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Neutral Tandem, Inc. (NASDAQ:TNDM)

Q2 2008 Earnings Call Transcript

August 5, 2008 10:00 am ET

Executives

Richard Monto – General Counsel

Rian Wren – President and CEO

Rob Junkroski – CFO

Analysts

Simon Flannery – Morgan Stanley

John Bright – Avondale Partners

James Breen – Thomas Weisel Partners

Tim Horan – Oppenheimer

Jonathan Ho – William Blair & Company

Will Power – Robert W. Baird

Mark DeRussy – Raymond James

Operator

Good morning, ladies and gentlemen, thank you for standing by. Welcome to the Neutral Tandem second 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, August 5, 2008. I’d now like to turn the conference over to Mr. Richard Monto, Secretary and General Counsel of Neutral Tandem. Please go ahead, sir.

Richard Monto

Thank you, and welcome to the Neutral Tandem second quarter 2008 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. Neutral Tandem undertakes no obligation to update any forward-looking statement.

In our remarks, we 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 introduce Rian Wren, Neutral Tandem’s President and CEO.

Rian Wren

Thank you, Richard, and I’d like to thank all of you for joining our second 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 by the progress we continue to make toward our long-term objective of being the tandem provider of choice for competitive carriers. We reported another record quarter with $28.6 million in revenue, which reflects a 39.5% increase over the second quarter of 2007. This translated into strong profitability as our net income grew to $5.6 million during the quarter, which is a substantial increase over the $800,000 we earned in the year ago period. Rob Junkroski, Neutral Tandem’s CFO, will provide additional detail on the financial results later in the call.

Despite the headwinds facing the broader economy, we do not believe we have been noticeably affected by these macroeconomic challenges. We believe that our network provides a more efficient and cost effective solution for our customers and that our market reach, the extent of interconnections and customer profile positions us to operate successfully throughout a wide range of economic environments. We believe that the strong results we reported this quarter reflect the successful execution of our three strategic growth initiatives, which are broadening our geographic presence, expanding our interconnections with new and existing customers, and increasing traffic types across our network.

We continue to expand into new markets across the United States. This past quarter, we successfully commenced operations in eleven new markets, bringing the total number of operational markets to 82 as of June 30, 2008. This increases our addressable footprint in these markets to approximately 539 million telephone numbers assigned to carriers. Our customers can terminate traffic to approximately 346 million of these numbers. Our plans for the last six months of 2008 include the addition of 12 more markets, bringing our projected total markets served to 94. These markets will increase our addressable footprint to approximately 566 million telephone numbers assigned to carriers.

We continue to see benefits from the network affect, which is a key component of our growth strategy. As we discussed on earlier calls, the value of our service offering increases with the number of customers connected to our network. To that end, during the second quarter, we continued to interconnect with Verizon Wireless in many of the markets we serve. With the establishment of these interconnections now essentially complete, and some traffic beginning to flow, we continue to expect that our customers will begin terminating traffic over all of these new interconnections at some point during the fourth quarter of 2008. However, I should reiterate that the full impact of the Verizon Wireless interconnections is expected to be realized in the first quarter of 2009. This process occurs because it takes some time for all of our customers to start sending traffic over all of the new interconnections, even if they are traffic ready. I would also note that the increased revenue contribution from terminating traffic over these new interconnections has been incorporated into our revised guidance numbers, which Rob will discuss later in the call.

In addition, as I previously discussed, 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 business, we are cautiously optimistic that we can increase minutes transmitted 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 at tandem function. However, the calls supported are inter market in nature versus local. We market our tandem switch access service to inter exchange carriers also referred to as IXCs, and have entered into contracts with several customers. While we are currently delivering a relatively small amount of traffic, we hope to develop these relationships over the next several quarters and grow this opportunity with existing and new IXC customers.

Additionally, during this past quarter we entered into a settlement agreement with Level 3 pursuant to which the parties agreed to withdraw or dismiss as appropriate all of their pending disputes being heard between various regulatory bodies and courts. Concurrent with the execution of the settlement agreement, we entered into a direct connection agreement pursuant to which Level 3 will accept transit traffic from us. We are pleased that this dispute is being resolved and look forward to putting this matter behind us.

Finally, I would like to update you on our continued progress towards deploying an advanced technology platform. Since the beginning of 2006, we have made significant investments in soft switch technology, which improves network scalability and offers our customers a state of the art platform to help them more cost effectively exchange all types of traffic. Once we decided to use only this next generation technology in our network, we began deploying soft switches at all of our new switch sites, as well as replacing most of our older switching technology with soft switches.

For example, we recently completed a major technology replacement in New York following earlier replacement in our California, Florida and Georgia networks. Going forward, we plan to make a similar soft switch replacement in our Michigan and Ohio networks. At the completion of these upgrades, all but two of our 30 switch locations will use soft switch technology. These investments reduce our operating expenses and improve our capital efficiency and position us to be able to deliver future service offerings.

Additionally, as our customers convert to IP connectivity, we are capable of connecting with them using SIP interconnections, which is a more efficient and cost effective way to exchange traffic. As a result of these investments, we believe we now operate the largest soft switch IP capable local tandem transit network in the United States enabling us to be the interconnector provider of choice for carriers as they upgrade their networks to IP connectivity.

Looking forward to the remainder of the year, we continue to see favorable industry trends for our business, particularly the continued increase in wireless and cable subscriptions, helped by continued migration of subscribers from the incumbent local exchange carrier landline services to competitive carriers. We also plan to continue to prioritize our market launches based on our customers’ 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. To that end, as I mentioned earlier, we plan to commence operations in 12 new markets over the last six months of the year, bringing the number of new markets established during 2008 to a total of 30.

In closing, we are pleased with our results for the second quarter of 2008. Not only do we have a strong quarter in our core business, but we also continue the successful implementation of our interconnection with Verizon Wireless and the development of new services. We believe that this will help us drive growth and profitability going forward.

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

Rob Junkroski

Thank you. As Rian mentioned, we are very pleased with the achievements made during the second quarter of 2008. Turning to our results, our second quarter 2008 revenue was $28.6 million compared with $20.5 million in the second quarter of 2007, an increase of 39.5%. In the second quarter of 2008, we transited 14.2 billion minutes across the network, up from 9.8 billion minutes in the second quarter of 2007, an increase of 44.9%. This increase in minutes was driven by our growth in both new and established markets, the beginning of traffic terminating to Verizon Wireless and the introduction of tandem switch access services.

During the second quarter, we saw good growth in some of the newer markets in which we recently commenced operations. These markets are generally lower rate markets due to the fact that the regulated ILEC rates against which we compete are lower than in our initial markets. This contributed to a lower ARPU for the quarter, which we also expect to slightly impact the full year ARPU. However, we are seeing more of our revenue drop down to the bottom line as we increase our margins through the cost reductions we’ve gained by scaling our business. As Rian noted previously, we’ve gained cost efficiencies by deploying next generation soft switch technology, as well as in-sourcing our signaling assets and optimizing our nationwide interconnection network. Therefore, due to increased minutes and decreased cost as a percentage of revenue, we don’t anticipate that the reduction in ARPU will have an impact on our revenue and earnings projections.

Turning to expenses, our network and facilities expense, which is the operations expense associated with transiting calls through our network was $9.4 million in the second quarter of 2008 compared to $6.9 million for the second 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 serve. Combined operating expenses consisting of operations, sales and marketing and general and administrative expenses came to $7.8 million during the second quarter of 2008, up from $7.5 million during the second 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 $12 million for the second quarter of 2008 compared to $6.6 million for the second quarter of 2007. Included in adjusted EBITDA is the impairment of fixed assets of $200,000 resulting from the decision to replace circuit switch equipment with IP switching equipment in our Michigan and Ohio markets. Depreciation and amortization increased by approximately $600,000 from $2.2 million in the second quarter of 2007 to $2.8 million in the second quarter of 2008. Our operating margins in the second quarter of 2008 were 29.4% compared to 20% in the second quarter of 2007, reflecting our ability to increase revenues while decreasing costs as a percentage of revenue. We will record accelerated depreciation in our Michigan and Ohio markets through November 2008 as our circuit switches are replaced with IP switching equipment.

Pre-tax income was $9 million for the second quarter of 2008 compared to pre-tax income of $2.2 million for the second quarter of 2007. Our income tax expense for the second quarter of 2008 was $3.3 million compared to an income tax expense of $1.4 million for the second quarter of 2007. Our effective tax rate for the six months ended June 30, 2008, was approximately 37%. Net income for the second quarter of 2008 was $5.6 million or $0.17 per diluted share compared to net income of $800,000 or $0.03 per diluted share for the second quarter of 2007.

Taking a look at our current financial condition, our balance sheet as of June 30, 2008, is showing approximately $183.2 million in total assets, up from $166 million at December 31, 2007. Our long-term debt, which includes both current and long term amounts, is $5.3 million and continues to amortize. Our total stockholders’ equity as of June 30, 2008, is $158.9 million, while our cash and cash equivalents are $97.6 million, and our share count is approximately 31.9 million shares.

I’d now like to address our revised outlook for 2008. Based on our actual results for the first half of the year and our current belief about minute based revenue trends, expenses, and the competitive environment, we’ve raised our expectations for certain guidance metrics and now estimate that revenue for the full year of 2008 will be between $117 million and $121 million, an increase from our previous forecast range of $112 million to $116 million. Adjusted EBITDA, a non-GAAP financial measure for the full year of 2008 will be between $47 million and $49 million, an increase from the previous forecast range of $39 million to $41 million. Adjusted EBITDA will exclude non-cash share based employee compensation.

Billed minutes for the full year of 2008 will be between 59.5 billion and 61.5 billion minutes, up from the previous forecast range of 56 billion to 58 billion minutes. CapEx for the full year of 2008 is expected to be between $23 million to $25 million, consistent with the previous forecast range. And we will commence operations in 30 new markets in 2008, up from the previous forecast of 25 new markets. I’d like to reiterate that our guidance takes into account the expected impact of the new revenues associated with terminating traffic to Verizon Wireless.

We remain excited by the opportunities we see for our company as we continue to expand our business. 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 up the call to questions. Operator?

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from the line of Simon Flannery with Morgan Stanley. Please go ahead.

Simon Flannery – Morgan Stanley

Thanks a lot. Good morning, Rian and Rob. Congratulations on the quarter, could you talk a little bit more about the guidance raise, and what exactly is behind the revenue, I guess particularly the MOU? To what extent is the organic growth in your existing market sort of ahead of plan versus layering in Verizon Wireless or Level 3 and some of the new markets you’ve put in there? What are sort of the components of that if you like? And you continue to build up your cash and I noted long term investments, may be you could describe what’s going on there and any thoughts about obviously the switch access businesses moving ahead, but uses of cash, any change in your thoughts there? Thanks.

Rian Wren

Okay, good morning, Simon. How are you doing?

Simon Flannery – Morgan Stanley

Good, thank you.

Rian Wren

With regards to your first question on revenue, there really are three components to the decision to raise guidance. One has to do with our comfortable feeling with our core business and our core markets with regard to growth. And then there are three other components, one is the new markets. And as I’ve been describing to everyone, we are beginning to see the effect of the markets that we put on last year typically taking market that are somewhere 12 months and older, beginning to start to accelerate in their growth. And so that has given us a little bit of input into our guidance calculation.

Secondly, we’ve made some estimates with regards to new services, which is really around the terminating access product and the Verizon Wireless. And we tried our best to put a measured approach although challenged ourselves to accomplish as much as we could in those two areas. Clearly Verizon Wireless, as we’ve been reporting over the last two quarters has gone very smoothly. We are very pleased with the relationship that we’ve developed with them, and we’ve essentially put the bulk of our circuits in place at this point in time, and now it’s really a component of process where our customers begin to route the traffic. So, although we don’t directly control that process, indirectly we’ve got routing orders out, and we are giving ourselves a challenge to accomplish that as quickly as possible. So, Verizon Wireless is a fairly strong component of our reasons for guidance.

Now on your second question, I think what you’ll see from us today on the call is that our core business continues to give us great confidence in our continued growth. We focused on that pretty heavily in the first quarter because of the payback associated with that. We are pleased where we have gotten with regards to development of the terminating switch access product. Although we didn’t spend as much time focusing on that, we expect that to grow over the course of this year. And so those types of services are really a continuation of the growth around the core fundamental capability of the business being an independent tandem provider.

We have recently as we’ve mentioned to you begun to look down the road a bit with regards to leveraging the technology platform we’re putting in place to become much more valuable and to offer more services to the carrier base that we support. To that end, we told you that we were searching to bring on some very specific talent to the company, we’ve achieved that this quarter by hiring two key product development engineers focused on the wireless infrastructure, signaling infrastructure and data and hosting side of the business. Don’t have much more to say about that than that but we are making progress with regards to really developing the future service platform in the future.

And so specifically to your question on the balance sheet, we hold that in abeyance so that we can take advantage of some investments that we may make which we haven’t decided on yet of course at this point in time with regards to developing for the future, and we will be open with that as we get closer to any decisions. Obviously our investor base will be the first that we will speak to.

Simon Flannery – Morgan Stanley

Okay, thank you.

Operator

Thank you, sir. Our next question comes from the line of John Bright with Avondale Partners. Please go ahead.

John Bright – Avondale Partners

Thank you. Good morning, Rian and Rob. You’ve raised the number of markets I think up to 30 from 25, yet you are holding your CapEx flat, can you tell us what’s taking place there?

Rob Junkroski

Sure. Our aggressive approach to position us to an all IP network which we are all but there has allowed us to gain significant economies of scale with regards to our capital efficiency, and not just on the operating side but with regards to capital spend required to build out and the markets you are seeing it in real time. So, we maintained our capital forecast level with previous forecasts even though we’ve raised our guidance both in minutes and in revenues and we feel fairly comfortable in that respect. So you are starting to see the tail off in the investments that we’ve made with regards to the size that we are, our negotiating leverage with regards to our contractual capabilities for technology and equipment and just the basic efficiencies associated with the soft switch architecture that we now have also deployed.

John Bright – Avondale Partners

Okay. And Rian of the 12 markets that remain for ’08 in the last six months, could you discuss what large markets might remain and is it fair to characterize those markets as likely lower rate markets?

Rian Wren

I think it is fair to characterize them as such although not any lower than where we are now. So most of the rate markets that we will go in into for the remainder of this year and what we will talk about obviously in the future about next year are in a consistent range of what we actually were putting in late last year. The markets that we just introduced in the second quarter, the 11 that we put in place, we actually deployed three what we call hub switching markets, and that was Houston, Charlotte and Las Vegas. The remaining markets for this year will all be secondary markets and they will be basically hubbed off of the switch sites that we have in place. So, we continue to see – you’ll continue to see both number of market growth from us both this year and next year, those markets will be smaller Tier 2, Tier 3 type cities as we continue to expand our scope and reach inwards. With regards to major switching markets, we think right now we have our hubs adequately positioned. That may change a little bit but not greatly.

John Bright – Avondale Partners

Last question then, a looking forward question, you talked about the inter-market business in nature for tandem switch access, you are cautiously optimistic, you said you’ve entered some contract, what are you going to be able to do, Rian, to drive that business? I think you mentioned that you might be able to impact that, how’re you going to be able to drive that business forward?

Rian Wren

With regards to the terminating switch access business, it’s really in the execution mode at this point in time. We’ve been quite successful with signing up key major accounts, many of them have requested silence with regards to who they are, but they’re the major exchange carriers in the US. Secondly in terms of what I’ll call the production trials, beyond the initial technology trials, but actual production traffic that we are flowing today, we’ve learnt a bit from them and we’ve been incorporating some tweaks with regards to the interconnection architecture that they would like from us, again being driven primarily by the desire to move toward a direct hand off with SIP technology as opposed to going through gateways. So we are actually adjusting for that, and then it is a matter of meeting their needs and executing. So, we see a pretty clear path with regards to growing that. Again, it is very difficult to size how successful we will be there. As soon as we get a better feel on that, we’ll obviously be open and describing that with you. But at this time, it’s really not really many roadblocks in the way, more of an execution.

John Bright – Avondale Partners

Got you. Rob, what was the headcount at the end of the quarter?

Rob Junkroski

131.

John Bright – Avondale Partners

Thank you, gentlemen.

Operator

Thank you. Our next question comes from the line of James Breen with Thomas Weisel Partners. Please go ahead.

James Breen – Thomas Weisel Partners

Thanks, guys. Just a couple of questions, one, can you talk about any potential impact of the Alltel purchase by Verizon. I know you put the Verizon numbers in there, just some color there? And secondly, as you are talking about growing out of some of these other markets in the second half, and they seemed like more secondary markets, talk about the capital costs associated with that and potential expenses associated with those relative to the primary markets? Thanks.

Rian Wren

To your first question, both Alltel and – Alltel is an existing customers of ours although at this point in time, they are not a very large customer. They were growing, they were beginning to grow with us. Verizon Wireless as you know has not at this point in time made a decision to begin routing traffic through us as an originating customer. So the risk associated with the merger is always the traffic that moves between two of our particular customers. And specifically with regards the Alltel-Verizon Wireless situation, it is de minimis. I think we had mentioned before it’s in the range of 14,000 minutes, something like that, it’s very, very de minimis. So, there’s no impact with regards to our current business with regards to that.

And then the second question was cost of secondary market. Well, as you know, and that’s why Rob has been describing that as move forward, our cost of capital or our percent of capital spent to revenue will begin to move downward with regards – towards more of a single digit number and the main reason is that the secondary markets are very, very little in capital because they are essentially a point of presence into the market and then we hub off of the existing markets and that’s where the capital is placed to grow with regards to the growth of the business.

So most the capital will be now growth based. Other than the aspect of new investments that we may choose to make, may be in really the second half of the year with regards to testing and development services that we may beginning to leverage off of the platform, new services. I think I did miss though, I think I mentioned that there is one major switch market in the second half that I didn’t see in our sheet here and that is St. Louis, and so we will be deploying one more switch market in the second half of this year.

James Breen – Thomas Weisel Partners

Great, thanks. And just one follow up in terms of the revenue breakdown between wireless and the cable/CLEC space, can you just talk about sort of the different trends you are seeing in the vertical?

Rian Wren

Yes. The trend that we are seeing which I think you would find commensurate with what you’ve been hearing from the different segments is that cable as a percentage of our business has begun to rise a little bit. Obviously, we’ve all listened to the great success that Comcast continues to have, particularly on the phone side, and we serve them pretty much everywhere we operate. And so cable has moved up from slightly from around 14% to mid 14.5%, 14.3% to 14.5% of our business. Wireless, we’ve seen – these numbers are from the end of last year to today. We’ve seen a significant growth in wireless from 60% of our business upwards of 65%. So wireless continues to show robust growth.

And as you would expect the CLEC space, mainly focused on enterprise is as a percent of our business dropped slightly from about 21% to just under 20% and change. So, really what we are beginning to see here is a continued almost acceleration with regards to the traditional landlines moving from the incumbent carriers to the competitive space. In the second quarter announcement, the Bell companies has now raised over an 8% year to year increases in landline loss. So, there is a three-year sequential increase in landline loss moving to the carriers that we’ve seen.

The wireless companies with their recent introduction of (inaudible) to our unlimited packages I think continue to see great minute growth, and of course the substitution from landline to wireless only I’ve seen numbers that range from 13% of the households to as high as 16% of the households are now wireless only. So, in that space cable wireless continues to be major customers segments for us and that momentum of people shifting from traditional landlines to competitive carriers continues to bode well for our business.

James Breen – Thomas Weisel Partners

Great, thank you very much.

Operator

Thank you, sir. Our next question comes from the line of Tim Horan with Oppenheimer. Please go ahead.

Tim Horan – Oppenheimer

Thanks, guys. Couple of questions, maybe more market size related. Rian, at the end of the day what percentage of the US market do you think you can actually serve from an interconnection basis, one? And secondly what do you think the size of the terminating access market is at this point now that you’ve gotten to kind of study it a little bit better.

And then on the third front, you showed a huge amount of operating leverage this quarter, do you think your expense run rate and your headcount and the facilities that you have can handle the growth over the next couple of years or we’ll continue to see a lot of leverage in kind of a three to four year period, or do you think you’d kind of rather hold margins more in this range? Thanks.

Rian Wren

Okay. First question, I think where the markets go today, as of the second quarter, we are currently in 45 of the top 50 MSAs and 76 of the top 100 MSAs. With regards to our plans for this year with the additional 12, 11 plus 12, over the 30 markets that we’re putting in place, that number should change by the end of the year. We should be covering all 50 of the top 50 MSAs and 88 of the top 100 MSAs. And my information tells me that the top 100 MSAs cover about 78% of the population of all the MSAs in the US. So, I think we are going to get fairly significantly penetrated. In fact, many of the comments that we’ve recently have been getting from customers is their surprise at just how pervasive Neutral Tandem is with regards to its deployment, not only in the major markets, but we can reach pretty deep. So, we have been getting some very good comments on that. So, I think we are going to have some fairly good coverage over the next couple of years here across the population.

Secondly, the terminating switch access, I wish I had a more refined answer for you Tim, we really haven’t done given our focus for this quarter much more a evaluation of the size of that market. We do think that as we mentioned in the last call that it’s probably about a third of the size of the transit business. And yet because it’s been developed and it’s been in existence, people obviously have been terminating to local exchange carriers for the better part of 15 years, 18 years since divestiture. Many of those carriers have found way to get around the tandem, so there’s some level of direct connection from the carriers’ network down to the end office. We are still trying to size that. I think we are not going to really know specifically until we get down the road a few and see how the growth of the business is. So, we are hoping as I said in the past that we can grow that segment into a 10% to 15% contributor to the revenue stream for Neutral Tandem. But again those are aspirational numbers without a lot of the analytics behind them.

Tim Horan – Oppenheimer

And just in that regard, once you have the markets built up of local interconnection, is it very difficult to add the access component onto it, is it just software upgrade to you switches?

Rian Wren

No, it doesn’t require any technology upgrades to our switches. What it requires is the terminating carriers to be willing to accept that type of traffic. It is essentially a different type of regulated traffic called access. They currently receive it from the incumbent tandems of the Bell companies and it is a matter of getting them to allow for our facilities that are already in place with them to carry a different type of traffic. So, it requires customer agreement. Everything that we do with regards to traffic and arrangements, interconnections with our terminating carriers, we do completely above board. For those of you that follow the industry, there are a lot of carriers out there, who will arbitrage different types of traffic. That’s not the case with Neutral Tandem. We do not do that, never have and never will. And so we gain agreements from our customers that they will accept the access traffic under the access conditions, rules, et cetera. And so that takes some effort (inaudible) more contract negotiation, and then it’s the selling process with the exchange carrier that’s necessary to effectuate us getting that business.

Tim Horan – Oppenheimer

But it is fair to say so far people didn’t really open to your service?

Rian Wren

Yes, I think in general – I mean I think because typically a terminating carrier will receive revenue with terminating access traffic which is different than local transit traffic, they are much more cautious with regards to your interconnection process, the generation of billing records that we provide them so that they can continue to receive that revenue. So, there is a little bit of more caution and rigor involved in the testing and trial of that than is with the existing business. But in general, once you get through and you have a relationships with them and you prove that you have integrity in that process, they are generally receptive to it.

Tim Horan – Oppenheimer

And then on the expenses front, it seems like once you have the special access lines connected into the switches that you should have an awful lot of leverage as you fill up on minutes on to that capacity?

Rian Wren

Well, we do. Again, the minutes will always drive capacity and capacity drives more connections, okay. The leverage really comes from the operating side of the business which kind of gets to your third question is you are beginning to see what’s driving our operating efficiencies and our margins is many fold. And the first is, I mentioned the deployment of the technology. The operation of the soft switches significantly reduce our operating expenses, not just capital efficiencies, but our operating expense, floor space, power, utilities, people, et cetera. Secondly, as you see the full year impact of our decision last year to in-source our signaling assets which again directly affected our operating profits. Next is our network optimization. We have hundreds of thousands of trunks connecting our switch sites to our customer locations and we are continually optimizing those to get them to the most efficient past the capacity level interconnections as necessary, and that’s driving the cost out of our business.

Next is just the people, operational efficiencies, the ability for us to grow our business this year. And as you know just gradually increased the headcount, just volume with regards to expanding our margins. And again this year obviously we’ve ramped down with our successful completion of settling with Level 3, we’ve ramped down expenses that we have expected to incur for regulatory and legal expenses. So, all of that has contributed to a very significant increase in our guidance. We continue to see that moving forward, we continue to see the operation expense scaling the business. I hope that responsive to your question.

Tim Horan – Oppenheimer

Very helpful, thank you.

Operator

Thank you, sir. Our next question comes from the line of Jonathan Ho with William Blair & Company. Please go ahead.

Jonathan Ho – William Blair & Company

Good morning. First question is what type of impact should we expect on OpEx from the settlement at L3? And then second question relates to the competitive environment and whether you guys are seeing any traction from any new players?

Rian Wren

Yes. On the first question, Jonathan, essentially what we want to say there is that you are seeing in the margins guidance a change. Essentially when you look at the expansion in our cash flow, that’s included. And here is the reason why. One is we really have always been reluctant to signal to any of our competitors what the cost of representing ourselves, particularly with Level 3 matter wise. And again, it was all an estimation to begin with, and we’ve had conversation of the ups and downs because of the time and lumpiness of litigation, which doesn’t flow smoothly over the quarter. So, it’s all an estimation anyway. And essentially what we’ve done is fundamentally reduced our legal expense forecast for the year down to normal operations. Level 3 was a bit of an aberration. So essentially if you look at the guidance that we have, we strive very hard to give you something that we actually will end up in those ranges.

With regards to competition, I would think everybody would expect that with a business that’s growing and a market that’s actually growing due to the share shift and a business that’s as successful as Neutral Tandem, it’s going to attract competitors. So, we fully expect that, we’ve been talking about it, we’ve talked about Level 3 who was really the root of I think our dispute. And essentially they have been fairly vocal about the fact that they want to and in fact say they do offer these services and are offering these services. I am sorry we’ve talked about them. I would think that there would be other people that will come into a market that is becoming more and more open and competitive, so I would expect to see competition. We are large enough at this point in time where it is difficult to see whether people are making any inroads at this point in time. Obviously our business continues to grow. We welcome competition. We think that we’ve got the size, scale, scope and the value proposition in the relationships with our customers that we think we can compete fairly robustly with others that come into the marketplace. We actually welcome it because we think the more competitive the marketplace gets, the more deregulated it will become.

Jonathan Ho – William Blair & Company

Last question on Peerless Networks and their patent infringement lawsuit, can you just give us some overview of what’s happening there?

Rian Wren

Yes. With respect to the – what I would say is with respect to our claims for patent infringement, we think that the complaint we filed speaks for itself, it’s available. If you happen to read that complaint, you will know that it provides that the CEO of Peerless was at one time the Chief Operating Officer and President of Neutral Tandem, and I think that offers some context with regards to the actual infringement case. But fundamentally, that action is us taking steps to protect the intellectual property that we invented and developed and perfected over the last several years.

Jonathan Ho – William Blair & Company

Great, thank you.

Operator

Thank you, sir. Our next question comes for the line of Will Power with Robert W. Baird. Please go ahead.

Will Power – Robert W. Baird

Great, thanks for taking the question. Congratulations on the results. A couple of things, first is a bit of a follow-up to the margin, earlier margin expansion question, obviously good leverage in the quarter, nice margin expansion sequentially and year over year, how should we think about kind of the long term planning there now in terms of EBITDA margin targets, is it a bit 40% type level achievable over the next one or two years, how should we think about that as a starting point?

Rian Wren

Well, I think it certainly wouldn’t be a question, but I would caution to say that Neutral Tandem has not finished with fundamentally leveraging the broadest, most interconnected tandem interconnection network in the country at this point in time with regards being independent of the Bell Company. And so we are focused and I am talking more a little further out now with regards to becoming a tandem infrastructure service provider to allow the customers that we already have these relationships with as opposed to just an interconnector between them.

So having said that, what I mean is that we think that the margin that we are demonstrating clearly is sustainable, we think they probably could be increased. However, we are looking to grow this company sizably over the next several years and we will be making some investments and some new product launches over the next year or so here as we try to take advantage of what we build. And I think the asset that Neutral Tandem has is a significant part of the Neutral Tandem story. We’ve got a great business, we’ve great relationships with our customers, but the assets that’s being created across United States, with the technology that we’ve been aggressive deploying I think opens up a lot of opportunity for us to begin to be other things to the existing customers.

So having said that, I think to be direct to your question, yes, I think if we wanted to do nothing but expand margins, there’s opportunity for that, but I think we are going to be investing for the future. And as the other individual, yes, I suspected them. We’ll see competitive inroads and we will see people come into the business, and as I mentioned we welcome them. So I think we’ve got a lot of flexibility with regards to where we are and who we are and the strength of our balance sheet and we look forward to that challenge.

Will Power – Robert W. Baird

Great, thank you. And then my second question relates to price per minute transported in Q2 and how we should think about that moving forward. I think you may have alluded to this in the comments and I apologize if I missed that but I guess I’d be interested in any color on what might have driven the price per minute trends in Q2 and then again by extension how we should think about the various elements there in the second half of the year. Thanks.

Rian Wren

Sure, we did mention it. We have been forecasting that we would be maintaining our ARPU at about 0.2. [ph] What you’ll see in the guidance is just a slight movement downward. We wanted to be open with that. It’s primarily driven by some pretty quick growth that we are starting to see in the markets we put in last year. And the focus on that and the implementation of Verizon Wireless has had the effect of a little bit of a slight decrease. Even though it’s still above what we’ve projected, we wanted to signal that it potentially could be a little below at the end of the year, mainly driven by structural pricing. In other words, it’s fundamentally driven by the rates our pricing power is really discounted off of the incumbent monopoly telephone provider, not necessarily monopoly anymore, because obviously we are out there competing with them. So, it is these – their rates that tend to be regulated, and then we come in with a jaded proposition across that.

So, it’s really driven by the structure of the industry not necessarily at this point a deregulated marketplace pricing scheme. So, for one, we called it out because we want to be completely transparent to everything else going on in our business. Obviously, you are seeing the execution of scaling to the point where it gets overwhelmed by the ability for us to scale our cost structure, and so we just want to call it out. We don’t see it as a precipitating problem, and as we try to make an estimate this year, again it’s an estimate of the mix between our transit business, our access business, Verizon Wireless growth, et cetera and we try to put a forecast out there that is conservative.

Will Power – Robert W. Baird

Okay, great. Thank you.

Operator

Thank you, sir. Our next question comes from the line of Mark DeRussy with Raymond James. Please go ahead.

Mark DeRussy – Raymond James

Good morning. Rian, want to circle back to the switched access opportunity and if I am hearing you correctly, it sounds like one of the issues you are working on is to sort of increase the network effect, if you will, by expanding the number of local carriers that would be willing to accept the traffic, the switched access traffic, can you talk a little bit more – I know you touched on this earlier about some of the incentives and perhaps dis-incentives the local carriers would to accept the traffic, any color there would be helpful?

Rian Wren

Sure, I’ll give you a little color. The dis-incentive is that, one, obviously all of these carriers are very busy in our operations areas competing in a fairly robust marketplace at this point in time, so any new work that they need to do obviously needs to be looked at. When they look at accepting this traffic over us, they actually essentially already received this traffic and so they are receiving over us is some work at that they have to do and necessarily they want to make sure that we don’t in the process interrupt any revenue attainment that they are currently receiving, so that’s something that they have to work through with regards to getting comfortable with that.

The positive from their perspective is that they receive this traffic over the same facilities groups that Neutral Tandem places between our network and theirs and we cover the cost of that. So, there’s some efficiency associated with them reducing the costs that they will incur to receive this traffic. So there are some upsides to it and there’s some caution to it. So, it is really just a process of working through some of those issues with the carriers. Some of them get it pretty quickly, some of them take same time, and generally what we find is just trying to get the attention of carriers that are very busy with a whole number of operational issues trying to do that.

Mark DeRussy – Raymond James

Thanks, that’s helpful. And then when it comes to Verizon Wireless and your ability to take them on as a customer to use your interconnect services, it sounds like that’s not in your guidance, just want to verify that? And if you could give us a sense of where you are in the process of your discussions with Verizon, the caveat being that any type of negotiation with Verizon can take a long time?

Rian Wren

Yes. Where we are is, we’ve just finished probably one of the most intensive interconnection operations with Verizon Wireless, and my hats off to Verizon Wireless. I think that they have worked with us as cooperatively as we could have asked and I think they’ve gained as a result of that some respect from Neutral Tandem with regards how quickly and efficiently Neutral Tandem can interconnect with them because a lot of work was done by us and a lot of work was done by them. So what we wanted to do was take stock of that a little bit, start utilizing those facilities with our customers. And in parallel our account teams are actively discussing with Verizon Wireless the opportunity for them to avail themselves of the opportunity to use those facilities to originate the same traffic on us. We are taking that in a very slow and measured approach, not trying to rush one thing before it should be. But we are engaged in discussions with them and at this point I’d say we feel that the discussion are going well.

I don’t think – I think Verizon Wireless is a fairly strong competitor and I think when and if they make a decision I don’t think it’s going to be that drawn out, I think that they would make a decision to either use us or not. So, we are cautiously optimistic about that. I also wouldn’t expressly exclude a complete exclusion of any expectation that we wouldn’t get some traction [ph] from guidance. I mean as I mentioned to you on the guidance side, we have tried to balance driving the company to be as aggressive as possible, and at the same time responsible with regards to the numbers that we provide you people. And so we have a range and we as a group here intend to compete for Verizon Wireless business and we have an expectation on ourselves that we will accomplish that sometime this year we will see, nothing ventured, nothing gained.

Mark DeRussy – Raymond James

Thanks.

Operator

Thank you, sir. (Operator instructions) And we do not have any further questions, I would like to turn it back to management for any closing remarks.

Rian Wren

Okay. Let met just wrap up. Very pleased as I mentioned with the quarter, I am glad for the participation in today’s call. We as a group of managers are very excited about the business and want to reiterate that we are busy here in Chicago working hard to grow the business and we expect to continue to earn your investment in our business. So thank you very much for your time today and we look forward to next quarter’s call.

Operator

Ladies and gentlemen, this concludes the Neutral Tandem second quarter earnings conference call. If you would like to listen to a replay of today’s conference, please dial 303-590-3000 or 1-800-405-2236 and enter pass code 11117152. Once again if you would like to listen to a replay of today’s conference, please dial 303-590-3000 or 1-800-405-2236 entering pass code 11117152. ACT would like to thank you for your participation, you may now disconnect. Have a very pleasant day.

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Source: Neutral Tandem, Inc. Q2 2008 Earnings Call Transcript
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