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Neutral Tandem, Inc., (NASDAQ:TNDM)

Q3 2008 Earnings Call Transcript

October 28, 2008, 10:00 am ET

Executives

Richard Monto- General Counsel

Rian Wren - President and CEO

Rob Junkroski - CFO

Analysts

Simon Flannery - Morgan Stanley

John Bright - Avondale Partners

Mark DeRussy - Raymond James

Will Power - Robert W. Baird

James Breen - Thomas Weisel Partners

Tim Horan - Oppenheimer

Jonathan Ho - William Blair

Donna Jaegers - D.A. Davidson

Operator

Good morning, ladies and gentlemen, and thank you for standing by. Welcome to the Neutral Tandem third quarter earnings teleconference. During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator Instructions). This conference is being recorded today, Tuesday, October 28, 2008.

I would now like to turn the conference over to Richard Monto, the Company's General Counsel. Please go ahead, sir.

Richard Monto

Thank you, and welcome to the Neutral Tandem third quarter 2008 earnings conference call. In our remarks today we will include statements that are considered forward-looking within the meaning of federal securities laws. The forward-looking statements are based on current expectations and are subject to substantial risks and uncertainties that may cause actual results to differ materially from the forward-looking statements. A description of certain of the risks and uncertainties accompanying these forward-looking statements can be found in our earnings release issued today and in certain of our SEC filings. Neutral Tandem undertakes no obligation to update any forward-looking statement.

In our remarks, we will also refer to non-GAAP financial measures, which we believe, in combination with GAAP results, provide additional analytic tools to understand our operations. Tables that reconcile non-GAAP financial measures to GAAP results are also included in our earnings release issued today.

Now, for the substance of the call I'd like to introduce Rian Wren, Neutral Tandem's President and CEO.

Rian Wren

Thank you, Richard, and I'd like to thank all of you for joining our third quarter 2008 earnings call.

As you will note from this morning's release, we are very pleased with the strong financial and operational results for this quarter. We reported another record quarter, with $31.2 million in revenue, which reflects a 38.1% increase over the third quarter of 2007. This translated into strong profitability as our net income grew to $6.2 million during the quarter, which is a substantial increase over the $2 million we earned in the year-ago period. Rob Junkroski, our Chief Financial Officer, will provide additional detail on the financial results later in this call.

Our results for the third quarter are even more impressive when we view them in context of today's overall economic environment and the challenges facing many companies and industries across the global economy. We do not believe that we have been noticeably affected by these macro-economic challenges so far and continue to maintain and build a healthy balance sheet. We continue to believe that our market reach, extent of interconnections and customer profile, positions us to operate successfully throughout a wide range of economic environment. We also believe we will continue to see favorable industry trends for our business, particularly the increase in wireless and cable subscriptions driven by the continued migration of subscribers from the incumbent local exchange carrier wireline services to competitive carriers.

This past quarter's strong results can be attributed to the continued successful execution of our three growth initiatives, which are broadening our geographic presence, expanding our interconnections with new and existing customers and increasing traffic types across our networks. We continue to expand into new markets across the United States. This past quarter, we successfully commenced operations in 9 new markets, bringing the total number of operational markets to 91 as of September 30, 2008. This increased our addressable footprint to approximately 600 million telephone numbers assigned to competitive carriers. Our customers can now terminate traffic to approximately 372 million of these numbers.

Our plans for the last three months of 2008 include the addition of 8 more markets, bringing our projected total markets served to 99. These new markets will increase our addressable footprint to approximately 629 million telephone numbers assigned to competitive carriers.

Of note, our customers, as of September 30, 2008, can route traffic to approximately 62% of Neutral Tandem's total addressable footprint in the current 91 operational markets. However, when calculated for just the 27 new markets added in 2008, our customers can only route traffic to approximately 37% of the addressable footprint in these markets. This demonstrates that we have continued opportunity to increase growth as we further deepen our interconnections in these new markets as well as all of our existing and future markets.

We continue to realize the benefits from the network effect, which is the key component of our growth strategy and the fundamental strength of our business. As we’ve discussed on earlier calls, the value of our service offering directly increases with the number of customers connected to our network. To that end, during the third quarter, we essentially completed our interconnection efforts with Verizon Wireless in our current operating markets. We will continue to extend our interconnections with Verizon Wireless as we enter into new markets in which both companies operate. This was a very large interconnection project and has met our expectations to-date. I'd like again to thank both teams for completing it ahead of schedule. This was truly an impressive achievement.

In addition, as I’ve previously discussed, we are also working to increase the types of traffic we interconnect and carry over our network. While we remain primarily focused on growing our core Local Transit business, we are optimistic that we can increase minutes transmitted across the Neutral Tandem network by developing our Termination Services business. These new product offerings, which include the switch access service that I have described to you previously, are similar to our core business in that we continue to perform a tandem function. However, the calls supported are inter-market in nature versus local.

Unlike our Local Transit business, we also market these terminating services to inter-exchange carriers, also referred to as IXCs, and have entered into contracts with several customers. Over the past few months, as we have expanded our delivery of this type of traffic, we have also fine-tuned our product offering. For example, some carriers differ with respect to how they desire to physically interconnect to exchange inter-market traffic, and we have developed flexible options to meet their needs. These differences in interconnection methodology relates, in part, to our continued progress towards developing -- deploying an advanced all-IP technology platform.

As we have discussed on the last call, since the beginning of 2006, we have made significant investments in soft-switch technology, which improves network scalability and offers our customers a state-of-the-art platform to help them more cost effectively exchange all types of traffic. Once we decided to utilize this next generation technology in our network, we began deploying soft-switches at all of our new switch sites as well as replacing most of our older switching technology with soft-switches.

To that end, during the second quarter earnings call, we announced our plan to replace the circuit switch technology in our Michigan and Ohio networks. I am pleased to report that these upgrades are now complete. Going forward, we have decided to replace our three remaining circuit switches in the Illinois, Indiana and Minnesota markets. Once this upgrade is complete, our network will be 100% IP. These investments reduce our operating expenses and improve capital efficiency and position us to be able to deliver future service offerings.

As we have marketed our terminating services to some IXCs and other existing customers who have converted to IP infrastructure, we are finding that many of these carriers prefer to connect with us using IP interconnections. They do not want to use the existing TDM or circuit switch interconnections that they are required to utilize when interconnecting with the incumbent local exchange carriers for the same traffic types. This validates our belief that, going forward, supporting IP interconnections will be our customers' preferred methodology for both local and inter-market interconnection. In fact, we have one major customer who is now connected with us solely using IP technology for both local and inter-market services.

We feel that our customers' desire to interconnect using IP connections is a strong indication of the value of our network, as we believe we now operate the largest IP-capable soft-switch local tandem transit network in the United States. This will allow us to be the interconnection provider of choice for carriers as they update their networks to IP connectivity.

Looking forward, we have started focusing on our customers' originating switched access needs. This is a new type of traffic for us to carry on our network since we have typically focused our efforts on terminating traffic for our customers. Over the past several months, we have worked to develop originating switched access services and are currently testing these services with a few of our customers. We are hopeful that originating switched access services will enable us to further grow our business.

In closing, we are very pleased with our results for the third quarter of 2008. We believe that we are making strong progress across all the three of our strategic priorities while remaining focused on our core business. We remain excited by our growth opportunities, which we believe will allow us to continue to drive profitability for our shareholders.

With that, I'd like to turn the call over to Rob Junkroski for a financial review.

Rob Junkroski

Thank you. As Rian mentioned, we are very pleased with our financial and operational achievements made during the third quarter of 2008.

Turning to our results, our third quarter of 2008 revenue was $31.2 million compared with $22.6 million in the third quarter of 2007, an increase of 38.1%.

In the third quarter of 2008, we transited 15.9 billion minutes across the network, up from 10.7 billion minutes in the third quarter of 2007, an increase of 48.6%. This increase in minutes was driven by our growth in both new and established markets, the start of traffics exchanged with Verizon Wireless and the introduction of terminating services minutes.

Turning to expenses, our network and facilities expense, which is the operations expense associated with transiting calls through our network, was $11.2 million in the third quarter of 2008 compared to $8.2 million in the third quarter of 2007. The increase in network and facilities expense was largely due to greater traffic volumes transiting our network and an increase in the number of markets we serve.

Combined operating expenses consisting of operations, sales and marketing and general and administrative expenses, came to $7.6 million during the third quarter of 2008, up from $7.2 million during the third quarter of 2007. The increase was primarily due to higher employee expenses, including additional headcount required to grow the business, offset by a decrease in litigation expenses.

Adjusted EBITDA, a non-GAAP financial measure, was $13.4 million for the third quarter of 2008 compared to $7.4 million for the third quarter of 2007.

Depreciation and amortization increased by approximately $800,000 from $2.8 million in the third quarter of 2007 to $3.6 million in the third quarter of 2008.

Our operating margins in the third quarter of 2008 were 28.2% compared to 19.5% in the third quarter of 2007, reflecting our ability to increase revenues while decreasing costs as a percentage of revenue.

We recorded accelerated depreciation of our Detroit and Cleveland circuit switches during the third quarter of 2008 and will continue to do so through October when the circuit switches are replaced with IP-switching equipment. We expect to record accelerated depreciation related to the retirement of our Illinois, Indiana and Minnesota circuit switches beginning in the fourth quarter of this year.

As Rian noted previously, we’ve gained cost efficiencies by deploying next generation soft-switch technology as well as in-sourcing our signaling assets and optimizing our nationwide interconnection network. These impacts, combined with our ability to grow our business while adding less incremental headcount is the main driver of our third quarter operating margin expansion.

Pretax income was $9.5 million for the third quarter of 2008 compared to pretax income of $3.5 million in the third quarter of 2007. Our income tax expense for the third quarter of 2008 was $3.3 million, compared to an income tax expense of $1.6 million for the third quarter of 2007. Our effective tax rate for the three months ended September 30, 2008 was approximately 34.7%.

Net income for the third quarter of 2008 was $6.2 million, or $0.19 per diluted share, compared to net income of $2 million, or $0.08 per diluted share for the third quarter of 2007.

Taking a look at our current financial condition, our balance sheet as of September 30, 2008 is showing approximately $190.4 million in total assets, up from $166 million at December 31st, 2007. Our total long-term debt, which includes both current and long-term amounts, is $4.2 million and continues to amortize. Our total stockholder equity as of September 30th, 2008 is $169.1 million, while our cash and cash equivalent are $106.3 million, and our share count is approximately 32.2 million shares.

I'd now like to address our outlook for the remainder of 2008. Based on our actual results for the first three quarters of the year and our current belief about minute-based revenue trends, expenses in the competitive environment, we affirm our forecasts from last quarter for the following metrics and continue to estimate that revenue for the full year of 2008 will be between $117 and $121 million. Adjusted EBITDA, a non-GAAP financial measure, for the full year of 2008 will be between $47 million and $49 million. Adjusted EBITDA will exclude non-cash share-based employee compensation, and billed minutes for the full year of 2008 will be between 59.5 billion and 61.5 billion minutes.

In addition, we are revising our projections with respect to CapEx in a number of new markets in which we will commence operations. We now estimate that CapEx for the full year of 2008 is expected to be between $21 million to $23 million, down from the previous forecast range of $23 million to $25 million, and we will commence operations in 35 new markets during the full year of 2008, as opposed to the previous guidance of 30 new markets.

We remain excited by the opportunities we see for our Company as we continue to expand our business. We are excited for the things to come and believe that our initiatives have positioned us to drive shareholder value.

That concludes our remarks. We would now like to open the call to questions. Operator?

Question-and-Answer Session

Operator

Thank you, sir. Ladies and gentlemen, we will now begin the question-and-answer session. (Operator Instructions). And our first question comes from Simon Flannery with Morgan Stanley. Go ahead please.

Simon Flannery - Morgan Stanley

Thanks a lot. Good morning. It's a couple of quick ones. First, on capital spending, perhaps you can just give a little more color on that. The spending guidance is down, and yet your number of new markets is up. Perhaps talk about some of the buckets that are there. And can you give us a sense of what -- given next year you won't have any soft -switches to replace, what would be the CapEx number that you might consider to be more maintenance levels once you're past that program?

And then the other thing is sort of on pricing per minute. Anything that you're seeing in terms of [Bell] pricing actions or that umbrella and anything we should be watching for with the pending FCC review of inter-carrier comp? Thanks.

Rian Wren

Good morning, Simon. The first question, with regards to the CapEx -- I began to refer to this in the second quarter call -- is that you're starting to see the decisions that we made starting in 2006 to begin to move rapidly into a soft-switch environment is beginning to pay its dividends more so now.

During the course of the year -- midway through the year is when we made the decision to further move in the two markets -- the Ohio and Detroit markets -- and then, more recently, the remaining three, and it's proven that both from a strategic customer standpoint, but also from a current efficiency, both capital and operating expense standpoint, to be the right decision. And these technologies are a lot more capital efficient with regards to the growth associated with our network than the old circuit switch technology.

So you're fundamentally seeing our ability to expand our network in a bigger way at a reduced -- it's just called per-unit type cost. So you're seeing a lot of that efficiency. There are many components to that because the penalties associated with multiple switch locations go away with the circuit switch technology, and in some cases you can have a penalty as high as a 30% port penalty when you have to have multiple circuit switches. And so that's all manifesting itself in us being able to do more with less.

With regards to the capital for next year, we're not in a position today to really outline exactly what the capital number will be. We're working on that right now. But with regards to the core business, it will be growth-oriented. I don't know if you want to --

Rob Junkroski

Yeah, growth-oriented, and it will be consistent with what we've said in past discussions, that the core business in the later years -- being in 2009 and beyond -- will probably be in the high single digits as a percentage of our revenue to support the core business growth.

Rian Wren

Now, we're also evaluating some strategic investments, although they won't be very large initially with regards to the particular platform application services that we'll begin testing in the near future in more of a lab environment with our customers. And as that becomes more service-based and more successful with regards to our development process, we may be making some investments in that area.

Lastly, with regards to your question on pricing trends, really no difference from what we talked about in the second quarter. We have not seen any activity from the incumbent local exchange carriers to raise or lower their prices. It's a fairly stable umbrella price with regards to their activities.

Simon Flannery - Morgan Stanley

Okay. And anything out of the inter-carrier comp order?

Rian Wren

Well, with regards to the inter-carrier compensation order, let me first say that nothing really officially has been published, so there's no order to really look at just yet. What all of the industry participants have been working on have been their interactions directly with the staff of the commission, and we have had ours. We have been down there several times, most recently yesterday.

When we look at that from the perspective of Neutral Tandem, there is [25.11] really two areas. One is the whole umbrella deals with what carriers pay each other to terminate each other's calls, and that fundamentally is a question involving the originating and terminating carriers. So essentially, we expect that activity in that area should be fairly transparent to us since we're not an originating carrier but a carrier that provides a switch transport service.

The other aspect that we have heard down there that may be looked at is the issue associated with unidentifiable traffic, sometimes known as, or referred to, as phantom traffic. There, again, that's an issue that has to do with the originating carriers identifying their traffic and paying the appropriate terminating rate for that traffic, and the potential for arbitrage, given that the terminating rate varies quite drastically based on location and type of traffic.

Neutral Tandem supports reform with regards to phantom traffic. We like to view our tandem as a transparent vehicle to transport calls from one carrier to another, and we don't see activity there having any material effect on Neutral Tandem.

Simon Flannery - Morgan Stanley

Thanks, Rian.

Operator

Thank you. And our next question comes from John Bright with Avondale Partners. Go ahead please.

John Bright - Avondale Partners

Thank you. Good morning. Rian, can you talk about 2009 and what the relationship might be between -- will the relationship remain the same between traffic and new markets as we get into '09? Or how should we be thinking about that looking forward?

Rian Wren

Again, I can give you a qualitative answer. We have not -- we're not in a position yet to roll out '09 specifics. But I think you can expect that Neutral Tandem will continue to deploy as deeply as economically justified and demanded by our customers. There is -- we have a significant footprint in place. It tends to be centered mainly in the heavily populated metropolitan areas. You've seen us throughout '08 move more and more into the secondary markets. You will continue to see us push into secondary and tertiary type markets.

So you will see a growth plan for Neutral Tandem with regards to the core business, in terms of markets. And I also would refer to you -- we tried to give you some additional color on the growth opportunities vis-a-vis our existing and our new markets.

I mentioned in my prepared remarks that the 27 markets that we added this year were really only 37% interconnected, and what that means is that we have physical facilities between our tandems in those markets and the local end offices of our customers. It gives you a little bit of a flavor, as I've been describing to you, that it takes time for us and our carrier customers to actually affect the physical interconnection process that usually takes somewhere close to 18 months in a particular market to get up to a significant penetration.

Just a little more specifics on that, a couple key numbers. In total, in aggregate of all of our 91 operating markets, we connect – on an average of 62% of all those addressable phone numbers. In the 27 new markets, it's only 37% because we just started deploying those this year, and over the course of the next year or so, that penetration number will come up. When you look at markets that have been in service for close to four years, the beginning of our business, those penetration numbers are as high as 90% connected. So, you can begin to see the timing necessary to deeply interconnect into the markets with regards to where we are and throughout this year.

And then to get back to your question, we do intend to have, as an effect as we can, continued expansion program next year.

John Bright - Avondale Partners

Second question. You mentioned terminating services. How significant were they in the quarter? And then, also, you talked about a new effort on the originating side. Maybe you can flesh out what you think that opportunity looks like as well?

Rian Wren

Sure. We have seen a pickup in our efforts, not just contractually, but also in processing minutes in our terminating services. We don't break those out as a matter of course, but we have seen, along the line of our expectations, a beginning of a growth process in regards to terminating services, and those are both services that we sell to both the inter-exchange carriers and our originating local exchange companies. We actually expect to see that begin to ramp a little more aggressively in 2009.

With regards to the originating side, that is a brand new area, and we have been working on that, and it gets back to our concept that we are a tandem provider, and most of our focus of our business so far has been on terminating calls for carriers to the interconnected carriers on our network. There is a lot of business or services that are same customers that we have -- originate, and they use the local exchange -- or the incumbent local exchange carriers’ tandems for originating switch services.

Examples of those would be 800-service. A large amount of minutes have switched access from an originating carrier -- be it a wireless carrier, for instance, where a wireless customer may dial an 800-number attempting to get to, say, a service center. The originating carrier will basically identify who owns the 800-number. Typically it is an inter-exchange carrier. and then they switch that call through an incumbent local exchange originating tandem -- typically the same tandem is used as terminating -- to send that call for the inter-exchange carrier. And we have now been testing and actually have been processing calls for some of our customers to provide a cheaper tandem service. In this case, it would be the originating carrier that would pay that charge.

So that's an example of an originating service that is very adjacent to what we do. It's a tandem function. It begins to show you further that there are many more minutes that go through these tandems on the originating side. Other services that use that type of switched access tandem service would be things like trouble calls, 611, information calls, 411, and potentially even dial-around, where somebody dials around their presubscribed inter-exchange carrier. So it's just a further penetration of services associated with the tandems to leverage our interconnections.

John Bright - Avondale Partners

Last question. Rob, in the current quarter, G&A came in certainly below our expectations. You mentioned some legal expenses that you didn't have in the quarter. Is that an absolute run rate that you feel comfortable with? How should I think about that as we head into the next year?

Rob Junkroski

I'm sorry, clarify. Was it the gross margin numbers?

John Bright - Avondale Partners

G&A?

Rob Junkroski

G&A numbers are, yes, down because of the legal fees, the litigation expenses, but up substantially due to the non-cash comp numbers that flow into that line item also. But going forward, it looks like it's a -- I think we're at a pretty steady state number. There were really no anomalies in the quarter other than the swing, but I think that swing is permanent from the litigation expenses.

Again, we don't -- just to -- you guys are all familiar with the model. We don't have a very heavy headcount. It's only 134 at the end of the quarter. We added 3 people in the quarter, and I believe we've only added 8 the full -- maybe even less than 8, the full year. So that line item is driven basically by -- or the G&A line item is driven mostly by headcount expenses. So we will be able to lever those, and we'll be able to squeeze out more efficiencies out of our G&A line item also going forward.

John Bright - Avondale Partners

Great. And last question, on the tax rate -- 35% on the tax rate. What -- versus -- is that a number that we should think about going forward? Or should we think 38%?

Rob Junkroski

No, I think that 30%-, yes, 35%, 36% is a good number. It's a difficult number for us to calculate on a quarterly basis because of the treatment of option exercises. So in quarters where we have option exercises, we get a very large tax benefit from that and, obviously, we don't have any way of controlling that, our employee base, on that activity. But I think the mid-30s. We're just slightly under 35% effective rate for the third quarter. For the full year, 35%, 36% is a good number, I think.

John Bright - Avondale Partners

And I'm sorry; did you break out the percentage of revenues from core services versus other services?

Rob Junkroski

We did not.

John Bright - Avondale Partners

Thank you.

Operator

Okay, thank you. And our next question comes from Mark DeRussy with Raymond James. Go ahead, sir.

Mark DeRussy - Raymond James

Hi. Good morning, everyone. Rian, want to get back to the discussion on penetration. What was the number you said you get to when a market is about 18 months old? I just want to clarify that point.

Rian Wren

Well, I actually -- I don't think I said it that way. What I said on the 18 months is I think that's a good guide for, on average, what it would take us to get the market -- I call it sufficiently penetrated. And that might be -- and again, without having a lot of analysis behind these metrics, just to be responsive to your question, it might be around the average.

Mark DeRussy - Raymond James

Okay. Okay. Okay, that's fair enough. And you mentioned also that some of your original markets are penetrated close to 90%, and I'm just wondering if, for example, we really ratchet it down the new market development expense, would you expect over a course of 3 or 4 years to get that penetration to drift up towards that 90% number that you referred to?

Rian Wren

Yes, I expect that over the course of -- it gets tougher -- the curve in terms of penetration starts off -- it's almost like an S curve. It starts off relatively slow. Then you get into a high growth rate in terms of people connecting their switches. And then as you get deeper penetrated, the next percent or two becomes more difficult.

The reason that we've just recently - in the older markets reached so high has been the achievement that we talked about, being able to get Verizon Wireless connected to our network. That was a major interconnection process that really helped us to get to that point in time. Our aspirations would be that we would get all markets in the 80%-plus interconnected market. I don't see reasons why over time we would not, and that was the point of trying to describe to the investors here that we want to make sure that as we -- they understand the dynamics and operating requirements to physically interconnect and then to get traffic routing between the carriers, and that's -- in some sense, you might think that that is -- that we'd like to see that occur faster, and we would.

But it also begins to demonstrate to you the amount of effort that the carriers, their operations groups and ourselves have to go through to construct the network, and it creates a real fortifying desire to maintain and to do business with us. So it has a lot to do with the network effect in total with regards to being interconnected, and provided we maintain our price value offered to our customers and the service quality, we expect that that will bode well for us as new competitors, obviously, will come into the marketplace.

Mark DeRussy - Raymond James

But that's one of the takeaways is that you open a market; you don't get an initial huge pop. So if you guys were to slow that down, we still have some lengths of growth as those markets ramp up. I guess the final question around this topic would be in those more mature markets, you're penetrated in the 80% to 90% range in terms of, I guess, connections, but could you speak to or give us some color around your thoughts as to how much of the addressable traffic you guys are seeing across your network?

Rian Wren

Well, you do bring up a little refinement that obviously drives a little complexity. There are two states. One is getting interconnected, and if that has an issue with getting interconnected with what we'll call the initial set of capacity and then growing it over time because the carriers will generally not give you the ultimate amount of capacity you'll need until you actually route traffic. And so, as we interconnect, there are two factors that really determine the revenue growth of our business within that market.

One is the amount of interconnections across disparate carriers. So you might be 100% interconnected to one carrier, but you really need other carriers to be connected so they can trade traffic. So, that's a component of how fast is that disbursement occurring, and that really is a little bit out of our control. It involves how fast other carriers begin to connect, and that's why you have that S-curve in terms of growth.

Next, once you have the connections, then we actually go through the second process, where we issue routing orders, which basically is giving our customers the phone numbers that are on our network that they can route to, and that's a secondary and somewhat different process for them to route within that.

With regards to the amount of traffic that they route, typically -- our business is becoming more complex, but when you look at the local component of the business, typically when a carrier determines to use Neutral Tandem, their local switches will be programmed to route all of the calls associated with the codes that we give them through Neutral Tandem, provided that we have sufficient capacity to handle those calls, and that's the process of continually filling up the interconnection tranches and then growing them to get the remainder of the traffic. So, theoretically, over time on the local side of the business, we should be getting most of their traffic.

On the newer terminating services businesses, a little bit of a different business. The function we perform is the same, a tandem terminating service. But with regards to originating carriers, they do have choices for these services. So, in many cases, it is directly proportional to how competitive we are on those intermarket routes, and then for the IXCs, since they really don't -- at this point, the choices for terminating choice to access are just beginning to develop with regards to competition that we believe we're the first there. To the extent that we have the capacity, what we've been seeing is that these carriers send as much as they possibly can through our tandems, gated only by the capacity we have to terminate the calls.

Mark DeRussy - Raymond James

Okay. Thanks very much.

Operator

Thank you. And our next question comes from Will Power with Robert W. Baird. Go ahead please.

Will Power - Robert W. Baird

Great, thanks. Good morning. A couple of questions. First -- I guess, first, congratulations of getting the Verizon interconnection completed. Can you give us some sense for how much of that benefit you might have realized in Q3 versus what the expectation might be on a full quarter basis in Q4 and heading into 2009.

Rian Wren

Yes, well, I can't give you the exact numbers since in general we really don't break out customer by customer details. But I can tell you that what we're referring to there is essentially all the physical interconnection has been done. With regards to them we are adding -- with us our customers routing traffic to Verizon Wireless, it is right in line with our expectations, so we put a plan out for what we thought would ramp throughout the third quarter, and we have met those expectations. We have a plan that we expect that to continue on for the fourth quarter, and it's in line and consistent with the revenue guidance that we gave you.

What I will say is that we do believe that we will accomplish, essentially, most of the routing in the fourth quarter, which is positive. The sooner we get the routing going, the faster we experience the revenue benefit from it. So we see routing occurring as we had expected, and we do believe we'll complete essentially the routing in the existing operating markets for Verizon Wireless in the fourth quarter.

Will Power - Robert W. Baird

Okay, okay, thanks. And then the second question -- if I look at the full year of revenue and EBITDA guidance, if I'm doing my math right, and I look at the implied margin, it seems to imply a lower EBITDA margin in Q4 from where you would have been in, I guess, in Q3. And I guess what I'm trying to understand is ,are there higher seasonal costs, or what might be the additional costs we should be thinking about as the revenue ramps?

Robert Junkroski

There is a little bit of seasonality in the fourth quarter. It's hard to say exactly what that is, given our short history in growth. We go through a lot of seasonality, so it's hard to measure the seasonality. There is some in the fourth quarter. We should be at the high end of the EBITDA. I think the guidance is in the about 40%, if I remember correctly, for the full year, and we should be at -- be able to easily achieve that number.

Will Power - Robert W. Baird

Okay, and then maybe this last question -- Rob, I think you had alluded to higher depreciation expense in Q4, may be probably well perhaps continuing into '09. I guess I'd be interested in more color on that. But any sense for, yes, the magnitude of that?

Robert Junkroski

Yes. The first -- it was two projects. The Michigan and Ohio switches were -- circuit switches were decommissioned, and the bulk of that accelerated depreciation took place in the third quarter. It did bleed over into the fourth quarter, and for that project we'll have just over $200,000, about $225,000 in accelerated depreciation from that project in the fourth quarter. We also, Ryan, just announced that we are going to do the remaining circuit switches in Illinois, Indiana and Minnesota, and that will be about $900,000 in the fourth quarter. So in total, the fourth quarter will have accelerated depreciation of about $1.1 million.

That will continue into the first and second quarters of 2008 -- not at that magnitude. First quarter of 2009 should be just under $1 million, and then the second quarter it wanes down to about $200,000.

Will Power - Robert W. Baird

Okay, great. Thanks. That's helpful.

Operator

Thank you. And our next question comes from James Breen with Thomas Weisel Partners. Go ahead please.

James Breen - Thomas Weisel Partners

Thank you very much. Just a couple of questions. One, from a revenue breakdown perspective, can you talk about the percentage that came from wireless versus CLEC versus cable versus VOIP?

Rian Wren

Sure. For the third quarter of 2008, we've actually broken it out in five categories. Cable is now 15% of our revenue contribution. CLEC is 19%. The interexchange carriers are 4%. VOIP providers are 4%. And wireless is 58%.

James Breen - Thomas Weisel Partners

Okay. And so, that the interexchange category was just blended in with some of the other carriers before?

Rian Wren

Yes. When we started there, it wasn't significant enough to really make it a category. We track it now as a separate category.

James Breen - Thomas Weisel Partners

Okay, great. And then just with respect to competition in just your core business, have you seen any increased pressure from competitors at Level 3 and so forth?

Rian Wren

Well, with regards to competition, I've always -- I've maintained that competition has been growing since the time Neutral Tandem started introducing services. Just before I address specifically your question. Customers have always had the opportunity to self-provision this service by directly connecting, and then they always had a fallback position, which predominantly was the primary way that they interconnected with each other, which was the incumbent local exchange carrier, to transit it through their switch. Four years ago -- in the building where over the last four year, Neutral Tandem is now offering that service and I think, close to almost 60% of the population by the end of this year. So, significant competition now with regards to Neutral Tandem.

Since then, and since Neutral Tandem's success has been public, there have been several other carriers who have announced service and purport to be offering this type of service. With regards to their direct success, it's very difficult to tell. I think in many of the cases, better information would come directly from them. But we continue to believe that we compete fairly well.

From a Level 3 standpoint, we have not -- I can guess to be qualitatively -- we have not heard their name as much in the marketplace in that case. So it's hard to answer your question with regard to how well they're doing, although we do believe there are at least several players who are attempting to emulate Neutral Tandem in the marketplace.

James Breen - Thomas Weisel Partners

Okay. But in generally you haven't seen those players having an impact on pricing.

Rian Wren

No. From the standpoint of what we've had to deal with, with our customers, we haven't seen that come back to us as a necessary thing that we need to address at this point in time.

James Breen - Thomas Weisel Partners

Great, thank you.

Operator

Okay, thank you. And our next question comes from Tim Horan with Oppenheimer. Go ahead please.

Tim Horan - Oppenheimer

Good morning, guys. Thanks. I had a couple questions, and good quarter. The price per minute, the way I calculate it, is kind of down 7% year-over-year. Is that just a mix issue? May be what's -- maybe you can discuss what's driving that.

Rian Wren

Yes, it's clearly a mix issue. I think if you go back to second quarter, we had forecasted, if you go out into our guidance, we had forecasted a decrease for the year around that range, and it's mainly driven by the pickups in all the markets that we've been developing. And when you look at the structural prices in the industry, the prices in the newer markets are less than the older markets. So it's mainly being driven by that. It's our expansion. And our evaluation of the mix between that core business growth and the mix of our newer services, which are different with regards to pricing too. So it's a little bit of an estimation process we go through to determine both the mix and the geography, where the minutes are going to come from. And so when we look at the third quarter, we believe that our estimate for the year is still very good and consistent with what we saw in the third quarter.

Tim Horan - Oppenheimer

And you think we'll reach some stability on that at some point, or will the trends be down there for a couple of years, just as you do the bottoms-up analysis of new markets versus legacy?

Rian Wren

Our goal is to reach a little stability in that we don't see major changes because most of the new markets are all in the same range now. So with regards to core business, we see that probably gradually decreasing a little bit, but not drastically. That may or may not manifest itself in a total ARPU for us, given the growth that we're starting to see in our terminating services business and depending on how successful we will be with originating services. So it's going to become a little bit of an estimation process as we go forward, but we don't see any drastic downturn in that.

Tim Horan - Oppenheimer

Great. And on the expense run, I know you guys commented on the operating expense. Can you talk about maybe the network expenses? Or maybe I missed it. Is this a good run rate, kind of this 36% of revenues? It was up quite a bit. Or do you think it should trend down as a percentage of revenues? Or maybe the $11.2 billion that you did, is that a good run-rate?

Rian Wren

I think -- my view would be I think you're going to see a trend to continue to go down, but slower. We have -- what's driving our margins are really three things, and the first is the new technologies we're putting in, that it costs us a lot less to maintain them, to operate them, to house them. So everything associated with the new technology is driving down our operating expense in addition to being more capital efficient.

Secondly, the biggest cost we have, direct cost we have, is our transmission facilities between our tandems and our customer switches, and we continue to have optimization processes there. As we grow our volumes, what we do is we groom those circuits, and we can buy at a higher capacity level, which reduces the per unit cost of that. So each year we continue to have very good results in that area, and those are really the two areas that are really driving our gross margin.

And then, lastly, is the human resource scaling. As you've seen this year probably more dramatically than anything else is now that we've got the fundamentals of our infrastructure in place, our people costs are highly scalable, and I don't know --

Robert Junkroski

$930,000 per employee that we generate in revenue, and that's only going up. It’s I don't have a trend number on it, but trust me it's getting higher every quarter.

Rian Wren

So I think to your question, Tim, is that we believe they will continue to decrease. I think each quarter that the decrease will be a little less because it gets tougher and tougher to find the savings, but we still several quarters.

Robert Junkroski

In the -- Tim, just to clarify -- optically, you guys probably saw about a 67% gross margin in the second quarter going down to 64% in the third quarter. As we explained during our second quarter call, the gross margin in the second quarter was slightly inflated, probably by about a 1.5 points to 2 points on a couple of one-time items, some of them related to the settlement with Level 3 and some other settlement issues with just normal course disputes that settled favorably on our side. So on a normalized basis, that's more on the 65%, 65.5% gross margin range for the second quarter.

Now, in the third quarter, we dropped to 64%, but there was some direct costs related to our installation projects related to Verizon wireless. We took advantage of some opportunities to put in capacity probably beyond what we originally estimated that we were going to need for future services with Verizon Wireless. So we've got a fairly good amount of capacity and -- in the current cost -- that is not producing revenue yet in the third quarter.

Tim Horan - Oppenheimer

Very good. And on Verizon, I know it’s -- you don't want to talk specifically about a customer, but you guys obviously added a lot of capacity. Do you think you're at -- maybe give us a round number. You have 20% run rate on potential revenues you can get from them -- 10%, 50%? Even where -- where do you think you are on the potential in the quarter and maybe run rate now?

Rian Wren

Tim, first of all, I probably don't want to give you that, but second of all, I don't think I know it as I sit here.

Tim Horan - Oppenheimer

Sure, I understood. Then maybe two other questions, then, if you don't mind.

Rian Wren

I will say, though, what I do know is that we do believe that we should be -- at least in the operating markets that we are, and that we will be terminating -- we will get most of our customers to complete the routing process in the fourth quarter.

The last thing I will tell you about Verizon Wireless is -- I think it's fair to tell you that we did complete contractual negotiations with Verizon Wireless with regards to them becoming a customer of Neutral Tandem. Verizon Wireless actually has begun to route some traffic to Neutral Tandem. I will caution you, though, that at this point, it's just reasonably small, and we really don't want to comment any further on how far -- what the potential of that volume would be, and the main reason is their decision process has proven to us to be extremely decentralized, almost on a market basis. And so we believe going forward we will be incorporating our view of that, and we have, in guidance that we give forward. But we do believe it's a good step forward with us, and we do believe that it begins to demonstrate again that when people get to operate with Neutral Tandem and look at the quality of the operations and our network that it is a compelling offer, and I think we've come a long way with that company, a compelling offer in the marketplace.

Tim Horan - Oppenheimer

Well, congratulations on that. Maybe just two more, if you don't mind. I'm sorry to monopolize here. They'll be quick. Are you seeing any effects of the economy at all? The CLEC stocks have really melted down here. Sprint's stock is melting down. Are you seeing consumers pull back at all in maybe minutes of use in either wireless in your legacy markets or CLEC in your legacy markets that are more mature?

Rian Wren

We really haven't, and I think it has to do with a little bit of where we sit in the service chain here. Generally, what's been supporting our business has been -- and I think if -- so far we have AT&T and Verizon communications that have reported -- you've seen an acceleration of wireline loss to the competitive space, and not really a small one. Somewhere in the low 8s to now 9% of overall wireline losses. And a good proportion of that's skewed on the consumer side of the business. That is going to the cable companies and the wireless-only households. And so the subscriptions -- and that demand continues to push more and more minutes into the space that we tend to serve.

Secondly, I think you'll note that most of the cable or wireless plans are plans associated with either a bundled set of minutes or an unlimited offer package. And so there really isn't any drive for consumers to call less or to spend less time on the phone since they really don't realize any benefits of doing so. So I think those trends have been helping us. The plans, the family and friends plans, have been generating more and more calling, and I think even though it's been a very difficult environment, you're seeing that strength still in those sectors. And given the fact that we're in the middle of all that, as I mentioned in my comments, we have not noticeably seen an impact on us so far.

Tim Horan - Oppenheimer

Great. And just lastly, real quick, what's the major risks to the intercarrier comp reform? If they move to all Voice over IP or all bill-and-keep, would that even have an effect on you being that you provide tandem services?

Rian Wren

Well, theoretically, the answer would be no because the basis of what's going on with intercarrier compensation has to do with the process between an originating carrier and a terminating carrier. So the issue around that has been that if they unify a single terminating rate, really to try to eliminate arbitrage around those rates, I think the winners and losers will be more on the originating and terminating carriers with regards to what that rate ultimately does for their revenues. The fact that these carriers may use a third party to deliver the call really doesn't get into the process of the originating carrier being responsible to pay to the terminating carrier that terminating rate. So essentially, it should not affect the tandem providers.

Tim Horan - Oppenheimer

That's perfect. Thanks a million guys.

Operator

Okay, thank you. And our next question comes from Jonathan Ho with William Blair. Go ahead please.

Jonathan Ho - William Blair

Congratulation, guys, on the quarter. Just a quick question on renewal pricing. Are you guys able to raise prices in some of the earlier markets that you've penetrated? And generally speaking, are most customers still signing on a one-year contract basis?

Rian Wren

Yes, typically our contracts are on sort of an evergreen process where they roll year to year. Our minutes are generally not captive in a minimum volume rate. With regards to pricing, we have not made -- and do not plan to make -- any price increases this year or as we look forward, even though some of the discounts in some of the older markets are much more generous than in newer markets. And the main reason is that we want to continue to maintain a very strong price value offered to our customers, particularly as new competitors attempt to create their own networks. So we're continuing to try to keep our customers extremely happy at this point in time with regards to the value they receive on a core business as we begin to introduce to them new services in other areas. So the answer to your question is no. We don't see any price increase.

Jonathan Ho - William Blair

And also, with regard to intermarket traffic, you guys have talked a little bit about that. Can you give us maybe some color on some of the challenges there and just the timing that you think it'll take in terms of more of a ramp in that side of the business?

Rian Wren

Yes, it's -- there are really -- when you look at our termination services, it really has two major flavors. One would be where an originating carrier's trying to complete a call across territories. That service there is a very competitive service because there's a lot of wholesale long distance providers who will take that call. And so that's a very different or what I'll call hypercompetitive market space, and our offer there, we believe we have the strongest value offer where we can service that customer when that call terminates on our network into one of our connected carriers. So we don't have a secondary carrier that actually finally completes the call. So our whole thesis has been around keeping minutes entirely on our network. In doing so, we can be extremely competitive and offer value savings to our customers in that marketplace.

And having said that -- take any calls. So most wholesale players will take any call and typically use the incumbent local exchange carrier to terminate that call. So there, our challenges are making sure that we can provide as robust a terminating footprint as possible to those customers. On the other side, where we're directly focused on interexchange carriers to terminate calls, the challenges there that we've spoken about have been, there are new market for us, developing the confidence level and the operational experience with those carriers. We believe that we're making great progress on that, down the road on that. And again, it has to do with the terminating footprint. That is a different jurisdictional type traffic, and we are attempting to get very specific agreements from all of our terminating carriers that they will accept that traffic and we can work out the passing of that process. So it's a little bit more work, but we think that we're making good progress on it.

Jonathan Ho - William Blair

Great. Thank you.

Operator

Okay, thank you. And our next question comes from Donna Jaegers with D.A. Davidson. Go ahead please.

Donna Jaegers - D.A. Davidson

Hi, thanks for taking the questions. Just three quick ones, and I'm sort of new to the story, so forgive me if these questions are a little stupid. Do you ever talk about same-store minutes versus the minutes of use you're generating in the new markets to give us some flavor there as far as how fast the existing markets are growing?

Rian Wren

Donna, this is Rian. We actually don't, and the main reason is is that as this market -- as we entered this market four years ago, it was fundamentally either build it yourself or a monopoly service provided by the incumbent carriers, and as such, the structure of it -- and particularly with regards to pricing -- was very arbitrary and therefore comparisons between markets, it's very difficult without getting very, very detailed, and I think we've always felt that it's really not -- it really doesn't help people analyze our business. And so we've attempted to try to blend all of the minutes and provide guidance on a minute basis and an overall average ARPU basis.

I think that's worked well for us because the more and more services that we provide through the tandems, all they do is exacerbate that problem because they're all regulated by various different agencies, whether it be the state or the federal at this point in time with some of the intermarket activities.

We do believe that the trend, and as discussed before, this intercarrier compensation reform process, has been trying to unify the rates. So we do believe over time, over the next several years, you will start to see a minute being treated as a minute, and it'll be easier to take a look at that process.

Donna Jaegers - D.A. Davidson

Okay. Two other question questions, if I could. Obviously it looks like the Alltel acquisition is going to go through with Verizon Wireless. Do you do much business with Alltel, and do you see that combination hurting you or helping you down the road?

Rian Wren

Well, the first answer is yes. Alltel is a customer, and they're a customer that is beginning to grow with us, very recent addition to our customer list. The exposure that we have with combinations has to do with traffic that would go between two merging carriers. The issue specifically with Alltel and Verizon Wireless is both of those carriers are fairly new to us, and so the amount of traffic that one sent to the other is fairly negligible as we look at our business today. And so the fact that they're coming together is good because we have a very strong and growing relationship with Verizon Wireless, and we think our agreements with them will obviously apply to Alltel, and we'll be connected to them in a much more aggressive way going forward.

The traffic that would have went between Alltel and Verizon Wireless, you would expect that over the next year to 18 months that they will begin to handle that themselves as they merge their networks. So that traffic will be more of a lost opportunity for us to go after, but it would be a small piece of the overall traffic that Alltel and Verizon Wireless could offer us as customers.

Donna Jaegers - D.A. Davidson

Okay. Great. That makes a lot of sense. And then one last quick question. I'm sort of -- congratulations on interconnecting with Verizon Wireless, but I'm sort of puzzled. Why wouldn't Verizon Wireless use MCI's own tandem network since they have that network out of region? Or can you maybe explain to us how Verizon Wireless, how you're interconnecting with them? Is it more within their own landline region or outside of it?

Rian Wren

Well, the first breakthrough we had with them was the ability to terminate to Verizon Wireless and offices. And I think your question is why wouldn't Verizon Wireless use Verizon Communication's tandems to originate calls, and the answer is they will. In the markets where Verizon Communication owns and operates the incumbent tandem, Verizon Wireless, I believe, will choose to use their partner's tandem for that origination, and that's the same case for AT&T. AT&T wireless uses AT&T in the markets where AT&T is the franchised incumbent carrier. In the markets -- the traffic that we're beginning to see from Verizon Wireless is in the markets that's not inside their jurisdiction and where they don't have a tandem, and that's the cases in the AT&T markets and the Qwest markets. So I think to your point, you're right. Where they own the tandem, they will use their own network.

Donna Jaegers - D.A. Davidson

Okay, that makes sense. Thanks so much.

Operator

Thank you. And ladies and gentlemen, that does conclude our question-and-answer session. I would now like to turn the conference back over to Rian Wren for any closing statement.

Rian Wren

Okay. Again, I really appreciate everybody taking the time out today to listen to where we are. We, again, feel -- given the environment that we're all attempting to work through -- feel very, very good about where we are. We're cautious. We're going to keep our eye on the ball here. We look very favorably on where we've been to date and how we think about the year, and we're working hard at where we're going to take this business. So we look forward to speaking with you in the not-too-distant future to give you the fourth quarter results, and we'll speak to you at that point.

Operator

Ladies and gentlemen, this concludes the Neutral Tandem third quarter earnings teleconference. If you'd like to listen to a replay of today's conference, please dial 800-405-2236 or 303-590-3000, with the pass code 11121257. ACT would like to thank you for your participation, and you may now disconnect.

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Source: Neutral Tandem, Inc., Q3 2008, Earnings Call Transcript
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