About a month ago, I read one of the most compelling investment cases I've ever come across on Seeking Alpha. The company was Neutral Tandem, Inc. (TNDM), and here is a link to the article. Unfortunately, I was slow in doing my due diligence and the stock ran up over 20%. But over the last couple of days, an unfavorable patent ruling and analyst downgrade sent TNDM back under $16, and I bought in. Let me outline why I think TNDM is still a great value/growth story, despite the patent ruling and downgrade.
For the big picture of why TNDM offers a rare growth-at-deep-discount opportunity, you won't do better than the thorough analysis provided in the recent article by Cale Smith at Islamorada Asset Management (link above). However, I'll do a short summary to whet your appetite.
Neutral Tandem's network provides interconnection services between various wireless, wireline, cable, and broadband telephony companies. As the first, and by far the largest, provider of this service, the network effect (or Metcalfe's law) provides TNDM with a strong competitive advantage against newer competitors.
From a valuation perspective, at today's price, TNDM has a market cap of $537 million. Subtract out the $161 million in cash on the balance sheet (TNDM is debt-free) and you've got an enterprise value of $386 million. Compare that to their earnings of $41.3 million in 2009 and you've got an EV/earnings ratio of 9.3. (Free cash flow for 2009 was $38.3 million) How are they doing for growth? From '08 to '09 revenues grew from $121 to $169 million (40%) and earnings went from $24 to $41 million (72% growth).
For this year, management projects revenues of $185-200 million, representing top line growth of 9-18%. And these revenue projections exclude any possible contribution from the ethernet exchange business TNDM recently entered.
If that seems like a promising investment premise, let's consider how the unfavorable patent ruling changes things. TNDM had sued their competitor, Peerless Networks, for infringement of this patent, basically seeking for Peerless to seek competing with them and pay them damages. Yesterday (according to Peerless) the U.S. Patent and Trademark Office rejected all 23 claims in the patent, which would seem to leave TNDM more susceptible to competition and reduced profits. That's certainly the interpretation behind today's downgrade.
I disagree that this ruling significantly changes TNDM's competitive landscape. If you look at the patent, the claims seem extremely flimsy. I'm not a patent attorney, but I've been involved in the preparation of a number of patents as an inventor. For an invention to be patentable, it must be novel, non-obvious and useful. And the non-obvious requirement precludes inventions that simply combine existing technologies.
So let's look at TNDM's patent in light of these requirements. The patent basically claims the use of existing networking technologies to create a network to pass traffic between different phone call telecommunications networks. I doubt it qualifies as novel, but it's very difficult to see how this patent could have overcome challenges to its obviousness.
Why would TNDM have filed the patent then? I can't say for sure, but it seems likely that it was a filing by a young company trying to impress investors. I doubt it was seriously intended to protect against competition. TNDM states in their filings that patents are not a major part of their intellectual property strategy:
Our success is dependent in part upon our proprietary technology. We rely principally upon trade secret and copyright law to protect our technology, including our software, network design, and subject matter expertise. We enter into confidentiality or license agreements with our employees, distributors, customers and potential customers and limit access to and distribution of our software, documentation and other proprietary information. We believe, however, that because of the rapid pace of technological change in the communications industry, the legal protections for our services are less significant factors in our success than the knowledge, ability and experience of our employees and the timeliness and quality of our services.
Then why might they have filed suit against Peerless? Again, this would seem to be a legal action aimed at investors. TNDM may simply have been trying to scare off the investors of Peerless to make it harder for them to raise funds to build a competing network.
This hypothesis seems to be borne out by the fact that TNDM did not file a similar suit against Level 3 Communications (LVLT). LVLT competes in the same market, but it's not their main business and they wouldn't need to raise funds to build their network, so suing them didn't serve the same (superficial) purpose.
So I would argue that TNDM's business is in the same position today as it was last week. There are a couple of competitors (Level 3 and Peerless) trying to catch up as TNDM continues to grow its dominant position. Peerless and Level 3 have been working to take market share from TNDM for several years, and that hasn't stopped TNDM from growing their revenues 62% in '07, 41% in '08 and 40 % in '09.
It's true that their rate of growth is slowing somewhat, but their profits are growing much faster than revenues, and at today's price TNDM doesn't need to grow at all to be very profitable for its investors.
Disclosure: Author holds a long position in TNDM at $16.