Tinet Kickstarts Neutral Tandem's New Growth Initiatives

Maxwell Smart was an idiot that employed cutting edge communications. Mr. Market represents today's idiots that don't understand, and can't differentiate among, telecommunication companies. Intense price competition doesn't always result in Level3 [LVLT] like financial performance. Yet, that is exactly how the market is treating Neutral Tandem [TNDM].

Disruptive technologies and commodity offerings do result in revenue challenges, but all companies aren't affected equally. The downfall of LVLT and most similar companies was severe over capacity and usage of debt, two factors that do not negatively affect TNDM. Neutral Tandem is debt free and asset light, as they have taken advantage of industry over building and leased their fiber at attractive rates. They have also stayed out of the retail business of their customers and also not pursued enterprise business in competition with those same customers. They've remained wholesalers and have, consequently, be able to gain market share of carrier business.

While TNDM has gained share, total minutes are growing 20+ percent, prices are falling. Revenue is flat, but margins remain healthy. Their niche in voice switching remains solid and viable for the forseeable future. But growth is elusive and a company needs to grow. Management has pointed the company in the direction of termination of international calls and ethernet exchange. They have been expensing all of their expansion efforts and have the balance sheet to accomplish the mission.

Thursday the company jump started their international and ethernet plan. They announced the acquisition of Tinet, an Italy based IP transit and ethernet services company. TNDM is paying $95MM in cash or 6.1X post synergies EBITDA; 7X without the synergies. After the all cash transaction, TNDM will still have over $90MM of cash on hand. The balance sheet will remain strong as TNDM continues to project throwing off over $30MM of free cash next year.

Tinet, with sales of $56MM and EBITDA of $10MM, brings a strong presence in wholesale IP transit and about $5MM of ethernet revenue. The combination of TNDM's North American voice business with Tinet's international data networks offers significant new business opportunities within the customer base. The combined network will offer future ethernet customers over 100 locations worldwide, much broader than any of the fledgling ethernet providers. This growth area now looks much more promising and the CEO states that ethernet revenue should be growing nicely in 2011. Additionally, termination of international calls should ramp up revenue as TNDM solicits Tinet's customer base.

The combined company, at 6/30/10, would have had sales of $230MM and $99MM of EBITDA. After deducting $95MM of cash for the acquisition, the enterprise value of TNDM is only $236MM or 2.4X combined EBITDA. TNDM is cheap.

Maxwell Smart, I mean Mr. Market, will eventually accept that TNDM's voice market isn't near-term terminal or become ethernet exchange believers. Short sellers, over 10% of the float, have made a killing on the ride down and must be near the exit point as the bottom must be near for a company with no debt and lots of cash per share. We may be several quarters away, but at $10 Neutral Tandem is a buy. I thought so at $13 and I'm a bigger believer after yesterday's announcement. I bought more shares on Friday and harbor no thoughts that TNDM will follow the path of Level3.

I Need My Head Examined

Be cautious, look over your shoulder, lighten up on rallies, all make sense and generally describe my investment behavior. But it gets boring staying with the same long term holds, dividend plays, and anti-inflation stocks. So, in the midst of the recent melt down, I opened a new position that will either do extremely well, as everyone seems to hate the company, or limp on as another Level3. In fact, it is a Level3 competitor. I invested long in the telecom field. I need my head examined.

The latest proof of my increasing dementia is my purchase of Neutral Tandem, TNDM. This is a relatively young company that went public in the Fall of 2007 and has grown rapidly in sales and profits. 2010 revenue is projected to be $180M and analysts predict earnings per share of $1.11. TNDM currently sells for $13; a PE of 11. It went public at about $17 and was in the mid 30's as recently as 6 months ago. It's gone the opposite way of the market.

The company is performing wonderfully. May 5th TNDM announced 1st quarter results and revenue grew 17% due to a 26% increased in minutes billed. EPS was flat for the quarter. They have $171M of cash and no debt- a rock solid balance sheet.

So why doesn't anyone like the company and why has the stock price been cut by nearly 2/3rds? I wish I knew for sure. The concerns that have been discussed are a patent battle with competitor Peerless [ since they already compete, and the company has other competitors, the worst outcome is high attorney fees], recent competition from both Peerless and Level3 [ revenue growth shows the company is holding its own, but flat earnings on a 26% increase in billable minutes the indicates pricing pressure of competition], and finally more direct traffic between carriers that doesn't require tandem switching.

Neutral Tandem's business is the switching of calls between new carriers [Sprint, cable, etc] and telecoms majors. TNDM doesn't compete with their customers like other carriers do and their tandem system is state of the art. They are the big player in this subset of telecom. Competitive pressure and the future of IP switching will not decimate revenue and earnings overnight. They are also expanding into ethernet switching which should add new revenue streams.

The stock price trend is down and it sure could continue, especially if the market continues to hemorrhage, but I think $13 is a good entry point. At an EV/EBITDA ratio of 3, you usually do well with a position, especially if the balance sheet is sound.

I've pulled the trigger so lets see how it turns out.

Are Longleaf and Fairfax Visionaries Or Just Stuck?

Years ago, like nearly everyone else who resided in Omaha, Nebraska, I drank the Level3 Kool-Aid. Level3 was an offshoot of Kiewit Construction and everything the Kiewit guys touched turned to gold. They built roads, tunnels, big buildings and mined coal and aggregates. They bought the failed Continental Can Company, stripped it and came out with huge profits. They started a fiber optic company that became the forerunner of MCI and sold it to WorldCom. Level3 was a do-over of a business that they had already made billions in and directed by the same management team that led the former success. Additionally, the managers and accountants of Kiewit would once again make sure the venture was run soundly. But Kiewit was a private company. You could only envy, you couldn't participate unless you worked there.

Level3 eventually went public. We could all get in and become Kiewit millionaires. Omaha did. In the dot-com bubble it hit $158 per share. It became not only the darling of Omaha, but the high tech investing world. It has been all downhill from there. Paper fortunes have been lost and many margined fortunes sunk real fortunes. The devastation has been significant on Omaha Kiewit wannabes. I thank my lucky stars that I wasn't a pig as I often am. I made a few dollars and have watched the saga from the sidelines.

Walter Scott, Level3's Chairman and former Kiewit CEO, has a great business reputation, in spite of Level3's performance. He has an engineers mind, a businessman's nose, and integrity. Those qualities have attracted some quality associates: Warren Buffett, Leucadia Financial, Mason Hawkins of Longleaf, and Prem Watsa of Fairfax Financial Holdings. The first two have done bond financings while the latter two have done both bonds/convertibles and common stock. To the best of my knowledge Berkshire and Leucadia are not involved with Level3 at the present time.

Southeastern Asset Management, Hawkins' company owns 429 million shares and Watsa's Fairfax owns 139 million shares. Both Fairfax and Southeastern each own about a $100 million in a convertible issue paying 15%! I'm not sure if the potential convertible shares are factored into the ownership totals and it really doesn't matter. Included or not, these two guru investors have placed a huge bet on Level3's future. They own approximately 35% of the company, possibly more. While respected value investors, they must be betting on the company's franchise value and moat. LVLT sells at over 4 X Book and has virtually no tangible book value, it's $6 Billion of debt dwarfs it's equity, interest charges gobble up over $1/2 Billion per year, and net earnings have been rare over it's lifespan. It doesn't fare well under almost any value investing metrics. Yet, two guys smarter than me have parked lots of money here. Additionally, both have the bulk of their net worth tied up in their companies, so they aren't some Wall Street hotshot playing with other peoples money while skimming large fees. They must believe.

It's obvious that they too have drunk the LVLT Kool-Aid. Will the result be different from the losses sustained by many of the Omaha faithful? Buffett and Leucadia were attracted by the generous terms offered by LVLT, made a well calculated investment and have exited. Hawkins and Watsa have the bulk of their money at risk in common stock. Their 15% yields on the convertibles is attractive, but the majority of their investment pays no interest. Whether they are under or above water on their positions, they are believers. They still own a ton of LVLT shares.

None of the other security companies are even close in their devotion to Level3, in fact, many other holders are indexers and smaller institutional positions. Analysts aren't impressed. The stock is the province of penny stock speculators and two, well respected value investors. Not the usual bedfellows. When the share price moves it is the result of rumors touting a Google or Sprint acquisition, not any improvement in financial condition. Why do Hawkins and Watsa stay and should I join them?

I think I'm going to keep watching this drama from the sidelines. I had a taste of the Kool-Aid, but have been able to kick the habit. With $6 Billion of junk debt, declining revenue, and poor operating results, I see lots of dilution ahead. LVLT has been masterful at balance sheet management as they have restructured, refunded, converted, and issued securities along their route to telecom survival. But, more of their debt will get turned into equity. Even at a discount, more shares equals dilution.

If Level3 doesn't work out well for Fairfax and Longleaf it won't sink their funds, but individual investors would be better off staying away from dilution prone balance sheets.