In recent years, I have seen a trend of analysts shunning asset–heavy stocks for their more efficient counterparts. However, investors should not confuse capital inefficiencies with competitive advantages derived from assets. Asset intensive companies also typically face less threats from substitute products and the entry of new competitors. EarthLink, Inc. (NASDAQ:ELNK), a domestic IT services, network and communications company, belongs to this category of companies with a significant network footprint covering most of the country. Furthermore, EarthLink, Inc. (NASDAQ:ELNK) sports a decent 3.4% dividend yield and has the strongest balance sheet amongst its peers. It is also valued attractively at 4.1 times EV/EBITDA, at a discount to its peers.
Hard assets provide barriers to entry
Although there is a trend of companies moving towards asset-light business models with an eye on better margins, hard assets represent barriers to entry that really keep new entrants and competitors at bay. In EarthLink, Inc. (NASDAQ:ELNK)’s case, its broad network footprint covering more than 90% of the U.S. is not easily replicated, with the estimated cost to build networks of EarthLink’s scale running into billions of dollars. EarthLink is not resting on its laurels and it expanded its data center presence with the opening of several new next generation data centers in Chicago and Dallas in the past year.
The trend is not only a trader’s best friend
The adage “the trend is your best friend” does not just work for traders; investing based on fundamental analysis could derive valuable insights from observing trends in operating metrics. For example, while many listed companies quote “strong recurring revenues” as one of their key investment metrics, it is necessary to examine trends such as the amount of customers failing to renew or cancelling their existing contracts and the length of existing customer relationships. EarthLink, Inc. (NASDAQ:ELNK)’s customer churn for both its business and consumer segments are on a downward trend, with consumer churn of 2.2% in the first quarter of 2013 representing a historical low, according to its most recent investor presentation. In addition, more than 70% of consumer subscribers have been with EarthLink for more than five years. Customers who stay longer with EarthLink tend to be happier customers as well. This results in tangible benefits such as less customer complaints, which are a drain on call center resources, and a lower occurrence of late customer payments and defaults.
Signficant tax assets to reduce future taxable income
The ideal stock investment from a tax advantaged viewpoint, is a turnaround or transition story with accumulated retained losses offsetting growing earnings. EarthLink, Inc. (NASDAQ:ELNK) is such a stock with growth in its IT services business offsetting the decline in revenues from its legacy products and services such as voice services. EarthLink has significant tax assets that will help to reduce income taxes going forward. In addition to more than $700 million of net operating losses (NOLs) for state income tax purposes, EarthLink, Inc. (NASDAQ:ELNK) also has federal NOLs amounting to close to $500 million. Furthermore, it will also be able to utilize depreciation and amortization tax shields from its 2010 purchase of One Communications, which is treated like an asset acquisition for taxation purposes.
Peer comparison
EarthLink’s peers include TW Telecom Inc (NASDAQ:TWTC) and Windstream Corporation (NASDAQ:WIN). EarthLink, Inc. (NASDAQ:ELNK) is valued by the market at 4.1 times EV/EBITDA, at a discount to its peers. In comparison, TW Telecom and Windstream trade at higher EV/EBITDA multiples of 10.1 and 6.0, respectively.
Windstream Corporation (NASDAQ:WIN) was formed as a result of a merger between Alltel‘s local wireline business and Valor Communications in 2006. While it was previously a rural local exchange carrier, Windstream Corporation (NASDAQ:WIN) successfully expanded beyond its regional footprint of 16 states in 2006 to become a significant player at the national level now serving 48 states in the country. Its consumer and business broadband business segments also grew from below 40% of sales in 2006 to over 70% of 2012 turnover, helping to negate the fall in traditional voice revenues. Windstream has also maintained an annual dividend of $1.00 per share since its inception and sports a forward dividend yield of 12.7%. However, in my view, the high dividend yield is insufficient to compensate for the financial risks associated with a high gearing of 890%.
TW Telecom Inc (NASDAQ:TWTC) will be one to consider for the patient investor. Its significant investment plans to support future revenue growth in the long term, could possibly come at the expense of weaker financial results in the near term. These investments include expanding distribution research through the hiring of more sales personnel, spending more on innovation to churn out new products and speeding up customer connectivity through upgrading of technology. Given that cash needs to be set aside for such investments, it is not surprising that TW Telecom Inc (NASDAQ:TWTC) does not pay a dividend. Instead, it has spent more than $100 million on share repurchases in 2013 year-to-date.
Conclusion
Notwithstanding Windstream’s high dividend yield of 12.7%, I will not consider it given its huge debt load. I also prefer EarthLink over TW Telecom, given that I believe that a free cash flow generative company should reward its shareholders with dividends. In addition, it is the least leveraged amongst its peers with no significant debt maturities until 2019. EarthLink, Inc. (NASDAQ:ELNK) is also significantly undervalued on both an absolute and relative basis at 4.1 times EV/EBITDA, which makes it a strong investment candidate.
The article This Stock Is Cheaper and Safer than Its Peers originally appeared on Fool.com and is written by Mark Lin.
Mark Lin has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Mark is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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