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Neutral Tandem, Inc. (NASDAQ:IQNT)

Q2 2012 Earnings Conference Call

August 7, 2012 10:00 am ET

Executives

G. Edward Evans – Chief Executive Officer

Richard Monto – Senior Vice President of External Affairs, General Counsel and Secretary

Surendra Saboo – President and Chief Operating Officer

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

Analysts

Simon Flannery – Morgan Stanley & Co. LLC

Barry McCarver – Stephens, Inc.

George Sutton – Craig-Hallum Capital Group LLC

Hamed Khorsand – BWS Financial, Inc.

Donna Jaegers – D. A. Davidson & Co.

Timothy Horan – Oppenheimer Securities

Steven J. Beckert – Robert W. Baird & Co.

Brian Grad – DLS Capital Management LLC

Operator

Good morning, ladies and gentlemen. Thank you standing by. Welcome to the Inteliquent Second Quarter 2012 Earnings Call. During today’s presentation, all parties will be in a listen-only mode, and following the presentation, the conference will be opened for question. (Operator Instructions) This conference is being recorded today, August 7, 2012.

And I would now like to turn the conference over to Richard Monto, General Counsel. Please go ahead.

Richard Monto

Thank you, and welcome to the Inteliquent’s Second Quarter 2012 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 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. Inteliquent undertakes no obligation to update any forward-looking statements. 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 hand the call over to Ed Evans, Inteliquent’s CEO.

G. Edward Evans

Thank you, Richard, and good morning, everyone. Thank you for joining us today to discuss our second quarter results. Today, I’ll provide a brief summary of our operational results for the second quarter. Surendra Saboo, our President and COO, will take you through a more detailed look at our operational performance; and then Rob Junkroski, our CFO, will provide a detailed review of our financial performance. We will provide time for questions following the prepared comments.

Before I discuss our performance for the second quarter, I’d like to update you on the proposed dividend recapitalization and discretionary stock repurchase program we announced earlier today. Our Board of Directors regularly review strategic alternatives available to enhance shareholder value. Several months ago, our Board of Directors took the additional step of forming a Special Committee to review the strategic options available to the company. The Special Committee with significant input from the management team presented the results of its review to the full Board at a recent Board meeting.

The review of our options was wide ranging including a possible sale of the company, merger and acquisition opportunities, recapitalization options, as well as balance sheet efficiency. The Special Committee engaged Lazard as its financial advisor and Kirkland & Ellis as its legal advisor.

During our most recent Board meeting, the Special Committee recommended and the full Board approved our intention to move forward with the dividend recapitalization and discretionary stock repurchase program.

The proposed recapitalization plan will include raising $75 million to $100 million in debt through a new Term A loan. The proceeds of the loan will be combined with $80 million of cash on our balance sheet, and will be paid out as a special one-time dividend to shareholders. Assuming we are successful in raising the $75 million to $100 in new debt, the one-time cash dividend would be in a range of approximately $4.80 to $5.65 per share.

We are engaging with commercial banks regarding the debt component of the recapitalization, and anticipate completing the transaction around the end of the third quarter or shortly thereafter.

Of course as indicated in our press release issued earlier today, this plan is contingent on our ability to successfully access the commercial bank market and raise the new debt as well as a variety of other factors described in our press release. Please refer to the press release for a full discussion of those factors.

Raising $75 million to $100 million in debt will lever the company to about 1 to 1.5 times adjusted EBITDA. We believe this level of debt is very manageable. Even after paying out the cash dividend, we will still have about $30 million in cash on the balance sheet.

Additionally, we will continue to have significant capacity to pursue acquisitions, if we identify an asset we would like to acquire. Also we anticipate securing a revolving line of credit that will remain undrawn unless needed at some time in the future.

As also mentioned in our press release, the Board of Directors has authorized the company to repurchase up to $50 million of stock in the open market. The stock repurchase program will expire in three years. We do not currently have any plans to repurchase any stock under this program. But we believe it make sense to have this authorization in place to allow us to repurchase shares opportunistically if price levels become attractive. I want to emphasize however, that in the near-term, it is our intention to pay the special one-time cash dividend and not repurchase shares.

We believe our strategic plan will allow the company to continue to execute on our business plan of developing and diversifying our product and service offerings for voice, data, video and other new services, while maintaining the capital resources and capacity to evaluate M&A opportunities that may present themselves in the future.

Our strategic plan also creates better balance sheet efficiency and allows the company to distribute proceeds in a non-dividend tax environment. Ultimately, we believe our plans will create both short-term and long-term value for our shareholders.

Turning to our performance of the second quarter, our financial results fell below our projection, and as a result, we are lowering our full-year financial estimates as stated in our press release. Revenue for the quarter was $68.3 million, an increase of 4.9% over last year. Adjusted EBITDA, a non-GAAP financial measure, came in at $18.5 million for the quarter, a decrease of 18.9% from the same quarter last year.

Our results for the quarter were negatively impacted by several unexpected challenges we are working to address.

On the expense side, our results were negatively impacted by about $1.5 million in unbudgeted expenses incurred during the first six months of 2012 in connection with the strategic review. Additionally, the economics around our terminating services product have been changing slightly, and Surendra will have more detail around this in his comments.

On the revenue side, we continue to see some delay in getting a large customer implemented on our 8YY service. The delay was not caused internally, but by the customer needing to deploy additional assets to handle the traffic. I am pleased to report that the migration of this traffic is now nearly complete, and we are seeing more of the expected minutes on our network today.

In addition, during the second quarter, we also experienced a loss of LTS traffic, Local Transit Service from a mid-sized customer. The customer migrated its traffic after we were unable to reach terms regarding several points on a new deal. As a result, the customer elected to move its local transit traffic.

While we are hopeful we can win this traffic back at some point in the future, we are removing it from our projections for the year. The net result is that the voice business did not perform up to our expectations during the second quarter.

On a positive side, we continue to see strong momentum in our Access Homing Tandem product, and recently launched our new all-in-one termination service. The all-in-one service allows customers to send long distance traffic to us without being charged any fees from the terminating carrier. We include the termination charge in the fee we invoice our customers. We believe we can compete effectively for this traffic with our low cost structure, and that the customers will like the simplicity of the one-stop offering.

Between the roll-out of this new service and the continued momentum from our Access Homing Tandem product, we believe we will be able to make up some of the lost ground during the remainder of the year.

On another positive note, the data business continued to show solid results and pricing stabilization. In the U.S., we have seen our Ethernet business grow by over 50% this year and the pipeline continues to be strong. In Europe, even with the macro-economic headwinds, we are continuing to experience solid growth.

We also are continuing to roll-out of hosted communications product. With a few months now under our belt, we have found that it is taking the Value-Added Resellers a little longer than anticipated to begin selling the product in the market. While we continue to see solid indicators of demand, we are pushing our revenue expectations out a couple of quarters in order to give the VARs more time to deploy the product, set their sales organizations up and move forward. Surendra will have a lot more detail on the current status of the hosted communications in his remarks.

In conclusion, as we’ve stated in our prior calls, we anticipated this year would be challenging, as we invested in our business to expand our product set, and to diversify our revenue stream. Even so, I am disappointed with results from the second quarter.

That said, I do believe we’re making good progress towards our goal and we will be laser focused on these objectives as we move forward. I remain very confident in our business plan, and I look forward to providing updates as we progress.

With that, I’ll turn the call over to Surendra Saboo, our President and Chief Operating Officer.

Surendra Saboo

Thank you, Ed. As we completed the second quarter, we continued to execute on the opportunities we have with our voice, IP transit and Ethernet services, as well as continuing to market our hosted services. I would like to take a few minutes to provide an overview on some of the key developments that occurred during the second quarter of this year.

The largest gains in minutes and revenue during the second quarter came from our terminating services, largely due to the Access Homing Tandem product, which has gained significant traction over the past several quarters. Terminating services is now the largest revenue component of our voice services portfolio. International voice termination minutes also grew at a healthy rate, accounting for more than 6% of our voice revenues in the second quarter.

We have been diversifying our voice business for several years, and are now at the point where local transit, our legacy voice product contributes less than 40% of our total voice revenues. Terminating, originating and international voice services have all higher ARPUs than local transit, thus providing some support to the ARPU decline seen in previous years. However, originating services and international voice services have lower gross margins, which contributed to the overall decline in voice margins.

In addition, as Ed noted in his remarks, we are adjusting our expectations concerning the economics around our terminating services. In connection with these services, terminating to certain wireless carriers, we pay the wireless carrier a portion of the revenue we receive from the long distance provider for our tandem services.

During the second quarter, we reached an agreement with a wireless carrier that resulted in an unexpected increase in our payments, although we were able to partially offset it with additional revenue from new incremental services that carrier purchases from us.

In addition, based on recent discussions with certain other wireless carriers, we anticipate that the total payments we make may increase. Accordingly, we have included these additional payments in our financial projections for the remainder of the year.

In negotiation with wireless carriers, we will be attempting to address this issue by obtaining new business from the carrier as that results in additional revenue to offset any incremental payments we make. However, the increased payments for terminating services traffic will result in some margin compression for the service.

As an update to our Direct Inward Dialing or DID product, that we introduced earlier this year, it continues to gain traction and grow. This service allows us to assign our telephone numbers to enterprise applications and charge end-office access fees for terminating calls to those numbers. It is part of our terminating services portfolio. The revenue contributed from this service during the second quarter was $1.2 million, and we hope to grow it significantly as the year progresses and we move into 2013.

Turning our attention to IP transit, we carried 7.1 terabits of traffic over our network in the second quarter of 2012, which represents a growth of 44% over second quarter of 2011. Our average revenue per megabit over the same period decreased by 22%. However, our IP transit revenue in second quarter 2012 grew by 13% compared to second quarter of 2011.

With respect to our EtherCloud service, we continue to see strong customer demand for our one-stop multi-location Ethernet service. Since its introduction in the second quarter of 2011, we have built a healthy base of customers and continued to grow our sales pipeline.

Our customer base for Ethernet services worldwide has grown to 225 at the end of second quarter 2012, as compared to 158 at the end of second quarter 2011. During the second quarter, billed bandwidth for Ethernet services was approximately 600 gigabits, which is a 77% increase over second quarter 2011. We continue to be encouraged by the demand for our EtherCloud service, and expect it to be a significant part of our growth strategy in the future.

Moving on to Hosted Services, our newest service offering launched earlier this year, we continue to work with Cisco and their Value-Added Resellers to secure our first end-user customer.

As you may recall, this new service jointly developed with Cisco is a wholesales white-labeled offering to Cisco’s channel partners for them to deliver a full suite of unified communication and collaboration capabilities to their enterprise customers in lieu of a premise-based solution.

The sales cycle for the Value-Added Resellers to secure an end customer deal has been significantly longer than anticipated. Three factors have played a role in the delay. The first has to do with end customer demand for hosted or cloud-based solutions for their phones systems.

In our experience, the demand for a hosted solution over a premise-based solution has been much more muted than originally expected. The move to cloud-based services is happening, but at a much slower pace.

The second has to do with the bundling and packaging of the Hosted Services to the end customer. Again, based on our recent experience with the cloud-based or Hosted Service, the end customers are generally looking for a total OpEx solution with a single bill. This has required us to work with the VARs to reshape the offer into more of one-stop solution.

For example, we are now bundling our EtherCloud product with our HCS offering as a way for the end customer to connect to our hosted platform. We are also working with the VARs and Cisco Capital to provide phones and routers that go on the customer premise on a leased basis, so there is zero CapEx involved in using the hosted solution.

And finally, the third issue we have faced is the readiness of the valued-added resellers in selling the product in the marketplace. Although there is a great desire to offer Hosted Services, the training and incentive plans for their sales agents are taking more time to roll-out than anticipated.

Looking forward though, we have signed two more agreements with Cisco Value-Added Resellers bringing the total number to four. Some of the Value-Added Resellers are now actively selling the Hosted Collaboration Service and have started providing us visibility into the sale pipeline.

Given the delay in end customer acquisitions, we do not anticipate having any material Hosted Services revenue this year, but continue to believe that this service has market demand, and will gain momentum in the future.

That concludes my update on operational matters. I would now like to turn the call over to Rob Junkroski for a financial review.

Robert M. Junkroski

Thank you, Surendra. Turning to our results, our second quarter 2012 revenue was $68.3 million compared to $65.1 million in the second quarter of 2011, an increase of 4.9%. Data revenue increased by $2.5 million, while voice revenue increased by $700,000. The increase is data revenue was primarily due to the increase in traffic measured in megabits per second. Traffic increased to 7.7 terabits per second carried in the three month ended June 30, 2012 from 5.2 terabits carried in the three months ended June 30, 2011.

Offsetting the increase in megabits per second was a decrease in the average fee from $2.85 per megabit for the three months ended June 30, 2011, to $2.26 per megabit for the three months ended June 30, 2012. The increase in voice revenue is primarily due to increase of minutes of use billed to 32.8 billion minutes carried in the three months ended June 30, 2012 from 32.5 billion minutes carried in the three months ended June 30, 2011, an increase of 0.9%.

Turning to expenses, our network and facilities expense, which is the operations expense associated with transiting voice and data traffic through our network, was $30 million in the second quarter of 2012, compared to $26.3 million for the second quarter of 2011. The increase in network and facilities expense is due to changes in the mix of voice services we provide and an increase in the IP transit and Ethernet services.

Combined operating expenses consisting of operations, sales and marketing, and general and administrative expenses came to $22.1 million during the second quarter of 2012, compared to $18.8 million during the second quarter of 2011. The increase primarily resulted from higher employee expenses, including additional headcount and professional fees. The fees associated with the review of our strategic alternatives mentioned in the press release totaled $900,000 during the second quarter.

Adjusted EBITDA, a non-GAAP financial measure, was $18.5 million for the second quarter of 2012, down 18.9% compared to $22.8 million for the second quarter of 2011. Adjusted EBITDA margin, a non-GAAP financial measure for the three months ended June 30, 2012 was 27.1%, down from 35% for the three months ended June 30, 2011. The decrease in adjusted EBITDA margin was primarily related to higher network and facilities expenses, employee expenses and professional fees.

Depreciation and amortization expense was $7.8 million for the second quarter of 2012, compared to $7.4 million for the second quarter of 2011. Income from operations for the three months ended June 30, 2012 was $8.4 million or 12.3% of revenue, compared to $12.6 million for the three months ended June 30, 2011, or 19.4% of revenue.

Pre-tax income was $7.8 million for the second quarter of 2012 compared to pre-tax income of $12.9 million for the second quarter of 2011. Our income tax expense for the second quarter of 2012 was $4.1 million, compared to an income tax expense of $5.8 million for the second quarter of 2011.

Our effective tax rate for the three months ended June 30 was approximately 52.4% compared to an effective tax rate of approximately 45.3% for the three months ended June 30, 2011. The increase in our effective income tax rate primarily resulted from certain foreign entity transaction taxes and certain non-cash compensation that was non-deductible. Net income for the second quarter of 2012 was $3.7 million or $0.12 per diluted share compared to net income of $7.1 million or $0.20 per diluted share for the second quarter of 2011.

For the quarter, the average revenue per minute was $0.155 for all voice services, while the average revenue per minute was $0.134 per minute for local transit services, $0.150 per minute for terminating services, $0.211 per minute for originating services, and $0.372 per minute for international services. On the data side of our business for the quarter, our normalized average IP transit service revenue was $2.10 per megabit, and $4.23 per megabit for our EtherCloud service.

Taking a look at our current financial condition, our balance sheet as of June 30, 2012 is showing approximately $318.2 million in total assets, up from $302.8 million at December 31, 2011. Our total stockholders’ equity as of June 30, 2012 is $272.8 million, while our cash and cash equivalents are $110.2 million and our share count is approximately 31.8 million shares.

As announced in our press release earlier today, we have revised our financial projections for fiscal year 2012. Our revised estimates are based on management’s current belief about business trends, expenses, and macro-economic and competitive environment. We now estimate revenue for fiscal year 2012 is expected to be between $280 million and $290 million. The revenue breakdown by service for fiscal year 2012 is expected to be approximately 74% voice, 21% IP transit and 5% Ethernet.

Adjusted EBITDA, a non-GAAP financial measure, for fiscal year 2012 is expected to be between $74 million and $82 million. Billed voice minutes for the fiscal year 2012 are estimated to be between 133 billion minutes and 138 billion minutes. Capital expenditures for fiscal year 2012 are expected to be between $25 million and $30 million.

That concludes our remarks. We’d now like to open the call for questions. Operator?

Question-and-Answer Session

Operator

Thank you, sir. We will now begin the question-and-answer session. (Operator Instructions) Our first question is from the line of Simon Flannery with Morgan Stanley. Please go ahead.

Simon Flannery – Morgan Stanley & Co. LLC

Okay. Thank you very much. Good morning. On the special dividend it’s somewhat unusual to have this range of payments, and I understand it is somewhat contingent on the funding environment. But can you give us a better sense of should we use the mid-point, what’s your confidence. Are you really trying to get to the high-end or is that going to depend on Q3 results? What are all the questions around that, and when do you expect we’ll get some clarity on these items?

And then you talked about having a strategic review. Did dividends come into that discussion, and why did you decide not to initiate a dividend given your liquidity position and cash flow generation? Thanks.

G. Edward Evans

Yeah. I think taking the first question first, it’s our strong preference to be at the high-end of the range. We are giving ourselves a range there because of the bank markets, and what they may look like at the time that we’re actually out there. But it would our preference to do the full amount, and you have to risk-adjust it from there.

With respect to the ongoing dividend, yes, absolutely we had a lot of discussions around that. We felt like this is a really good start, and given the fact that we’re in the midst of lowering our guidance here for the full-year, candidly, I like to have a little bit more clarity and a little bit more visibility into future cash flows of the organization before we start committing to a regular and ongoing dividend, although that discussion has occurred regularly. And I think at some point that probably will become a part of our normal strategy.

Simon Flannery – Morgan Stanley & Co. LLC

All right. Thank you.

Operator

Thank you. Our next question is from the line of Barry McCarver with Stephens & Company. Please go ahead.

Barry McCarver – Stephens, Inc.

Hey, good morning, guys. Ed, in your prepared remarks, you mentioned several near-term challenges that the company was addressing. It seems like there were a lot of kind of one-time items and events regarding new contracts, customer delays and implementations that all kind of came to a head in the second quarter. Should we assuming a nice little pop in 3Q, as some of these issues kind of get put to rest or do you expect to see business continue to struggle a little bit?

G. Edward Evans

I think we feel better about the third quarter, given where we are right now. I think there’s obviously things that can occur anytime within the business. But specifically, we had as an example, a product that went with an enhanced services product, where we deliver traffic to customers, and there was an agreement between certain customers not to charge anything for end office fees.

Certain people within that group made a decision that they wanted to come out of that and start getting paid for some of that traffic. And so we essentially eliminated that product on sort of a flash cut basis, and then began migrating that traffic back on to our new all-in-one service.

The good news is that, that traffic has come back on and continues to come on, and we think it actually has significantly more upside than what the older product did. However, we did take those minutes off the network in the second quarter, and now we started to add them back on.

So there were a lot of sort of one-time weird things that were out there that certainly did it in the second quarter. Early indications of the minutes that we’re seeing on the network right now indicate that we are getting those back, and they do look fairly healthy right now.

So I think it’s early to be seeing, and obviously we don’t give quarterly guidance. But to your point, there were a lot of sort of anomalies that occurred in the quarter that were a bit unusual for us and obviously caught us by surprise.

Barry McCarver – Stephens, Inc.

Okay, that’s very helpful. And then one question about the Value-Added Resellers that Surendra mentioned on the Hosted Solutions. I believe you said that some of them were actively selling, and that they were providing some visibility into kind of the sales pipeline there. Doesn’t sound like they’re giving you any indication for anything to happen in 2012, but is that an early 2013 event or is it still too early to tell?

Surendra Saboo

This is Surendra. I think, and we do anticipate closing some deal this year. The sales pipeline visibility allows us to at least look at the actual end customers, maybe even go to meetings with the VARs, and meet with the end customer. So it has actually given us a better idea about the traction there. So we do expect some deals to be closed, but not significant revenue generated yet for this year.

Barry McCarver – Stephens, Inc.

Okay. And then, Rob, did you give the breakdown of revenue between voice, IP Transit, Ethernet? If you did, I missed it, and apologize.

Robert M. Junkroski

We did not give it. We had – local transit was 29.6% of our revenue. Terminating services was also 29.6% of our revenue. Originating services was 10.6% of our revenue, and international voice was 4.5% of our revenue. Ethernet was 3.7%, IP transit 21.9%, and just a fraction for the Hosted Service.

Barry McCarver – Stephens, Inc.

Okay, great. Thank you.

Operator

Our next question is from the line of George Sutton with Craig-Hallum Capital Group. Please go ahead.

George Sutton – Craig-Hallum Capital Group LLC

The strategic options that you took a fairly wide-ranging view; I’m curious relative to potential sale of the company, because that was one of the things you mentioned, does this suggest that, that process is over, and I’m wondering how long has the process taken?

G. Edward Evans

The process has concluded with respect to a sale of the organization, yes. Now, that being said, we are a public company, so obviously there is always an opportunity for somebody to show up. With respect to when the Special Committee was formed, it was in January – January, February?

Robert M. Junkroski

Yes. It was just a little bit after that.

G. Edward Evans

A little after that.

Robert M. Junkroski

Yes, the Board began some time ago (inaudible) a few months back.

George Sutton – Craig-Hallum Capital Group LLC

Okay. And then relative to the local transit customer loss that you mentioned, you have in recent past to our knowledge been winning most of the available traffic that’s been out there. Was there something unique to this specific customer situation that you would want to mention?

G. Edward Evans

Yeah, a little bit. It’s a bit of a interesting situation in that, we felt like we had kind of reached agreement on the local transit side. But with respect to the terminating services side, we were unable to reach an agreement, and that was going to be a relatively new service for us. As what looks like more of negotiating tactic than anything else, the carrier elected to move all of their traffic off of us.

And interestingly enough, it doesn’t look to us, from what we can see, like they moved it to a competitor, so much as they moved it back on to the bill tandems, which is a much more expensive way for them to go.

It’s disappointing, we continue to work with the customer, and we hope we can win back that business. They were a good customer and we’d certainly like to have them. But it is what it is at this point in time. We felt like we went as far as we could go from a pricing perspective in order to maintain profitability, and we just weren’t able to reach in terms that were acceptable to them.

George Sutton – Craig-Hallum Capital Group LLC

Okay, great. Thank you.

Operator

Thank you. Our next question is from the line of Hamed Khorsand with BWS Financial.

Hamed Khorsand – BWS Financial, Inc.

Hey, good morning, guys. Just really one question here, just given where the traffic is in Q2 with the anomalies and the expected boost in Q3, what does that do to your network and facilities expense, and how does that look from a margin standpoint as a percentages of sales?

G. Edward Evans

It’s a great question, because with the loss of traffic in the second quarter, obviously, it takes a certain amount of time to sort of groom the network back. So in some areas, I’m sure we started grooming back on capacity, where it’s lot easy than others, we’re probably still hopeful that we can win back traffic, and fill up those pipes again.

So it certainly is going to have and did have an impact on margin in the second quarter. I would imagine we could mitigate a little bit of that in the third quarter, but grooming the network isn’t an overnight event. It tends to take a quarter or two to get the network sort of balanced with where the traffic flow is.

Hamed Khorsand – BWS Financial, Inc.

Okay, great. Thank you.

Operator

Our next question is from the line of Donna Jaegers with D. A. Davidson. Please go ahead.

Donna Jaegers – D. A. Davidson & Co.

Hey guys, thanks for taking the questions. On Surendra, your comments on increased payments to the wireless carriers, can you give us a little more color on that?

Surendra Saboo

This specific case that Ed just pointed out with a wireless carrier that we are negotiating on the terminating services, and we didn’t come to an agreement on that. Usually, in the past, we’ve not had to pay wireless carriers to terminate to them, since they did not have any ability to charge access fees.

But more recently, wireless carriers have – because they cannot charge access fees, they are now starting to demand some terminating payments for them to terminate. So that what’s been going on, and that is part of the issue that we had with one wireless company where we’re not able to reach agreement, and they took a lot of their local transit traffic away from us.

Donna Jaegers – D. A. Davidson & Co.

Is it your understanding on that one wireless customer that migrated the traffic, are they getting those kind of termination payments from the incumbent?

Surendra Saboo

We don’t know if they are.

G. Edward Evans

What we can tell is that, the amount that was being asked for was substantially out of market from what we’ve seen, and wasn’t within our realm of profitability, and so we elected to walk away.

Donna Jaegers – D. A. Davidson & Co.

Okay, great. Thanks guys.

Operator

Thank you. The next question is from the line of Tim Horan with Oppenheimer. Please go ahead.

Timothy Horan – Oppenheimer Securities

Thanks guys. Thanks guys. Actually I have three follow-ups. And just on this last question, I guess the wireless carrier doesn’t have the ability to block traffic for you or even charge you, but they really have the ability then to stopping you for services or stop sending traffic to you. Is that kind of their negotiating leverage over you? And just two follow-ups.

Surendra Saboo

Yeah. That’s exactly right and that’s sort of – so we continue to terminate traffic to this wireless carrier, although they elected to take the local transit business away.

Timothy Horan – Oppenheimer Securities

Got you. You’re just not paying them?

Surendra Saboo

Right.

Timothy Horan – Oppenheimer Securities

And then to chip on the previous question here, on the margins here for the second half of the year, you’re basically guiding down 150 to 200 basis points decline in EBITDA margins for the second half of the year; if you run through the numbers, I think that’s correct.

And I guess because you were kind of hedging on the ability to kind of on the margins for the second half of the year. It sounds like the operating expenses are clearly going up, and SG&A or is one expense going up more than the other?

G. Edward Evans

I think a lot of it was network expense in the second quarter, because again we saw traffic that came down, and we still had to pay for the facilities that were in place. So you had that piece that’s there, and how long does it take to actually groom that off.

Obviously, what we would like to do is replace that traffic and put more minutes on it, not have to worry about grooming the network down. Given where we are today, I just don’t know how that sort of plays out. And I’ll let Rob handle sort of the second half of the question.

Robert M. Junkroski

Yeah. In terms of SG&A, in second quarter, we had as we called out, there was $900,000 of expenses related to our strategic evaluations. So that’s obviously an expense that will go away for the rest of the year.

So the forecast that we – the guidance that we’ve put out takes all of these things into consideration. So there is really no one thing that’s going to drive up SG&A for the rest of the year, and actually with the elimination of the one – what I’ll call one-time costs on the deal evaluation fees, both legal, banker fees, all the fees involved there, it should go away at the second half of the year.

Timothy Horan – Oppenheimer Securities

Yeah, sorry, I was normalizing the amount. I apologize for that. But it sounds like the gross margin is coming down for the second half for these reasons in your guidance anyway.

Robert M. Junkroski

Yeah. Well, gross margins come down because of the network expense you got. It takes time to rationalize the network, and groom out the direct cost related to the loss of traffic.

Timothy Horan – Oppenheimer Securities

Great. And then just lastly, on the strategic review, what was the impetus for that? Did you have someone approach to buy the company or were you just frustrated where the stock price was or just trying to figure out where to invest new dollars?

G. Edward Evans

No, there really wasn’t any single deal, I think the Board does this – we do this on a regular basis. We have done it over some period of time and we just reached a point when we got back to January, we felt like there was an opportunity to really sort of head one of a couple of different directions, and the Board elected to put together the committee and look at all the alternatives and see what the best result would be. So really no impetus other than internal fiduciary responsibility.

Timothy Horan – Oppenheimer Securities

Thanks a lot, guys.

Operator

Thank you. Our next question is from the line of Steven Beckert with Robert W. Baird. Please go ahead.

Steven J. Beckert – Robert W. Baird & Co.

Hi guys, thanks for taking the question. First, just circling back to the lost local transit carrier, is it fair to say that the loss of that carrier accounts for the bulk of the lower voice revenue or bulk of the lower voice guidance for the year?

And then, Ed, if you could just comment more broadly on the local transit or rather maybe voice pricing environment generally, obviously you guys have done a really good job of stabilizing your own pricing. Is that a result of you guys being more selective or is that indicative of what you’re seeing in the market as well?

G. Edward Evans

I think it’s a little bit of both. The answer to the first question, yes, the bulk of the takedown you’re seeing for the remainder of the year is the loss of traffic from the single customer. The rest of it would be sort of a normal attrition that we’ve seen on LTS.

With respect to pricing, yeah, I think our guys have done a good job of being more selective and selling the value proposition that we have today. I think we’re getting down to a point and pricing within that product right now that to move over a 10% cost savings doesn’t make a lot of sense frankly.

The pricing is so low within the product, that today that extra 10% there is a lot of headaches involved with moving the traffic just to save a little bit of money. So we do think there has been some stabilization there, and we feel pretty good about it right now.

Steven J. Beckert – Robert W. Baird & Co.

That’s great, thanks. And then, kind of the same question on the IP transit side of things. Obviously, pricing still continues, I’d say, it’s downward trajectory there. Are we ever going to approach a bottom there or where do you see IP transit pricing going over the next year or so?

G. Edward Evans

I think it continues to fall as it has been. I think a lot of what you’re seeing there frankly has been our ability to go after more selective IP transit accounts, as opposed to directly competing with some of the known very low cost providers around the marketplace today. We have elected to go in a different direction and focus more on the value proposition that we have. And I think our team has been very successful in doing that and mitigating that sort of following nice pricing.

We’re not simply matching every price that appears in the market today. We are being selective and we do believe we offer some value-add in what our network has to offer.

So I suspect that you’ll continue to see prices falling at a rate similar to what you’ve seen this year. Is there a bottom? I continue to believe that at some point, yes, there has to be a bottom. I know you can’t lay fiber in this country for $1 a megabit today.

So at some point, those capacities out there got to get build up, and pricing has got to turn. I don’t know when that is, and I don’t know if I live long enough to see it, but I continue to hang on to that theory.

Steven J. Beckert – Robert W. Baird & Co.

That’s great. Thanks a lot, guys.

Operator

Our next question is from the line of Brian Grad with DLS Capital Management. Please go ahead.

Brian Grad – DLS Capital Management LLC

So just to kind of reiterate what a couple of guys back said, so basically you shopped the company around, nobody cared, and your best alternative is to return the cash to shareholders. Is that dividend going to be classified as a return of capital or is it going to actually be a dividend since it’s such a large amount?

G. Edward Evans

Yeah, that’s a great question. I don’t know, but I have an answer for you. I would assume it’s a dividend.

Brian Grad – DLS Capital Management LLC

Okay. And have you guys thought about issuing a super low cost convertible to a stock buyback as well? That seems to be a pretty popular thing to do right now.

G. Edward Evans

Yeah. I think we continue to, and we will on a go-forward basis look at all the different alternatives that are out there, and I don’t think there is anything that’s off the table. But we won’t get into specifics about what we’re considering now or in the future, but I don’t think anything is off the table.

Brian Grad – DLS Capital Management LLC

All right. Okay, thank you.

G. Edward Evans

Yeah.

Operator

Thank you. Our next question is a follow-up from the line of Tim Horan with Oppenheimer. Please go ahead.

Timothy Horan – Oppenheimer Securities

Thanks guys. With all the access charge rules that are changing right now, it seems like there’s been a little bit of disruption in the marketplace, do you still think there’s more opportunity there? Maybe you can just describe some of the risk and opportunities as you’ve gotten a little bit information over the last few months. Thanks.

G. Edward Evans

Yeah. I think we do continue to believe there is more opportunity there. I think what the rules did is they provided a certain degree of clarity that didn’t exist in the marketplace before. We were never an organization that was sort of known as one of the arbiters that were out there that played in a lot of, what I would call, the gray areas if you will.

So bringing more clarity to the different rate structures I think actually helps us and allowed us to do things like creating this all-in-one plan that we’re introducing right now for terminating services and things like that.

So I think we continue to believe there’s some upside there. As you can see from the SEC filings that are going out between various companies, not ours but others, there is still some debate about how to read the rules, and how to interpret those rules. None of those seem to dramatically or materially impact us right now.

But as those things kind of settle out, everybody sort of comes to some sort of conclusion as to what the rulings actually mean, I think it creates even more opportunity for us.

Timothy Horan – Oppenheimer Securities

Thank you.

Operator

Thank you. That’s all the questions that we have in queue at this time. I’d like to turn the call back over to management for closing remarks.

G. Edward Evans

Well, I’d like to, again, thank everybody for attending the call today. I’d also like to thank the Inteliquent team. It’s a difficult quarter, and while I’m disappointed in the results, I’m certainly not disappointed in anybody’s effort within the organization.

I think a lot of people are working very hard to do what we told the market we’re going to do, and we’re going to laser focused in trying to do that. So I look forward to continued updates and thank you again for joining the call.

Operator

Thank you, ladies and gentlemen. That does conclude our conference for today. We’d like to thank you for your participation. And you may now disconnect.

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