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Neutral Tandem, Inc. (NASDAQ:TNDM)

Q4 2008 Earnings Call Transcript

February 5, 2009 10:00 am ET

Executives

Richard Monto – General Counsel

Rian Wren – President and CEO

Rob Junkroski – CFO

Analysts

Tim Horan – Oppenheimer

John Bright – Avondale Partners

Will Power – Robert Baird

James Breen – Thomas Weisel

Jonathan Ho – William Blair

Mark DeRussy – Raymond James

Operator

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Neutral Tandem fourth 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 is Thursday, February 5th, 2009. I would now like to turn the conference over to Richard Monto, our General Counsel. Please go ahead, sir.

Richard Monto

Thank you, and welcome to the Neutral Tandem fourth quarter and full year 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 those 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 and 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 fourth quarter and year end 2008 earnings call. As you will note from this morning’s release we are very pleased with the strong financial and operational results for the fourth quarter, as well as, our performance for the full year. We reported another record quarter with $34.9 million in revenue, which reflects a 40.7% increase over the fourth quarter of 2007. This translated into strong profitability as our net income grew to $8.2 million during the quarter, which is a substantial increase over the $1.8 million we earned in the year-ago period. Rob Junkroski, our CFO, will provide additional detail on the financial results later in this call.

Despite today’s economic environment and the challenges facing many companies and industries across the global economy, our fourth quarter and full year financial performance was strong and in line with our expectations. At this time we do not believe that we had been noticeably affected by these macroeconomic challenges. And we continue to maintain and build a healthy balance sheet. We intend to keep a sharp eye on the situation as economic conditions could potentially affect us at some point. However, despite this cautious statement, 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 environments while executing on our long term growth plans. We also continue to believe that we will see favorable industry trends for our business. Particularly the increase in wireless and cable telephony subscriptions driven by the ongoing migration of subscribers from incumbent local exchange carrier wireline services to competitive carriers. In fact, it is possible that the challenging economic conditions might actually reinforce the trend of subscribers seeking low cost options and moving from incumbent local exchange carriers to competitive wireless or cable providers. Or, eliminating a landline in favor of exclusively using a wireless carrier. Neutral Tandem is well positioned to benefit from this trend since we provide services to these types of competitive carriers.

Looking back at 2008, the success we achieved is a result of our continued focus on and execution of our long term growth strategy, which primarily consists of broadening our geographic presence, expanding our interconnections with new and existing customers, and increasing types of traffic across our network.

Let me take a few minutes to discuss these strategies and share with you a few of our accomplishments for 2008. This past year we successfully commenced operations in 36 new markets bringing the total number of operational markets to 100. This expansion has enabled us to continue to increase the amount of telephone numbers to which we can terminate calls. I’d note that we recently refined the data we use to calculate our addressable phone numbers by removing certain numbers such as paging numbers, which are not addressable by us. Based on this exercise, as of year-end 2008, the total number of addressable telephone numbers assigned to competitive carriers in the 100 operational markets we serve has increased to 601 million. As of year-end 2008 our customers can terminate traffic to approximately 391 million of these numbers.

Our plans for the full year 2009 include the addition of 30 more markets. Bringing our projected total markets served to 130. But note, our customers as of year-end 2008, had (inaudible) traffic to approximately 65% of Neutral Tandem’s total addressable footprint in the current 100 operational markets. This is an increase of 53% or 136 million phone numbers when compared with the numbers our customers could reach at the end of 2007. Significantly, a large portion of this increase was generated by new connections in the 64 markets we established in 2007 or earlier. In fact, these earlier markets contributed approximately 62% of the growth in all phone numbers during 2008. In comparison, the 36 new markets we established in 2008 contributed approximately 38% of our growth in phone numbers. This demonstrates that we have continued opportunity to increase growth as we deepen our interconnections in our established markets, as well as those recently launched and planned for the future.

As we increase the numbers our customers connect – number of customers connected to our network, our deepening our penetration in existing markets, and establishing new markets we continue to leverage the benefits of network effect, which is the key component of our growth strategy and the fundamental strength of our business. As I previously discussed, the value of our service offering directly increases with the number of customers connected to our network. We believe that the scalability of our business model and the momentum we have generated has helped us create a position from which we will be able to grow our core business by also allowing for expansion into new types of traffic.

To that end, we began working during 2008 to increase the types of traffic we can interconnect and carry over our network. While we remain focused on growing our core local transit business, we are optimistic that we can increase minutes transited across the Neutral Tandem network by developing our termination service business. These new product offerings, which include the terminating switched access service that I had 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 market these terminating services to interexchange carriers, also referred to as IXCs. And have entered into contracts with several of these carriers. Over the past few months we had expanded our delivery on this type of traffic. And we expect this trend to continue in 2009.

We have also fine-tuned our product offering to support our customers’ expectations to physically interconnect using an IP or circuit-switched interface to exchange inter-market traffic. Our ability to be flexible on technology and interconnection methodology is an important strength we have in providing solutions that meet our customers’ needs.

We are able to offer a variety of options and expanded services, in part, as a result of our continued progress towards deploying an advanced, all-IP technology platform. 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 circuit-switched technology with soft-switches.

As you may recall, we previously announced our plan to replace the remaining three circuit switches in our Illinois, Indiana, and Minnesota networks. These replacements are well under way and are expected to be completed by April of this year. Once completed, our network platform will be 100% IP compatible. These investments reduce our operating expenses and improve capital efficiency while facilitating our ability to deliver new service offerings in the future. As a result, we believe we now operate the largest IP-capable tandem transit network in the United States. This positions us to be the interconnection provider of choice for carriers as they upgrade their networks to IP. This has been reinforced by several of our existing customers who have migrated their connections with us to IP.

Looking forward into 2009, we will continue to evaluate our ability to provide solutions to meet our customers originating switched access needs. An example of an originating access call is a toll-free call that an originating carrier would send to our (inaudible) switch. We would then route that call to the appropriate IXC that provides the toll-free service. 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. We are hopeful that the originating services will enable us to further grow our business.

Looking beyond 2009, we recently began work on developing a lab for research and development purposes. In the lab we will be able to test potential applications and could result in new service offerings or features that are complementary to our existing services. We allocated a small amount of capital for this exercise, which is included in the CapEx guidance we provided today.

In closing, we are very pleased with our results for year-end and fourth quarter of 2008. Despite the strong headwinds and uncertainty that’s plagued much of the broader economy, we believe that we are making strong progress across all three of our strategic priorities by remaining focused on our core business. As we begin to move into 2009, 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 our financial review.

Rob Junkroski

Thank you. As Rian mentioned, we are very pleased with our financial and operational achievements made during the full year and fourth quarter of 2008. Turning to our results, our fourth quarter 2008 revenue was $34.9 million, compared with $24.8 million in the fourth quarter of 2007; an increase of 40.7%. In the fourth quarter of 2008 we transited 18.1 billion minutes across the network, up from 11.8 billion minutes in the fourth quarter of 2007; an increase of 53.4%. This increase in minutes was driven by our growth in both new and established markets and the increase of terminating service minutes.

Turning to expenses, our network and facilities expense, which is the operations expense associated with transiting calls through our network, was $10.6 million in the fourth quarter of 2008. Compared to $8.7 million for the fourth 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 $8 million during the fourth quarter of 2008. Up from $6.4 million during the fourth quarter of 2007. The increase was primarily due to higher employee expenses including additional headcount associated with our business growth. Adjusted EBITDA, a non-GAAP financial measure, was $16. 8 million for the fourth quarter of 2008. Up 69.7% compared to $9.9 million for the fourth quarter of 2007. The adjusted EBITDA margin for the fourth quarter of 2008 was 48.1% up from 39.9% in the year-ago period. Included in adjusted EBITDA for the fourth quarter of 2008 is another expense of $600,000 related to a write-down of an investment in auction rate securities, offset by one-time income items totaling $600,000.

Depreciation and amortization increased by $1.1 million from $3.3 million in the fourth quarter of 2007 to $4.4 million in the fourth quarter of 2008. We’ve recorded accelerated depreciation of our Detroit and Cleveland circuit switches through October 2008 and are recording accelerated depreciation of our Illinois, Indiana, and Minnesota circuit switches until these switches are replaced with IP switching equipment.

Income from operations for the three month ended December 31st, 2008 was $11.9 million or 34.1% of revenue, compared to $6.4 million for the three month ended December 31st, 2007 or 25.8% of revenue. This reflects our ability to increase revenues while decreasing costs as a percentage of revenue. As Rian noted previously, we have gained cost efficiencies by deploying next generation soft switch technology, as well as insourcing our signaling assets and optimizing our nationwide interconnection network. These impacts, combined with our ability to grow our business while adding less incremental headcount, are the main drivers of our operating margin expansion.

Pretax income was $12.1 million for the fourth quarter of 2008 compared to pretax income of $4.1 million for the fourth quarter of 2007. Our income tax expense for the fourth quarter of 2008 was $3.9 million compared to an income tax expense of $2.3 million for the fourth quarter of 2007. Our effective tax rate for the three months ended December 31st, 2008 was approximately 32%. This compares to an effective tax rate of approximately 56% for the three months ended December 31st, 2007.

Net income for the fourth quarter of 2008 was $8.2 million or $0.25 per diluted share, compared to net income of $1.8 million or $0.06 per diluted share for the fourth quarter of 2007. Taking a look at our current financial condition, our balance sheet as of December 31st, 2008 is showing approximately $196.5 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 $3.2 million and continues to amortize. Our total stockholder equity as of December 31st, 2008 is $179.9 million while our cash and cash equivalents are $110.4 million. And our share count is approximately 32.4 million shares.

Turning to our full year results for fiscal year 2008, revenue was $120.9 million compared to $85.6 million during fiscal year 2007; an increase of 41.2%. Billed minutes for fiscal year 2008 were 61 billion, up 48.8% from 41 billion in fiscal year 2007 as we further develop markets and customers. Network expenses for fiscal year 2008 were $40.3 million compared to $30.2 million for fiscal year 2007. Combined operating expenses consisting of operations, sales and marketing, and general and administrative expenses were $30.9 million for 2008 compared to $26.7 million in fiscal year 2007. The increase was primarily due to higher employee expenses including additional headcount associated with our business growth.

Adjusted EBITDA, a non-GAAP measure, for the fiscal year of 2008 was $51.4 million, up from $29.7 million during fiscal year 2007, an increase of 73.1%. The adjusted EBITDA margin for fiscal year 2008 was 42.5%. Included in adjusted EBITDA for fiscal year 2008 is an impairment of fixed assets of $200,000 and other expense of $1.1 million. The other expense of $1.1 million consists of $500,000 incurred in conjunction with our follow-on offering from earlier in the year and $600,000 from a write-down in investment in auction rate securities. These were partially offset by the one-time fourth quarter income items totaling $600,000 mentioned earlier.

For the full year, depreciation and amortization increased by approximately $2.9 million from $11.1 million in 2007 to $14 million in 2008. As noted in the third quarter call, we recognized a remaining accelerated depreciation on our Detroit and Cleveland circuit switches during the fourth quarter. And it started to record accelerated depreciation related to the retirement of our Illinois, Indiana, and Minnesota circuit switches. Income from operations for fiscal year 2008 was $35.4 million or 29.3% of revenue, compared to $17.7 million for fiscal year 2007 or 20.7% of revenue.

Pretax income for fiscal year 2008 was $36.8 million, up from $12.5 million for fiscal year 2007. Our income tax expense for fiscal year 2008 was $12.8 million, compared to income tax expense of $6.2 million for fiscal year 2007. Our effective tax rate for fiscal year 2008 was approximately 35%. This compares to an effective tax rate of approximately 50% for fiscal year 2007. Net income was $24 million for fiscal year 2008 or $0.72 per diluted share, compared to $6.3 million or $0.24 per diluted share during fiscal year 2007. We incurred $22.3 million of capital expenditures for fiscal year 2008 as compared to $20.1 million in capital expenditures in fiscal year 2007.

I’d now like to address our outlook for 2009. Based on our actual results for fiscal year 2008 and our current belief about minute-based revenue trends, expenses, and a competitive environment, we estimate that revenue for the full year of 2009 is expected to be between $151 million and $158 million. Adjusted EBITDA, a non-GAAP financial measure, for the full year of 2009 is projected to be between $66 million and $70 million. Adjusted EBITDA will exclude non-cash, share-based employee compensation. Billed minutes for the full year of 2009 are expected to be between 81 billion and 85 billion minutes. CapEx for the full year of 2009 is projected to be between $18 million to $20 million. And we plan to commence operations in 30 new markets during the full year of 2009.

We remain excited by the opportunities we see for our company as we continue to expand our business and execute our long term growth strategy. 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. We will now begin the question-and-answer session. (Operator instructions). And our first question is from Tim Horan with Oppenheimer. Please go ahead, sir.

Tim Horan – Oppenheimer

Guys, can you hear me? Great. Wanted to talk a little bit more about the overall growth and the market, Rian. Do you have a view out there with economy impacting so negatively a lot of businesses? What we’re seeing in terms of overall minutes growth in the market, would you say you have a fairly good view on that? And then maybe a little legacy market sources, the new markets you entered. Can you talk about – I know you gave the percentage of how much came from each, but can you give us a sense of how fast the legacy markets are growing at in terms of minutes? Are they growing 30% still, 20%, 40% versus your overall growth that you reported?

RianWren

I’m not even sure I can – unfortunately I have a feeling I may disappoint you again. In terms of overall growth, we have a view into minutes that we acquire in the transit business. And so typically what we see is as we turn up interconnections to switches and we give our customers the routing numbers, they tend to quickly fill the facilities that we put in place. What we don’t know is this in toto [ph]. How is a carrier’s total business performing? What we have generally seen is that we haven’t seen a fall off in our type of minutes. I think in many cases, particularly in the carriers who offer an unlimited or flat-rated type package, they may not be seeing them either. Mainly because there’s not a lot of incentive for people to reduce their calling patterns because it’s included in their base price. So we haven’t seen – we haven’t seen a reduction from that standpoint. And trying to estimate what the total wireless minutes are doing or CLEC minutes are doing, all we really see is our piece that we take with regards to carrier-to-carrier type traffic.

Tim Horan – Oppenheimer

Sure.

Rian Wren

I wish I could help you a little bit more, but in general we haven’t – when we look at the quarter-to-quarter performance, and we’ve actually seen as you’ve noted, a little backend acceleration into ’08. That is really being driven by our expansion into new services. We haven’t seen our local transit business performing as we had expected. We’ve now began to get a little bit more traction on the terminating piece of our business as we had forecasted and had expected. So it’s difficult – in many cases because we’re in that growth stage for us to really get the nuances of what’s happening with the individual carriers.

Tim Horan – Oppenheimer

We had a mid percentage of revenues now coming from legacy markets versus new markets in total, then we can calculate the different growth rates, or maybe you can just talk about what you’re seeing in terms of growth?

Rian Wren

Well, I think in general, when you look at – we’ve never really cut the numbers that way, but I think you could see from the standpoint of – if you look at 2008, all the new number growths that we’ve developed, 62, almost two-thirds of those numbers came from existing markets. And what that means is there were a lot of carrier switches, whether it be a market that was established a year ago, two years ago, or three years ago, that we still had interconnected with. And I, over the costs, explained the process it takes to get fully interconnected deeply . And so because we continue to interconnect in existing markets, and the existing markets are a large part of our business, almost two-thirds of all new numbers came from the existing markets, not the new ones because it takes time for each market to get–

Tim Horan – Oppenheimer

Sure. And are existing markets like 90% of your numbers now, 80%, or is it higher even?

Rian Wren

I guess it would depend on what you could call an existing market.

Tim Horan – Oppenheimer

Well, I guess, relative to that number you gave at two-thirds coming from the existing markets, what was the base on that number?

Rian Wren

Let me just quickly – we think coming into ’07, I think that’s the exact number we were connected to. I don’t have in front of me the exact number of connections we had in the beginning of ’08. But as I mentioned, we ended 136 million numbers in ’08, and 62% of those came from existing markets. The vast majority – so I’m thinking somewhere between probably 60% to 80% of our new numbers are coming from existing markets.

Tim Horan – Oppenheimer

Sure. I get that number (inaudible), Randy. Let me just – on the revenue permitted, it looks like you expect the trends there to kind of continue down again around in the mid single digit declines or so. Is that being driven by going at the lower price markets and the new services having slightly lower prices?

Rian Wren

Yes. Well, it’s being driven by, first point that you brought up, is that a lot of the pricing structure, again, to remind everybody, that we typically provide a discount off the incumbent tandem pricing. And the markets that are later in our expansion, typically have lower rates. The new products have a mix, but they generally – they generally command at a rate that’s similar to what our average bin. So they aren’t necessarily lower, but newer transit markets produced that. And so as we forecasted last year, I think we did a little better at the end of the year than we had forecasted. And that is a result of come of the uptake of the newer products. So what we forecast for ’09, we’ve tried to do the same thing to look at what we think will be generated by the new markets in the quarter trend of business, and then what the up-tick will be on the new product. And then we try to estimate what that would be. And that’s generally why we stopped trying to provide the guidance as the overall (inaudible) guidance.

Tim Horan – Oppenheimer

Rian, and just the last thing, what is new products’ percentage of revenue? You might have said that. I’m sorry if I missed it.

Rian Wren

I think when we ended the year in the fourth quarter, it was about 7%, was the terminating business. And going forward, we’re looking – we’re probably not breaking that all out, and the reason is, it is the same thing we do. Whether it be a terminating service to an exchange carrier, or transit service to a local carrier, we perform the same function. But we’ve been describing it to people to show them that, in fact, there are all types of minutes that go through tandems. But in essence, whether it’s originating, terminating a local or inter-exchange minute, it is all a tandem minute to us. But to be – to be responsive to your question, in the fourth quarter, we had hit, I think, close to 7% from some of the new products.

Tim Horan – Oppenheimer

Great quarter. Thanks, guys.

Rian Wren

Thank you.

Tim Horan – Oppenheimer

Thank you.

Operator

Thank you. And our next question comes from John Bright from Avondale Partners. Please go ahead, sir.

John Bright – Avondale Partners

Thanks. From Evendale [ph] ha? Rian, Rob a straightforward solid quarter. Rian, where could the penetration of the addressable numbers go? I think you gave about a 65% number now. What is that number for your legacy markets? And are there any structural barriers in your current, more recent markets, and future markets to think that they won’t hit the same level of penetration?

Rian Wren

Well, as I said in the call, today, if you look at the advocate company, we’re touching 65% penetration of potential numbers in the markets we operate. That varies by market from ones that were just turned up, let’s say, a month ago, where it’s probably in the single digit to 10% level to as high as a 90% penetrated in markets that are five years old. We would expect that over time, over the next couple of years, we will drive to 65% higher towards our more mature markets. So we don’t know exactly how high, but it will be in a high 80% to 85%, approaching 90%, when we finish our total build.

John Bright – Avondale Partners

Okay. And, Rob, a couple of questions on the quarter itself. How many hub locations did you end up with at the end of ’08? And what should we think about as far as the 30new markets in 2009?

Rob Junkroski

We ended up with 31 hubs and in ’08, and that served a hundred markets that we announced. The 30 new markets, there’s one hub out of those 30 new markets.

John Bright – Avondale Partners

Okay. And couple of questions – on the current quarter, one, looks like the absolute dual networks and facilities expense went down sequentially, lightly. Is that correct, and if so what was the dynamic happening there?

Rob Junkroski

Yes. At the fourth quarter, there’s an expense – there’s some cyclicality to the network expense because the carriers typically put in their moratoriums. We put in moratoriums on network grooms and such. So the fourth quarter is typically going to have fewer non-recurring charges that you get when you’re billing your network. You have to pay a lot of one-time charges to carriers. And those slowed down considerably in the fourth quarter. So that’s why we’re seeing that dynamic.

John Bright – Avondale Partners

Okay. And the fourth quarter tax rate also a bit lower than before, nothing to get too concerned about. What’s the thought on the tax rate for the fourth quarter and any thoughts that you might get looking forward to 2009?

Rob Junkroski

Yes. Well, the drastic change year-over-year was – last year, we had the expense from the warrants, the warrant expense, from being a pre-IPO company, was not deductible for tax purposes. So it caused our effective rate to be extremely high. And then, this quarter – this quarter of 2008, it didn’t come into play. That’s why the tax rate came back down to a normalized level. The fourth quarter, also on tax rate, was a little bit low because the deductibility of stock – when – and our employees cannot exercise stock options. That income to the employee becomes deductible to the company. So we had some employees who took advantage of that in the fourth quarter, and that dropped our tax rate a little bit also.

John Bright – Avondale Partners

And then for 2009, should we be thinking something similar to the ’08 rate? Or should we be taking–?

Rob Junkroski

The full year ’08 rate, mid-30s, I think, is a good number.

John Bright – Avondale Partners

Okay. And last couple of cleanup ones. One, any reason, if I look at the minutes that you – in the 2008 timeframe that I shouldn’t be modeling similar patterns of performance for 2009, meaning an accelerating rate from the fourth quarter run rate base?

Rob Junkroski

Well, we’ve built – our thoughts are into our guidance numbers. I don’t see any change in – general change – in how – how things will build out other than the lot large numbers starts to take more effect now that we’re getting bigger and bigger. But we’ve built everything into our guidance and I think you’ll see we’re doing a pretty good job at that.

Rian Wren

And let me add to that after that, John, is, when you think about the new services, mainly around our new terminating service business. You need to think about that a little bit from the standpoint of – it’s really services that are coming on from the existing infrastructure. So unlike local business where it grows very smoothly and incrementally because we connect and we route, we connect and we route. A terminating customer, when they decide to connect, we have an expansive network in place already. So they’re ramped up in terms of services could happen faster than typically connecting to a local carrier as we begin to build out that painstaking interconnections in the market. Those exist. So as a terminating guide comes in, you might get acceleration. And then it’ll level off and accelerate as the next one does. That would be the case for both the terminating side and one in it if we actually start to roll out in a big way the originating sides a similar type of effect can occur. So it could get to be a little, a little bit more choppy.

John Bright – Avondale Partners

Okay. And then, Rob, just from a headcount standpoint, leading ’08? And maybe expectations for ’09?

Rob Junkroski

Sure. We left ’08 with 137 employees. We’ll have some modest growth to that in ’09, but we added 11 people in ’08. So we started the year with 126, added 11. I would say it would probably be something similar in ’09.

John Bright – Avondale Partners

Gentlemen, solid quarter, thanks.

Rob Junkroski

Thank you.

Operator

Thank you. Our next question comes from Will Power with Robert Baird. Please go ahead, sir.

Will Power – Robert Baird

Great Thanks. A couple of questions, first, I wonder if you could update us on the status of competition, either from the bells and their tandems as well as other independent players in the marketplace? And then, secondly, as I look at EBITDA guidance, it obviously looks very good. But I look at the implied margin guidance and those suggest a level that’s below where you exited ’08. I guess I’m just wondering how conservative that is versus other potential cost increases that we should be thinking about. Thanks.

Rian Wren

Okay. I’ll start with the competition and – and Rob can help me out on the EBITDA guidance. In terms of competition, let me just step back for a second. What I’ve been thinking about is – some extent has always been competition. The incumbent exchange carrier has probably provided – although it’s not the latest technology, a rock solid service state have been – for years, have provided transit service to these carriers. And some customers have always had the option to use that.

More so, they’ve also had the option to self-provide the service. We refer to it as direct connect. And as we talked over the calls, we have indicated that customers do directly connect. It’s part of the business. We haven’t seen any major changes in trend associated with that. But customers do have choice to self-provide or to use the incumbent provider. And I think the incumbent provider basically serves them well.

We’ve talked about new entrants. There are a number of new entrants that we talked about, both large companies, existing companies that have relationships with these carriers. Some existing carriers typically see that to have tandems who have looked at our business, and attempted to serve it. And more recently, new startups had come into the marketplace.

So when I think of competition, we believe competition exists, and we generally welcome competition because I think it makes everybody better, including ourselves. And the reason I say that is that we stand ready to compete with them. We have a patented manage service offering that includes the bundling of transmission, switching, management of those services, and redundancy of that package. We have a solid product, and I think that’s why we have succeeded to the extent we had. We packaged that and laid on top of that a significant value proposition, which includes good savings and fantastic service. We talked to our customers to get feedback that our service parameters are outmatched by nobody with regards to the up time and the response rate that we can do. The fact that we’ve invested in the technology, we now give them capacity in a matter of minutes versus days, all based on being on the IP platform.

And lastly our network reach is very, very significant at that. So on top of that we now begin with multiple services serving not just your transit needs, but their terminating needs, ultimately their originating needs. And the fact that we're busy working on complimentary services, I think we're going to stand pretty well with regards to maintaining our position. Having said that, I do believe the competition has become – exists and has become very active in the marketplace. With regard to any success by competitors, I think the information on that is better gained from themselves. We don’t have a jacket of information, but I think overall, you would expect the competition would become fairly robust over time.

Will Power – Robert Baird

Okay. Thanks, that's helpful. And then I guess Rob on the margins?

Rob Junkroski

Yes on the margins. The fourth quarter as mentioned and John's section of that call, there's a little cyclicality in the fourth quarter, which caused margins – EBITDA margins to be higher in that fourth quarter because we have higher gross margin because of lower network expenses and non-recurring charges. Obviously, that slows down. On the G&A side, things – professional services tend to slowdown in the fourth quarter, i.e. , the lawyers kind of take vacations. So the fourth quarter, 48% is probably not a good representation of the whole, I think, 42.5% for the year and our midpoint of our guidance would be in 44% still showing some expansion there – so again the 48% is not – it needs to be adjusted for certain things. I don’t have the exact set of parameters that I would take out of that to normalize it completely, but it be several points lower. So I think we're moving in to 2009 with guidance slightly above the – few points above where we ended the full year 2008. And I think it's a good place to right now.

Rian Wren

Yes. I would add to what Rob said because this relates to your previous question Will, is that as you know we've cleaned up throughout 2008 many of our outstanding regulatory obligation issues. And that's where it comes down to a small amount of activity in resources for us. But you are aware too, again relating to competition, that we do have an outstanding patent litigation case where we brought against a new start who we believe is infringing on our patent. And we have progressed in that case where we've become quite active in 2008. And we have, we're allocating sizable resources during the course of this year to vigorously represent ourselves in that situation. So it's a onetime thing throughout 2008 that we are prepared for and it's built in to our guidance.

Will Power – Robert Baird

Okay. Great. Thank you.

Operator

Thank you. And our next question comes from James Breen with Thomas Weisel. Please go ahead, sir.

James Breen – Thomas Weisel

Thank you very much. Just a few questions, one, sort of building upon some of the questions asked already, when you look at the terminating switch access business relative to the tandem business that you sort of founded the company upon. Can you give us some color in terms of the sizing of that business? Is it approximately the same size as the tandem business is, twice as big, half as big, so forth? And also the originating side? And ultimately is it your goal to make that part of the business as large as the tandem part of the business. Thank you.

Rian Wren

Sure. Let me try. It’s just always been a challenge for not only ourselves, but I know the analysts out there that are following this business. But in general, when you look at the totality of voice calling, somewhere between 60% and 70% of all calling is typically local, in jurisdiction. It's a local phone call. Its so therefore, generally the other 30% to 40% heading on – where you put it is long distance in nature, calls outside the local calling scope. So at a broad gauge, you could say that the traffic that is coming into the market, which would be that type of traffic where you terminate services. It’s long distance in nature. And therefore, you could say the total size probably could be as large as a third the size of local business.

We've attempted to try and model that, but you have to make a number of assumptions. Because the long distance carriers, which were – and the local carriers, which was generated all the way back in divestiture, back in 1984. And since that time, the long distance carriers have optimized their networks by doing quote direct connects down to end offices that had a lot of traffic. So you have to take that 30% and factor it down by, I guess, in terms of how much of that existed. And then within that, they used tandems to terminate the rest of the traffic, and that’s the target segment that we go after. So it's somewhat we know, somewhat less than third size of our local business.

And then the customers in that zone, because of consolidation over the years, are much fewer than local. There are hundreds of local exchange carriers, but there are probably a dozen major players in the exchange and long distance business. And so it’s a highly concentrated customer set ,which we are making great progress on. And we think, in general, the totality of it is somewhat less than a third of the local business.

On the originating side, and I say it's really in development so we haven’t done too much work. But I recently would come across some information that talked about the number of active 800 phone numbers. 800 phone numbers are numbers that are toll free in nature, and typically sold by exchange carriers. And I think as of the end of – I'm not sure whether it was ’07 or ’08. It’s probably’07. It’s an SEC number. There were close to 24 million to 25 million of active 800 phone numbers out there. A sizable business, and those of you who use these numbers everyday know that there's a significant amount of traffic for people calling at various different enterprises with toll free service. So we do believe that these are very accretive to our business, and will be nicely added to the growth still that we're experiencing in the local side.

James Breen – Thomas Weisel

And when you think about the two separate products from a margin perspective – you already talked about the revenue being about the same and the new products were existing. Are the margins about the same from (inaudible) sector?

Rian Wren

They are.

James Breen – Thomas Weisel

Okay. Great. Thank you very much.

Operator

Thank you. And our next question comes from Jonathan Ho from William Blair. Please go ahead, sir.

Jonathan Ho – William Blair

Hi. Good morning. Great results. In looking at your guidance range, we view your business as being fairly predictable. What are some of the swing factors that could lead you to end up either at the low end or the high end of your guidance range, just in terms of the minutes?

Rian Wren

Typically, we've been working on guidance. We build it. We've been – we have a difficult process sometimes as you do to decide the markets. So we build our momentum – momentum view in terms of what we have. We look at estimates in terms of what might happen with direct connects. And then we look at all the additives in terms of expansion of both the new markets and more importantly into existing markets. We look very heavily at how many new switches we expect to connect to in bulk. And then we look at the sales activity. So that builds our base. And we do that in a way that we think we've been able to kind of give you a range that’s fairly comfortable.

So we've done that correctly. We should be targeting somewhere, if everything hits the way we think, somewhere in the middle of that range. On the new stuff, as I was telling you before, because we have the existing network in place, and some of these carriers are highly concentrated, if we estimated our goal set for this year, that should still keep us within that range. If we are more successful than we thought, there you could see upside potential. On the downside, the thing that could affect us would be a significant increase in people direct connecting, which that’s un-forecastable.

The other would be nature (inaudible) by potential competitors, we know they've been trying – but as I said, we believe we have such a relationship with our customers today and such a strong product and reach that we feel we'll fair well in that zone. So again, our business is one that – generally it's been slow moving it’s a big exciting network that kind of moves and grows slowly. We have an expected – in the core for things to be wildly swinging either up, or down at all.

As we enter into bringing in new types of traffic in an existing network, to the extent we do that, the swing should be more up than anything. Again we feel pretty comfortable giving you what we've talked about, taking all of the input we have and the knowledge we have on our business, to think – I think that’s a good guidance thing to look at.

Jonathan Ho – William Blair

Great. Can you update us a little bit in terms of the MSA penetration you guys have given us sort of metrics early on that you associated a lot of the top 100 MSAs. Can you just maybe give us a sense of the next 30 that you're going to give in terms of the number of adjustable lines and sort of the viewpoint on the penetration and the minutes, I guess the rate for the minutes coming from these new territories?

Rian Wren

Typically you'll find that most of the minutes because the business have grown so big we'll be a small percentage coming from the new markets and that’s because the new markets take several years to get fully penetrated. So in general, the thirty new markets we're going to this year will contribute very little to the online growth. It will be more ten, eleven impact. Having said that, the markets that we're entering into now can be secondary markets. We're going deeper and deeper into the MSAs. I don’t have in front of me right now the exact number – marketing person had an illness in the family or I'd look at them right now and give you the number, but I do think that we are very close to the top 100, sure [ph], and have been moving in to the secondary markets. Perhaps we could give you an update on that we'll take it to data [ph].

Jonathan Ho – William Blair

Do you have a sense of how many lines will be added in terms of the addressable lines not the connected, but the addressable on the study?

Rian Wren

My sense would be in the tens of millions. On the additive [ph], but I don’t have the number in front of me, the market tend to be small.

Jonathan Ho – William Blair

Okay. But there's no real CapEx that’s required, you just run a line up your hub facility.

Rian Wren

Correct. As Rob said, we do have planned one hub market, which would require a switch and all the other ones would be no CapEx, it would just be growth.

So basically, we have in our capital plan this year is one platform to go in the rest is basically growth in existing new markets because they're all growing off the existing platform and then we've allocated less than approximately 10% for our developmental efforts to go forward.

So you really, at this point, you're starting to see the model begin to really show it's scale, both in terms of direct costs, in terms of operating costs, when you look at what we've achieved this year and aided 11 people, and by the way two of those were forward looking people, we added seven markets and effectively nine people to handle that with the two additional being forward looking. So the operating and direct scaling is really starting to hit its stride and the capital efficiency is starting to kick in. So we are really getting to the point where we've been trying to get to.

Jonathan Ho – William Blair

Well, my last question is on forward looking type services.

We had talked at one point about opportunities for the carriers now that you have sort of this, additional connection between all the major carriers and maybe offering overflow type services or other ancillary services associated with the interconnection positioning that you guys have between the different carriers even within their own networks.

Can you talk about that opportunity and whether there's progress on that side or is still in development?

Rian Wren

If it’s the Chilean [ph] development– let me say this, A lot of what we're planning to do in laboratory has to do with this– literary dozens of companies out there that have some very innovative applications that could be hosted and interconnected to our network and could become synergistic or incremental to our core value of just transporting the call. And we're about to go off and test a number of those things. At the same time, as we have been describing (inaudible) that we built now is a very expansive fully interconnected soft switch holding media type capable network.

We've been looking at things we could do for our carriers that would be eyeing the connection. Mainly focus at the wireless world. And we are in the process of having concept meetings with a variety of the nation's wireless guys to look at and to discuss with them the extent of the interconnection that we have with their networks and everybody else's and the capabilities that can be driven off our platforms.

I won't say much more than that because that may result in nothing or it may result in some very interesting things that we may do. But we are in that stage now where we're going in our concept meetings to talk to these players. And it will be different types of people we meet with. With regards to integrating our networks and providing more services to them. We hope to be successful, we look t those things as postal nine [ph] some of those things could be tested earlier but what we do find is we have a number of different ways that we could grow into our carrier base and we're really into the mood [ph] to focus on the most efficient and the most probable of success for both ourselves and our customers.

Jonathan Ho – William Blair

Great. Thank you.

Operator

Thank you. And my next question comes from Mark DeRussy, please go ahead sir.

Mark DeRussy – Raymond James

Hi, good morning everybody. Nice quarter. Rian, I wondered if you could educate us a little bit more about the origination business, who are the customers, what's the business model, what would be the decision making process, who are the competitors, what is unique about your ability to provide that service, what do you guys bring to the table that differentiates you?

Rian Wren

Okay. That’s an interesting question because you're right because the originating side is a very different business than the terminating side.

Typically in the terminating side you have a carrier who wants to terminate the call to somebody and we facilitate that process. We get them to the endpoint and deliver that call to whoever they want terminated.

On the originating side, particularly–there's this number of services, but the one that fits, the largest is the 800 toll free call. Essentially, the people who sell 800 numbers are interchange carriers, the longest carriers with advanced networks who could basically deliver someone who dials the call into a business or enterprise. The way it typically happens is the originating carrier, whether it be wireless, cable carrier or CLECs, their subscriber dials the 800 number, and generally the practice has been the originating carrier doesn't – may or may not know, who owns, which interchange carrier owns that phone number that they have to deliver to.

Many cases they would just send that call to the local interchange carrier's tandem. So typically, that call would be routed to a tandem, and the tandem would do the identification of the carrier, it has a process to look at a data base and say "oh, this number is owned by xyz carrier" and they routed to them which all the ICs are connected to the tandems. If you think about it, we're a tandem, and we're all connected to those carriers who have other calls that need to get to, to the IC.

More recently, because of our terminating service business, we have been entering into direct interconnections between our networks and ICs. Those agreements have been negotiated in a two way fashion, not only can they terminate calls to us for terminating service, but we may pass to them traffic on the originating side. Now what's interesting about this is since the interchange carrier really doesn’t know where the 800 calls are coming from, in many cases, they would receive that call from an incumbent tandem.

Because it's an incumbent tandem those rates that the incumbent tandem would have charged the interchange carrier to deliver the call to them which generally regulated and being fair and reasonable. What has occurred over time is that there have been players in this industry who have inserted themselves between an originating carrier and the interchange carrier and convinced the people to route the calls to them and then what they do is they deliver it to the interchange carrier and that’s an interesting prospect on how they would do that. They might be charging that interchange carrier a significantly higher price than the incumbent tandem carrier.

And convincing the local originating carrier to send them that traffic by giving them a remittance for a credit for doing that. The person who loses out many cases is the interchange carrier who's just trying to receive the 800 call is now being charged higher. So that’s an interesting dynamic right now.

What we have done and our philosophy for the beginning of this company has to provide interconnection service at a fair and reasonable value. We do not look for regulatory faults, for ways to arbitrage situations. And as a result, the arrangements we have with the interchange carriers is to make sure that our rates are very consistent. If what they would have paid if they went to the normal process of a local tandem carrier.

They like that. They believe that’s fair and are working with us. We're trying to find a way, in a partnership way between ourselves and some interchange carriers to correct the situation that’s existed, where people have been inserting themselves and reaping benefits in that way.

So when you look at all that, that’s why we say it's in development, we're in a process of making sure we had direct connections , so that's an efficient connection to the exchange carrier.

Were making sure the contracts are viewed by this people as fair and competitive and then were trying to have conversation with the originating carriers to have them route traffic through us in a way that the industry is correct.

And so that gives you a little round now –maybe of the interchange carriers you could go into the industry, you could see that there are a lot of disputes because of this issue. There are a lot of law suits between interchange carriers and these middle people who have been passing the traffic to them. And that’s all – you go out and look, you'll see public cases where that goes on.

We're trying to clean up and to be an effective and a value provider to this service. And we think in the end, that’s the right way to grow your business.

Mark DeRussy – Raymond James

Ok. Sounds interesting at the very least. You've got the opportunity to save the ICs considerable dollars.

Rian Wren

Yes.

Mark DeRussy – Raymond James

Thanks

Operator

Thank you. And gentlemen there are no more questions at this time.

Richard Monto

Thank you very much. We're very pleased to be able to speak with you today, we look forward to the first quarter call and we wish everybody a great day.

Operator

Ladies and gentlemen, this concludes the Neutral Tandem fourth quarter earnings teleconference. If you would like to listen to a replay of today's conference call, please dial 1-800-405-2236 and use the conference id number 11125691. ACT would like to thank you for your participation, you may now disconnect.

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