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.

Prepare For Disappointment

I had great hopes that last Thursday would be a good stock market day for me. I was sorely disappointed. Mentally I was ready for some lousy results on three of my companies that were reporting earnings that day, but the rest of Wall Street wasn't as sanguine and brutally punished those securities.

The percentage moves were huge for a one day period. Bunge had been trading around $54 and was pummeled to $46, Neutral Tandem was taken down from $13 to $10.50, and Brunswick moved up from $14 to $17.50 [ a short put that stopped working ]. Lots of shares changed hands, probably lots were momentum driven, as the market reacted first and studied, if they did, later.

If a person's investing time horizon is longer than a nano-second, BG and TNDM were, and still are, attractive at those lower prices. The negative bet against BC will also still work, but it will work better for new money as it continues to act strongly. It will take another couple of quarters before company results start looking promising and I feel smart again. Bunge has already climbed back to $52; that's up $6 from the day of panic.

Nap time.

Ray Charles Couldn't Miss This Opportunity

Since Neutral Tandem is down about a dollar since I launched my latest telecom investment, I decided to review the wisdom, or lack thereof, of that decision. I remain convinced and Ray has to be with me. He would have been able to see the value if he was still with us and I'm sure he can see this no brainer from above.

Here are the fundamentals on TNDM:

Forward P/E 10X

Earnings Yield 10%

EV/EBITDA 2.7X

P/B 1.6X

ROE 19%

Cash per share $6

$184 million cash and NO DEBT

Negatives? Revenue growth has slowed as prices are coming down, but market share is growing as minutes handled is growing by 25%. This trend will likely continue, but the company has a neutral business model, it doesn't compete with its customers like other competitors do, and an amazing stable of customers. It's service offerings are growing and customers are buying more. An ethernet exchange is the next growth area, much larger than the current switching opportunity, and it has a leg up on its competition again due to its neutral positioning and established customer base. TNDM is priced like it is going out of business, but it isn't and that's where the opportunity arises.

Neutral Tandem presents at William Blair's Growth Conference on Wednesday. Maybe Ray and the Blues Brothers will help TNDM impress the Chicago investment house's attendees and the market will start to appreciate this very cheap stock.

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.