Will Neutral Tandem Be Vindicated? Valuation Shows Limited Downside Risk

| About: Inteliquent, Inc. (IQNT)

The price of Neutral Tandem (NASDAQ:TNDM) drifted from over $30/share in mid-2009 to about $15/share currently. It was almost $19/share at the end of 2007, following its IPO on 11/07. Since the end of 2007 to 2010 estimated year end figures, revenues have grown to 2.3 times and EBIT to 3.4 times.

This article addresses an investment opportunity. It assesses the fundamental value of TNDM, particularly in view of its most recent, and major, strategic acquisition.

The metrics selected for analysis, particularly free cash flow, regard fundamental valuation.


TNDM provides voice, data and video interconnection services worldwide. On 10/1/2010 the company acquired Tinet, a global carrier exclusively committed to the IP Transit and Ethernet wholesale market. The acquisition combines TNDM’s interconnection services for wireless, wireline, cable and broadband companies with Tinet's global IP backbone.

Together with Tinet, TNDM expands from wholesale voice to wholesale data –to provide voice, IP Transit and Ethernet solutions to carriers, service providers, and content management firms worldwide. With 14 Ethernet Exchanges, the company is now the largest Ethernet Exchange provider in the U.S., a top 10 global IPv4 backbone provider and the number one IPv6 network worldwide.

TNDM’s traditional wholesale voice transit services are principally provided to competitive local exchange carriers (CLEC), including wireless, wireline, cable and broadband telephony companies. CLECs using the company’s services can route their traffic to other destinations (telephone numbers) that are reachable by the network without the need to establish direct switch-to-switch connections with competing incumbent local exchange carriers (ILEC). These are required by the Telecommunications Act of 1996 to provide tandem transit services to CLECs.

TNDM is compensated on a per-minute basis for traffic switched by its network.

TNDM, as a common carrier, benefits from its legal rights established by federal and state statutes to gain connection with ILECs and to request interconnection with CLECs for termination traffic to carriers that do not used TNDM. Generally cooperation is negotiated satisfactorily. However, refusal to accept traffic may disrupt TNDM’s ability to provide service.

Operational Risk

Carriers represent 97% of FYE 12/09 revenues; non-carriers account for 3%. At 2009 year end there were 99 carriers originating traffic and 116 carriers connected to the network. The top five customers amount to 64% of total annual revenues; the two largest, Sprint Nextel and AT&T, accounted for 23% and 14%, respectively.

Beyond the risk of concentration, the adoption of IP-based interface by carriers increases the risk of revenue loss when IP-based customers implement direct connections, which is less complex and more advantageous. Furthermore, there is an economic incentive for direct connection between carriers when their traffic volume becomes sufficiently large.

Contributing to business risk is the competitive landscape of competing ILECs and other service providers such as level 3 Communications, Peerless Network, and Hypercube.

Despite of many risk factors, including the secular loss of fixed lines to mobile wireless, and the market share loss of ILECs to CLECs, consistent growth in EBIT (see the table below) suggests that management has managed operational risk satisfactorily. Consistent EBIT growth supports consistent FCF growth, which in turn energizes fundamental value.

Rapid growth in market coverage (137 markets in the US as of 12/31/09) and gains in the business gained by CLECs, relative to ILECs supported consistent EBIT growth.


In 2/16/10 TNDM launched its Ethernet Exchange in the United States (see here - pdf).

On 6/3/10 Telx announced the joint effort with TNDM. From TNDM viewpoint the relationship “will enable us to create the largest Ethernet Exchange platform in the nation” (see here).

On 10/1/10 TNDM acquired Tinet, a global carrier exclusively committed to the IP Transit and Ethernet wholesale market (see here).

The rationale for these actions, and principally for the acquisition, rests on a major secular trend in global telecommunications: convergence of voice and data. Specifically, circuits in an IP network carry more traffic than on a traditional TDM network. It is economically advantageous to deliver calls over IP than TDM. TDM networks are robust, reliable, and time-proven to deliver clear sound. The cost is the complexity of the person-to-person circuit involved, and the lack of flexibility to adequately respond to the new needs of the mobile world.

In an IP environment the connection is to the network, from any device. VoIP allows the communication to align to the person-to-person requirement, rather than phone-to-phone.

TDM was designed with the specific bandwith to support only voice. IP provides greater broadband flexibility and delivers enhanced VoIP transmission quality with increased bandwith use effectiveness.

TNDM’s acquisition moves the company up in the technology curve and lessens pricing for volume. Further, business Ethernet is estimated to grow very rapidly over the next 10 – 12 years, in the range 12 to 14% per year.

The acquisition, by itself, does not guarantee success. Strategically, however, the combined entity gathers the attributes necessary to effectively respond to major trends in global telecommunications. It moves TNDM further into the right field for expansion and further technical development.

Beyond the appropriate investment decision, the acquisition puts a premium in management’s capacity to execute and turn opportunity into shareholder value. There are numerous cross-sell opportunities in Tinet’s data-minded client roster on one hand, and TNDM’s voice and Ethernet exchange products. Likewise, there are opportunities in bringing Tinet’s footprint to bear in Ethernet Exchange and voice.

The challenge lies in appropriately integrating processes, skills, and roles and accountabilities; and in modularizing an expanded product set into solutions that address the needs of (a larger market and) an expanded set of (prioritized) clients and prospects. A result-based reward incentive program for the combined entity and clear value driven objectives ought to go a long way in motivating performance for taking advantage of the opportunities at hand.

Performance Assessment

The table shows metrics relevant to the estimation of fundamental value, principally free cash flow (FCF).

  • FCF = Free Cash Flow = NOPAT - Net Investment in Operating Capital during the period
  • NOPAT = Net Operating Profits after Taxes = EBIT (1 – Tax Rate)
  • ROIC = Return on Invested Capital = NOPAT / Operating Capital
  • Operating Capital = NOWC (Net Op. Working Capital) + OLTA (Operating LT Assets)
  • Cash & Marketable Securities is shown net of debt.
Neutral Tandem Table --Selected Metrics
(Amounts in millions of US$, unless otherwise noted) FYE 12/06 FYE 12/07 FYE 12/08 FYE 12/09 4-Yr. Avg. (2006-09)
Revenues 52.87 85.55 120.9 168.91 107.06
Revenue Growth (y-o-y) 89% 62% 41% 40% 58%
EBIT 5.50 17.73 35.40 63.97 30.65
EBIT / Revenues 10% 21% 29% 38% 25%
EBIT Growth (y-o-y) 532% 222% 100% 81% 234%
Cash Flow from Ops. 4.66 24.14 35.15 56.40 30.09
CF f/Ops.Growth (y-o-y) nm 418% 46% 60% 175%
Free Cash Flow -2.5 13.06 21.13 41.81 18.38
FCF / Revenues -5% 15% 17% 25% 13%
FCF Growth (y-o-y) nm nm 62% 98% 80%
Cash (& Market.Secs.) 7.17 104.44 110.41 161.41
Cash Growth (y-o-y) nm 1357% 6% 46% 470%
# Shares 23.48 26.38 33.24 33.91
# Shares Growth (y-o-y) -2% 12% 26% 2% 10%
Q 9/09 Q 9/10 YTD 9/09 YTD 9/10 Change (y-o-y)
Revenues 44.69 46.54 124.18 136.04 10%
EBIT 17.29 13.31 47.77 40.65 -15%
Cash Flow from Ops. 19.07 17.25 45.35 46.50 3%
Free Cash Flow 15.56 13.07 34.60 34.28 -1%
Cash (& Market.Secs.) 158.67 204.83 158.67 204.83 29%
# Shares 34.18 33.51 33.85 33.62 -1%

Of particular interest is 3.2 times growth in Dollar revenues (from $52.87 million to $168.91 million) in three years, and 3.2 times growth ($13.06 million to $41.81 million) in two years. Such performance is enabled by a combination of requirements (NOWC and OLTA) that result in robust FCF generation; FCF / Operating Capital is recently running at more than 50%. Likewise, ROIC is currently running at more than 50%.

These measures have been achieved despite the large cash balances on the balance sheet, prior to the Tinet acquisition on 10-1-2010.

These growth figures support management’s view that there is room to grow in traditional voice telephony switching despite the secular loss of fixed lines to mobile wireless, and the market share loss of ILECs to CLECs. Management has been able to grow rapidly in the markets covered in the US and to pick up some of the business gained by the CLECs.

To be sure, the Tinet acquisition promotes a new and expanded value proposition; from wholesale voice into wholesale data. TNDM together with Tinet, hold a strong competitive position to provide voice, IP Transit and Ethernet solutions to carriers, service providers, and content management firms worldwide. The combined company is now the largest Ethernet Exchange provider in the U.S., a top 10 global IPv4 backbone provider and the number one IPv6 network worldwide.

The acquisition has been conservatively executed; costing less than half of $200 million in cash and marketable securities held by the company on 9/30/10.

Management has shown adept at achieving growth, delivering value metrics that create shareholder value, and in carrying out a strategic vision that appropriately positions the company for growth. This background sets the stage for execution in an expanded scale.

Fundamental Value

Fundamental value is conservatively estimated at $25.00/share. This is based on the formulas and assumptions shown below.

  • Enterprise Value = Present Value of FCF growing at g, discounted at WACC
  • g = FCF Growth Rate
  • WACC = Weighted Average Cost of Capital
  • Equity Value (Fundamental) = Enterprise Value + Cash – Debt
  • Share Fundamental Value = Equity Value / # Shares.


  • Base FCF is $41.81 million, g is 5%, and WACC is 11%.
  • Base FCF is based on FYE 12/09 FCF, taking into account YTD 9/10 FCF. It is a conservative figure based on actual performance and current opportunity.
  • Growth of FCF at 5% is also conservative in comparison with historical growth; particularly 62% in FYE 12/08 and 98% in FYE 12/09. Only marginal FCF growth, if any, is expected in FYE 12/10.
  • WACC is estimated conservatively at 11%. Persistence in growth, zero debt, and significant surplus cash on the balance sheet (estimated at $100 million after paying for the Tinet acquisition) would support a reduced WACC estimate.

The estimate represents over 60% gain from the current $15.40/share, stock price. Implicit in the conservative assumptions is the potential of a larger gain.

No credit for operating improvement due to the acquisition has been included in the assumptions. Keep in mind that the acquisition was financed by surplus cash. My figures show that the combined operation should substantially expand revenues (some 30%), and EBIT (between 15% and 25% absolute Dollar expansion). Note that EBIT feeds NOPAT which is the operational source of cash flow generation in the business.

Having said this, the context for the estimate is a medium term horizon. The challenging job in execution; integrating Tinet’s clients, resources, processes, and skills, is yet to be played. As it is generally the case, unexpected events will occur, one way or another, adding volatility to the trajectory estimated. The message: keep an eye on the stability and permanency of attributes supporting performance.


From this perspective the track record of performance is not fully reflected on the price of the stock. In fact, there is a significant opportunity in the discount of stock price to fundamental value.

Implicit in the fundamental value estimate is the opportunity for the combined company to execute business integration over a medium term horizon.

For the investor, listening to the music and ignoring intermittent market noise is a requirement. The company’s attributes supporting fundamental value provide the light to see the path to follow.

Supporting investment opportunity is a history of operational and financial performance, durable financial attributes supporting efficiency in the use of operating capital, recurring creation of shareholder value, conservative financial policy, evident core competence in telecommunications, and the vision behind the Tinet acquisition, and prospects of sustained secular growth.

A positive response to the title of this article requires widespread marketplace recognition and acceptance of the company’s performance, as it is, and of the opportunity it has constructed.

Divergences between fundamental value and market prices are part and parcel of market behavior. Rational expectations, fundamental valuation, and risk/benefit arbitrage, ought to advance the appreciation for the value attributes of Neutral Tandem, and in so doing provide the impetus for closing the price/value gap and for the vindication of performance the company has already earned.

The valuation as constructed, in my opinion, presents very limited downside investment risk in comparison with the upside in benefit.

Disclosure: I am long TNDM.