More On Neutral Tandem

Courtesy of a new friend, below is more info on Tarpon Folio holding Neutral Tandem, TNDM, which will report its second quarter earnings this Thursday. Also, here is more on TNDM from another investor that recently wrote-in, too.

The write-up below recently appeared on Value Investors Club. The author, who’d like to remain anonymous, reached out to me on some questions before he posted this. Although I believe TNDM is worth more than the author indicates, and have a few other comments I might add if time allowed, I nonetheless thought he did a solid job of analyzing the company. He gave me the okay to post the below here.

Ever since my interview on TNDM a few months back, I’ve had a pretty steady stream of emails and phone calls about the company from other portfolio managers, analysts, and individual investors. In short, while I cannot give specific investing advice here, I will say that I have been averaging down on TNDM in the Tarpon Folio over the past few months. The size of my position is a touch smaller than it was three months ago, but that’s much more a function of (a) other opportunities and (b) clearing out some higher cost-basis shares than being indicative of the company’s prospects in any way. I continue to maintain that the competitive threat from Peerless Networks is vastly overblown – it’s in a box canyon that the market doesn’t seem to recognize. I also continue to believe it is the number of switches and not per minute pricing that is the key variable when it comes to attracting new customers. At some point, the market will recognize this, and in the meantime, I continue to be okay just waiting.

The write-up follows. Please note that certain tables included in the original write-up weren’t translating well to HTML below, but you can download the entire write-up complete with those tables in PDF form here.

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Neutral Tandem (TNDM)

Neutral Tandem (TNDM) is a company whose stock has been oversold to all-time lows on fears of
slowing growth, increasing competition, and patent issues. This has driven shares to fall from a high of
$34.56 to $11.98 as of last close (7/12/2010). However, Neutral Tandem’s healthy free cash flows and
strong financial position (over $170M in cash and no debt) make the company an attractive investment
opportunity at these prices. Although headwinds such as competition are legitimate, I believe that TNDM
shares are currently priced for a worst-case scenario in the company’s future and should offer at least a
25-35% return at current prices.

Background

Some background is necessary to understand Neutral Tandem’s core business of interconnecting voice
carriers. Calls made from one voice carrier to a different voice carrier require either a tandem switch to
rout the call or a direct connection between the carriers in the relevant markets. Due to the high costs of
establishing direct connections, most voice carriers will choose to transit their calls with tandem switches.

Before Neutral Tandem entered the market, this meant most carriers used the network of tandem
switches owned by the “Baby Bells”, called the incumbent local exchange carriers (ILECs). By law, ILECs
were required to rout all traffic, including the calls of competing carriers, with their tandem switches.
ILECs charged competing carriers by the minute for calls requiring routing by their tandems at rates
regulated by state commissions and the FCC. Not only were the ILEC tandems inefficient for operating
with competing carriers since they had been designed by for a monopolistic carrier, but ILECs were in
general unhappy about having to give up use of their overburdened tandem networks to competitors and had an incentive to not “fully cooperate” in establishing the interconnections competing carriers required.

Neutral Tandem’s Operations

Neutral Tandem was founded in 2003 to provide an alternative to the ILEC tandem switching network. Over the course of 6-7 years, it has built its own national tandem switching network that offers three main advantages over the ILECs:

1. Neutrality. Its eponymous neutrality refers to the fact that it does not compete with voice carriers like an ILEC does, thus ensuring that carriers do not need to rout calls through their biggest competitors.

2. Cost savings. Since Neutral Tandem designed their tandem switch scheme to maximize efficiency for routing calls from many different carriers it is able to undercut the ILECs’ rates by 20-25%.

3. Quality and services. Finally, Neutral Tandem has built a higher quality product than the old ILEC tandems using new IP soft-switch tandems and offering features such as quality of service reporting,
traffic reports, and redundancies in the network to ensure more reliable service.

With its first mover advantage, Neutral Tandem has managed to grow its network into the largest
alternative tandem switching network in the US. Neutral Tandem routed 87.8 billion minutes of calls in
2009 and currently serves almost all of the major carriers, with the exception of the wireline ILECs such
as AT&T and Verizon wireline (although it does serve AT&T and Verizon wireless). Its network also
handles all types of voice carriers: wireline competitive local exchange carriers (CLECs), cable
companies, VoIP, wireless, and long-distance carriers interexchange carriers (IXC). Wireless carriers and
cable companies account for 65% of revenue, IXC carriers account for 20%, and the rest is from CLECs
and VoIP.

Like the ILECs, Neutral Tandem charges carriers on a per minute basis for calls that go through their
tandem switches. Revenue recognition is straightforward and is recorded each month based on the
number of minutes trafficked for each specific tandem switching service Neutral Tandem offers. The
tandem switching business is highly scalable and as Neutral Tandem’s network expands, operations
become more efficient, capex decreases as a percentage of sales, and margins increase. This had led to
rapid growth in the sales, profits, and margins in the past 3 years (see tables in original PDF here).

Future Growth

Neutral Tandem’s core business of voice tandem switching is benefiting from the secular trends of
consumers increasingly moving towards wireless, cable, and broadband carriers. As fewer consumers
use wireline ILEC services, more calls will be routed through Neutral Tandem’s network. Beyond these
secular trends, there are several services that are potential drivers of growth for Neutral Tandem (and
potential catalysts for the stock).

60-70% of Neutral Tandem’s revenues currently come from providing tandem routing services for local
calls. While Neutral Tandem is still expanding into new markets to grow its local call services, it is now
entering mainly smaller less profitable markets. Interconnections within larger existing markets also
provide room for Neutral Tandem’s local tandem services to grow. However, the drivers of Neutral
Tandem’s future growth in its core voice business are in two different areas: terminating switched access and originating services.

1. Terminating switched access. In the terminating switched access business, Neutral tandem uses its network to terminate long-distance calls for long-distance carriers, or interexchange carriers (IXC). This is currently 20% of Neutral Tandem’s revenue and management has stated that it may double within a year. Neutral Tandem is also seeking to grow its business by providing terminating services for international long-distance carriers. Neutral Tandem has recently solved the technology aspects of this international service, and is currently working to resolve the contractual aspects with international carriers.

2. Originating switched access. Originating switched access services essentially serve 800 number calls. 800 number calls need to be translated by a tandem to determine which carrier to send it to. Recently, TNDM has begun to offer originating services. However, management has said growth in this area is
currently stalled since Neutral Tandem cannot match the marketing fees often paid to carriers. Future
growth of originating services will depend on whether a number of current lawsuits filed by others will lead to the FCC restricting the marketing fee practice.

Neutral Tandem has also begun a service outside its core business of voice tandem switching in late
2009. It is a joint venture with TelX to launch an Ethernet exchange network. I won’t spend too much time describing this venture since it is a very new venture in a very young industry that will likely interest growth investors more than value investors. The basic concept of this service is to provide efficient interconnection services for companies using the Ethernet system. The Ethernet interconnection industry has been projected to be worth twice as much as the voice tandem business, but this remains to be seen.

Neutral Tandem is behind the main competitors in this new space, CENX and Equinix, by roughly 8
months. That being said, Neutral Tandem has two large advantages in the Ethernet interconnection
industry: 1) its existing network that it can leverage, and 2) existing business relationships with many of the potential Ethernet exchange customers. As a value investor, I would not necessarily invest in TNDM on the potential prospects of the Ethernet exchange network, but growth investors may, which I will discuss in the catalysts section.

Current Concerns

Three main concerns have been contributing to the recent sell-off of TNDM :

1. Competition. Over the past year, Neutral Tandem has seen increasing competitive pressure from firms such as Level 3 and Peerless Networks that has led to a large sell-off. While management has said
that they have retained all major customers, they have admitted that there has been increased price
pressure. This is reflected by the decreasing average rate per minute from 0.19c/minute in 2009 to
0.18c/minute in Q1 of 2010. (While this decrease is occurring partly because of competition, part of the
decrease can also be attributed to Neutral Tandem entering new smaller markets that generally yield
lower rates.) Management was quoted as saying that they had “seen some of the toughest pricing that I
pretty much expect to see”. Regardless of whether this is the case, management appears to be taking the competition seriously and stated that it is competing aggressively to retain customers and gain new ones with long-term contracts and leveraging its ability to provide comprehensive solutions to customers (e.g. broader geographic coverage, more capacity to handle call traffic).

Even with increasing competition, Neutral Tandem has several competitive advantages. First, no
competitor has a tandem network approaching Neutral Tandem’s network’s size. This means that
competitors can only offer a partial solution to carriers at best and makes it unlikely that Neutral Tandem will lose business with carriers that have a national presence (No major customers have been to competitors thus far). Second, Neutral Tandem has built a network with very few quality issues while it is reported that some competitors have had issues with their tandem switching quality. Therefore, large scale defections of Neutral Tandem’s customers are unlikely, and the main legitimate concern is margin compression in local markets.

However, as I’ll discuss in my valuation, even if the easy days of growth are over and margins decline, Neutral Tandem is priced so that in most scenarios is remains a compelling buy. Furthermore, as I discussed previously, the international long-distance, originating access services, and Ethernet exchange are both potential growth areas for Neutral Tandem that could counteract competition in the tandem market.

2. Patent Litigation. In June 2008, Neutral Tandem sued Peerless Networks for patent infringement of its tandem network design, but Peerless Network responded by questioning the validity of Neutral Tandem’s patent and calling for the USTPO to re-examine the patent. Initial action by the USTPO in
March 2010 has been to reject Neutral Tandem’s patent claims, although the USTPO’s final decision on
the re-examination and the Court’s final ruling will not likely be until this fall. This patent dispute and the unfavorable developments have contributed to the sell-off of TNDM in 2010. However, I believe that concerns regarding the patent are overblown.

First, remember that Peerless Networks and likely other competitors have already been infringing on
Neutral Tandem’s patent for over a year to date. An unfavorable ruling for Neutral Tandem would
therefore not materially alter the competitive environment. Second, the company’s balance sheet is
immune to an unfavorable ruling since the company does not appear to assign its patent any value on its books. (Or if they do, it is negligible and filed under “Other assets” which is valued at $511,000.) So while Neutral Tandem may lose its patent battle, it will not fundamentally change its competitive environment. Any favorable ruling on the patent case, while unlikely based on recent developments, will be a catalyst for TNDM and a deterrent against Neutral Tandem’s competition though.

3. Fear of Obsolescence. Similar to the issue of competition, I believe that growth investors have also steadily fallen out of favor with TNDM because of the fear of eventual obsolescence due to VoIP. VoIP
relies on IP-switching technology that greatly reduces the cost and complexity of creating direct
connections between carriers, thereby bypassing the need for tandem switches. However, even
assuming a constant high growth rate of 31.1% CAGR in residential VoIP lines, based on past growth in
VoIP lines, it will still be approximately 7-8 years before VoIP overtakes the number of current US
residential wirelines. This also assumes that there will be no slowdown in VoIP growth due to necessary
infrastructure investments or regulatory hurdles.

Even if adoption occurs at this high rate, it is important to remember that establishing direct connections between VoIP carriers will still take time and that tandem switching will still be necessary for connecting VoIP with wireless carriers and the remaining wireline carriers. Therefore, while the terminal value of Neutral Tandem’s core business of tandem switching should be discounted for the risks of VoIP adoption, an all-VoIP network that makes tandem switching obsolete is still years away.

Valuation

Based on 2009 results and today’s prices, TNDM is attractively valued with a 9.8% FCF yield, FCF/EV of
18.5%, and a low 2.6 EV/EBITDA multiple. (See tables here again.)

Note: EV and all following calculations use an adjusted cash measure that includes auction rate securities (ARS). Neutral Tandem currently has $171M in cash and cash equivalents and holds par value $12.9M of ARS. Beginning on 6/30/2010, it will have the right to sell these ARS back to UBS at par value. Therefore, I use an adjusted cash figure of $184M.

I consider two useful scenarios in valuing Neutral Tandem: 1.) “worst-case” scenario and 2.) a “normal”
scenario. Both scenarios use the low ends of management guidance given for FY2010. In the worst-case
scenario, I assume that revenue steadily declines and that EBITDA margins decline 17% by 2014
(compared to 2010) due to competition and pricing pressure. To approximate the risk of faster-than
expected VoIP adoption and competitive pressures I substantially discount the terminal value based on
2014 FCFs (as per the tables here).

After adding back cash to the DCFs, I estimate that this “worst-case” scenario implies a fair value for
TNDM at approximately $10.90-$11.20 per share. This implies a decent margin of safety with a 6%-9%
downside risk at current trading levels of $11.98.

In the more likely “normal scenario”, I model very modest growth occurring at declining rates until 2014 but that EBITDA margins will decline by 14% in 2014 (compared to 2010) from pricing pressure. Terminal value is increased from the worst-case scenario to approximate a more modest level of expected risk (again, as per the tables here):

After adding back cash to the DCFs, I conservatively estimate that under normal circumstances TNDM’s fair value should be at least $15-$16.20, representing a 25%-35% upside from the current price of $11.98.

Note that the 2010 guidance figures used in both valuations assume there is no sales contribution from
the Ethernet exchange project. These guidance figures do assume a $4M operations cost and $4M in
capex related to the Ethernet exchange project. Therefore, if the Ethernet exchange development is
stopped after 2010 (due to poor results or low revenue) actual EBITDA and FCFs will be higher than I
estimated. If the Ethernet exchange project is continued, one would hope that it provided enough FCF to
offset its costs though. Given the competent management of Neutral Tandem thus far, I feel the risk of a
serious capital budgeting mistake with respect to the Ethernet exchange is low though.

In summary, TNDM shares are oversold mainly due to fears of competition, lawsuits, and future growth.
These are all legitimate concerns, but TNDM shares are trading at worst-case scenario prices. Estimates
of the fair value of Neutral Tandem’s business suggest that TNDM shares are conservatively worth at
least $15-$16.20, representing a 25-35% upside from current prices.

Catalysts

1. Value/Activist investor attention. In a May 13, 2010 13D filing ValueAct Small Cap Partners
disclosed that they had purchased 6.2% of Neutral Tandem at an average price of $15.15. ValueAct has
a reputation for being long-term value-oriented investors with an activist bent. Barron’s reports that
ValueAct sits on roughly half of their holdings’ boards. While I do not know their exact plans for their
TNDM position, a potential board seat or further acquisitions of Neutral Tandem’s stock could be a
catalyst for the stock.

2. Growth in core business: Management has outlined how their terminating business and originating
businesses could see increased growth this year. Management has already set expectations low by
predicting results at the lower range of its guidance. If the core business can grow better than expected,
catalysts could include beating guidance expectations and analyst upgrades.

3. Positive Ethernet exchange news. There may be surprise revenues from the Ethernet exchange
being developed. Management has not factored in any potential Ethernet exchange revenue, but has
noted it is possible to see Ethernet revenue this year. Neutral Tandem has also been stressing the
exchange’s growth opportunities to growth investors recently, devoting an entire presentation and
conference call this May to the Ethernet exchange. If growth investors begin to buy TNDM based on
potentially favorable developments in this Ethernet venture, I believe that value investors could exit their
positions at share prices at or above the fair value of TNDM’s core tandem switching business.

4. Share buyback. With a mountain of cash, if TNDM decides not to aggressively pursue the Ethernet
exchange venture for whatever reason, another share buyback could occur. In the latest 10Q, the
company reported that $15.4M of shares was still available for repurchase as of 3/31/2010. Given the
high FCF and large cash position of Neutral Tandem, it is certainly possible that more buybacks could be
announced.

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This site and the above are for educational and informational purposes only. Nothing contained here should be construed by anyone as an invitation or solicitation to buy or sell any security. This site does not contain personalized legal, tax, investment, or financial advice. Users of this site should consult with a qualified adviser to obtain advice suited to their personal circumstances. Any links provided here to other web sites are for informational purposes only.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.
This entry was posted in Our Portfolios and tagged . Bookmark the permalink.

6 Responses to More On Neutral Tandem

  1. Andrew says:

    This is for both the guest and Cale. I’ve though about this company, but I decided to pass. One thing I can’t get my head around is how you think competition isn’t that big of an issue. Other than a national network – which I’m assuming is realistically a function of invested capital – how can TNDM defend its moat by other means besides margin compression? I realize some of its growth initiatives will come to fruition, but that isn’t the core of the valuation.

    • Cale Cale says:

      Hi Andrew,

      To be clear, competition is an issue, but my point is that it is not nearly as much of one as TNDM’s share price would indicate. That’s also the ironic thing about TNDM here…margins are actually expanding, not decreasing. Adjusted EBITDA is the relevant metric, as it best illustrates any company’s performance in an environment of declining prices. So yes, per minute prices are falling, but TNDM’s costs are falling even faster. Can this continue forever? No. But pricing won’t fall forever, either.

      The biggest competitor in the legacy tandem interconnect business is Peerless Networks. (Let’s disregard direct connections as competition because they don’t make sense in most cases.) Peerless competes on price, as their network is only a fraction of the size of TNDM’s. While price is marginally important to large customers, it’s still of less importance to all customers than the number of switches they can connect to upon immediately jacking in. Peerless doesn’t own their network, which among other things means it costs them more to serve their customers than TNDM. So, Peerless charges less and pays more. There is simply no way they can ever build a network of the same size as TNDM…they’re not creating the cash to ever come close, so they can’t fund it internally, and I don’t think any VCs are going to fund that bet, either. Peerless is in around 20 markets. TNDM is in about 150. The network effects are already too strong.

      Interestingly, just today Peerless came out with a release saying that between some cash from a mysterious backer and credit lines (hunh?), they have $14M in capital that they will use to expand in 15 more markets over the next 12 months. So, again, they’ll never catch up. And I think that Peerless release today could be a sign that they’re not super healthy, as using any kind of debt to expand means there will be even less money to plow back into the business. I will concede that even those 15 new Peerless markets next year will exert more downward pressure on Neutral’s prices in those markets…but that assumes a handful of variables remain static over that time, and you can’t overlook that the Ethernet EXchange could change the equation altogether a year out, either.

      I think the right way to think about Peerless is as a company being propped up by Verizon to exert pricing pressure on TNDM. Big Telco wants a second source of supply for everything, and I suspect that is largely why Peerless exists – to reduce the pricing paid by Big Telco for tandem interconnect services in their markets with the most traffic. At some point, though, Peerless, which appears to have had trouble raising equity capital from VCs based on the release today, is going to have to decide whether to start raising rates, or learn to live with adding 15 markets a year and begging for capital every December. And they’ll run out of cash long before they can build a network of the size that will convince anyone to completely abandon TNDM – which has lost zero customers to date, mind you. So Peerless is in a box canyon. They’ll continue to be a thorn in TNDM’s side, but that shouldn’t be confused with being a real competitor.

      So I guess the answer to your question is: they can best defend their moat – which is built on network effects, not price – by doing what they have been doing…proactively lowering prices to keep customers, and continuing to intelligently expand both in new markets and in new services, like Ethernet eXchange. That will enable them to keep gaining the scale that helps costs drop faster than pricing.

      Will margins stay as high in the legacy business over the next few years? No – but it won’t be because the moat is weakening. It will in a sense be because they’re defending it. And I’m okay with that, given the valuation.

      In the meantime, their biggest current competitor seems considerably less healthy, and other catalysts seem likely to emerge. Thursday oughta be interesting one way or the other…

      Hope that helps. Thx for the thoughts.

      Cale

  2. Jim H says:

    Cale: any new thought on TNDM following earnigs release and crunch on the share price?

  3. Tom Mulen says:

    Hey Cale,

    Thanks for the great story. Can you share your thoughts now after the Q2 earnings miss ?

    Thanks