Neutral Tandem: Suffering from a Supply/Demand Imbalance

One of the few successful IPO stocks from late in 2007 is Neutral Tandem Inc (TNDM). The company is a telecom technology firm that essentially facilitates the connection between carriers. The company offers an alternative to the traditional ILEC tandem services and it operates in specific geographic markets. Revenue is earned through the number of minutes the carrier actually uses as it connects calls through Neutral Tandem’s infrastructure.

Management has laid out a three part initiative to drive growth over the next several years:

1. Broaden geographic presence: As the company increases the number of geographic markets it operates in, the number of potential connections expands geometrically. If a company has a base of 20 geographic markets and it adds just one more market, this one addition represents 20 possible connections between markets and hundreds of thousands of individual lines. TNDM entered an additional 30 markets in 2007 which brings the total to 64.
2. Expand customer base: Neutral Tandem serves large and small carriers. Similar to the number of geographical markets, each additional customer that TNDM acquires represents a significant increase in the number of potential connections. Most recently, the company signed an agreement with Verizon Wireless (VZ), giving Tandem access to a large number of VZ’s wireless lines. The contract will begin to add revenue in 2008 but will not be fully integrated until the end of the year or early 2009. Additional customers like VZ push incremental revenue higher and make future earnings much easier to estimate.

3. Grow volume of minutes: Since the company actually bills for the number of minutes between carriers, it needs to offer high quality service and have a strong reliable technology platform. TNDM grew its minutes 66% in 2007 to a total of 41 billion and is guiding further increases to 56-58 billion minutes in 2008.

Since pricing its IPO in November, the balance sheet has remained very healthy. The company has over $100 million in unrestricted cash and very little long-term debt. Capital expenditures will continue to be high as the company expands into 25 new markets in 2008. However, management has affirmed that 2008 will likely be the peak of capital expenditures with roughly $23-25 being spent to roll out the platform and technology necessary to serve these markets. While there will still be significant spending in 2009, the growth should begin to level out, allowing more of the incremental revenue to flow to the profit line.

TNDM shares have most recently been weak as a number of private investors filed to sell a block of 4.5 million shares. The deal was announced early last week and shares traded lower until the stock actually sold for $18 on Friday morning. This kind of transaction is typical of small companies a few months after their IPOs. In fact, the stock may have been held back over the last 5 months as investors expected this type of transaction to eventually happen. Since the transaction took place at a price well above the $14 IPO price, original investors are still up on their purchase.

As the market soaks up the additional supply, the potential for the stock to trade higher is very good. Fundamentally the company continues to execute on its growth strategy and is finding success in rolling out new markets. Technically, the stock is still trading in a healthy pattern above the IPO price. Supply imbalances have offered investors an opportunity to purchase at a discount and the supply should quickly be absorbed, allowing the stock to resume trading on fundamental measures.

Disclosure: Author has a long position in TNDM.