Neutral Tandem (NASDAQ:IQNT) Q3 2012 Earnings Call November 7, 2012 10:00 AM ET
Richard L. Monto - Senior Vice President, General Counsel and Secretary
G. Edward Evans - Chief Executive Officer, Director and Chairman of Capital Allocation Committee
David Zwick - Chief Financial Officer, Principal Accounting Officer and Executive Vice President
Hamed Khorsand - BWS Financial Inc.
Ladies and gentlemen, welcome to the Inteliquent Third Quarter 2012 Earnings Call for the 7th of November, 2012. [Operator Instructions] I would now hand the conference over to Richard Monto, General Counsel. Please go ahead, sir.
Richard L. Monto
Thank you, and welcome to the Inteliquent third 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 those 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 statement. 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. And thank you for joining us today to discuss our third quarter results. First, I will provide an update on our proposed settlement with a large customer followed by an overview of our operational results. And then David Zwick, our CFO, will provide a detailed review of our financial performance, as well as some new operational metrics. We will provide time for questions following our prepared comments.
First, I'd like to update you on our previously disclosed dispute with one of our largest customers. As we have previously discussed, one of our largest customers had alleged that we had improperly delivered long-distance voice traffic to their network in breach of our interconnection agreement. Over the past few months, we've been working with that customer to resolve the dispute, and to renegotiate our commercial agreement with that customer. We recently reached a proposed verbal agreement with the customer, that will include the customer continuing to use our services, and will resolve material outstanding claims between the companies. The final documentation is still being completed. However, if we finalize the settlement, we will pay the customer a one-time payment of $9 million.
In addition, as part of the overall settlement, the customer has agreed to continue to purchase services from Inteliquent at new negotiated rates. While we expect the future revenue from the customer to be significantly less, we are pleased that it appears we will retain the majority of their traffic, and we will have the opportunity to continue and possibly expand our relationship going forward. I should note that there can be no assurance that we will reach a definitive final settlement agreement relating to this matter.
During the quarter, we made significant changes to the senior management team. I believe these changes are a natural progression as we continue to transition the company, and I'm very pleased with the current management team's progress, and I'm confident we have the right people in the right positions to execute on our plan going forward.
From an operational perspective, our results were disappointing. While our voice business performed about as expected, our data business was weaker than forecast. Our revenues for the quarter were $68.8 million. The data business was affected by larger than anticipated price decreases with a couple of our larger data customers, as well as sales results that were below expectations.
In order to bring additional focus to our performance, I've reorganized the sales organization to segregate our voice and data businesses. We now have separate senior sales management for the data and voice businesses. Specifically in the data business, I have promoted one of our top individuals, to now manage the sales organization globally. I believe this will bring additional focus to our data sales, as well as allowing our voice management to be even more focused on voice sales. I look forward to sharing our successes with you in future quarters.
Operations expenses for the quarter increased to $13.5 million. Excluding several one-time items, our expenses were up by $2 million over the second quarter of 2012. The details of the increase are available in the press release. However, as a result, we initiated a thorough internal review of our cost structure. The review has resulted in a reduction of nonstrategic headcount within the organization. We are looking at all areas of the operations expenses as we continue to find ways to operate more efficiently. I am confident that we will identify several additional areas for improvement within the company.
Network expenses increased to $32.4 million for the quarter, and we have also begun an aggressive review our network cost structure. We are very focused on grooming the network to be more efficient reducing our cost per circuit while not in any way jeopardizing network quality. I am pleased to report that during the recent events around Sandy, our network teams did an outstanding job of maintaining network integrity. We received a large number of compliments from our customers during this tragic event. And I want to thank everyone in our company for a job well done during this time.
Our adjusted EBITDA, a non-GAAP financial measure, was $17.3 million for the quarter, down from $22 million in the third quarter of 2011. The majority of the decrease is attributable to higher network cost, employee cost and tax expenses. All 3 of these areas are getting significant attention, as I previously described.
We recently completed a strategic review of our HCS offering. After having been in the market for some time now with this product, it became more and more apparent that this is not a business we should continue to pursue. After seeing the competitive nature of this segment and not having sufficient control over the distribution and the product offering, we've elected to exit the business. We are in the process of selling the hardware and have eliminated or repurposed the headcount associated with the business. David will walk through the write-downs in this -- on this product in his segment later on.
While the HCS product is not an area we wish to pursue, we remain very bullish on Hosted Solutions. Several months ago, we began building a team of product and engineering assets to begin development of interoperability solutions targeted at carriers. We have a proven ability to service these customers and we've made substantial amount of progress in developing a suite of products. We've spent a few months visiting carriers to review our plans and we hope to introduce our first couple of services to the market during the first quarter of 2013. We've already identified several carriers that have agreed to beta test our solution.
While it is too early to forecast the impact of these services on our business in the short term, I'm very pleased with the reception we have seen from the carrier thus far. We hope to provide you a more detailed look at these products during the next quarter.
In summary, the transition of the organization is continuing. We have a great team of individuals that are working very hard to make this company a success and to get us back on a growth path. While I am disappointed in our results for the quarter and for the year thus far, I believe we are making the changes necessary to get back on track.
I'll now turn the call over to our new CFO, Mr. David Zwick.
Thank you, Ed. In a nutshell, our financial results for the third quarter were weak. Total revenue was $69 million, representing 1% sequential growth from the second quarter and 2% year-over-year growth compared to the third quarter of 2011. As most of you know, we operate a voice business and a data business. The voice business consists of 4 product lines: termination services, local transit services, origination services and international voice services. The data business consists of 2 product lines: IP transit services and Ethernet services.
Our voice revenue has been fairly stable over the past 5 quarters as illustrated in the chart containing our press release this morning. Quarterly voice revenues have fluctuated between $50.7 million and $53.5 million. This has resulted from a fairly stable number of minutes fluctuating from $32.8 billion to $34.2 billion per quarter, and a fairly stable average revenue per minute, fluctuating from $0.00154 to $0.00158.
As we look forward to the fourth quarter, we foresee several issues that will likely impact the stability that the voice business has exhibited in the recent past. First, as Ed mentioned, the dispute with one of our largest customers is expected to result in us retaining the customer relationship, but at a significantly lower rate schedule. Second, our DID termination voice product, which we launched earlier this year, has faced execution challenges. It continues to grow, but not at the rate of growth that had been expected initially.
Turning to our data business. Data revenues continue to be driven in large part by our IP transit product. Our Ethernet product, on the other hand, is performing well, a real bright spot for us, but its size is still small relative to that of IP transit.
In the third quarter, data revenue was $16.6 million, representing a 5% decrease from the second quarter and roughly flat compared to the third quarter of 2011. Our data traffic continues to grow at a nice pace. Traffic increased by 41% to 8.2 terabits in the third quarter of 2012 from 5.8 terabits in the third quarter of 2011. However, over the same period of time, our average price decreased by 30% to $2.01 per megabit from $2.86 per megabit. In the quarter, we can -- we did continue to add customers and achieved a milestone by surpassing 1,000 data customers.
Looking forward to the fourth quarter, we are adjusting our views in the performance of our IP transit product. Pricing is declining faster than we had previously estimated, and volume growth estimates are also being tempered somewhat.
Moving on to profitability. Adjusted EBITDA was $17.3 million in the third quarter of 2012, representing a 6% decrease from the second quarter, and a 21% decrease compared to the third quarter of 2011. Our adjusted EBITDA margin was 25.1% in the third quarter, down from 27.1% in the prior quarter, and 32.6% in the third quarter of 2011. One of the large factors that impacted our adjusted EBITDA performance in the third quarter compared to the prior quarter was an error by us, related to the launch of a new voice termination product, that results in approximately $1 million of unrecoverable costs.
In the third quarter, there were 5 items that were added back to EBITDA in the calculation of adjusted EBITDA. I'll walk through each. First, noncash compensation expense was $2.5 million during the quarter. This is an adjustment that we make to EBITDA every quarter. Second, we recorded an expense for the estimated carrier settlement for $9 million. I should note that there can be no assurance that we will reach a definitive final agreement related to this matter. Third, as Ed mentioned, we decided to shut down our HCS business line. As a result, we have recorded an impairment of $1.8 million. Fourth, we recorded an additional $0.7 million expense for value-added taxes, that we owe in certain European countries related to prior periods. This brings the total amount of unpaid VAT liabilities on our balance sheet to $2.5 million, including penalties and interests. Fifth, 8 employees were let go during the third quarter, resulting in a severance charge of $0.2 million. We expect to also incur a severance charge in the fourth quarter.
Capital expenditures totaled $6.2 million in the third quarter, compared to $5.7 million in the second quarter of 2012, representing 9% of third quarter revenue. Year-to-date, CapEx is approximately 10% of revenue.
We generated cash flow of $3.6 million in the quarter. We ended the quarter with an unrestricted cash balance of $114 million. At the end of October, we paid a special cash dividend, which amounted to approximately $97 million.
As announced in our press release issued earlier today, we have revised our financial projections for 2012. Revenue for 2012 is expected to be $265 million to $275 million. This is approximately 5% lower than our previous projection of $280 million to $290 million.
Adjusted EBITDA for 2012 is expected to be $60 million to $65 million. This is approximately 20% lower than our previously -- than our previous projection of $74 million to $82 million.
Capital expenditures for 2012 are expected to be $25 million to $30 million, which is unchanged from our previous projection. Revenues are expected to be less than previously estimated due to 3 main factors: the new economic agreement, that we expect will govern the relationship with one of our largest customers, a softer ramp up than previously forecasted in our growing DID voice product and larger than expected pricing declines in our IP transit service.
Adjusted EBITDA is expected to be impacted primarily by lower voice revenues and gross margins related mainly to the new proposed economic agreement with one of our largest customers. This agreement is expected to be retroactive through October 5, 2012. As mentioned previously, it is expected to significantly reduce the rates the carrier pays to us. It is also expected that we will begin to pay the carrier a significant amount for terminating long-distance voice minutes to them.
Other factors impacting our adjusted EBITDA estimates include higher than expected operating expenses, and lower than expected data gross margins.
Finally, I'd like to highlight 1 new item in our quarterly earnings press release. For the first time, we've included a chart containing selected financial and operating metrics for the past 5 quarters. We do intend to provide these metrics on a go-forward basis as a way of tracking key trends.
That concludes our remarks. We would now like to open up the call to questions. Operator?
[Operator Instructions] The first question comes from Hamed Khorsand from BWS Financial.
Hamed Khorsand - BWS Financial Inc.
Just trying to get -- figure out here, you're looking at network cost and talking about reducing it. I'm just looking at historically what those costs have been when your revenues were at similar levels. And I'm looking at like about $5 million or so reduction. Could you guys provide some color on that?
G. Edward Evans
Well, I don't know. If you're looking at revenues don't correlate directly to volume so as pricing has been coming down, volume would be -- go up, therefore you'd need more network in order to support the same amount of traffic. So I'm sure that's probably what the Delta is.
Hamed Khorsand - BWS Financial Inc.
Okay. No but -- you were talking about managing your network expenses. So managing...
G. Edward Evans
Yes, specifically what we're looking at is going back and re-, sort of auditing the network and looking for circuits that may be up and running a network that we're not using any longer. That can happen over a period of time, you can kind of get a little sloppy and have a lot of circuits that you're not using. It also has to do with being much more proactive in dealing with our vendors with respect to what we pay for those circuits, and going back and renegotiating cost associated with those vendors and basically demanding lower pricing from our vendors with respect to circuit cost going forward. Those are the 2 biggest elements.
Hamed Khorsand - BWS Financial Inc.
Alright do you think that, that's going to cost -- how much of savings are we talking about significance or just minor just to keep the business up, up [ph].
G. Edward Evans
No, I mean. I think it's early to say right now. I think we're going through that, and we're hopeful that we're going to find cost savings in there. But I don't know specifically what bag [ph] you think it's going to be. Obviously, more is better and we're going to try and get what we can without sacrificing any of the network quality.
Our next question comes from Matt Chapman [ph].
I just wanted to get a sense on your visibility going into 2013, now that this large customer contract has been negotiated. And then also since on -- what are the chances of the 2 other large customers that you have coming in and wanting some of these same pricing discounts that you're giving to this 1 customer that you recently renegotiated?
G. Edward Evans
Well, I'll take the second one first. And that is the pricing of the new contract is more in line with where the other carriers are today. That particular carrier was out of market and was higher priced, than what the other carriers had been. And they had been out of market for some time and so the adjustment really brought them down in line with where the other carriers are. So while there's always a risk of additional pricing pressure, we don't see it as a significant risk with respect to the other large carriers, because frankly, they're all kind of in that range today, and not materially different from each other. And I'm sorry I missed the first part -- -- oh the first part was on visibility into next year. I think we'll have a better sense of that as we go through this quarter. One of the metrics that we just don't have a lot of clarity on right now is because we're going to be paying a termination charge to this carrier for long-distance right now. That means we have to effectively raise our rates to our customers. And when we do that, those updates will go into the lease cost routing tables across the country and than our then customers will make a decision whether to continue to send us that traffic or not. So in some cases, we expect to lose some of those minutes because they may be able to find another lower cost way to get into this particular carrier. It's very difficult to forecast that. So I think it's going to take us really the fourth quarter to understand. Our pricing has been raised today and it's out there and we'll start to see what those minutes look like. And from that, I think we'll be able to better extrapolate what next year is going to look like. But I just think for that particular segment of the business right now, it's just -- it's difficult to forecast it because we don't know how much of that traffic may move.
Okay. And then on the data side, I mean, can we assume the standard pricing declines and pretty much a stable run rate of traffic, I guess, growth?
G. Edward Evans
I think so. We don't see anything that looks materially different right now, other than we've got to get significantly more focused on sales. And we've got to get out there, I think our guys have done a pretty decent job. But we've got some areas within the organization that frankly, need to step up and kind of get it going. We've made some changes in order to accommodate that, and I certainly look for better sales performance in 2013 than I've seen in 2012.
Our next question comes from Alex Claus.
I guess, can you talk a little bit more about the sales reorganization? I guess, when this took place, how long of a ramp you think it will be until their up ready to sell the data product. And then, I guess would you be interested in acquiring any additional assets to support the data side of the business?
G. Edward Evans
With to the respect sales reorg it's been sort of in process, if you will, over the last 30 days. There haven't been a lot of personnel changes, it's been more about responsibility changes. I think we've got a talented group of individuals right now, but previously, we were sort of cross-selling between voice and data products. And had product management that at times crossover between voice and data products, and in my opinion, that caused a little bit of distraction. And so by making it a little bit more cylindrical and getting the voice guys really focused on voice and taking the data stuff off of their plate, and now in turn getting the data guys focused on data, I just, I think we're going to bring more focus into it. In the U.S. in 2012, we did a sort of first step of dividing data a little bit into sort of IP transit and Ethernet type of separate sales forces, if you will. I mean there's still a little bit of cross-selling but generally speaking, it's separated. We're now expanding that out into Europe and to Asia, and I was over in Asia, I'm sorry, over in Europe about 2 weeks ago and started that transition. So it's going on right now. I suspect it'll go relatively quickly. And we're also in the same process of doing of doing that in Asia right now as well. So it goes fairly quick. It's -- there will be some incremental data sales people that we're going to be adding within Europe and within Asia, in order to ramp those up, and get them more focused on the Ethernet product which has sort of been out shining star here so far. So we want to start doing better and doing more with the stuff that's working well, and clearly the Ethernet product is doing that for us.
[Operator Instructions] The next question comes from Robert Chapman.
I was wondering if you look at this from the top down a lot higher than just sort of 2013 projections, which is of course we're all looking forward to seeing. Lazard conducted a process with you all that was more strategic in nature versus day-to-day or quarter-to-quarter, and have probably allowed them to present to you and for you to look at yourself at, how your business and your network compares to those of some of your competitors horizontally, for example, Level 3? And I would like to hear your thoughts on reflecting on that, how your network and how your business compares to theirs and maybe someone else that you'd like to choose that competes as well? And what do you think about transition more to model that seem to be more beneficial longer term than the one that you're in now which is obviously voice centric?
G. Edward Evans
Yes, well, I think comparing us to -- looking at Level 3, who obviously has a very good business that someday perhaps will be profitable. I think we've made it very clear that we've got a model that is profitable and works. And so, I'm very confident in our ability to compete against anybody that's out there right now. That doesn't concern me at all. To your point, yes, we are voice centric today. We are migrating away from being voice centric to being more data centric as we certainly see more growth that's going on there. But you're right, I mean we conducted a very thorough review of the organization where we are. We've got a business that's very profitable. It certainly has the ability to grow once we sort of get through the transition piece that we're going through right now. And we're very comfortable in where we are right now in the space, and I think we'll continue to see that. Around the process, there were certainly a lot of uncertainty with respect to the dispute that we've discussed earlier here in the conference call. And I think now that we've got much more visibility into that, and we know where we're going to be, I think we're much better positioned to more accurately forecast where the business can go, and we do think there is opportunity to grow the business as we go forward.
Can you compare that networks between the 2 companies? And again, I'm going to focus on Level 3 just to make it easier for you. I don't want you to go through about [ph] the rev comparisons. But could you maybe compare it geographical differences, the structural differences at all, as best as you can and maybe in, what 30 seconds or less.
G. Edward Evans
I mean, they're obviously facilities-based and they own a lot of their own fiber. I think we've found some fairly unique areas to go in with respect to pop that are out there. As you know, one of the things that every content delivery network or every ISP want's -- Ethernet guy wants this diversity. And so rarely do they contract with just a Level 3 or with just a Cogent and whoever. Typically, they want diverse paths and I think one of the unique things about our network because we are a lease-based facility is that we can go to a customer and assure them that we can provide diversity across the network by using different vendors that are out there. And so there's always going to be 2 or 3 different guys that are out there. Nobody's going to choose a single vendor. Level 3 the biggest difference being that they are facilities-based, they own their own fiber and with the merger of global crossing obviously gives them a much larger footprint. They tend to be focused on much larger deals than typically we're focused on. I think we focus on, from an of the Ethernet perspective, a sort of 20 to 50 to 100 locations kind of site were Level 3 is focusing on thousand level sites that are out there, and so we target different areas I think in what we doing. But I certainly think there's a lot of room for both that are out there. I think Level 3 is a pretty rational competitor, frankly. We don't see them doing crazy things in the market, they're very rational. They've got a great network. And I think we do, too.
There appears to be no further questions. Please continue is there another point you wish to raise?
G. Edward Evans
Okay. I think we're done. Thank you for joining us today. We look forward to catching up with you guys in the next quarter. Thanks.
This concludes the Inteliquent Third Quarter 2012 Earnings Call. Thanks for participating. You may now disconnect.