:                                                        |       |                           |       |   |   |
| Assets acquired pursuant to capital  lease agreement                                      |       | $                              | —     |   | $ | 8,117 |   |

 

The accompanyingnotes are an integral part of these financial statements.

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**EARTHLINK, INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSUNAUDITED**

**1.  Organization**

EarthLink, Inc.(“EarthLink” or the “Company”) is a total communications provider, providingintegrated communication services and related value-added services toindividual consumers and business customers utilizing Internet Protocol, or IP,based technologies.  EarthLink’s coreservice offerings are dial-up and wireline broadband Internet access servicesand value-added services. EarthLink’s growth initiatives have recently includedIP-based voice services, municipal wireless broadband services and services forbusiness customers.

**2.  Basis of Presentation**

*Basis of Presentation*

Thecondensed consolidated financial statements of EarthLink, which include theaccounts of its wholly-owned subsidiaries, for the three and six months endedJune 30, 2006 and 2007 and the related footnote information are unaudited andhave been prepared on a basis consistent with the Company’s auditedconsolidated financial statements as of December 31, 2006 contained in theCompany’s Annual Report on Form 10-K, as amended, as filed with the Securitiesand Exchange Commission (the “Annual Report”). All significant 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, 2007 are not necessarily indicative of the results anticipatedfor the entire year ending December 31, 2007.

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

*Adoption of Recent AccountingPronouncements*

On January 1, 2007,EarthLink adopted the consensus reached in Emerging Issues Task Force (“EITF”)Issue No. 06-2, “Accounting for Sabbatical Leave and Other Similar BenefitsPursuant to FASB Statement No. 43.” EITF Issue No. 06-2 provides recognitionguidance on the accrual of employees’ rights to compensated absences under asabbatical or other similar benefit arrangement. The adoption of EITF Issue No.06-2 resulted in a $4.0 million increase to accumulated deficit and accruedliabilities as of January 1, 2007.

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

*Reclassifications*

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

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**3.  Recent Accounting Pronouncements**

InSeptember 2006, the Financial Accounting Standards Board (“FASB”) issuedStatement of Financial Accounting Standards (“SFAS”) No. 157, “Fair ValueMeasurements,” which establishes a framework for reporting fair value andexpands disclosures required for fair value measurements. SFAS No. 157 iseffective for financial statements issued for fiscal years beginning afterNovember 15, 2007 and interim periods within those fiscal years. TheCompany is currently assessing the impact of the adoption of this standard onits financial statements.

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

**4.  Earnings per Share**

Netincome (loss) per share has been computed according to SFAS No. 128, “Earningsper Share,” which requires a dual presentation of basic and diluted earningsper share (“EPS”).  Basic EPS representsnet income divided by the weighted average number of common shares outstandingduring a reported period.  Diluted EPSreflects the potential dilution that could occur if securities or othercontracts to issue common stock, including stock options, warrants, restrictedstock units, phantom share units and contingently issuable shares (commonly andhereinafter referred to as “Common Stock Equivalents”), were exercised orconverted into common stock. The dilutive effect of outstanding stock options,warrants and restricted stock units is reflected in diluted earnings per shareby application of the treasury stock method. Phantom share units andcontingently issuable shares are reflected on an if-converted basis. Inapplying the treasury stock method for stock-based compensation arrangements,the assumed proceeds were computed as the sum of the amount the employee mustpay upon exercise and the amounts of compensation cost attributed tofuture services and not yet recognized.

Thefollowing table sets forth the computation for basic and diluted net income pershare for the three and six months ended June 30, 2006:
|                                                         | ** ** | **Three Months**                                              | ** ** | **Six Months**         | ** ** |
|---------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                              | ** ** | **Ended**                                                          | ** ** | **Ended**                   | ** ** |
| ** **                                              | ** ** | **June 30, 2006**                                        | ** ** | **June 30, 2006** | ** ** |
| ** **                                              | ** ** | **(in thousands, except per share data)** | ** ** |
| ** **                                              | ** ** | ** **                                                         | ** ** | ** **                  | ** ** |
| Net income (A)                                          |       | $                                                                  | 16,567     |                        | $          | 32,921 |   |
|                                                    |       |                                                               |       |                        |       |
| Basic weighted average common shares outstanding  (B)   |       | 132,779                                                            |       | 132,147                     |       |
| Dilutive effect of Common Stock  Equivalents            |       | 2,118                                                              |       | 2,571                       |       |
| Diluted weighted average common shares outstanding  (C) |       | 134,897                                                            |       | 134,718                     |       |
|                                                    |       |                                                               |       |                        |       |
| Basic net income per share (A/B)                        |       | $                                                                  | 0.12       |                        | $          | 0.25 |   |
| Diluted net income per share (A/C)                      |       | $                                                                  | 0.12       |                        | $          | 0.24 |   |

 

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Duringthe three and six months ended June 30, 2006, approximately 13.8 million and16.0 million options and warrants were excluded from the calculation of dilutedEPS because the exercise prices plus the amount of compensation costattributed to future services and not yet recognized exceeded the Company’saverage stock price during the respective 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, 2007because such inclusion would have an anti-dilutive effect. As of June 30, 2007,the Company had 20.6 million options outstanding, 28.5 million warrants outstandingand 1.1 million restricted stock units outstanding. These options, warrants andrestricted stock units could be dilutive in future periods. In addition,approximately 28.4 million shares underlie the Company’s convertible debtinstruments, which could be dilutive in future periods.

**5.  Investments**

*Investmentsin marketable securities*

Investmentsin marketable securities are accounted for in accordance with SFASNo. 115, “Accounting for Certain Investments in Debt and EquitySecurities.” 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. Short-terminvestments also include investments in asset-backed, auction rate debtsecurities with interest rate reset periods of 90 days or less but whoseunderlying agreements have original maturities of more than 90 days, based onthe provisions of Accounting Research Bulletin No. 43, Chapter 3A, WorkingCapital-Current Assets and Liabilities, which allows classification ofinvestments based on management’s view. Investments in marketable securitieswith maturities greater than one year from the balance sheet date, excludinginvestments in asset-backed, auction rate debt securities with interest resetperiods of 90 days or less, are considered long-term investments in marketablesecurities. The Company has invested in government agency notes, asset-backeddebt securities (including auction rate debt securities), corporate notes andcommercial paper, all of which bear a minimum short-term rating of A1/P1 or aminimum long-term rating of A/A2.

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 as liquidityrequirements, the Company occasionally sells its investments in marketablesecurities prior to their stated maturities. Available for sale securities arecarried at fair value, with any unrealized gains and losses, net of tax,included in unrealized gains (losses) on investments as a separate component ofstockholders’ equity and in total comprehensive income (loss). As of December31, 2006 and June 30, 2007, gross unrealized losses were $0.3 million and grossunrealized gains were nominal. The Company believes its gross unrealized lossesare temporary because management has the intent and ability to hold theseinvestments until maturity, at which time the Company would expect to receivethe amortized cost basis of the investment based on the underlying contractualarrangement.

Realizedgains and losses are included in interest income and other, net, in theaccompanying Condensed Consolidated Statements of Operations and are determinedon a specific identification basis. The Company has not realized any significantgains or losses on its investments in marketable securities during the periodspresented.

*Investments in other companies*

Asof December 31, 2006 and June 30, 2007, minority investments in other companieswere $59.3 million and $55.1 million, respectively, and are classified asinvestments in other companies in the Condensed Consolidated Balance Sheets.The Company 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 (losses) gains included in stockholders’ equity and accumulatedother 

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comprehensive income(loss). Minority investments in other companies as of December 31, 2006 andJune 30, 2007 included $11.0 million of investments carried at cost and $48.3million and $44.1 million, respectively, of investments recorded at fair value.As of December 31, 2006 and June 30, 2007, gross unrealized losses were $6.5million and $13.3 million, respectively, and there were no gross unrealizedgains.

During the three months ended June 30, 2007, the Companyreceived a $0.2 million cash distribution from eCompanies Venture Group, L.P. (“EVG”),a limited partnership that has invested in domestic emerging Internet-relatedcompanies, which was recorded as a gain on investments in other companies inthe Condensed 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.Management also regularly evaluates whether declines in the fair values of itsinvestments below their cost are potentially other than temporary. Thisevaluation consists of several qualitative and quantitative factors regardingthe severity and duration of the unrealized loss as well as the Company’sability and intent to hold the investment for a period of time which may besufficient for an anticipated recovery in market value. During the three andsix months ended June 30, 2006 and 2007, the Company did not recognize anylosses due to other-than-temporary declines of the value of investments.

*Investment in equity 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. As ofDecember 31, 2006 and June 30, 2007, EarthLink’s and SK Telecom’s economicownership interest in HELIO was approximately 48 percent, and EarthLink’s andSK Telecom’s voting interest was 50 percent.

Pursuantto the HELIO Contribution and Formation Agreement, the Company has contributed$220.0 million of cash and non-cash assets to date, including $122.0 millionduring 2005, $78.5 million during 2006 and $19.5 million during the six monthsended June 30, 2007.

InJuly 2007, EarthLink and SK Telecom entered into a loan agreement with HELIO pursuantto which EarthLink and SK Telecom could lend up to $200.0 million toHELIO.  Under the terms of the agreement,EarthLink and SK Telecom may each purchase from HELIO up to $100.0 million ofHELIO’s secured promissory notes (the “Promissory Notes”).  The Promissory Notes may be purchased byEarthLink and SK Telecom from time to time over a one year period commencing onthe date of the agreement.  ThePromissory Notes bear interest at 10.00% per annum, payable at maturity, andmay be pre-paid by HELIO at any time without penalty.  The Promissory Notes mature on July 23, 2010,unless amounts become due and payable earlier by acceleration or otherwise.

InJuly 2007, EarthLink and SK Telecom purchased initial Promissory Notes of $30.0million each.

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. As a result, the Company records itsproportionate share of HELIO’s net loss in its Condensed Consolidated Statementof Operations. The Company is amortizing the difference between the book valueand fair value of non-cash assets contributed to HELIO over their estimateduseful lives. The amortization increases the carrying value of the Company’sinvestment and decreases the net losses of equity affiliate included in theCondensed Consolidated Statement of Operations. During the three and six monthsended June 30, 2006, the Company recorded $15.4 million and $22.9 million,respectively, of net losses of equity affiliate related to its HELIOinvestment, which is net of amortization of basis differences and certain otherequity method accounting adjustments. During the three and six months endedJune 30, 2007, the Company recorded $40.1 million and $69.4 million,respectively, of net 

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losses of equityaffiliate related to its HELIO investment, which is net of amortization ofbasis differences and certain other equity method accounting adjustments.

Thefollowing table presents summarized statement of operations information ofHELIO for the three and six months ended June 30, 2006 and 2007:
|                | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **     | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **     | ** ** | **2006**                         | ** ** | **2007**                       | ** ** | **2006** | ** ** | **2007** | ** ** |
| ** **     | ** ** | **(in thousands)**          | ** ** |
|           |       |                             |       |                           |       |   |   |   |   |
| Revenues       |       | $                                | 5,712      |                           | $          | 33,185 |   | $ | 11,192 |   | $ | 63,544 |   |
| Operating loss |       | (37,952                          | )          | (84,971                        | )          | (59,895 | ) | (150,085 | ) |
| Net loss       |       | (35,468                          | )          | (83,852                        | )          | (55,377 | ) | (146,981 | ) |
|                |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |

 

**6.  Purchased Intangible Assets and Goodwill**

*PurchasedIntangible Assets*

Thefollowing table presents the components of the Company’s acquired identifiableintangible assets included in the accompanying Condensed Consolidated BalanceSheets as of December 31, 2006 and June 30, 2007:
| ** **                                   | ** ** | **As of December 31, 2006** | ** ** | **As of June 30, 2007** | ** ** |
|----------------------------------------------|------------|-------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                   | ** ** | **Gross**                                       | ** ** | ** **                                  | ** ** | **Net** | ** ** | **Gross** | ** ** | ** ** | ** ** | **Net** | ** ** |
| ** **                                   | ** ** | **Carrying**                                    | ** ** | **Accumulated**                             | ** ** | **Carrying** | ** ** | **Carrying** | ** ** | **Accumulated** | ** ** | **Carrying** | ** ** |
| ** **                                   | ** ** | **Value**                                       | ** ** | **Amortization**                            | ** ** | **Value** | ** ** | **Value** | ** ** | **Amortization** | ** ** | **Value** | ** ** |
| ** **                                   | ** ** | **(in thousands)**                         | ** ** |
|                                         |       |                                            |       |                                        |       |   |   |   |   |   |   |   |   |
| Subscriber bases and customer  relationships |       | $                                               | 384,336    |                                        | $          | (337,708 | ) | $ | 46,628 |   | $ | 387,659 |   | $ | (344,282 | ) | $ | 43,377 |   |
| Software, technology and other               |       | 3,864                                           |       | (1,551                                      | )          | 2,313 |   | 3,864 |   | (2,015 | ) | 1,849 |   |
| Trade names                                  |       | 10,857                                          |       | —                                      |       | 10,857 |   | 10,857 |   | — |   | 10,857 |   |
| Total                                        |       | $                                               | 399,057    |                                        | $          | (339,259 | ) | $ | 59,798 |   | $ | 402,380 |   | $ | (346,297 | ) | $ | 56,083 |   |

 

Amortization ofintangible assets in the Condensed Consolidated Statements of Operations forthe three and six months ended June 30, 2006 and 2007 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 and other assets acquired in conjunction withthe purchases of businesses and subscriber bases from other companies that arenot deemed to have indefinite lives. Definite lived intangible assets areamortized on a straight-line basis over their estimated useful lives, which aregenerally three to six years for subscriber bases and customer relationshipsand one to six years for acquired software and technology. As of December 31,2006 and June 30, 2007, the weighted average amortization periods were 3.3years for subscriber base assets and customer relationships and 4.1 years forsoftware and technology. Based on the current amount of definite livedintangible assets, the Company expects to record amortization expense ofapproximately $8.9 million during the six months ending December 31, 2007 and$12.9 million, $10.0 million, $6.9 million, $6.3 million and $0.2 millionduring the years ending December 31, 2008, 2009, 2010, 2011 andthereafter, respectively. Actual amortization expense to be reported in futureperiods could differ materially from these estimates as a result of assetacquisitions, changes in useful lives and other relevant factors. The Company’sidentifiable indefinite lived intangible assets consist of trade names.

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**7.  Long-Term Debt**

In November 2006, the Company issued$258.8 million aggregate principal amount of Convertible Senior Notes dueNovember 15, 2026 (the “Notes”) in a registered offering, which reflects theexercise by the underwriters of their option to purchase an additional $33.8million of principal to cover over-allotments. The Company received netproceeds of $251.6 million after transaction fees of $7.2 million. The Notesbear interest at 3.25% per year on the principal amount of the Notes untilNovember 15, 2011, and 3.50% interest per year on the principal amount of theNotes thereafter, payable semi-annually in May and November of each year. TheNotes 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 after anyfive 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) upon theoccurrence of specified corporate transactions; (4) if the Company has calledthe 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 November15, 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, 2006 and June 30,2007, the fair value of the Notes was approximately $277.3 million and $277.9million, respectively, based on quoted market prices.

In connection with the issuance of theNotes, the Company entered into separate convertible note hedge transactionsand separate warrant transactions with respect to the Company’s common stock toreduce the potential dilution upon conversion of the Notes (collectivelyreferred to as the “Call Spread Transactions”). The Company purchased calloptions to cover approximately 28.4 million shares of the Company’s common stock,subject to adjustment in certain circumstances, which is the number of sharesunderlying the Notes. In addition, the Company sold warrants permitting thepurchasers to acquire up to approximately 28.4 million shares of the Company’scommon stock, subject to adjustment in certain circumstances. See Note 8, “Stockholders’Equity,” for more information on the Call Spread Transactions.

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**8. Stockholders’ Equity**

*Comprehensive Income (Loss)*

Comprehensiveincome (loss) includes unrealized gains and losses on certain investmentsclassified as available-for-sale, net of tax, which are excluded from theCondensed Consolidated Statements of Operations in accordance with SFASNo. 130, “Reporting Comprehensive Income.” Comprehensive income (loss) forthe three and six months ended June 30, 2006 and 2007 was as follows:
|                                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                    | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                    | ** ** | **2006**                         | ** ** | **2007**                       | ** ** | **2006** | ** ** | **2007** | ** ** |
| ** **                                    | ** ** | **(in thousands)**          | ** ** |
| Net income (loss)                             |       | $                                | 16,567     |                           | $          | (16,290 | ) | $ | 32,921 |   | $ | (46,252 | ) |
| Net unrealized gains (losses) on  investments |       | 3,139                            |       | (2,255                         | )          | 5,384 |   | (6,798 | ) |
| Total comprehensive income (loss)             |       | $                                | 19,706     |                           | $          | (18,545 | ) | $ | 38,305 |   | $ | (53,050 | ) |

 

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

*Share Repurchases*

Sincethe inception of the Company’s share repurchase program, the Board of Directorshas authorized a total of $550.0 million for the repurchase of EarthLink’scommon stock. As of June 30, 2007, the Company had $95.3 million availableunder the current authorizations. The Company may repurchase its common stockfrom time to time in compliance with Securities and Exchange Commissionregulations and other legal requirements, including through the use ofderivative 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.

Duringthe three and six months ended June 30, 2006, the Company purchased 2.3 millionand 2.5 million shares, respectively, of its common stock for an aggregatepurchase price of $19.5 million and $21.1 million, respectively. The Companydid not repurchase any shares of its common stock during the three and sixmonths ended June 30, 2007.

*Call Spread Transactions*

Inconnection with the issuance of the Notes (see Note 7, “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 the earlier of the maturity datesof the related senior convertible notes or the first day all of the relatedsenior convertible notes are no longer outstanding due to conversion orotherwise.  As of December 31, 2006 andJune 30, 2007, the estimated fair value of the call options was $58.4 millionand $60.0 million, respectively.

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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, 2006 and June 30, 2007, the estimatedfair value of the warrants was $41.0 million and $42.8 million, respectively.

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

**9.  Stock-Based Compensation**

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

Stock-basedcompensation expense under SFAS No. 123(R) was $3.7 million and $7.4 millionduring the three and six months ended June 30, 2006, respectively, and $2.9million and $10.8 million during the three and six months ended June 30, 2007,respectively. The Company classifies stock-based compensation expense withinthe same operating expense line items as cash compensation paid to employees.

Includedin stock-based compensation expense for the six months ended June 30, 2007 was$4.9 million of stock-based compensation expense related to Charles G. Betty,EarthLink’s former President and Chief Executive Officer. Mr. Betty passed awayon January 2, 2007. Pursuant to Mr. Betty’s employment agreement, all unvestedstock options and restricted stock units immediately vested and became fullyexercisable upon death. In addition, the Leadership and Compensation Committeeof the Board of Directors extended the exercise period of Mr. Betty’sstock options until December 31, 2008. This date represents the exerciseperiod if Mr. Betty had terminated employment after serving the full term ofhis employment agreement, which was set to expire in July 2008. During the sixmonths ended June 30, 2007, EarthLink recorded stock-based compensation of $3.5million related to the accelerated vesting of 1.1 million stock options and120,000 restricted stock units and recorded stock-based compensation expense of$1.4 million related to the extension of the exercise period for Mr. Betty’sstock options.

*StockIncentive Plans*

TheCompany has granted options to employees and directors to purchase the Company’scommon stock under various stock incentive plans. The Company has also grantedrestricted stock units to employees and directors under various stock incentiveplans. Under the plans, employees and non-employee directors are eligible toreceive awards of various forms of equity-based incentive compensation,including stock options, restricted stock, restricted stock units, phantom shareunits and performance awards, among others. The plans are 

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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 ten yearsor less, and vest over terms of four to six years from the date of grant.Restricted stock units generally vest over terms of three to four years fromthe 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 December31, 2006 and June 30, 2007, approximately 29,000 and 32,000 phantom shareunits, respectively, were outstanding.

*Warrants*

Priorto December 31, 2000, the Company issued warrants to purchase shares ofthe Company’s common stock to certain members of its Board of Directors,customers, consultants, lessors, creditors and others. As of June 30, 2007,warrants to purchase a total of 52,000 shares of common stock were outstandingat an exercise price of $5.50. The warrants are currently exercisable and expirein October 2007.

Duringthe year ended December 31, 2006, the Company sold warrants in connection withthe issuance of Notes permitting the purchasers to acquire up to approximately28.4 million shares of the Company’s common stock. See Note 8, “Shareholders’Equity,” for a description of those warrants.

*OptionsOutstanding*

Thefollowing table summarizes information concerning stock option activity as ofand for the six months ended June 30, 2007: 
|                                             | ** ** | **Stock Options**                                    | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term (Years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|--------------------------------------------------|------------|-----------------------------------------------------------|------------|----------------------------------------|------------|------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                       | ** ** | **(shares and dollars in thousands)** | ** ** |
|                                             |       |                                                      |       |                                   |       |                                                             |       |                            |       |
| Outstanding as of December 31, 2006              |       | 20,470                                                    |       | $                                      | 11.27      |                                                             |       |                            |       |   |
| Granted                                          |       | 2,156                                                     |       | 7.36                                   |       |                                                             |       |                            |       |
| Exercised                                        |       | (663                                                      | )          | 7.79                                   |       |                                                             |       |                            |       |
| Forfeited and expired                            |       | (1,408                                                    | )          | 11.64                                  |       |                                                             |       |                            |       |
| Outstanding as of June 30, 2007                  |       | 20,555                                                    |       | $                                      | 10.95      |                                                             | 6.3        |                            | $          | 5,424 |   |
| Vested and expected to vest as of June  30, 2007 |       | 18,995                                                    |       | $                                      | 11.17      |                                                             | 6.1        |                            | $          | 4,554 |   |
| Exercisable as of June 30, 2007                  |       | 12,558                                                    |       | $                                      | 12.70      |                                                             | 4.8        |                            | $          | 3,099 |   |

 

The aggregate intrinsicvalue amounts in the table above represent the closing price of the Company’scommon stock on June 30, 2007 in excess of the exercise price, multiplied bythe number of stock options outstanding or exercisable. The total intrinsicvalue of stock options exercised during the three and six months ended June 30,2006 was $0.7 million and $1.8 million, respectively.  The total intrinsic value of stock optionsexercised during the three and six months ended June 30, 2007 was $0.4 millionand $1.2 million, respectively. 

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The intrinsic value of stock options exercisedrepresents the difference between the Company’s common stock at the time ofexercise and the exercise price, multiplied by the number of stock optionsexercised.

The followingtable summarizes the status of the Company’s stock options as of June 30, 2007:

| Stock Options Outstanding | ** ** | **Stock Options** | ** ** |
|-------------------------------------|------------|------------------------|------------|
| ** **                          | ** ** | ** **             | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Exercisable** | ** ** |
| ** **                          | ** ** | ** **             | ** ** | ** ** | ** ** | **Average** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                          | ** ** | ** **             | ** ** | ** ** | ** ** | **Remaining** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **Range of**                   | ** ** | **Number**             | ** ** | **Contractual** | ** ** | **Exercise** | ** ** | **Number** | ** ** | **Exercise** | ** ** |
| **Exercise Prices**            | ** ** | **Outstanding**        | ** ** | **Life** | ** ** | **Price** | ** ** | **Exercisable** | ** ** | **Price** | ** ** |
| ** **                          | ** ** | ** **             | ** ** | **(in thousands)** | ** ** | ** ** | ** ** | ** ** | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| $                                   | 3.90       |                   | $          | 5.56 |   | 1,394 |   | 5.3 |   | $ | 5.36 |   | 994 |   | $ | 5.46 |   |
|                                | 5.81       |                   | 6.90       |   | 2,495 |   | 7.9 |   | 6.65 |   | 805 |   | 6.17 |   |
|                                | 7.10       |                   | 7.82       |   | 2,994 |   | 9.2 |   | 7.37 |   | 468 |   | 7.50 |   |
|                                | 7.99       |                   | 9.24       |   | 2,366 |   | 7.0 |   | 8.94 |   | 1,545 |   | 8.90 |   |
|                                | 9.25       |                   | 9.93       |   | 2,456 |   | 6.3 |   | 9.58 |   | 1,373 |   | 9.63 |   |
|                                | 10.06      |                   | 10.06      |   | 2,193 |   | 3.2 |   | 10.06 |   | 2,193 |   | 10.06 |   |
|                                | 10.36      |                   | 10.51      |   | 2,108 |   | 7.7 |   | 10.37 |   | 1,052 |   | 10.37 |   |
|                                | 10.56      |                   | 15.63      |   | 2,081 |   | 6.8 |   | 11.50 |   | 1,660 |   | 11.59 |   |
|                                | 16.82      |                   | 51.44      |   | 2,468 |   | 2.5 |   | 26.90 |   | 2,468 |   | 26.90 |   |
| $                                   | 3.90       |                   | $          | 51.44 |   | 20,555 |   | 6.3 |   | $ | 10.95 |   | 12,558 |   | $ | 12.70 |   |

 

*ValuationAssumptions for Stock Options*

The fair value ofstock options granted during the six months ended June 30, 2006 and 2007 wasestimated using the Black-Scholes option-pricing model with the followingassumptions:
|                         | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------|------------|---------------------------------------------------|------------|
| ** **              | ** ** | **2006**                                          | ** ** | **2007** | ** ** |
|                    |       |                                              |       |   |   |
| Dividend yield          |       | 0                                                 | %          | 0 | % |
| Expected volatility     |       | 43                                                | %          | 39 | % |
| Risk-free interest rate |       | 4.86                                              | %          | 4.88 | % |
| Expected life           |       | 4.3 years                                         |       | 4.3 years |   |

 

Theweighted average grant date fair value of options granted during the six monthsended June 30, 2006 and 2007 was $3.96 and $2.83, respectively.

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

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*RestrictedStock Units*

The following tablesummarizes the Company’s restricted stock units as of and for the six monthsended June 30, 2007:
|                              | ** ** | **Restricted  Stock Units** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
|-----------------------------------|------------|----------------------------------|------------|---------------------------------------------------------|------------|
|                              |       |                             |       |                                                    |       |
| Nonvested as of December 31, 2006 |       | 1,180,000                        |       | $                                                       | 8.57       |   |
| Granted                           |       | 147,000                          |       | 7.40                                                    |       |
| Vested                            |       | (177,000                         | )          | 10.18                                                   |       |
| Forfeited                         |       | (60,000                          | )          | 8.50                                                    |       |
| Nonvested as of June 30, 2007     |       | 1,090,000                        |       | 8.15                                                    |       |
|                                   |            |                                  |            |                                                         |            |  |

 

The fair value ofrestricted stock units is determined based on the closing trading price ofEarthLink’s common stock on the grant date. The weighted-average grant datefair value of restricted stock units granted during the six months ended June30, 2006 and 2007 was $9.44 and $7.40, respectively. As of June 30, 2007, therewas $6.2 million of total unrecognized compensation cost related to nonvestedrestricted stock units. That cost is expected to be recognized over aweighted-average period of 3.0 years. The total fair value of shares vestedduring the six months ended June 30, 2007 was $1.3 million, which representsthe closing price of the Company’s common stock on the vesting date multipliedby the number of restricted stock units that vested. No shares vested duringthe six months ended June 30, 2006.

**10.Income Taxes**

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

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

**11. Related Party Transactions**

UponHELIO’s formation, EarthLink and HELIO entered into a services agreement forEarthLink to provide to HELIO facilities, accounting, tax, billing,procurement, risk management, payroll, human resource, employee benefitadministration and other support services in exchange for management fees.However, as HELIO has developed it business, the extent to which HELIO relieson EarthLink to provide these services has decreased. EarthLink believes thatproviding these services to HELIO enabled HELIO to more quickly and cost effectivelylaunch its business than if it had purchased these services from thirdparties.  The management fees weredetermined based on EarthLink’s costs to provide the services, and managementbelieves such fees are reasonable.  Thetotal amount of fees that HELIO pays to EarthLink depends on the extent towhich HELIO utilizes EarthLink’s services. Fees for services provided to HELIO are reflected as reductions to theassociated expenses incurred by EarthLink to provide such services. During thethree and six months ended June 30, 2006, fees received for services providedto HELIO were $0.5 million and $1.2 million, respectively. During the three andsix months ended June 30, 2007, fees received for services provided to HELIOwere $0.5 million and $0.9 million, respectively.

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

InJuly 2007, EarthLink entered into a loan agreement with HELIO pursuant to whichEarthLink could lend up to $100.0 million to HELIO in the form of PromissoryNotes (see Note 5, “Investments”). Also in July 2007, EarthLink purchasedinitial Promissory Notes of $30.0 million.

*eCompanies*

Duringthe three months ended June 30, 2007, the Company received a $0.2 million cashdistribution as a result of its investment in EVG. Sky Dayton, a member ofEarthLink’s Board of Directors, is a founding partner in EVG.

**12.  SegmentInformation**

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

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

TheCompany evaluates performance of its segments based on segment income fromoperations. Segment income from operations includes revenues from externalcustomers, related cost of revenues and operating expenses directlyattributable to the segment, which include costs over which segment 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 and stock-based compensation expense under SFAS No. 123(R),as they are not evaluated in the measurement of segment performance.

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Informationon reportable segments and a reconciliation to consolidated income fromoperations for the three and six months ended June 30, 2006 and 2007 is asfollows:
|                                       | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                            | ** ** | **2007**                                          | ** ** | **2006** | ** ** | **2007** | ** ** |
| ** **                            | ** ** | **(in thousands)**                             | ** ** |
| **Consumer Services**                 |       |                                                |       |                                              |       |   |   |   |   |
| Revenues                              |       | $                                                   | 286,717    |                                              | $          | 264,115 |   | $ | 578,184 |   | $ | 540,767 |   |
| Cost of revenues                      |       | 88,163                                              |       | 86,406                                            |       | 176,211 |   | 172,230 |   |
| Gross margin                          |       | 198,554                                             |       | 177,709                                           |       | 401,973 |   | 368,537 |   |
| Direct segment operating expenses     |       | 156,877                                             |       | 141,258                                           |       | 331,448 |   | 306,983 |   |
| Segment operating income              |       | $                                                   | 41,677     |                                              | $          | 36,451 |   | $ | 70,525 |   | $ | 61,554 |   |
|                                  |       |                                                |       |                                              |       |   |   |   |   |
| **Business Services**                 |       |                                                |       |                                              |       |   |   |   |   |
| Revenues                              |       | $                                                   | 45,379     |                                              | $          | 48,088 |   | $ | 63,624 |   | $ | 95,842 |   |
| Cost of revenues                      |       | 24,530                                              |       | 29,433                                            |       | 28,831 |   | 59,475 |   |
| Gross margin                          |       | 20,849                                              |       | 18,655                                            |       | 34,793 |   | 36,367 |   |
| Direct segment operating expenses     |       | 14,830                                              |       | 16,118                                            |       | 17,421 |   | 32,787 |   |
| Segment operating income              |       | $                                                   | 6,019      |                                              | $          | 2,537 |   | $ | 17,372 |   | $ | 3,580 |   |
|                                  |       |                                                |       |                                              |       |   |   |   |   |
| **Consolidated**                      |       |                                                |       |                                              |       |   |   |   |   |
| Revenues                              |       | $                                                   | 332,096    |                                              | $          | 312,203 |   | $ | 641,808 |   | $ | 636,609 |   |
| Cost of revenues                      |       | 112,693                                             |       | 115,839                                           |       | 205,042 |   | 231,705 |   |
| Gross margin                          |       | 219,403                                             |       | 196,364                                           |       | 436,766 |   | 404,904 |   |
| Direct segment operating expenses     |       | 171,707                                             |       | 157,376                                           |       | 348,869 |   | 339,770 |   |
| Segment operating income              |       | 47,696                                              |       | 38,988                                            |       | 87,897 |   | 65,134 |   |
| Stock-based compensation expense      |       | 3,734                                               |       | 2,898                                             |       | 7,402 |   | 10,778 |   |
| Amortization of intangible assets     |       | 3,122                                               |       | 3,542                                             |       | 5,035 |   | 7,038 |   |
| Facility exit and restructuring costs |       | (117                                                | )          | —                                            |       | (117 | ) | — |   |
| Other operating expenses              |       | 13,725                                              |       | 12,365                                            |       | 28,616 |   | 31,085 |   |
| Income from operations                |       | $                                                   | 27,232     |                                              | $          | 20,183 |   | $ | 46,961 |   | $ | 16,233 |   |

 

The primarycomponent of the Company’s revenues is access and service revenues, whichconsist of narrowband access services (including traditional, fully-featurednarrowband access and value-priced narrowband access); broadband accessservices (including high-speed access via DSL, cable and wireless technologies,IP-based voice and fees charged for high-speed data networks to small andmedium-sized businesses); and web hosting services. The Company also earnsrevenues from value-added services, which include ancillary services sold as add-onfeatures to the Company’s access services, search and advertising revenues.

Consumer accessand 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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data networks forsmall and medium-sized businesses; installation fees; termination fees; feesfor equipment; regulatory surcharges billed to customers; and web hosting.

Informationon revenues by groups of similar services and by segment for the three and sixmonths ended June 30, 2006 and 2007 is as follows:
|                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **             | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **             | ** ** | **2006**                         | ** ** | **2007**                       | ** ** | **2006** | ** ** | **2007** | ** ** |
| ** **             | ** ** | **(in thousands)**          | ** ** |
| **Consumer  Services** | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Access and service     |       | $                                | 258,187    |                           | $          | 231,729 |   | $ | 522,418 |   | $ | 474,788 |   |
| Value-added services   |       | 28,530                           |       | 32,386                         |       | 55,766 |   | 65,979 |   |
| Total revenues         |       | $                                | 286,717    |                           | $          | 264,115 |   | $ | 578,184 |   | $ | 540,767 |   |
|                   |       |                             |       |                           |       |   |   |   |   |
| **Business  Services** |       |                             |       |                           |       |   |   |   |   |
| Access and service     |       | $                                | 44,418     |                           | $          | 47,327 |   | $ | 61,847 |   | $ | 94,282 |   |
| Value-added services   |       | 961                              |       | 761                            |       | 1,777 |   | 1,560 |   |
| Total revenues         |       | $                                | 45,379     |                           | $          | 48,088 |   | $ | 63,624 |   | $ | 95,842 |   |
|                   |       |                             |       |                           |       |   |   |   |   |
| **Consolidated**       |       |                             |       |                           |       |   |   |   |   |
| Access and service     |       | $                                | 302,605    |                           | $          | 279,056 |   | $ | 584,265 |   | $ | 569,070 |   |
| Value-added services   |       | 29,491                           |       | 33,147                         |       | 57,543 |   | 67,539 |   |
| Total revenues         |       | $                                | 332,096    |                           | $          | 312,203 |   | $ | 641,808 |   | $ | 636,609 |   |

 

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 and related results of operationsand identifiable assets are in the United States and additional geographicinformation is thus not material nor meaningful.

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

Certain statementsin this Quarterly Report on Form 10-Q are forward-looking statementswithin the meaning of the Private Securities Litigation Reform Act of 1995,Section 27A of the Securities Act of 1933, and Section 21E of theSecurities Exchange Act of 1934. The words “estimate,” “plan,” “intend,” “expect,”“anticipate,” “believe” and similar expressions are intended to identifyforward-looking statements. These forward-looking statements are found atvarious places throughout this report. EarthLink disclaims any intention orobligation to update or revise any forward-looking statements, whether as aresult of new information, future events or otherwise. Although EarthLinkbelieves that its expectations are based on reasonable assumptions, it can giveno assurance that its goals will be achieved. Important factors that couldcause actual results to differ from estimates or projections contained in theforward-looking statements are described under “Safe Harbor Statement” in thisItem 2.

*The following discussion should be read in conjunction with theaccompanying unaudited Condensed Consolidated Financial Statements and relatedNotes thereto and with “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” and the audited Consolidated FinancialStatements and the Notes thereto contained in the Annual Report on Form 10-Kfor the year ended December 31, 2006, as amended.*

**Overview**

EarthLink,Inc. is a total communications provider, providing integrated communicationservices and related value-added services to individual consumers and businesscustomers utilizing Internet Protocol, or IP, based technologies.  Our core service offerings are dial-up andwireline broadband Internet access services and value-added services. Ourgrowth initiatives have recently included IP-based voice services, municipalwireless broadband services and our services for business customers.

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

Wealso have a joint venture with SK Telecom Co., Ltd. (“SK Telecom”), HELIO.  HELIO is a non-facilities-based mobilevirtual network operator (MVNO) offering mobile communications services andhandsets to consumers in the U.S.  HELIOwas formed in March 2005 and began offering its products and services duringApril 2006.

*IndustryBackground*

Sincethe inception of our business, we have expanded from a traditional dial-upInternet service provider to a total communications provider. The Internetaccess market in the U.S. grew dramatically from the mid-1990s through 2000 buthas recently experienced slower growth, as the market has reached a maturestage of growth. Since 2000, broadband Internet access has been steadilyreplacing dial-up. During 2006, the number of households with broadband accesssurpassed the number of households with dial-up access. Focused, value-pricednarrowband access, which provides service with a limited set of features at alower cost, is still attracting households new to the Internet or currentInternet users interested in reducing their cost of Internet access.

Consumerscontinue to migrate to broadband due to the faster connection and downloadspeeds provided by broadband access, the ability to free up their phone linesand the more reliable and “always on” connection. The pricing for broadbandservices, particularly for introductory promotional periods, services bundledwith video and telephone services, and services with slower speeds, has beendeclining and is approaching prices for traditional dial-up services, making ita more viable option for consumers that continue to rely on dial-up connectionsfor Internet access. In addition, advanced applications such as online gaming,music 

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downloads andphoto sharing require greater bandwidth for optimal performance, which adds tothe demand for broadband access.

Currently,most residential broadband consumers access the Internet via DSL or cable, butan increasing array of alternative broadband access technologies, such aswireless broadband and broadband over power lines, are now available. Theavailability of these alternatives may further encourage future broadbanddeployment and market penetration. The growth of mobile devices that supportemail and sales of laptop computers and other mobile devices create an increasingneed for portable and mobile Internet access. In addition, one of theoutgrowths from the rapid deployment of broadband connectivity has been theadoption of Voice over Internet Protocol (“VoIP”). VoIP is a technology thatenables voice communications over the Internet through the conversion of voicesignals into data packets. VoIP technology presents several advantages over thetechnology used in traditional wireline telephone networks and enables VoIPproviders to operate with lower capital expenditures and operating costs whileoffering both traditional and innovative service features.

*RevenueSources*

Weprovide access services (including traditional, fully-featured narrowbandaccess and value-priced narrowband access; high-speed access via DSL, cable andwireless technologies; and IP-based voice) and value-added services (includingancillary services sold as add-on feature to our services, search andadvertising). Our subscriber base decreased from approximately 5.3 millionpaying subscribers as of June 30, 2006 to approximately 4.3 million subscribersas of June 30, 2007. The decrease in paying subscribers was primarily due tothe removal of approximately 753,000 subscribers that were under our marketingrelationship with Embarq Corporation (“Embarq”) and a decrease in premiumnarrowband subscribers. Total revenues decreased from $332.1 million during thethree months ended June 30, 2006 to $312.2 million during the three monthsended June 30, 2007. The decrease in total revenues was primarily due to adecrease in narrowband access revenues, offset by an increases in IP-basedvoice services revenues and value-added services revenues. Our traditional,premium-priced narrowband subscriber base and revenues have been declining dueto the maturity of this service. In addition, the mix of our narrowbandcustomers continues to shift towards value-priced narrowband access.

*BusinessStrategy and Risks*

For the past several quarters, management has beenfocused on expanding our presence in growth markets, including VoIP services,municipal wireless broadband services and business services. VoIP and municipalwireless broadband services are still in their early stages and continue toexperience operational and competitive challenges as we expand and improve our capabilities.Our ability to succeed in providing these new services will depend on whetherwe have a competitively-priced offering, improve the quality of these servicesand develop a reasonable cost structure to ensure an acceptable return on ourinvestment. We are currently in the process of evaluating each of our growthinitiatives in order to ensure these initiatives are complementary to ourlong-term strategy and would allow us to maximize shareholder value. Ourevaluation of these growth initiatives could result in a substantial change tosome or all of these growth initiatives.

Ourrecent business strategy has been to generate profits from our existing coreaccess services and to reinvest the cash generated from these services intovarious growth initiatives with the objective of generating a return on ourinvestments.

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Aswe reassess our business strategy, we believe the most important factors for usto be successful are the following:

·                  identifyingopportunities to improve the cost structure of our business without impactingthe quality of services we provide;

·                  maximizing thereturn on our subscriber acquisition costs by balancing aggressive promotionalpricing with the number of subscribers we are able to add and/or retain whilecontinuing to reduce and leverage operating costs;

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

·                  monitoring theoperations of our current growth initiatives, as well as our HELIO jointventure, to maximize the value to our shareholders and mitigate the risk of ourinvestments;

·                  exploring,identifying and investing in additional growth opportunities and successfullyimplementing strategies to deliver these services cost effectively;

·                  differentiatingour products and services to enable us to deliver high quality services thatimprove customers’ Internet experiences, including bundling our variouscommunications services; and

·                  exploringand evaluating potential strategic transactions that we believe may complementour current and future business activities, and successfully integrating anynew acquisitions and investments into our business.

Theprimary challenges we face in executing our business strategy are maintainingprofitability in our existing services, successfully implementing new productsand services, competition and purchasing cost-effective wholesalebroadband access.

*SecondQuarter 2007 Highlights*

Asdiscussed above, total revenues decreased during the three months ended June30, 2007 compared to the prior year period. However, overall operating expensesdecreased during the three months ended June 30, 2007 compared to the priorperiod. This was mostly due to a decrease in sales and marketing expenses as wemanaged the expenses associated with our core access services to mitigate theincreased spending for our growth initiatives. We continued to generate profitsand operating cash flow from our core access services. Additionally, our netlosses of equity affiliate related to our HELIO joint venture increased asHELIO incurred losses due to the start-up nature of their business. Thedecrease in total revenues and net losses of HELIO, offset by a decrease intotal operating costs and expenses caused overall profits to decrease duringthe three months ended June 30, 2007 compared to the prior period.

**GrowthInitiatives**

Ourgrowth initiatives have recently included IP-based voice services, municipalwireless broadband services and services for business customers. We arecurrently in the process of evaluating each of our growth initiatives and, ifnecessary, changing the underlying business models and cost structures, inorder to ensure these initiatives are complementary to our long-term strategyand would allow us to maximize shareholder value.

*IP-based voice. *In October 2005, we began offering the next generationof our VoIP services, EarthLink trueVoiceSM. EarthLink trueVoice is a competitive alternative totraditional telephone service and is available to EarthLink and non-EarthLinkhigh-speed Internet access subscribers. In late 2005 and 2006, we launched DSLand Home Phone Service, a new DSL and VoIP service, which uses CovadCommunications Group, Inc.’s (“Covad”) line-powered voice access that allows usto offer consumers low-cost phone services along with high-speed Internetaccess. In March 2006, we invested $50.0 million in Covad to fund the networkbuild-out of this service. DSL and Home Phone Service is now available in 12markets in the U.S. covering approximately 12.5 million households.

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*Municipal wireless broadband*.We have invested in wireless, or Wi-Fi, broadband access to deploy acompetitive alternative to DSL and cable for delivering broadband Internetaccess services. We began this initiative during 2005 by winning proposals tofinance, build and manage wireless broadband networks for the cities ofPhiladelphia, Pennsylvania and Anaheim, California. During 2006 and early 2007,we completed the initial phase for these networks and began offering ourmunicipal wireless broadband services. We also launched service in Milpitas, California and New Orleans,Louisiana, and have been selected by the cities of Alexandria, Virginia; SanFrancisco, California; Atlanta, Georgia; Houston, Texas; St. Petersburg,Florida; and Arlington County, Virginia to build, own and operate a wirelessbroadband network in those cities.

In March 2007, wepurchased a municipal wireless network from the city of Corpus Christi, Texasthat had already been deployed by the city. In June 2007, we transitioned theexiting network to our wireless network and began offering wireless Internetaccess to residents and businesses of Corpus Christi.

Wecurrently have approximately 150 square miles of wireless broadband networksbuilt out across all of our markets, covering 0.6 million households.

*Business services*.In April 2006, we acquired New Edge Holding Company (“New Edge”), asingle-source national provider of secure multi-site managed data networks anddedicated Internet access for businesses and communications carriers. Theacquisition of New Edge expands our service offerings to small and medium-sizedenterprises. During 2006, we introduced new products, including Small OfficeDSL and hosted Virtual Private Networks (“VPN”). In 2007, we built upon ourexisting portfolio of business solutions, by expanding our product offeringsand our distribution channels.

**JointVenture**

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. As of June 30, 2007, EarthLink and SKTelecom each had an approximate 48% economic ownership interest and a 50%voting interest in HELIO.  From its formation in March 2005 though June2007, EarthLink and SK Telecom invested an aggregate of $440.0 million of cashand non-cash assets in HELIO pursuant to the Contribution and FormationAgreement, including an aggregate of $39.0 million that was invested during thefirst six months of 2007.

InJuly 2007, we and SK Telecom entered into a lending agreement with HELIOpursuant to which we and SK Telecom could lend up to $200.0 million to HELIO.Under the terms of the agreement, we and SK Telecom may each lend HELIO up to$100.0 million in the form of promissory notes. In July 2007, we and SK Telecom purchased initial promissory notes of$30.0 million each.

HELIO launched its firstwireless voice and data service devices in during 2006, and launched its fifthexclusive device in the second quarter of 2007. HELIO targets young, connectedconsumers with an extensive array of features, including MySpace Mobile, videoservices, 3D and multiplayer games, and video, picture and text messaging, inaddition to its wireless voice and data services.  HELIO is currently marketing its servicesthrough a variety of means.

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**Acquisition**

In April 2006, weacquired New Edge. The acquisition of New Edge expands our service offeringsfor businesses and communications carriers. Under the terms of the mergeragreement, we acquired 100% of New Edge in a merger transaction for 1.7 millionshares of EarthLink common stock and $108.7 million in net cash, including cashto be used to satisfy certain New Edge liabilities and direct transactioncosts. In July 2007, approximately 0.8 million shares of EarthLink, Inc. commonstock that had been held in escrow were returned to us.

**MarketingAlliances**

We have an agreement withTime Warner Cable and Bright House Networks, companies whose networks pass morethan 30 million homes, to offer our broadband Internet access servicesover their systems.  In connection withthe agreement, Time Warner Cable and Bright House Networks receiveconsideration from EarthLink for carrying the EarthLink service and relatedInternet traffic. As of June 30, 2007, more than 40% of our consumer broadbandsubscribers were serviced via either the Time Warner Cable or Bright HouseNetworks network.

We had a marketingrelationship with Embarq, a spin-off of Sprint Nextel Corporation’s localcommunications business. The relationship provided that EarthLink was thewholesale high-speed ISP for Embarq’s local residential and small businesscustomers. The contracts associated with these arrangements expired in April2007, and we and Embarq did not renew the wholesale broadband contract. EffectiveApril 2007, we removed approximately 753,000 subscribers under the marketingrelationship from our broadband subscriber count and total subscriber count.

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**KeyOperating Metrics**

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,** | ** ** |
|----------------------------------------------|------------|-------------------|------------|-----------------------|------------|--------------------|------------|-------------------|------------|
| ** **                                   | ** ** | **2006**          | ** ** | **2006**              | ** ** | **2007**           | ** ** | **2007**          | ** ** |
| **Subscriber Data (a)**                      | ** ** | ** **        | ** ** | ** **            | ** ** | ** **         | ** ** | ** **        | ** ** |
| **Consumer Services**                        | ** ** | ** **        | ** ** | ** **            | ** ** | ** **         | ** ** | ** **        | ** ** |
| Narrowband access subscribers                |       | 3,366,000         |       | 3,261,000             |       | 3,208,000          |       | 3,042,000         |       |
| Broadband access subscribers                 |       | 1,744,000         |       | 1,831,000             |       | 1,849,000          |       | 1,092,000         |       |
| Total consumer services                      |       | 5,110,000         |       | 5,092,000             |       | 5,057,000          |       | 4,134,000         |       |
| **Business Services**                        | ** ** | ** **        | ** ** | ** **            | ** ** | ** **         | ** ** | ** **        | ** ** |
| Narrowband access subscribers                |       | 46,000            |       | 40,000                |       | 36,000             |       | 31,000            |       |
| Broadband access subscribers                 |       | 69,000            |       | 69,000                |       | 69,000             |       | 70,000            |       |
| Web hosting accounts                         |       | 119,000           |       | 112,000               |       | 109,000            |       | 106,000           |       |
| Total business services                      |       | 234,000           |       | 221,000               |       | 214,000            |       | 207,000           |       |
| **Total subscriber count at  end of period** |       | 5,344,000         |       | 5,313,000             |       | 5,271,000          |       | 4,341,000         |       |

 
|                                    | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                         | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                         | ** ** | **2006**                         | ** ** | **2007**                       | ** ** | **2006** | ** ** | **2007** | ** ** |
| **Subscriber Activity**            |       |                             |       |                           |       |   |   |   |   |
| Subscribers at beginning of period |       | 5,342,000                        |       | 5,271,000                      |       | 5,315,000 |   | 5,313,000 |   |
| Gross organic subscriber additions |       | 644,000                          |       | 471,000                        |       | 1,414,000 |   | 1,141,000 |   |
| Acquired subscribers               |       | 70,000                           |       | 34,000                         |       | 70,000 |   | 34,000 |   |
| Adjustment (b)                     |       | —                           |       | (753,000                       | )          | — |   | (753,000 | ) |
| Churn                              |       | (712,000                         | )          | (682,000                       | )          | (1,455,000 | ) | (1,394,000 | ) |
| Subscribers at end of period       |       | 5,344,000                        |       | 4,341,000                      |       | 5,344,000 |   | 4,341,000 |   |
|                               |       |                             |       |                           |       |   |   |   |   |
| **Churn rate (c)**                 |       | 4.4                              | %          | 4.9                            | %          | 4.5 | % | 4.7 | % |
|                               |       |                             |       |                           |       |   |   |   |   |
| **Consumer Services Data**         |       |                             |       |                           |       |   |   |   |   |
| Average subscribers (d)            |       | 5,137,000                        |       | 4,404,000                      |       | 5,146,000 |   | 4,701,000 |   |
| ARPU (e)                           |       | $                                | 18.60      |                           | $          | 19.99 |   | $ | 18.72 |   | $ | 19.17 |   |
| Churn rate (c)                     |       | 4.5                              | %          | 5.0                            | %          | 4.6 | % | 4.8 | % |
|                               |       |                             |       |                           |       |   |   |   |   |
| **Business Services Data**         |       |                             |       |                           |       |   |   |   |   |
| Average subscribers (d)            |       | 223,000                          |       | 211,000                        |       | 200,000 |   | 214,000 |   |
| ARPU (e)                           |       | $                                | 67.72      |                           | $          | 75.92 |   | $ | 52.96 |   | $ | 74.60 |   |
| Churn rate (c)                     |       | 2.9                              | %          | 2.7                            | %          | 2.9 | % | 2.7 | % |

 

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

(b) In April 2007,our wholesale contract with Embarq expired. As a result, we removed 753,000EarthLink supported Embarq customers from our broadband subscriber count andtotal subscriber count.

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(c)  Churn rate is used to measure the rate atwhich subscribers discontinue service on a voluntary or involuntary basis.  Churn rate is computed by dividing theaverage monthly number of subscribers that discontinued service during theperiod by the average subscribers for the period. Churn rate for the three andsix months ended June 30, 2007 excludes the impact of the Embarq adjustment.

(d)  Averagesubscribers or accounts for the three month periods is calculated by averagingthe ending monthly subscribers or accounts for the four months preceding andincluding the end of the quarterly period. Average subscribers or accounts forthe six month periods is calculated by averaging the ending monthly subscribersor accounts for the seven months preceding and including the end of the period.

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

**Resultsof Operations**

***ConsolidatedResults of Operations***

Thefollowing table sets forth statement of operations data for the periodsindicated:
| ** **                             | ** ** | **Three Months Ended**     | ** ** | ** ** | ** ** | ** **        | ** ** | **Six Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|------------|------------|-------------------|------------|--------------------------------|------------|------------|------------|------------|------------|
| ** **                             | ** ** | **June 30,**                    | ** ** | ** ** | ** ** | ** **        | ** ** | **June 30,**              | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **2006**                             | ** ** | **2007**   | ** ** | **$ Change** | ** ** | **% Change**              | ** ** | **2006**   | ** ** | **2007**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                             | ** ** | **(dollars in thousands)** | ** ** |
|                                   |       |                                 |       |       |       |              |       |                           |       |       |       |       |       |   |   |   |   |
| Revenues                               |       | $                                    | 332,096    |       | $          | 312,203           |       | $                              | (19,893    | )          | -6         | %          |       | $ | 641,808 |   | $ | 636,609 |   | $ | (5,199 | ) | -1 | % |   |
|                                   |       |                                 |       |       |       |              |       |                           |       |       |       |       |       |   |   |   |   |   |   |
| Operating costs and expenses:          |       |                                 |       |       |       |              |       |                           |       |       |       |       |       |   |   |   |   |   |   |
| Service and equipment costs            |       | 110,301                              |       | 110,472    |       | 171               |       | 0                              | %          |       | 200,373    |       | 221,630    |   | 21,257 |   | 11 | % |   |
| Sales incentives                       |       | 2,392                                |       | 5,367      |       | 2,975             |       | 124                            | %          |       | 4,669      |       | 10,075     |   | 5,406 |   | 116 | % |   |
| Total cost of revenues                 |       | 112,693                              |       | 115,839    |       | 3,146             |       | 3                              | %          |       | 205,042    |       | 231,705    |   | 26,663 |   | 13 | % |   |
|                                   |       |                                 |       |       |       |              |       |                           |       |       |       |       |       |   |   |   |   |   |   |
| Sales and marketing                    |       | 91,172                               |       | 76,186     |       | (14,986           | )          | -16                            | %          |       | 195,015    |       | 174,817    |   | (20,198 | ) | -10 | % |   |
| Operations and customer support        |       | 66,553                               |       | 65,936     |       | (617              | )          | -1                             | %          |       | 127,221    |       | 131,946    |   | 4,725 |   | 4 | % |   |
| General and administrative             |       | 31,441                               |       | 30,517     |       | (924              | )          | -3                             | %          |       | 62,651     |       | 74,870     |   | 12,219 |   | 20 | % |   |
| Amortization of intangible assets      |       | 3,122                                |       | 3,542      |       | 420               |       | 13                             | %          |       | 5,035      |       | 7,038      |   | 2,003 |   | 40 | % |   |
| Facility exit and restructuring costs  |       | (117                                 | )          | —     |       | 117               |       | -100                           | %          |       | (117       | )          | —     |   | 117 |   | -100 | % |   |
| Total operating costs and expenses     |       | 304,864                              |       | 292,020    |       | (12,844           | )          | -4                             | %          |       | 594,847    |       | 620,376    |   | 25,529 |   | 4 | % |   |
|                                   |       |                                 |       |       |       |              |       |                           |       |       |       |       |       |   |   |   |   |   |   |
| Income from operations                 |       | 27,232                               |       | 20,183     |       | (7,049            | )          | -26                            | %          |       | 46,961     |       | 16,233     |   | (30,728 | ) | -65 | % |   |
| Net losses of equity affiliate         |       | (15,351                              | )          | (40,054    | )          | (24,703           | )          | *                              |       |       | (22,942    | )          | (69,400    | ) | (46,458 | ) | * |   |   |
| Gain on investments in other companies |       | 352                                  |       | 210        |       | (142              | )          | -40                            | %          |       | 352        |       | 210        |   | (142 | ) | -40 | % |   |
| Interest income and other, net         |       | 4,334                                |       | 3,597      |       | (737              | )          | -17                            | %          |       | 8,550      |       | 7,100      |   | (1,450 | ) | -17 | % |   |
| Income (loss) before income taxes      |       | 16,567                               |       | (16,064    | )          | (32,631           | )          | *                              |       |       | 32,921     |       | (45,857    | ) | (78,778 | ) | * |   |   |
| Provision for income taxes             |       | —                               |       | 226        |       | 226               |       | *                              |       |       | —     |       | 395        |   | 395 |   | * |   |   |
| Net income (loss)                      |       | $                                    | 16,567     |       | $          | (16,290           | )          | $                              | (32,857    | )          | *          |       |       | $ | 32,921 |   | $ | (46,252 | ) | $ | (79,173 | ) | * |   |   |

 

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* denotes percentage isnot meaningful

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***SegmentResults of Operations***

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

Weevaluate 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 and stock-based compensation expense under Statement ofFinancial Accounting Standards (“SFAS”) No. 123(R), as they are not evaluatedin the measurement of segment performance.

Thefollowing tables set forth segment data for the periods indicated:
| ** **                            | ** ** | **Three Months Ended June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------|------------|-----------------------------------------------------|------------|------------|------------|-------------------|------------|
| ** **                            | ** ** | **2006**                                            | ** ** | **2007**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                            | ** ** | **(dollars in thousands)**                | ** ** |
| **Consumer Services**                 |       |                                                |       |       |       |              |       |   |   |
| Revenues                              |       | $                                                   | 286,717    |       | $          | 264,115           |       | $ | (22,602 | ) | -8% |   |   |
| Cost of revenues                      |       | 88,163                                              |       | 86,406     |       | (1,757            | )          | -2% |   |   |
| Gross margin                          |       | 198,554                                             |       | 177,709    |       | (20,845           | )          | -10% |   |   |
| Direct segment operating expenses     |       | 156,877                                             |       | 141,258    |       | (15,619           | )          | -10% |   |   |
| Segment income from operations        |       | $                                                   | 41,677     |       | $          | 36,451            |       | $ | (5,226 | ) | -13% |   |   |
|                                  |       |                                                |       |       |       |              |       |   |   |   |
| **Business Services**                 |       |                                                |       |       |       |              |       |   |   |   |
| Revenues                              |       | $                                                   | 45,379     |       | $          | 48,088            |       | $ | 2,709 |   | 6% |   |   |
| Cost of revenues                      |       | 24,530                                              |       | 29,433     |       | 4,903             |       | 20% |   |   |
| Gross margin                          |       | 20,849                                              |       | 18,655     |       | (2,194            | )          | -11% |   |   |
| Direct segment operating expenses     |       | 14,830                                              |       | 16,118     |       | 1,288             |       | 9% |   |   |
| Segment income from operations        |       | $                                                   | 6,019      |       | $          | 2,537             |       | $ | (3,482 | ) | -58% |   |   |
|                                  |       |                                                |       |       |       |              |       |   |   |   |
| **Consolidated**                      |       |                                                |       |       |       |              |       |   |   |   |
| Revenues                              |       | $                                                   | 332,096    |       | $          | 312,203           |       | $ | (19,893 | ) | -6% |   |   |
| Cost of revenues                      |       | 112,693                                             |       | 115,839    |       | 3,146             |       | 3% |   |   |
| Gross margin                          |       | 219,403                                             |       | 196,364    |       | (23,039           | )          | -11% |   |   |
| Direct segment operating expenses     |       | 171,707                                             |       | 157,376    |       | (14,331           | )          | -8% |   |   |
| Segment income from operations        |       | 47,696                                              |       | 38,988     |       | (8,708            | )          | -18% |   |   |
| Stock-based compensation expense      |       | 3,734                                               |       | 2,898      |       | (836              | )          | -22% |   |   |
| Amortization of intangible assets     |       | 3,122                                               |       | 3,542      |       | 420               |       | 13% |   |   |
| Facility exit and restructuring costs |       | (117                                                | )          | —     |       | 117               |       | -100% |   |   |
| Other operating expenses              |       | 13,725                                              |       | 12,365     |       | (1,360            | )          | -10% |   |   |
| Income from operations                |       | $                                                   | 27,232     |       | $          | 20,183            |       | $ | (7,049 | ) | -26% |   |   |

 

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| ** **                            | ** ** | **Six Months Ended June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------|------------|---------------------------------------------------|------------|------------|------------|-------------------|------------|
| ** **                            | ** ** | **2006**                                          | ** ** | **2007**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                            | ** ** | **(dollars in thousands)**              | ** ** |
| **Consumer Services**                 |       |                                              |       |       |       |              |       |   |   |
| Revenues                              |       | $                                                 | 578,184    |       | $          | 540,767           |       | $ | (37,417 | ) | -6% |   |   |
| Cost of revenues                      |       | 176,211                                           |       | 172,230    |       | (3,981            | )          | -2% |   |   |
| Gross margin                          |       | 401,973                                           |       | 368,537    |       | (33,436           | )          | -8% |   |   |
| Direct segment operating expenses     |       | 331,448                                           |       | 306,983    |       | (24,465           | )          | -7% |   |   |
| Segment income from operations        |       | $                                                 | 70,525     |       | $          | 61,554            |       | $ | (8,971 | ) | -13% |   |   |
|                                  |       |                                              |       |       |       |              |       |   |   |   |
| **Business Services**                 |       |                                              |       |       |       |              |       |   |   |   |
| Revenues                              |       | $                                                 | 63,624     |       | $          | 95,842            |       | $ | 32,218 |   | 51% |   |   |
| Cost of revenues                      |       | 28,831                                            |       | 59,475     |       | 30,644            |       | 106% |   |   |
| Gross margin                          |       | 34,793                                            |       | 36,367     |       | 1,574             |       | 5% |   |   |
| Direct segment operating expenses     |       | 17,421                                            |       | 32,787     |       | 15,366            |       | 88% |   |   |
| Segment income from operations        |       | $                                                 | 17,372     |       | $          | 3,580             |       | $ | (13,792 | ) | -79% |   |   |
|                                  |       |                                              |       |       |       |              |       |   |   |   |
| **Consolidated**                      |       |                                              |       |       |       |              |       |   |   |   |
| Revenues                              |       | $                                                 | 641,808    |       | $          | 636,609           |       | $ | (5,199 | ) | -1% |   |   |
| Cost of revenues                      |       | 205,042                                           |       | 231,705    |       | 26,663            |       | 13% |   |   |
| Gross margin                          |       | 436,766                                           |       | 404,904    |       | (31,862           | )          | -7% |   |   |
| Direct segment operating expenses     |       | 348,869                                           |       | 339,770    |       | (9,099            | )          | -3% |   |   |
| Segment income from operations        |       | 87,897                                            |       | 65,134     |       | (22,763           | )          | -26% |   |   |
| Stock-based compensation expense      |       | 7,402                                             |       | 10,778     |       | 3,376             |       | 46% |   |   |
| Amortization of intangible assets     |       | 5,035                                             |       | 7,038      |       | 2,003             |       | 40% |   |   |
| Facility exit and restructuring costs |       | (117                                              | )          | —     |       | 117               |       | -100% |   |   |
| Other operating expenses              |       | 28,616                                            |       | 31,085     |       | 2,469             |       | 9% |   |   |
| Income from operations                |       | $                                                 | 46,961     |       | $          | 16,233            |       | $ | (30,728 | ) | -65% |   |   |

 

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***Revenues***

Thefollowing table presents revenues by groups of similar services and by segmentfor the three and six months ended June 30, 2006 and 2007:
| ** **            | ** ** | **Three Months Ended**     | ** ** | ** ** | ** ** | ** **        | ** ** | **Six Months Ended** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------|------------|--------------------------------------|------------|------------|------------|-------------------|------------|--------------------------------|------------|------------|------------|------------|------------|
| ** **            | ** ** | **June 30,**                    | ** ** | ** ** | ** ** | ** **        | ** ** | **June 30,**              | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **            | ** ** | **2006**                             | ** ** | **2007**   | ** ** | **$ Change** | ** ** | **% Change**              | ** ** | **2006**   | ** ** | **2007**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **            | ** ** | **(dollars in thousands)** | ** ** |
| **Consumer Services** |       |                                 |       |       |       |              |       |                           |       |       |       |       |       |   |   |   |   |
| Access and service    |       | $                                    | 258,187    |       | $          | 231,729           |       | $                              | (26,458    | )          | -10%       |       |       | $ | 522,418 |   | $ | 474,788 |   | $ | (47,630 | ) | -9% |   |   |
| Value-added services  |       | 28,530                               |       | 32,386     |       | 3,856             |       | 14%                            |       |       | 55,766     |       | 65,979     |   | 10,213 |   | 18% |   |   |
| Total revenues        |       | $                                    | 286,717    |       | $          | 264,115           |       | $                              | (22,602    | )          | -8%        |       |       | $ | 578,184 |   | $ | 540,767 |   | $ | (37,417 | ) | -6% |   |   |
|                  |       |                                 |       |       |       |              |       |                           |       |       |       |       |       |   |   |   |   |   |   |
| **Business Services** |       |                                 |       |       |       |              |       |                           |       |       |       |       |       |   |   |   |   |   |   |
| Access and service    |       | $                                    | 44,418     |       | $          | 47,327            |       | $                              | 2,909      |       | 7%         |       |       | $ | 61,847 |   | $ | 94,282 |   | $ | 32,435 |   | 52% |   |   |
| Value-added services  |       | 961                                  |       | 761        |       | (200              | )          | -21%                           |       |       | 1,777      |       | 1,560      |   | (217 | ) | -12% |   |   |
| Total revenues        |       | $                                    | 45,379     |       | $          | 48,088            |       | $                              | 2,709      |       | 6%         |       |       | $ | 63,624 |   | $ | 95,842 |   | $ | 32,218 |   | 51% |   |   |
|                  |       |                                 |       |       |       |              |       |                           |       |       |       |       |       |   |   |   |   |   |   |
| **Consolidated**      |       |                                 |       |       |       |              |       |                           |       |       |       |       |       |   |   |   |   |   |   |
| Access and service    |       | $                                    | 302,605    |       | $          | 279,056           |       | $                              | (23,549    | )          | -8%        |       |       | $ | 584,265 |   | $ | 569,070 |   | $ | (15,195 | ) | -3% |   |   |
| Value-added services  |       | 29,491                               |       | 33,147     |       | 3,656             |       | 12%                            |       |       | 57,543     |       | 67,539     |   | 9,996 |   | 17% |   |   |
| Total revenues        |       | $                                    | 332,096    |       | $          | 312,203           |       | $                              | (19,893    | )          | -6%        |       |       | $ | 641,808 |   | $ | 636,609 |   | $ | (5,199 | ) | -1% |   |   |

 

*Consolidatedrevenues*

Theprimary component of our revenues is access and service revenues, which consistof narrowband access services (including traditional, fully-featured narrowbandaccess and value-priced narrowband access); broadband access services(including high-speed access via DSL, cable and wireless technologies, IP-basedvoice and fees charged for high-speed data networks to small and medium-sizedbusinesses); and web hosting services. We also earn revenues from value-addedservices, which include ancillary services sold as add-on features to ouraccess services, search and advertising revenues. Total revenues decreased from$332.1 million during the three months ended June 30, 2006 to $312.2 millionduring the three months ended June 30, 2007, which was comprised of a $22.6million decrease in consumer services revenue offset by a $2.7 million increasein business services revenue. Total revenues decreased from $641.8 millionduring the six months ended June 30, 2006 to $636.6 million during the sixmonths ended June 30, 2007, which was comprised of a $37.4 million decrease inconsumer services revenue offset by a $32.2 million increase in businessservices revenue.

Thedecreases in consumer services revenue was primarily attributable to decreasesin average consumer subscribers, from approximately 5.1 million during thethree and six months ended June 30, 2006 to approximately 4.4 million and 4.7million during the three and six months ended June 30, 2007, respectively. Theincreases in business services revenue was primarily attributable to increasesin ARPU, from $67.72 during the three months ended June 30, 2006 to $75.92during the three months ended June 30, 2007, and from $52.96 during the sixmonths ended June 30, 2006 to $74.60 during the six months ended June 30, 2007.Contributing to the increase in business services revenue during the six monthsended June 30, 2007 was an increase in average subscribers, from 200,000 duringthe six months ended June 30, 2006 to 214,000 during the six months ended June30, 2007. The increases in business services ARPU and average subscribers wereprimarily driven by our acquisition of New Edge.

*Consumerservices revenue*

*Access and service*.Consumer access and service revenues consist of narrowband access, broadbandaccess and voice services. These revenues are derived from monthly fees chargedto customers for dial-up Internet access; monthly retail and wholesale feescharged for high-speed, high-capacity access services

27

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including DSL, cable, satellite and wireless services;fees charged for IP-based voice services; usage fees; installation fees;termination fees; and fees for equipment. Consumer access and service revenuesdecreased 10% to $231.7 million and 9% to $474.8 million during the three andsix months ended June 30, 2007 compared to the prior year periods.  The decreases in consumer access and servicerevenues during the three and six months ended June 30, 2007 were primarily dueto decreases in average subscribers, offset by an increase in consumer accessand service ARPU.

Average consumer accessand service subscribers decreased due to the removal of 753,000 Embarqsubscribers from our subscriber count effective April 2007 and due to themigration of premium narrowband subscribers to broadband services and thecontinued maturing and ongoing competitiveness of the market for narrowbandInternet access. These decreases were offset by an increase in average PeoplePCsubscribers; an increase in average retail broadband subscribers due to thecontinued growth in the market for broadband access and our and our partners’efforts to promote broadband services; and an increase in average voicesubscribers due to the launch of EarthLink DSL and Home Phone Service in eightadditional markets during the end of 2006. We expect the mix of our narrowbandsubscriber base to continue to shift from premium narrowband access services toPeoplePC access services for the foreseeable future.

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

The increase in broadbandaccess and service ARPU was primarily due to a shift in the mix of ourbroadband customer base from wholesale DSL subscribers to retail DSLsubscribers and to retail cable subscribers due to the removal of Embarqwholesale subscribers; an increase due to the increase in our voice subscribers;and an increase as we are still receiving certain revenues under the Embarqtransition agreement. Partially offsetting these increases were generaldeclines in retail DSL prices introduced as a result of declines in costs fromour DSL service providers and the increased use of promotional pricing for ourservice offerings.

The decrease innarrowband access and service ARPU was due to the shift in the mix of ournarrowband subscriber base from premium narrowband access services, which aretypically priced at $21.95 per month, to our PeoplePC value-priced narrowbandaccess services, which are generally priced at $10.95 per month. During thethree and six months ended June 30, 2006, average PeoplePC access subscriberswere 1.4 million representing approximately 40% of our average consumernarrowband customer base, and during the three and six months ended June 30,2007, average PeoplePC access subscribers were 1.6 million, representingapproximately 50% of our average consumer narrowband customer base.

*Value-added services revenues.*Value-addedservices revenues consist of search revenues; advertising revenues; revenuesfrom ancillary services sold as add-on features to our Internet services, suchas security products, email by phone, Internet call waiting and email storage;and revenues from home networking 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 revenues; advertising our partners’products and services in our various online properties and electronicpublications, including the Personal Start PageTM; referring our customers to our partners’products and services; and monthly fees charged for ancillary services.

Value-addedservices revenues increased 14% to $32.4 million and 18% to $66.0 millionduring the three and six months ended June 30, 2007, respectively, compared tothe prior year periods due primarily to increases in sales of securityproducts. Also contributing to the increase for the six months ended June 30,2007 compared to the prior year period was increased search advertisingrevenues.

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*Businessservices revenue*

*Access and service*.Business access and service revenues consist of retail and wholesale feescharged for high-speed, high-capacity access services including DSL, cable,satellite and dedicated circuit services; fees charged for high-speed datanetworks for small and medium-sized businesses; installation fees; terminationfees; fees for equipment; regulatory surcharges billed to customers; and webhosting. We earn web hosting revenues by leasing server space and providing webservices to individuals and businesses wishing to present a web or e-commercepresence on the Internet.

Business access andservice revenues increased from $44.4 million during the three months endedJune 30, 2006 to $47.3 million during the three months ended June 30, 2007, andincreased from $61.8 million during the six months ended June 30, 2006 to $94.3million during the six months ended June 30, 2007. These increases were due toincreases in both ARPU and average subscribers, which were attributable to theacquisition of New Edge in April 2006, offset by decreases in web hostingrevenues primarily due to decreases in average web hosting accounts.

Our business broadbandsubscriber base consists of customers which are added through retail andwholesale relationships. Retail business services generally have an ARPUbetween $110 and $130 for non-networked solutions and an ARPU between $175 and $225for networked solutions. Wholesale business services generally have an ARPUbetween $60 and $80. The pricing of broadband services for small and mediumenterprises 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 costsincurred to provide our Internet access services, depreciation of our networkequipment and surcharges due to regulatory agencies. Service and equipmentcosts also include the cost of Internet appliances sold. Our principal providerfor narrowband telecommunications services are Level 3 Communications, Inc.,and our largest providers of broadband connectivity are Covad and Time WarnerCable. We also do lesser amounts of business with a wide variety of local,regional and other national providers. We purchase broadband access fromIncumbent Local Exchange Carriers, Competitive Local Exchange Carriers andcable providers. Cost of revenues also includes sales incentives. We also offersales incentives such as free modems and Internet access on a trial basis.

Totalcost of revenues increased 3% from $112.7 million during the three months endedJune 30, 2006 to $115.8 million during the three months ended June 30, 2007,and increased 13% from $205.0 million during the six months ended June 30, 2006to $231.7 million during the six months ended June 30, 2007. The increases weredue to increases of $4.9 million and $30.6 million in business services cost ofrevenues during the three and six months ended June 30, 2007, respectively,compared to the prior year periods, offset by decreases of $1.8 million and $4.0million in consumer services cost of revenues during the three and six monthsended June 30, 2007, respectively, compared to the prior year periods. Businessservices cost of revenues increased during the three and six months ended June30, 2007 due to increases in average monthly costs per subscriber, primarily asa result of acquired New Edge subscribers and their associated cost. Consumerservices cost of revenues decreased during the three and six months ended June30, 2007 due to the decreases in average subscribers. These decreases inconsumer service cost of revenues were offset by increases in sales incentivesdue to an increase in modems and other equipment provided to customersresulting from the increase in IP-based voice subscribers.

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***Salesand marketing***

Sales and marketingexpenses include advertising and promotion expenses, fees paid to distributionpartners to acquire new paying subscribers, personnel-related expenses andtelemarketing costs incurred to acquire and retain subscribers. Sales andmarketing expenses decreased from $91.2 million during the three monthsended June 30, 2006 to $76.2 million during the three months ended June 30,2007, and decreased from $195.0 million during the six months ended June30, 2006 to $174.8 million during the six months ended June 30, 2007. Thedecreases primarily consisted of decreases in consumer services sales andmarketing expenses, offset by increases in business services sales andmarketing expenses. The decreases in consumer services sales and marketingexpenses were primarily attributable to decreased spending for our premiumnarrowband services, offset by an increase in sales and marketing expenses forour voice products and an increase due to the launch of municipal wirelessbroadband services. The increases in business services sales and marketingexpenses were primarily due to the inclusion of New Edge sales and marketingexpenses.  For the remainder of 2007, weplan to exercise discretion in spending sales and marketing resources in aneffort to manage our overall cost structure.

***Operationsand customer support***

Operations and customersupport expenses consist of costs associated with technical support andcustomer service, providing our subscribers with toll-free access to ourtechnical support and customer service centers, maintenance of customerinformation systems, software development and network operations. Operationsand customer support expenses remained relatively constant at $66.6 million and$65.9 million during the three months ended June 30, 2006 and 2007,respectively. Operations and customer support expenses increased 4% from $127.2million during the six months ended June 30, 2006 to $131.9 million during thesix months ended June 30, 2007. The increase was primarily the result of anincrease in business services operations and customer support expenses due tothe inclusion of New Edge expenses. The increased expenses primarily consistedof increases in personnel-related costs and professional fees. Consumerservices operations and customer support expenses remained relatively constantduring the six months ended June 30, 2007 compared to the prior year period dueto a decrease in customer support expenses for narrowband access, offset by anincrease in expenses associated with our municipal wireless broadbandinitiative.

***Generaland administrative***

Generaland administrative expenses consist of fully burdened costs associated with theexecutive, finance, legal and human resources departments; outside professionalservices; payment processing; credit card fees; collections and bad debt.General and administrative expenses decreased 3% from $31.4 million duringthe three months ended June 30, 2006 to $30.5 million during the threemonths ended June 30, 2007, but increased 20% from $62.7 million duringthe six months ended June 30, 2006 to $74.9 million during the six monthsended June 30, 2007. The decrease during the three months ended June 30, 2007compared to the prior year period was attributable to a decrease in corporategeneral and administrative expenses, primarily personnel-related costs andprofessional and legal fees. The increase during the six months ended June 30,2007 compared to the prior year period was due to an increase in corporategeneral and administrative expenses and an increase in business servicesgeneral and administrative expenses. Corporate general and administrativeexpenses increased primarily due to $6.4 million of cash and non-cashcompensation expense related to the death of Mr. Betty, as more fully describedbelow, and an increase in legal fees. Business services general andadministrative expenses increased due to the acquisition of New Edge, whichcaused an increase in general and administrative expenses and bad debt expense.

Mr.Betty passed away on January 2, 2007. Pursuant to Mr. Betty’s employmentagreement, all unvested stock options and restricted stock units immediatelyvested and became fully exercisable upon death. In addition, the Leadership andCompensation Committee of the Board of Directors extended the exercise periodof Mr. Betty’s stock options until December 31, 2008. This daterepresents the exercise period if Mr. Betty had terminated employment afterserving the full term of his employment agreement, which was set to expire inJuly 2008.  During the six months endedJune 30, 2007, we recorded stock-based compensation expense of $3.5 millionrelated to the accelerated vesting of 1.1 million stock options and 0.1 millionrestricted stock units and recorded stock-based compensation expense of $1.4million related to the extension of the exercise period for Mr. 

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Betty’s stockoptions. We also recorded $1.5 million of compensation expense for a payment toMr. Betty’s estate in accordance with his employment agreement.

***Stock-basedcompensation expense***

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

|                            | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                        | ** ** | **2007**                                      | ** ** | **2006** | ** ** | **2007** | ** ** |
| ** **                      | ** ** | **(in thousands)**                         | ** ** |
| Sales and marketing             |       | $                                               | 862        |                                          | $          | 694 |   | $ | 1,703 |   | $ | 1,405 |   |
| Operations and customer support |       | 1,702                                           |       | 1,362                                         |       | 3,360 |   | 2,758 |   |
| General and administrative      |       | 1,170                                           |       | 842                                           |       | 2,339 |   | 6,615 |   |
|                            |       | $                                               | 3,734      |                                          | $          | 2,898 |   | $ | 7,402 |   | $ | 10,778 |   |

 

***Amortization of intangibleassets***

Amortization ofintangible assets represents the amortization of definite lived intangibleassets acquired in purchases of businesses and purchases of customer bases fromother companies. Definite lived intangible assets, which primarily consist ofsubscriber bases and customer relationships, acquired software and technologyand other assets, are amortized on a straight-line basis over their estimateduseful lives, which range from one to six years. Amortization of intangibleassets was $3.1 million and $3.5 million during the three months ended June 30,2006 and 2007, respectively, and $5.0 million and $7.0 million during the sixmonths ended June 30, 2006 and 2007, respectively. The increases inamortization of intangible assets were primarily due to the amortization ofidentifiable definite lived intangible assets resulting from the acquisition ofNew Edge in April 2006.

***Netlosses of equity affiliate***

We account for ourinvestment in HELIO under the equity method of accounting because we can exertsignificant influence over HELIO’s operating and financial policies.Accordingly, we record our proportionate share of HELIO’s net losses. Theseequity method losses are offset by increases in the carrying value of our investmentassociated with amortizing the difference between the book value of non-cashassets contributed to HELIO and their fair value. These increases, which resultin decreases in the net losses of equity affiliate in our statements ofoperations, are being recorded over the estimated useful lives of the non-cashassets contributed. Net losses of equity affiliate for the three and six monthsended June 30, 2006 of $15.4 million and $22.9 million, respectively, includedour proportionate share of HELIO’s net losses offset by amortization associatedwith recognizing the difference between the carrying value and fair value ofnon-cash assets contributed. Net losses of equity affiliate for the three andsix months ended June 30, 2007 of $40.1 million and $69.4 million,respectively, included our proportionate share of HELIO’s net losses offset byamortization associated with recognizing the difference between the carryingvalue and fair value of non-cash assets contributed. HELIO’s net loss hasincreased due to the start-up nature of HELIO’s operations and HELIO’s recentproduct launches. We expect HELIO’s net losses to continue to increase, and, asa result, we expect our net losses of equity affiliate to increase as we recordour proportionate share of HELIO’s net losses.

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***Interestincome and other, net***

Interest income andother, net, is primarily comprised of interest earned on our cash, cashequivalents and marketable securities; interest earned on our Covad investment;and interest incurred on our Convertible Senior Notes due November 15, 2026 (“Notes”).Interest income and other, net, decreased from $4.3 million during the threemonths ended June 30, 2006 to $3.6 million during the three months ended June30, 2007, and decreased from $8.6 million during the six months ended June 30,2006 to $7.1 million during the six months ended June 30, 2007. These decreaseswere primarily due to interest expense incurred on our Notes, offset by anincrease in interest income. The Notes were issued in November 2006 in a registeredoffering and bear interest at 3.25% per year on the principal amount of theNotes until November 15, 2011, and 3.50% interest per year on the principalamount of the Notes thereafter.

Interest income increaseddue to higher investment yields on our cash and marketable securities andincreases in our average cash and marketable securities balance. Alsocontributing to the increase in interest income for the six month period wasinterest earned on our Covad investment, as we began earning interest on our investmentin March 2006. Our weighted average investment yields increased fromapproximately 5.1% and 4.6% during three and six months ended June 30, 2006,respectively, to approximately 5.2% during the three and six months ended June30, 2007, as the U.S. Federal Reserve Bank increased interest rates during thefirst half of 2006. Our average cash and marketable securities balanceincreased from $268.5 million and $332.7 million during the three and sixmonths ended June 30, 2006, respectively, to $379.2 million and $381.2 millionduring the three and six months ended June 30, 2007, respectively. Our averagecash and investment balances increased over the past year as a result of cashraised by the issuance of convertible senior notes and cash provided byoperations, offset by investments in the HELIO joint venture, investments inour growth initiatives and capital expenditures.

***Provisionfor income taxes***

We have recorded incometaxes during the three and six months ended June 30, 2007 based on management’scurrent expectations in accordance with the interim reporting requirements ofSFAS No. 109, “Accounting for Income Taxes,” and Accounting Principles BoardOpinion No. 28, “Interim Financial Reporting.”

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

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**Liquidity and Capital Resources**

The following table setsforth summarized cash flow data for the six months ended June 30, 2006 and2007:

|                                                      | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                          | ** ** | **2007** | ** ** |
| ** **                                           | ** ** | **(in thousands)**                           | ** ** |
|                                                 |       |                                              |       |   |   |
| Net income (loss)                                    |       | $                                                 | 32,921     |   | $ | (46,252 | ) |
| Non-cash items                                       |       | 52,122                                            |       | 106,086 |   |
| Changes in working capital                           |       | (26,423                                           | )          | (26,673 | ) |
| Net cash provided by operating  activities           |       | $                                                 | 58,620     |   | $ | 33,161 |   |
|                                                 |       |                                              |       |   |   |
| Net cash used in investing activities                |       | $                                                 | (122,870   | ) | $ | (68,339 | ) |
|                                                 |       |                                              |       |   |   |
| Net cash (used in) provided by financing  activities |       | $                                                 | (19,958    | ) | $ | 4,432 |   |

 

*Operating activities*

Netcash provided by operating activities decreased during the six months endedJune 30, 2007 compared to the prior year period. This was primarily due to anincrease in costs related to our growth initiatives, including municipalwireless broadband and IP-based voice services, as we used cash generated fromour core access services to fund these initiatives, and an increase in costsdue to the acquisition of New Edge. Cash flows from operating activities havebeen adversely affected in 2007 due to funding of our growth initiatives in theform of increased operating and sales and marketing expenses; however, we areexploring ways to scale our growth initiatives economically and ways to moreeffectively manage expenses associated with our core access services.

Non-cashitems include items that are not expected to generate or require the use ofcash, such as depreciation and amortization relating to our network, facilitiesand intangible assets, net losses of equity affiliate, deferred income taxes,stock-based compensation and non-cash disposals and impairments of fixedassets. Non-cash items increased during the six months ended June 30, 2007compared to the prior year period due to an increase in net losses of equityaffiliate, an increase in stock-based compensation expense and an increase indepreciation and amortization expense.

Changesin working capital requirements include changes in accounts receivable, prepaidand other assets, accounts payable, accrued and other liabilities and deferredrevenue. Cash used for working capital requirements remained relativelyconstant at $26.4 million and $26.7 million during the six months ended June30, 2006 and 2007, respectively.

*Investing activities*

Cash used for investingactivities decreased during the six months ended June 30, 2007 compared to theprior year period, which was due to a decrease in cash used for investments inother companies, investments in HELIO and cash used for our acquisition of NewEdge in 2006, offset by an increase in net purchases of investments inmarketable securities and an increase in capital expenditures. Our investingactivities used cash of $122.9 million during the six months ended June 30,2006. This consisted primarily of $108.7 million net cash paid to acquire NewEdge, our $50.0 million investment in Covad, our $10.0 million investment inCurrent Communications, Group LLC and $39.5 million of contributions to HELIO.In addition, we used $13.9 million for capital expenditures, primarilyassociated with network and technology center related projects and $1.8 millionto purchase subscriber bases from other ISPs. Offsetting these investingoutlays were proceeds of $101.7 million from sales and maturities ofinvestments in marketable securities, net of purchases.

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Our investing activitiesused cash of $68.3 million during the six months ended June 30, 2007. Thisconsisted primarily of $26.8 million of capital expenditures, primarilyassociated with network and technology center related projects, $19.5 millionof contributions to HELIO, $19.3 million of purchases of investments inmarketable securities, net of sales and maturities, and $2.9 million topurchase subscriber bases from other ISPs. We have invested significantly inour network and technology center infrastructure, and we expect to continue toinvest capital to enhance the reliability and capacity of our network as wellas to improve the efficiency of our technical and customer support services. Inaddition, management continuously reviews industry and economic conditions toidentify opportunities to pursue acquisitions of subscriber bases, and we mayinvest in or acquire other companies.

*Financing activities*

Our financing activitiesused cash of $20.0 million during the six months ended June 30, 2006. Thisconsisted primarily of $21.1 million used to purchase 2.3 million shares of ourcommon stock and $2.0 million used to repay a note payable. Partiallyoffsetting cash used for financing activities were proceeds from the exerciseof stock options of $3.2 million during the six months ended June 30, 2006. Ourfinancing activities provided cash of $4.4 million during the six months endedJune 30, 2007, which primarily consisted of proceeds from the exercise of stockoptions. The decrease in net cash used in (provided by) financing activitiesfrom the prior year period was primarily due to a decrease in purchases of ourcommon stock.

**Off-BalanceSheet Arrangements**

As of June 30, 2007, wedid not have any off-balance sheet arrangements that have or are reasonablylikely to have a current or future effect on our financial condition, changesin financial condition, revenues or expenses, results of operations, liquidity,capital expenditures or capital resources that are material to investors.

**Share Repurchase Program**

The Board of Directorshas authorized a total of $550.0 million to repurchase our common stock underour share repurchase program. As of July 31, 2007, we had utilizedapproximately $454.7 million pursuant to the authorizations and had $95.3 millionavailable under the current authorization. We may repurchase our common stockfrom time to time in compliance with the Securities and Exchange Commission’sregulations and other legal requirements, and subject to market conditions andother factors. The share repurchase program does not require us to acquire anyspecific number of shares and may be terminated by the Board of Directors atany time. We have not repurchased common stock under this program since October2006.

**Income Taxes**

We continue to maintain afull valuation allowance against our deferred tax assets of approximately$372.0 million, consisting primarily of net operating loss carryforwards. Wemay recognize deferred tax assets in future periods when they are determined tobe realizable. To the extent we may owe income taxes in future periods, weintend to use our net operating loss carryforwards to the extent available toreduce cash outflows for income taxes.

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**Future Uses of Cash and FundingSources**

Weexpect to use cash to fund our HELIO joint venture. HELIO is our joint venturewith SK Telecom that markets wireless voice and data services in the U.S.Pursuant to the Contribution and Formation Agreement, we invested a total of$180.0 million of cash to date, including $19.5 million that was invested inthe first six months of 2007.

InJuly 2007, we and SK Telecom entered into a loan agreement with HELIO pursuantto which we and SK Telecom could lend up to $200.0 million to HELIO. Under theterms of the agreement, each of us and SK Telecom could purchase up to $100.0million of HELIO’s secured promissory notes (the “Promissory Notes”).  The Promissory Notes may be purchased by usand SK Telecom from time to time over a one year period commencing on the dateof the agreement.  The Promissory Noteswill bear interest at 10.00% per annum, payable at maturity, and may bepre-paid by HELIO at any time without penalty. The Promissory Notes mature on July 23, 2010, unless amounts become dueand payable earlier by acceleration or otherwise.

InJuly 2007, we and SK Telecom each purchased initial Promissory Notes of $30.0million. Any future investments in HELIO could adversely affect our cashposition.

We have expended and willcontinue to expend significant resources enhancing our existing services anddeveloping, acquiring, implementing and launching new services. These uses ofcash have been in the form of initial product development and infrastructurecosts, followed by sales and marketing costs to add customers that willgenerate recurring revenues. However, we are exploring ways to scale our growthinitiatives economically in order to improve the returns on our investments. Wealso expect to incur capital expenditures to maintain and upgrade our networkand technology infrastructure and to build wireless broadband networks incertain municipalities. The actual amount of capital expenditures in 2007 aswell as in future periods may fluctuate due to a number of factors which aredifficult to predict and could change significantly over time, including theresult of our reassessment of our business strategy. In connection with theevaluation of our municipal wireless broadband business, if we seek to modifyagreements with municipalities to build out their wireless networks, we couldincur additional costs. Additionally, technological advances may require us tomake capital expenditures to develop or acquire new equipment or technology inorder to replace aging or technologically obsolete equipment. We also expect tocontinue to use cash to acquire and retain new and existing subscribers for ourcore access services.

Ourcash requirements depend on numerous factors, including, the rate of marketacceptance of our and HELIO’s services, our ability to successfully develop newrevenue sources, our ability to maintain and expand our customer base, the rateof expansion of our network infrastructure, the size and types of acquisitionsin which we may engage and the level of resources required to expand our salesand marketing programs. We also could use cash to repurchase common stock underour existing share repurchase program.

Ourprincipal sources of liquidity are our cash, cash equivalents and investmentsin marketable securities, as well as the cash flow we generate from our coreaccess operations. As of June 30, 2007, we had $127.6 million in cash and cashequivalents. In addition, we held short- and long-term investments inmarketable securities valued at $229.5 million and $26.2 million, respectively.Short-term investments in marketable securities consist of investments thathave maturity dates of up to one year from the balance sheet date andasset-backed, auction rate securities that have interest rate reset periods ofup to one year from the balance sheet date, and long-term investments inmarketable securities consist of investments that have maturity dates of morethan one year from the balance sheet date.

During November 2006, we issued $258.8million aggregate principal amount of Convertible Senior Notes due November 15,2026 in a registered offering, which includes the exercise by the underwritersof their option to purchase an additional $33.8 million to coverover-allotments. We received net proceeds of $251.6 million after transactionfees of $7.2 million. We used $15.1 million of the proceeds for hedgetransactions to reduce the potential dilution upon conversion of theconvertible senior notes. The remaining proceeds will be used for generalcorporate purposes, which may include expenditures related to our growthinitiatives.

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Wehave a financing lease agreement with General Electric Capital Corporation tolease certain equipment necessary to build out our municipal wirelessinfrastructure in selected markets. Under the agreement, we can lease up to$75.0 million of assets. As of June 30, 2007, we had acquired approximately$8.1 million of equipment pursuant to the financing agreement.

Ouravailable cash and marketable securities, together with our results ofoperations, are expected to be sufficient to meet our operating expenses,capital requirements and investment and other obligations for the next 12months. However, as a result of other investment activities, we may seekadditional financing in the future. Except for our financing lease agreementdiscussed above, we have no commitments for any additional financing and haveno lines of credit or similar sources of financing. We cannot be sure that wecan obtain additional financing on favorable terms, if at all, through theissuance of equity securities or the incurrence of additional debt. Additionalequity financing may dilute our stockholders, and debt financing, if available,may restrict our ability to repurchase common stock, declare and pay dividendsand raise future capital. If we are unable to obtain additional neededfinancing, we may be required to reduce our planned capital expenditures and/orsuspend or reduce our investment activities, which could materially andadversely affect our prospects for long-term growth.

**Related Party Transactions**

*HELIO*

EarthLinkand HELIO have entered into a services agreement pursuant to which we provideHELIO facilities, accounting, tax, billing, procurement, risk management,payroll, human resource, employee benefit administration and other supportservices in exchange for management fees. However, as HELIO has developed itsbusiness, the extent to which HELIO relies on us to provide these services hasdecreased. We believe that providing these services to HELIO enabled HELIO tomore quickly and cost effectively launch its business than if it were to purchasethese services from third parties. The management fees were determined based onour costs to provide the services, and management believes such fees arereasonable.  The total amount of feesthat HELIO pays to us depends on the extent to which HELIO utilizes ourservices.  Fees for services provided toHELIO are reflected as reductions to the associated expenses incurred by us toprovide such services. During the three and six months ended June 30, 2006,fees received for services provided to HELIO were $0.5 million and $1.2million, respectively. During the three and six months ended June 30, 2007,fees received for services provided to HELIO were $0.5 million and $0.9million, respectively.

Wealso market HELIO’s products and services and purchase wireless Internet accessdevices and services from HELIO. During the three and six months ended June 30,2006 and 2007, revenues generated from HELIO and fees paid for products andservices from HELIO were minimal.

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

*eCompanies*

Duringthe three months ended June 30, 2007, we received a $0.2 million cashdistribution as a result of our investment in eCompanies Venture Group, L.P. (“EVG”).Sky Dayton, a member of our Board of Directors, is a founding partner in EVG.

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**Recent Accounting Pronouncements**

InSeptember 2006, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 157, “Fair Value Measurements,” which establishes a framework forreporting fair value and expands disclosures about fair value measurements.SFAS No. 157 is effective for financial statements issued for fiscal yearsbeginning after November 15, 2007 and interim periods within those fiscalyears. We are currently assessing the impact of the adoption of this standardon our financial statements.

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

**Safe Harbor Statement**

TheManagement’s Discussion and Analysis and other portions of this QuarterlyReport on Form 10-Q include “forward-looking” statements (rather than historicalfacts) that are subject to risks and uncertainties that could cause actualresults to differ materially from those described. Although we believe that theexpectations expressed in these forward-looking statements are reasonable, wecannot promise that our expectations will turn out to be correct. Our actualresults could be materially different from and worse than our expectations.With respect to such forward-looking statements, we seek the protectionsafforded by the Private Securities Litigation Reform Act of 1995. These risksinclude, without limitation, (1) that we may not successfully enhance existingor develop new products and services in a cost-effective manner to meetcustomer demand in the rapidly evolving market for Internet, wireless and IP-basedvoice communications services, including new products and services offered inconnection with our voice and municipal broadband network growth initiatives,and we expect these growth initiatives to not be profitable in their earlystages; (2) that our service offerings may fail to be competitive with existingand new competitors; (3) that competitive product, price or marketing pressurescould cause us to lose existing customers to competitors (churn), or may causeus to reduce prices for our services which could adversely impact averagerevenue per user; (4) that we may be unsuccessful in making and integratingacquisitions into our business, which could result in operating difficulties,losses and other adverse consequences; (5) that the continued decline of ournarrowband revenues could adversely affect our profitability and adverselyimpact our ability to invest in our growth initiatives; (6) that we may not beable to successfully manage the costs associated with delivering our wirelinebroadband services, which could adversely affect our ability to grow or sustainrevenues and our profitability; (7) that companies may not provide last milebroadband access to us on a wholesale basis or on terms or at prices that allowus to grow and be profitable; (8) that our commercial and alliance arrangementsmay be terminated or may not be as beneficial as anticipated, which couldadversely affect our ability to increase our subscriber base; (9) that ourbusiness may suffer if our third-parties for technical and customer support andcertain billing services are unable to provide these services, cannot expand tomeet our needs or terminate their relationships with us; (10) that serviceinterruptions or impediments could harm our business; (11) that government regulationscould force us to change our business practices; (12) that changes in, orinterpretations of, laws regarding consumer protection could subject us toliability or cause us to change our practices; (13) that we may not be able toprotect our proprietary technologies or successfully defend infringement claimsand may be required to enter licensing arrangements on unfavorable terms; (14)that we may be accused of infringing upon the intellectual property rights ofthird parties, which is costly to defend and could limit our ability to usecertain technologies in the future; (15) that we could face substantialliabilities if we are unable to successfully defend against legal actions; (16)that our business depends on the continued development of effective businesssupport systems, processes and personnel; (17) that we may be unable to hireand retain sufficient qualified personnel, and the loss of any of our keyexecutive officers could adversely affect us; (18) that we may not besuccessful in entering into arrangements with municipalities to build out andoperate municipal wireless broadband networks and we may not obtain asufficient number of customers to generate the returns anticipated on ourinvestments to construct and deploy municipal wireless broadband networks; (19)that municipal wireless networks may not perform as

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expected or mayresult in unanticipated costs, which could increase our churn and our cost ofproviding services; (20) that we may experience difficulties in constructing,upgrading and maintaining our municipal wireless network, which could adverselyaffect customer satisfaction, increase subscriber churn and reduce ourrevenues; (21) that the market for VoIP services may not develop asanticipated, which would adversely affect our ability to execute our voicestrategy; (22) that certain aspects of our VoIP service are not the same astraditional telephone service, which may limit the acceptance of our servicesby mainstream consumers and our potential for growth; (23) that our E911emergency services are different from those offered by traditional wirelinetelephone companies and may expose us to significant liability; (24) that ourability to provide our VoIP service is dependent upon third-party facilitiesand equipment, the failure of which could cause delays or interruptions of ourservice, damage our reputation, cause us to lose customers and limit ourgrowth; (25) that we may not realize the benefits we are seeking from ourinvestments in the HELIO joint venture or other investment activities as aresult of lower than predicted revenues or subscriber levels of the companiesin which we invest, larger funding requirements for those companies orotherwise; (26) that our stock price has been volatile historically and maycontinue to be volatile; (27) that our indebtedness could adversely affect ourfinancial health and limit our ability to react to changes in our industry orto implement our strategic initiatives; (28) that we may be unable torepurchase our convertible senior notes for cash when required by the holders,including following a fundamental change, or to pay the cash portion of theconversion value upon conversion of any notes by the holders; (29) that theconvertible note hedge and warrant transactions may affect the value of ourcommon stock; and (30) that some provisions of Delaware law, our secondrestated certificate of incorporation and amended and restated bylaws may bedeemed to have an anti-takeover effect and may delay or prevent a tender offerto takeover attempt that a stockholder might consider in its best interest.These risks and uncertainties, as well as other risks and uncertainties thatcould cause our actual results to differ significantly from management’sexpectations, are not intended to represent a complete list of all risks anduncertainties inherent in our business, and should be read in conjunction withthe more detailed cautionary statements and risk factors included in our Annual Report on Form 10-K for the year endedDecember 31, 2006, as amended.

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

*Interest Rate Risk*

We are exposed tointerest rate risk with respect to our investments in marketable securities. Achange in prevailing interest rates may cause the fair value of our investmentsto fluctuate. For example, if we hold a security that was issued with a fixedinterest rate at the then-prevailing rate and the prevailing interest ratelater rises, the fair value of the investment may decline. To minimize thisrisk, we have historically held investments until maturity, and as a result, wereceive interest and principal amounts pursuant to the underlying agreements.To further mitigate risk, we maintain a portfolio of investments in a varietyof securities, including government agency notes, asset-backed debt securities(including auction rate debt securities), corporate notes and commercial paper,all of which bear a minimum short-term rating of A1/P1 or a minimum long-termrating of A/A2. As of December 31, 2006 and June 30, 2007, net unrealizedlosses in these investments were not material. In general, money market funds are not subject to market risk becausethe interest paid on such funds fluctuates with the prevailing interest rate.In addition, we invest in relatively short-term securities and, therefore,changes in short-term interest rates impact the amount of interest incomeincluded in the statements of operations.

Thefollowing table presents the amounts of our cash equivalents and short- andlong-term investments that are subject to interest rate risk by range ofexpected maturity and weighted-average interest rates as of December 31,2006 and June 30, 2007. This table does not include money market funds becausethose funds are not subject to interest rate risk.
| ** **                                    | ** ** | **As of December 31, 2006** | ** ** | **As of June 30, 2007** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                    | ** ** | ** **                                      | ** ** | **Estimated**                               | ** ** | ** ** | ** ** | **Estimated** | ** ** |
| ** **                                    | ** ** | **Amortized**                                   | ** ** | **Fair**                                    | ** ** | **Amortized** | ** ** | **Fair** | ** ** |
| ** **                                    | ** ** | **Cost**                                        | ** ** | **Value**                                   | ** ** | **Cost** | ** ** | **Value** | ** ** |
| ** **                                    | ** ** | **(dollars in thousands)**            | ** ** |
| Included in cash and cash equivalents         |       | $                                               | 46,289     |                                        | $          | 46,289 |   | $ | 14,156 |   | $ | 14,156 |   |
| Weighted average interest rate                |       | 5.3                                             | %          |                                        |       | 5.2 | % |   |   |
| Weighted average maturity (mos.)              |       | 1.0                                             |       |                                        |       | 1.7 |   |   |   |
|                                          |       |                                            |       |                                        |       |   |   |   |   |
| Included in marketable  securities-short-term |       | $                                               | 215,181    |                                        | $          | 214,947 |   | $ | 229,762 |   | $ | 229,546 |   |
| Weighted average interest rate                |       | 5.2                                             | %          |                                        |       | 5.2 | % |   |   |
| Weighted average maturity (mos.)*             |       | 2.7                                             |       |                                        |       | 2.3 |   |   |   |
|                                          |       |                                            |       |                                        |       |   |   |   |   |
| Included in marketable  securities-long-term  |       | $                                               | 21,497     |                                        | $          | 21,460 |   | $ | 26,251 |   | $ | 26,198 |   |
| Weighted average interest rate                |       | 5.2                                             | %          |                                        |       | 5.2 | % |   |   |
| Weighted average maturity (mos.)              |       | 19.3                                            |       |                                        |       | 20.1 |   |   |   |

 

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* The maturity ofasset-backed, auction rate securities for purposes of this calculation isconsistent with management’s view as to the availability of such securities tofund current operating activities.

We are also exposed tointerest rate risk with respect to our convertible senior notes due November15, 2026. The fair value of our convertible senior notes may be adverselyimpacted due to a rise in interest rates. In general, securities with longermaturities are subject to greater interest rate risk than those with shortermaturities. Our convertible senior notes bear interest at a fixed rate of 3.25%per year until November 15, 2011, and 3.50% per year thereafter. As of December31, 2006 and June 30, 2007, the carrying value of our convertible senior noteswas $258.8 million, and the fair value was approximately $277.3 million and$277.9 million, respectively, which was based on quoted market prices.

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*Equity Risk*

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

The following tablepresents the carrying value and fair value of our financial instruments subjectto equity risk as of December 31, 2006 and June 30, 2007:
| ** **                                       | ** ** | **As of December 31, 2006** | ** ** | **As of June 30, 2007** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                       | ** ** | **Carrying  Amount**                            | ** ** | **Estimated  Fair   Value**                 | ** ** | **Carrying  Amount** | ** ** | **Estiated  Fair   Value** | ** ** |
| ** **                                       | ** ** | **(dollars in thousands)**            | ** ** |
| Investments in other companies for which  it is: |       |                                            |       |                                        |       |   |   |   |   |
| Practicable to estimate fair value               |       | $                                               | 48,325     |                                        | $          | 48,325 |   | $ | 44,123 |   | $ | 44,123 |   |
| Not practicable to estimate fair value           |       | 11,000                                          |       | N/A                                         |       | 11,000 |   | N/A |   |
| Call options                                     |       | 47,162                                          |       | 58,361                                      |       | 47,162 |   | 59,981 |   |
|                                                  |            |                                                 |            |                                             |            |  |  |  |  |  |  |  |  |

 

**Item4. Controls and Procedures.**

**Evaluation of Disclosure Controlsand Procedures**

Pursuantto Rule 13a-15(b) under the Securities Exchange Act of 1934 (the “ExchangeAct”), EarthLink’s management, including EarthLink’s Chief Executive Officerand Chief Financial Officer, evaluated the effectiveness of EarthLink’s disclosurecontrols and procedures (as defined under Rule 13a-15(e) under theExchange Act) as of the end of the period covered by this report. Based uponthat evaluation, EarthLink’s Chief Executive Officer and Chief FinancialOfficer concluded that EarthLink’s disclosure controls and procedures areeffective to ensure that information required to be disclosed in the reportsthat are filed or submitted under the Exchange Act, is recorded, processed,summarized and reported, within the time periods specified in the Securitiesand Exchange Commission’s rules and forms, and that such information isaccumulated and communicated to management, including EarthLink’s ChiefExecutive Officer and Chief Financial Officer, to allow timely decisionsregarding required disclosure.

**Changesin Internal Control over Financial Reporting**

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

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**Part II**

**Item 1.    Legal Proceedings.**

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

**Item 1A.  Risk Factors.**

There were no material changes from the risk factors disclosed inEarthLink’s Annual Report on Form 10-K for the year ended December 31, 2006, asamended.

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

None.

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

EarthLinkheld its 2007 annual meeting of stockholders on May 1, 2007. The followingsummarizes the voting results for the two proposals submitted for a vote of thestockholders at that meeting:

Proposal1.  To elect Terrell B. Jones and Linwood A. Lacy, Jr. to EarthLink’sBoard of Directors as Class II directors for a three-year term.
|                 | ** ** | **Terrell B. Jones** | ** ** | **Linwood A. Lacy, Jr.** | ** ** |
|-----------------|------------|--------------------------------|------------|-----------------------------------------|------------|
| Votes For       |       | 107,786,735 shares             |       | 105,964,337 shares                      |       |
| Votes Abstained |       | 9,618,073 shares               |       | 11,440,471 shares                       |       |

 

Inaddition, the terms of the following directors continued after the annualmeeting: Sky D. Dayton, Marce Fuller, William H. Harris, Jr., Robert M. Kavnerand Thomas E. Wheeler.

Proposal 2. To ratify the appointment of Ernst & Young LLP by the Audit Committee of the Board of Directors to serve as EarthLink’s independent registered public accounting firm for the fiscal year ending December 31, 2007.

Votes For—116,669,544 shares

Votes Against—587,911 shares

Votes Abstained—147,351 shares

Both of these proposals were approved by the EarthLink stockholders at the annual meeting.

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**Item 5.  Other Information.**

None.

**Item 6.   Exhibits.**

(a)          Exhibits.   The followingexhibits are filed as part of this report**:**
| 31.1   | Certification of Chief Executive Officer pursuant to  Securities Exchange Act Rules 13a-14 and 15d-14, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002. |
|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                          |
| 31.2   | Certification of Chief Financial Officer pursuant to  Securities Exchange Act Rules 13a-14 and 15d-14, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002. |
|   |                                                                                                                                                                          |
| 32.1   | Certification of Chief Executive Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                          |
|   |                                                                                                                                                                          |
| 32.2   | Certification of Chief Financial Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                          |

 

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#### **SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.
|        |           |   | EARTHLINK, INC.                               |
|--------|----------------|--------|-----------------------------------------------|
|   |           |   |                                          |
|   |           |   |                                          |
| Date:  | August 6, 2007 |   | /s/ ROLLA P. HUFF                             |
|   |           |   | Rolla P. Huff, Chief Executive Officer        |
|   |           |   |                                          |
|   |           |   |                                          |
| Date:  | August 6, 2007 |   | /s/ KEVIN M. DOTTS                            |
|   |           |   | Kevin M. Dotts,  Chief Financial Officer      |
|   |           |   | (principal  financial and accounting officer) |

 

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