Neutral Tandem, Inc. Q1 2008 Earnings Call Transcript

May.19.08 | About: Inteliquent, Inc. (IQNT)

Neutral Tandem, Inc. (NASDAQ:TNDM)

Q1 2008 Earnings Call

May 6, 2008 10:00 am ET

Executives

Richard Monto – General Counsel & Corporate Secretary

Rian J. Wren – President, Chief Executive Officer & Director

Robert M. Junkroski – Chief Financial Officer & Executive Vice President

Analysts

John Marchetti – Morgan Stanley

John Bright – Avondale Partners, LLC

Jeff Rosenberg – William Blair & Company, LLC

Timothy Horan – Oppenheimer & Company

Mark DeRussy – Raymond James & Associates

William Power – Robert W. Baird

Shane Larkin for James Breen – Thomas Weisel Partners

Operator

Good morning ladies and gentlemen. Thank you so much for standing by. Welcome to the Neutral Tandem first quarter earnings conference call. During today’s presentation all parties will be in a listen only mode. Following the presentation the conference will be opened for questions. (Operator Instructions) As a reminder this conference is being recorded today, Tuesday, the 6th of May, 2008. I’ll now turn the conference over to Mr. Richard Monto, General Counsel for Neutral Tandem.

Richard Monto

Welcome to the Neutral Tandem first quarter 2008 earnings conference call. In our remarks today we will include statements which 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 these 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 statements.

In our remarks today we also refer to non-GAAP financial measures which we believe in combination with GAAP results provided 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 & CEO.

Rian J. Wren

I’d like to thank all of you for joining our first quarter 2008 earnings call. As you will note from this morning’s release, we are pleased with the strong financial results for this quarter. Furthermore, we are excited about the progress we continue to make towards our long term objective of being the tandem provider of choice for competitive carriers. We reported another record quarter with $26.2 million in revenue which reflects a 48.9% increase over the first quarter of 2007. This resulted in strong profitability as our net income grew to $4 million during the quarter which is a substantial increase over the $1.7 million we earned in the year ago period. Rob Junkroski, Neutral Tandem’s CFO will provide additional detail on the financial results in his portion of the call.

Despite a challenging macroeconomic environment we continue to benefit from our core strategy. We believe that our network provides a more efficient and cost effective solution for our customers and that our market reach extent of interconnections and customer profiles positions us to operate successfully throughout a wide range of economic environments. We believe that the strong results we reported this quarter reflect the consistent and successful execution of our three strategic growth initiatives which are broadening our geographic presence, expanding our interconnections with new and existing customers, and increasing types of traffic across our network.

Our geographical presence continues to grow. This past quarter we successfully commenced operations in seven new markets bringing the total number of operational markets to 71. As of March 31, 2008 this will increase our addressable footprint in these markets to approximately 478 million numbers assigned to carriers. Our customers can terminate traffic to approximately 298 million of these numbers. Our plans for the remainder of 2008 include the addition of 18 new markets bringing our projected total markets served to 89. These new markets will increase our addressable footprint to approximately 543 million numbers assigned to carriers.

Another important component in our growth strategy is expanding the number of interconnections with have with both perspective and current customers. We believe that the value of our service offering increases with the number of customers connected to our network. As a result of our network affect, with each additional customer added we received incremental revenue not only from the traffic originated by that customer but also from existing customers that terminate traffic to the new customers. Ultimately, this network affect helps fuel operational and financial growth and enhances our value to our customers.

Although we do not typically provide commentary on individual agreements, I would like to note that we have begun implementing direct connections with Verizon Wireless in many of the markets we serve. This is a substantial implementation project that involves increasing capacity to augment facilities between us and our existing customers who originate traffic to Verizon Wireless and establishing new capacity between us and Verizon Wireless to terminate this traffic. In regards to timing, we continue to feel comfortable with our previous forecast as we expect the implementation of this agreement to take much of 2008 with the full impact of increased traffic not to be realized until 2009.

In addition, we are also working to increase the types of traffic we interconnect and carry over our network while we remain focused on our core local transit tandem business, we are cautiously optimistic that we can increase minutes transited across the Neutral Tandem network by developing our tandem switch access business. The minutes associated with this service are similar to our core business in that we continue to perform a tandem function however, the calls supported are long distance in nature versus local. We market our tandem switch access service to interexchange carriers and have entered in to contracts with several customers. While we are currently delivering a relatively small amount of traffic, we hope to develop these relations over the next several quarters and grow this opportunity with new and existing customers.

Finally, I would like to update you on our investments and progress towards deploying an advanced technology platform. Over the last two years we have made significant investments in soft switch technology that will offer our customers a state of the art platform for their tandem service needs. We believe that these investments position the company in the short term to increase the scalability of our networks to reduce costs for operations and greater capital efficiency. Along these same lines our recent deployment of dedicated signaling assets has provided us further cost efficiencies and greater flexibility with our signaling capabilities. In the long term we believe our national network using our next generation technology positions the company to asset our customers as they upgrade their network for IP interconnectivity. Neutral Tandem is investing in the technology and architecture of the future to maintain our status as the independent tandem provider of choice for the fast growing competitive carriers.

As 2008 takes shape we continue to see favorable industry trends for our business particularly the continued increase in wireless and cable subscriptions helped by the accelerating movement of subscribers from [ILEC] landline services through competitive carrier. As we become more integrated in to our customers’ networks we have been able to prioritize our market launches based on their interconnection needs. This enables us to more accurately plan traffic volumes and increase speed to revenue since many of our existing customers will use us in the new markets we open. We also believe that the scalability of our business model and a momentum we have generated has helped us create a position on which we’ll be able to grow our core tandem services business.

In closing, we are pleased with our results for the first quarter of 2008. Our core business remains strong and we continue to make steady progress implementing the network facilities for our customers to terminate traffic to Verizon Wireless. Ultimately, we believe we are well positioned to capitalize on our strategic initiatives and drive growth and profitability going forward.

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

Robert M. Junkroski

As Rian mentioned, we are very pleased with the achievements made during the first quarter of 2008. Turning to our results, our first quarter 2008 revenue was $26.2 million compared with $17.6 million in the first quarter of 2007 an increase of 48.9%. In the first quarter of 2008 we transited 12.9 billion minutes across the network up from 8.6 billion minutes in the first quarter of 2007 an increase of 50%.

Turning to expenses, our network and facilities expense which is the operations expense associated with transiting calls through our network was $9.1 million in the first quarter of 208 compared to $6.3 million for the first 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 served. Combined operating expenses consisting of operations, sales and marketing and general and administrative expenses came to $7.6 million during the first quarter of 2008 up from $5.7 million during the first quarter of 2007. The increase was primarily due to higher employee expenses including additional headcount required to grow the business.

Adjusted EBITDA, a non-GAAP financial measure was $9.2 million for the first quarter of 2008 compared to $5.8 million for the first quarter of 2007. Depreciation and amortization increased by approximately $600,000 from $2.7 million in the first quarter of 2007 to $3.3 million in the first quarter of 2008. Our operating margins in the first quarter of 2008 were 23.7% compared to 16.5% in the first quarter of 2007 reflecting the company’s ability to increase revenues while decreasing costs as a percentage of revenues. Pre-tax income was $6.3 million for the first quarter of 2008 compared to pre-tax income of $2.6 million for the first quarter of 2007. Included in pre-tax income is $600,000 of operating costs related to the secondary offering completed on April 2, 2008. Our income tax expense for the first quarter of 2008 was $2.2 million compared to an income tax expense of $900,000 the first quarter of 2007. Our effective tax rate for both periods was approximately 36%. Net income for the first quarter of 2008 was $4 million or $0.12 per diluted share compared to net income of $1.7 million or $0.07 per diluted share for the first quarter of 2007.

Looking at our current financial condition, our balance sheet as of March 31, 2008 is showing approximately $172 million in total assets up from $166 million at December 31, 2007. Our total long term debt which includes both current and long term amounts is $6.3 million. Our total stockholders’ equity as of March 31, 2008 is $149.6 million while our cash and cash equivalents are $96 million and our share count is approximately 31.4 million shares. During the quarter ended March 31, 2008 we reclassified $25.2 million in auction rate securities from cash and cash equivalents to investments and other assets.

Moving on to one additional item from the first quarter that I would like to discuss. On March 27th we announced the pricing of our secondary offering of 4.5 million shares of common stock at a price of $18 per share. While we did incur incremental one-time costs associated with this offering of $600,000 which is included in other expenses we are pleased with the increased float and new institutional shareholders that has resulted from the secondary.

Now, I’d like to review our outlook for 2008. Based on our actual results for the first quarter and our current belief about minute based revenue trends, expenses, the competitive environment, we affirm our prior outlook and continue to estimate that revenue for the full year of 2008 will be between $112 and $116 million. Adjusted EBITDA, a non-GAAP financial measure for the full year of 2008 will be between $39 million and $41 million. Adjusted EBITDA will exclude the non-cash charge for the change in fair value of warrants and non-cash share based employee compensation. Billed minutes for the full year 2008 will be between 56 billion and 58 billion minutes. Cap ex for the full year 2008 is expected to be between $23 and $25 million. And, we will commence operations in 25 new markets in 2008.

We remain excited by the opportunities we see for our company as we continue to expand our core business as well as foster new opportunities. 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.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of John Marchetti – Morgan Stanley.

John Marchetti – Morgan Stanley

A couple of quick question if I might, first off I just wanted to come back to your comment about the tougher macroeconomic environment and just where you guys are feeling that in your business. You talked obviously about strong subscriber trends in both wireless and cable and what you’re seeing on the minutes of use side and your expansion still seems to be very much on track. So, where are you guys sort of feeling this tighter economic environment? Are you seeing carriers in terms of what they’re doing with you either come back to you for different pricing? Obviously, you’ve always been pretty attractive there, just if you could help me understand that a little bit? Then secondly, on the Verizon Wireless stuff, what are your expectations maybe not this year but as you get in to 09 that that agreement might turn in to more than just for your existing customers being able to terminate traffic with Verizon?

Rian J. Wren

With the first question on the macroeconomic environment, I don’t think we were intending to say that we were experiencing an impact on that. In fact, I think the comment was more to the contrary that despite a lot of the news today about the volatility in the economic environment and I guess I’d reflect back on the first quarter in total. We don’t seen an impact in our growth and as a result, I think our growth for first quarter was a tidbit stronger than we had expected. I think the aspect of the environment is more in line with the fact that we continue to see great opportunity for our business and I think it’s mainly because of the underlying growth trend which is the continued acceleration of [ILEC] land line loss to the customer sets that we serve. The most recent first quarter announcements from the large incumbent carriers displayed again that their line losses have accelerated even further in to our market space.

On Verizon Wireless, the only thing that I could say there John is that when we spoke last in February with regards to the fourth quarter and end of year results, we were just starting to get our feet on the ground trying to implement our agreement with Verizon Wireless. At that point we were quite cautious because we weren’t quite sure how the two companies would work together. Today, I think we can say having several months now under our feet we feel very, very comfortable and we are pleased with the working relationship that’s been developed between the companies. So, I would venture to say that our relationship with regards to how we are operating together has been very satisfying for us from Neutral Tandem’s perspective. As a result, we’ve been making progress on those implementations slightly ahead of schedule with regards to what we had planned so we hope that turns in to the relationship not unlike most of the other interactions that we have at our carriers that once we interconnect and we develop our relationship around passing traffic that Verizon Wireless may perhaps choose in the future to use us also as a competitive trans provider in markets that they don’t have their own facilities. But, as of this point in time, we’ll still work with them on the terminating side.

Operator

Our next question is from the line of John Bright – Avondale Partners, LLC.

John Bright – Avondale Partners, LLC

Rian, scalability of your model, what structural barriers exist for the scalability of your model looking forward?

Rian J. Wren

I don’t foresee any structural barriers per say. I think we’ve been demonstrating the actual scalability with the regards to the ability to bring on revenue and do it as Rob had mentioned at continually decreasing costs and I think that is directionally proportional to the fact that a large proportion of our operating expense is operations people. The model is highly scalable from the standpoint that it’s only the major switched based markets where a technician or two are deployed. The entire provisioning, customer service and routing organization that exists in Chicago is incrementally increased only over a large portions of growth. So, from a people standpoint we continue to scale quite nicely. We also scale with regards to other aspects purchasing power. So, our purchasing power in regards to transport services which is the largest component of our direct costs continues to increase and we continue to enjoy a fairly robust marketplace with regards to competitive alternatives in transport services. Lastly, the ability to purchase technology, we’ve become a fairly significant purchaser as I mentioned, of soft switch technology and so we’ve been able to I think now renegotiate contracts. I think we’re on our third turn in that respect.

So, there’s nothing that I see with regards to stopping that continuation with regards to increasing traffic and continuing to reduce costs and as we hit the strive, the major implementation we have going on with Verizon Wireless we will accomplish the vast majority of that implementation and not have to directly add people at all with regard to that implementation. So, it’s been a real benefit of the business and the model structure of the business that we continue to look forward too.

John Bright – Avondale Partners, LLC

What expectation for Verizon do you have built in to guidance for 08 out of region?

Rian J. Wren

I’m not quite sure of the question when you say out of region.

John Bright – Avondale Partners, LLC

Well, if they start using your facilities outside of their region?

Rian J. Wren

We have none built in to the forecast at this point in time.

John Bright – Avondale Partners, LLC

For 2008?

Rian J. Wren

Correct.

John Bright – Avondale Partners, LLC

Two additional questions, one you mentioned in your prepared remarks the tandem switch access service, anything you can do to shape the cost and maybe the opportunity size associated with that and how much you might also have in your guidance in 08?

Rian J. Wren

With regards to the costs I think yes, as I mentioned to you the service that we perform there functionally from our standpoint is equivalent to local transit service, it’s a tangent switching service. The difference is the traffic that is actually being switched through our tandems is different jurisdictionally, it’s coming from our inter exchange carriers so it’s different customers that we’re talking to now. And, they’re traffic is usually coming from out-of-state and terminating in state. There is some in state but it’s generally out-of-state coming in state and we perform the same function. So, our cost structure is fundamentally the same and again, we can enjoy the leverage on that.

The pricing structure is a little different because it’s basically pricing off the legacy access rate structure that existed and is regulated by both the state and federal regulators. I think from a sizing standpoint and I believe it was John that asked the question, we’re still working on that. It’s fairly complex, a little bit more complex if you can believe it than the transit side. So, we aren’t in any position to describe sizing and we’re still developing our relationships with these accounts. I think the news today is as we had mentioned the work that we would do in our last call, today we talked that we do have several signed contractual relationships on the service and we are processing traffic from each of those carriers. Small as it may be, it’s in the stages of beginning to test out now and production mode with those carriers, the actual termination and this is not unlike the process you would go through introducing a new product with new customers. We’re pleased with the progress we have to date on that. We have built some expectation in to the guidance that we provided but, at this point in time not a significant amount.

John Bright – Avondale Partners, LLC

Two final ones quickly one, the speculation and rumors that exist about Deutsche Telecom buying Sprint, can you talk to what is the potential impact for Neutral Tandem? What size were Sprint and T-Mobile respectively as far as customers in the quarter?

Rian J. Wren

You’re asking the question what is the size of Sprint and T-Mobile?

John Bright – Avondale Partners, LLC

What was the size of the two of them as customers for Neutral Tandem in the quarter?

Rian J. Wren

I think we have reported that Sprint is a 25%, 26% customers because of its previous acquisition of Nextel. I don’t have in front of me the T-Mobile, I don’t know Rob if we’ve ever reported that?

Robert M. Junkroski

It’s one of our top 10 customers, it’s about 14%. T-Mobile is about 14% and Sprint is about 26% of our traffic.

John Bright – Avondale Partners, LLC

Then Rob lastly, two cleanups one headcount and it looked like to me at least in my models a slightly lower tax rate anything notable there?

Robert M. Junkroski

No. Headcount is approximately 125 or 126 as of the end of the quarter. And, nothing notable on the tax rate, I think we’re a full tax payer now so nothing out of the ordinary on the taxes, it just came in a little bit lower.

Operator

Our next question is from the line of Jeff Rosenberg – William Blair & Company, LLC.

Jeff Rosenberg – William Blair & Company, LLC

I wanted to ask a follow up on the T-Mobile/Sprint question. How much of the traffic is between the two of them, isn’t that the most relevant question in terms of what if down the road what the potential impact would be is how much traffic you’re currently connecting between them?

Rian J. Wren

I mean, that’s a relevant question and I think in the last day or so we took a look at somewhere in the mid single digits of a percent of the traffic we handle is between those two accounts.

Jeff Rosenberg – William Blair & Company, LLC

Then, back to the long distance information you’re giving us, can you talk a little bit about the competitive environment and how that differs from obviously we’re familiar with the competitive environment in your local transit market. What’s it look like in the long distance?

Rian J. Wren

It’s interesting because when you think about what we’re providing is we’re really providing the tandem function of the completion of an interexchange call. So again, it’s monopoly based service, the only people who provide that tandem switch function predominately are the incumbent telephone companies so the competitive environment is almost a mirror image of the local transit environment. Understand, we’re not providing a long distance service here, it is long distance carriers for instance like, let me just pick one, like AT&T who may be taking a call from Los Angeles to New York and it’s terminating to a non-affiliated carrier, let’s say it’s a Sprint Wireless carrier in Manhattan. AT&T will bring that call all the way to Manhattan and typically what they do is they hand it to Verizon, to the tandem and they switch it down to the end office of Sprint. In the process of doing that Verizon charges AT&T a terminating switched access fee. That’s what we’re competing with, is now that call can come to Neutral Tandem and we can switch it down to a variety of carriers.

Just to be clear, we’re not providing a long distance service which would be in a much more competitive intense environment because there are alternatives out there for [inaudible] transport. We’re providing a terminating switch access piece to that which heretofore has been a complete monopoly provided by the incumbent telephone companies. So, very similar to our environment that we have for local.

Jeff Rosenberg – William Blair & Company, LLC

Although, it seems like you were implying that the rates there are lower even though it’s still a monopoly offering and I assume it doesn’t have the same regulatory environment that your local tandem rates do. Can you talk a little bit about that?

Rian J. Wren

Yes, the rates are freely set. So, because its monopoly based service that tel companies can’t raise or lower those rates independently they have to get either approval by either the FCC if they’re an interstate rate or the individual state commission if they’re intrastate long distance call. Those rates are set, I mean the rate for the interstate is fairly common across the country since it is set by a central regulator and it’s not competitive from that standpoint. The competitive component would be how many choices do you to go switch the call and today it’s basically one through the Bell companies and that rate is set descriptively by the regulators.

Jeff Rosenberg – William Blair & Company, LLC

And that rate is lower than you typically see in the local situation?

Rian J. Wren

It varies. On interstate basis it’s pretty consistent. That’s one of the things we’ve been working on to see if we can market it at a rate that is consistent with our existing revenue. To date, that’s kind of where we’ve been. On a state basis, that rate varies all over the place because each state sets its own rate so it’s not unlike transit other than the fact that on the interstate basis the FCC has set it and I don’t off the top of my head know their exact rate but it’s allowed us to market it at a less of a discount but still at a consistent [RPOO] that we have.

Jeff Rosenberg – William Blair & Company, LLC

The last question I was going to ask you is can you just give us any sort of update on the trends you’re seeing in direct connects amongst your customers? I don’t know how real time you can measure that headwind that you’re seeing on a quarter-by-quarter basis but any kind of commentary there on whether there’s more or less of that going on than prior periods?

Rian J. Wren

Again, our answer here you tend to be unsatisfied because as I said it’s not a disconnect function where we can see it being disconnected, it’s traffic moving that you may or may not be able to see. We have not seen any pick up or reduction in that trend, I think it’s an intrinsic part of the business but we haven’t seen any areas where it has alarmed us.

Operator

Our next question comes from the line of Timothy Horan – Oppenheimer & Company.

Timothy Horan – Oppenheimer & Company

Rian, I think what you’re saying on the long distance tandem side on an interstate basis anyway you could probably get similar [RPOOs] as what you’re experiencing now. Do you have a degree of confidence around that at this point?

Rian J. Wren

I think the receptivity to it has been pretty strong because people have not had a choice to do it. The development of the product is a little more complex because typically – well, first of all it’s a different set of customers and they’re limited in scope. You could probably name the top seven or eight carriers, you could name the top carriers on your two hands. It’s not like the local exchange business where you might have 100 potential customers, you’ll probably have somewhat around 10. But, they are large and they have huge volumes and because the volumes are large and it’s been a captive audience they have built a lot more direct connections down to the end offices to try and bypass the tandems, we already have the traffic. The second challenge we have is because it’s interexchange and jurisdictionally long distance. We have to secure the rights to terminate this traffic to our interconnecting carriers.

We truly are blazing new ground here. There never was a neutral tandem prior to the company being established and as a result the interconnection laws have been designed around the incumbent carriers. So, we’re working our way in to that provider competitive service but we’re developing on the customer side a service that, as I mentioned here, has been received quite well and we’re trying to determine whether the value we can provide them is consistent with the economics we want to drive from a company standpoint. Then secondly, the big component is increasing the amount of minutes we can terminate by securing the rights to terminate this type of traffic to our interconnected carriers.

Timothy Horan – Oppenheimer & Company

I guess to that point no one has ever really provided this service before so on the pricing basis it hasn’t really been looked at by the regulators. Are there existing price lists that are out there on the interstate basis? Has anyone ever used them before?

Rian J. Wren

If I understand your question Tim, the pricing is fairly transparent. The FCC sets the interstate terminating access rate.

Timothy Horan – Oppenheimer & Company

I meant the tandem component of that.

Rian J. Wren

That’s a component of it so when they set the whole rate both the tandem and the office piece are set. It’s inclusive of that. On the state, same thing although that varies much more greatly. And, we do have to, even though it’s a choice, customers do demand a savings component to the service so we do have to under price the existing incumbent rates. I think the upside trend for the company is as more and more regulators begin to realize the extent of the competition in both the transit and access market, I think the longer term trend which will be consistent with carrier compensation reform that’s occurring now at the FCC is that some of these services may in fact become deregulated and will become much more market based pricing and flexibility on the [ILECs] will become a little bit greater. Now, that’s going to occur over a couple of years here but I think the emergence of companies like Neutral Tandem and the emergence of competitive alternative services for carriers in transit and tandem do lead down the path of deregulation.

Timothy Horan – Oppenheimer & Company

Just one more big question and one more little detailed one but it seems like the incumbents actually have to find losses have accelerated a little bit this quarter. You probably have more insight to this one than anyone. Do you see any particular segment gaining share or taking more of that share versus trends you’ve seen over the last year? Is wireless taking more share? Is it cable companies or [inaudible]?

Rian J. Wren

Well, the CLEC component is almost exclusively focused on the enterprise, on small business, small medium sized businesses. We have seen the cable industry accelerate their success. I think the most recent announcement by Comcast, they had a very good quarter and they continued to accelerate, not decelerate the share gain from the incumbent. So, even in our business we’ve seen the percentage of traffic begin to shift, as we’ve been saying it would, where the cable companies are growing as a percent of traffic for us. I think they’re close to 20% now of our business and wireless continues to grow. I think we’re seeing a shift where our business is becoming heavily weighted between wireless and cable.

Timothy Horan – Oppenheimer & Company

The rate incumbents gain market share does that not increase exponentially the amount of traffic companies can terminate between one to the other? Are you seeing that trend even though they’re gaining linear market share but it’s increasing exponentially traffic they can terminate from to one another?

Rian J. Wren

That’s correct. I think you’re talking about the network effect. The fact that our customer base continues to gain share that means we can originate and terminate more calls for them. It is a very nice effect. So, when a cable company takes on an extra 100 customers, those 100 customers can then send traffic to us through all the other existing carriers we connect to but those existing carriers now have 100 more termination points where they can send traffic to us where they use to send to the Bell Company so it is a two way impact.

Timothy Horan – Oppenheimer & Company

Lastly, I might have missed it, on the margin front any reason why EBITDA margins would trend down from here for the remainder of the year or in to next year? They seem to be kind of consistently trending up. I just didn’t know if there was anything this year?

Rian J. Wren

I’ll let Rob answer in a second but I think from my perspective I don’t believe so. We don’t see increasing costs. I think in the second quarter we will see a little bit more of the impact of the prep work that we’ve done for Verizon Wireless. I think the good news today is, and I don’t know if we’ve actually been called out on it but we actually have been, we continue to say that we are very comfortable with the forecast that we had given on the impact of Verizon Wireless. We are today though a little ahead of schedule and we are actually beginning to process and route traffic to Verizon Wireless and that’s a few months ahead of what we had hoped to do. I bring that up because we have put in place a significant amount of transport infrastructure to accelerate the implementation and a key component of that was making sure that we get the revenue on top of that and we actually are starting to make progress. Small at this point in time but still ahead of what we had hoped to do.

Operator

Our next question comes from the line of Mark DeRussy – Raymond James & Associates.

Mark DeRussy – Raymond James & Associates

A quick follow up to that last question about the margin, Rob are we going to see some gross margin pressure sequentially the next quarter or two because of this Verizon build out and because of you’re adding more markets? Can you maybe clarify that a little bit?

Robert M. Junkroski

I wouldn’t say it’s going to be downward pressure but it will mute any expansion in the next quarter.

Mark DeRussy – Raymond James & Associates

Then getting back to the switched access issue, could you talk a little bit about this opportunity in terms of the size of this market? I know a lot of people I talk to when they think about Neutral Tandem they’re trying to understand what your growth prospects are a couple of years down the road and obviously adding new revenues, new services is going to help sort of extend your growth rate. Is this a market that’s the same size as your local interconnect? Is it 10% of the size? Could you kind of give us some sort of ballpark figures?

Rian J. Wren

I can give you some qualitative discussion on it and some ballpark figures because as I mentioned we are still trying to work on it ourselves. In generally, I think roughly you could say it’s at least probably close to 30% of the size of the local transit business. The reason I say that is because the long distance calling is probably about 30% of all calling and 70% is local in nature, rough numbers. The work that we’re working through here Mark is this marketplace has been fairly competitive for quite some time. I mean, you have the AT&Ts, the Quest, the Global Crossings, the [XOs], a number of people who have both a retail offering in long distance and a wholesale offering to all the resellers. As a result of that, it’s been fairly competitive, they’ve been trying to reduce their costs structures and that’s why I had mentioned that typically when they terminate large amounts of traffic in to a state they will come to the tandems and then fan out from the tandems to connect to the end offices and ultimately the subscribers. Because of the costs pressures many of them have been optimizing their interconnection networks by directly connecting down to the high volume city based end offices.

So, of that 30% it will be some amount that’s already been captured through people self provisioning down to the end office. There’s that component of slicing that market and then for us, our true success will be determining how many of our existing interconnecting carriers we can strike arrangements with that allow us to terminate that traffic. The reason is that unlike local transit traffic, access traffic is in fact a fairly significant revenue stream for terminating carriers. The terminating carrier charges the interexchange carrier for end office terminations and the tandem provider charges the interexchange carrier for tandem terminating arrangements. The tandem piece is what we compete with, not the end office piece so there’s a little more development where we have to make sure that there’s an agreement for the terminating carrier to receive the traffic through us versus the incumbent even though they receive the traffic anyway, that their revenue stream will have integrity and be able to continue to process through the records, etc. that we give them.

To the extent that we’re successful in doing that, which we have been to a certain point and that our product produces enough value either in price or quality for these major interexchange carriers to want to choose us, we can get a decent piece of that marketplace. So, we do view it as two things, one is we don’t see it very different than being a tandem provider. The cost structure looks the same to us, the minutes look the same to us, it’s a different type of minute and we do believe that the market will move over the next two or three years to a minute is a minute independent of where it’s coming from or where it’s going and that’s why we’ve been trying to manage it as such. We don’t see it has very different than what we do today but we do believe it will be an ability for us to extend our growth beyond local which continues to grow robustly and continues to keep us focused probably 90% of our energy in that area in terms of operations. I think what I’m saying is it’s the next step in a fairly large and expanding tandem service business and we call that our core.

Mark DeRussy – Raymond James & Associates

Then I guess the following to that is we’re talking about incremental growth opportunities, you’ve got $90 million of cash on the balance sheet. Any update as to your thoughts there and putting that to use?

Rian J. Wren

Well, we continue to use our cash for expansion of our existing core business although it’s become cash flow positive at this time. We are developing and looking at developing capabilities to look at growth and expansion beyond the core business, we are starting to do that. At this point in time, and acquisition could be a part of that, at this point in time we have none in the planning stages or discussion stages. We are beginning to look at areas of business that are adjacent to what we do that may be attractive in terms of growth opportunities down in the future. But, at this point in time we really want to continue the expansion across the country as a tandem provider, solidify that position, solidify the interconnection with everybody and then begin to look at how we can leverage that in to adjacent or fairly consistent services that may be organic and may not.

Operator

Our next question comes from the line of William Power – Robert W. Baird.

William Power – Robert W. Baird

I guess two question, first I wonder if you could help us either size or frame the potential impact of the Verizon termination agreement for either the second half of this year or on I guess a full year 09 basis? Then secondly, I’d be interested in any updates on the Level 3 front, the disputes there.

Rian J. Wren

On the Level 3 I think the best way for us to guide you on the second half of this year is through our guidance. We have carefully relooked at our guidance when we prepared for this call and we continue to feel comfortable that that range is appropriate for this point in time. I think as we go through the second quarter, and we did mention that we felt pretty comfortable about the relationship there, we’re starting to see execution a little bit sooner than we had expected. I think if we look through the second quarter and we finish there, we’ll take another look at guidance and see whether that requires any change with regards to how we see the impact of Verizon Wireless. But, I think the best way for the second half of this year is really for the guidance. I think it’s unwise of us to try and break that out right now.

I think for full year impact, we see the ability to terminate to Verizon Wireless in the ultimate as sort of close to 10% of our terminating field. So, we see it as a fairly significant ability to terminate calls with regards to our business. We see it as almost a 10% component. Lastly, your last question was on –

William Power – Robert W. Baird

Just trying to get a sense for any update on Level 3 and the disputes that have been underway there.

Rian J. Wren

Let me say a few words on Level 3. First, let me just take a step back and sort of put it in time context for those of you who are familiar and those who may not be as familiar. If you remember back we initiated regulatory actions against Level 3 beginning in February of 07. At that point in time if you’d look at the amount of minutes that our customers terminated through us to Level 3 it was approximately 12% of all the minutes that we were terminating at that time. That was in February, that number I think we reported for the entirety of 2007 were about 9% of all of our minutes because we have grown. When you look at us today as we are on this call, the latest month, that number is reduced to just about 5% now and that’s because of the significant growth Neutral Tandem has experienced. The issue and the overall level of importance Level 3 has diminished and we believe it will continue to do so to be in the low single digits by the end of this year driven almost exclusivity by the continued growth of our business.

I wanted to kind of put that in context because then when you look at an update on the regulatory activities, even that small amount of traffic has now been fairly significantly reduced with regards to risk. So, let me give you the update on the regulatory activities. For those of you who want more detail I think in the 10Q we do detail out specific state-by-state activity so you’ll be able to get that there. But, let me just summarize, as I just mentioned, you recall we took actions in eight states. Since the last call Minnesota had gone ahead and adopted an earlier recommendation by the Staff or the Administrative Law Judge that had been issued in our favor so that now has become law and with that five out of the eight states that we initiated the action have now posted favorable orders and now by a matter of law have given us the right to continue terminating that traffic to Level 3. So, even though the number is small, even a smaller portion of that today is at risk.

The last three which were really California, Florida and Connecticut, let me take California and Florida. California, we did have the hearing, it was almost a year ago, it will be a year ago in June. There is no prescribed timeframe when the Administrative Law Judge needs to issue or render her decision. It has been long and waiting but we are still in the mode of waiting to hear what the Commission will say in the California hearing case. In Florida, as we reported last quarter, we had a break through with the Florida Commission had taken jurisdiction and has moved forward and set a hearing although that hearing won’t occur until September. Both of those states we continue to terminate traffic so again, we feel pretty good there. Of note of recent is Connecticut, Connecticut took a turn where after two staff recommendations, staff recommendations that Neutral Tandem believes were fairly poorly developed, recently the Department of Public Utilities did agree with the recommendation and basically they said that they do not have authority, unlike every other state that’s looked at this issue, or jurisdictional control over the dispute between Neutral Tandem and Level 3. That was one of the findings they had is that even though they are a department charged with regulating telecommunications they found that they do not have any authority or jurisdiction over this dispute.

They then took a further step which is somewhat inconsistent with the first finding and ordered that Neutral Tandem should stop offering competitive tandem services to customers in Connecticut that send calls only to Level 3. Now, we believe this ruling to be fairly inconsistent with all basis of competitive policy and probably more important with Connecticut law and although that the traffic at issue here is really not material it amounts to about two tenths of 1%, we have appealed the decision because we’re trying again, as I mentioned before, to create good public policy law with regard to interconnection rights. Interestingly enough the Department itself has joined with Neutral Tandem in a joint request to stay the order pending the appeal. That’s an update on all of the activity there and if you want more detail it will be in the 10Q.

Operator

Our next question is from the line of James Breen – Thomas Weisel Partners.

Shane Larkin for James Breen – Thomas Weisel Partners

Just real quick I saw that there’s a step down in your average revenue per minute this quarter and it looks like that same thing kind of happened last year. I’m just wondering if you could talk about the pricing environment and any seasonality that might be taking place there. Then, my other question is on the market launches, your new market launches, it looks like you’re rolling those out pretty aggressively. If you could talk a little bit about the trend there and how that might be unfolding through the rest of the year.

Rian J. Wren

On your first question I think the average revenue per minute, I don’t have those numbers exactly in front of me.

Robert M. Junkroski

I have them Rian. Really, it changed slightly it was out to the fifth decimal place changes, it was slightly over .002 and it’s still slightly over .002. In terms of pricing I think it was .0026 in the previous quarter and .0024 in this quarter on a permanent basis. So, it’s down a hair but nothing significant. In terms of pricing seasonality there’s really not seasonality in pricing at all.

Shane Larkin for James Breen – Thomas Weisel Partners

I was just wondering about the markets, you guys did seven this quarter and I was just kind of wondering if that’s the trajectory we’ll see for the rest of the year?

Rian J. Wren

We did seven this quarter, the probably [inaudible] about that is three of the seven were what we call made for switch markets. We put switches in Salt Lake City, Portland, Oregon and San Diego and then the other four were the secondary back home markets in to a verity of hub markets. So, it’s a fairly hefty first quarter with regards to implementation. We’ve talked about 18 more for the year. There are others that we’re looking at, we’re not in a position to talk about them yet. I think maybe over the next several months if our execution continues on line, this is one of the activities our operation team does the best. We have this down fairly pat with regards to implementing markets so we feel comfortable about the guidance we gave you there and we’ll decide whether we grow a little bit more this year or not maybe in the next several months. But, our strategy is to grow as rapidly as possible because we’ve really wrung out a lot of the risk associated with growth at this point in time given the profile of customers and relationships we have with them. One of our core strategies is to get there as fast as possible, to get the interconnections and to maintain our position as their provider of choice. We’re very bullish and we believe when we say it’s not just consistent with our local transit business but our entire core strategy which would include access and other services.

Operator

Management, there are no further question at this time, please continue with any closing comments.

Rian J. Wren

If there are no further questions I just want to reiterate we’re pretty pleased with the quarter. We feel that group as a whole has executed right on plan if not a little ahead of plan. We’re pleased with the development in terms of implementation of the Verizon Wireless project. There, we are slightly ahead of plan and we’re also pleased with the development of the access tandem services and the discussions we’ve had with customers there. We feel that we’re right where we want to be at this point in time. We want to reaffirm the guidance we gave back in February and we look forward to reporting our second quarter results.

Operator

Thank you ladies and gentlemen. This does conclude the Neutral Tandem first quarter earnings conference call. If you would like to listen to a replay of today’s conference in its entirety you can do so by dialing 1-800-405-2236 or 303-590-3000, input the access code 11112911. Once again those numbers 1-800-405-2236 or 303-590-3000, input the access code 11112911. We’d like to thank you very much for your participation today. You may now disconnect. Have a very pleasant day.

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