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TNDM > SEC Filings for TNDM > Form 10-Q on 9-Nov-2011All Recent SEC Filings

Show all filings for NEUTRAL TANDEM INC

Form 10-Q for NEUTRAL TANDEM INC


9-Nov-2011

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

This quarterly report on Form 10-Q contains "forward-looking statements" that involve substantial risks and uncertainties. All statements, other than statements of historical fact, included in this quarterly report on Form 10-Q are forward-looking statements. The words "anticipates," "believes," "expects," "estimates," "projects," "plans," "intends," "may," "will," "would," and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. Actual results or events could differ materially from the plans, intentions and expectations disclosed in the forward-looking statements we make. Factors that might cause such differences include, but are not limited to: the impact of current and future regulation, including intercarrier compensation reform currently pending at the Federal Communications Commission; the effects of competition, including direct connects; the risks associated with our ability to successfully develop and market international voice services and Ethernet services, many of which are beyond our control and all of which could delay or negatively affect our ability to offer or market international voice and Ethernet services; the ability to develop and provide other new services; the risk that our business and the Tinet business will not be integrated successfully; technological developments; the ability to obtain and protect intellectual property rights; the impact of current or future litigation; the potential impact of any future acquisitions, mergers or divestitures; natural or man-made disasters; the ability to attract, develop and retain executives and other qualified employees; changes in general economic or market conditions, including currency fluctuations; and other important factors included in our reports filed with the Securities and Exchange Commission, particularly in the "Risk Factors" section of our Annual Report on Form 10-K for the period ended December 31, 2010 and included elsewhere in this report. Furthermore, such forward-looking statements speak only as of the date of this report. We undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.


Table of Contents

Overview

We provide U.S. and international voice, IP Transit, and Ethernet telecommunications services primarily on a wholesale basis. We offer these services using an all-IP network, which enables us to deliver global connectivity for a variety of media, including voice, data and video. Our solutions enable carriers and other providers to deliver telecommunications traffic or other services where they do not have their own network or elect not to use their own network. These solutions are sometimes called "off-net" services. We also provide our solutions to customers, such as content providers, who also typically do not have their own network. We were incorporated in Delaware on April 19, 2001 and commenced operations in 2004.

Voice Services

We provide voice interconnection services principally to competitive carriers, including wireless, wireline, cable and broadband telephony companies. Competitive carriers use tandem switches to interconnect and exchange local and long distance traffic between their networks without the need to establish direct switch-to-switch connections. Competitive carriers are carriers that are not Incumbent Local Exchange Carriers, or ILECs, such as AT&T, Verizon and Qwest.

Prior to the introduction of our local service, competitive carriers generally had two alternatives for exchanging traffic between their networks. The two alternatives were interconnecting the ILEC tandems or directly connecting individual switches, commonly referred to as "direct connects". Given the cost and complexity of establishing direct connects, competitive carriers often elected to utilize the ILEC tandem as the method of exchanging traffic. The ILECs typically required competitive carriers to interconnect to multiple ILEC tandems with each tandem serving a restricted geographic area. In addition, as the competitive telecommunications market grew, the process of establishing interconnections at multiple ILEC tandems became increasingly difficult to manage and maintain, causing delays and inhibiting competitive carrier growth, and the purchase of ILEC tandem services became an increasingly significant component of a competitive carrier's costs.

The tandem switching services offered by ILECs consist of local transit services, which are provided in connection with local calls, and switched access services, which are provided in connection with long distance calls. Under certain interpretations of the Telecommunications Act of 1996 and implementing regulations, ILECs are required to provide local tandem transit services to competitive carriers. ILECs generally set per minute rates and other charges for tandem transit services according to rate schedules approved by state public utility commissions, although the methodology used to review these rate schedules varies from state to state. ILECs are also required to offer access services to competing telecommunications carriers under the Telecommunications Act of 1996 and implementing regulations. ILECs generally set per minute rates and other charges for switched access services according to mandated rate schedules set by the Federal Communications Commission for interstate calls and by state public utility commissions for intrastate calls. Our solution enables competitive carriers to exchange traffic between their networks without using an ILEC tandem for both local and long distance calls.

A loss of ILEC market share to competitive carriers escalated competitive tensions and resulted in an increased demand for tandem switching. Growth in intercarrier traffic switched through ILEC tandems created switch capacity shortages known in the industry as ILEC "tandem exhaust," where overloaded ILEC tandems became a bottleneck for competitive carriers. This increased call blocking and gave rise to service quality issues for competitive carriers.

We founded our company to solve these interconnection problems and better facilitate the exchange of traffic among competitive carriers and non-carriers. With the introduction of our services, we believe we became the first carrier to provide alternative tandem services capable of alleviating the ILEC tandem exhaust problem. By utilizing our managed tandem solution, our customers benefit from a simplified interconnection network solution that reduces costs, increases network reliability, decreases competitive tension and adds network diversity and redundancy. We have signed agreements with major competitive carriers and non-carriers and we operated in 189 markets as of September 30, 2011.

Following the introduction of our tandem interconnection services, we began to face competition from other non-ILEC carriers, including Level 3, Hypercube and Peerless Network. Over the past several years, this competition has intensified causing us to lose some traffic as well as significantly reduce certain rates we charge our customers in various markets, including with respect to our major customers. In addition, we believe that our customers are currently frequently establishing direct connections between their networks, even for what might be considered by historical standards to be lower traffic switch pair combinations. When our customers implement a direct connection, it reduces the traffic we carry and the revenue we earn.

Our business originally connected only local traffic among carriers within a single metropolitan market. In 2006, we installed a national IP backbone network connecting our major local markets. In 2008, we began offering terminating switched access services and originating switched access services. Switched access services are provided in connection with long distance calls. Our terminating switched access services allows interexchange carriers to send calls to us and we then terminate those calls to the appropriate terminating carrier in the local market in which we operate. Our originating switched access service allows the originating carrier in the local market in which we operate to send calls to us that we then deliver to the appropriate interexchange carrier that has been selected to carry that call. In both instances, the interexchange carrier is our customer, which means that it is financially responsible for the call. On October 1, 2010, we acquired Tinet, an Italian corporation that operates a global IP backbone network. As a result of the foregoing, our service offerings now include switching and carrying local, long distance and international voice traffic.


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Data and International Services

As part of our long-term growth strategy, we acquired Tinet, an Italian corporation. Tinet provides IP Transit and Ethernet services primarily to carriers, service providers and content providers worldwide.

With this acquisition, we evolved from a primarily U.S. voice interconnection company into a global IP-based network services company focused on delivering global connectivity for a variety of media, including voice, data and video. The acquisition expanded our IP-based network internationally, enabling global end-to-end delivery of wholesale voice, IP Transit and Ethernet solutions.

We have IP Transit and Ethernet service agreements with over 820 customers in over 70 countries. In 2010, we carried over 1 Terabit of customer IP traffic. We have over 100 points of presence (POPs) where we operate our equipment in carrier neutral facilities. Our core IP Transit network uses all Juniper equipment, which reduces complexity and allows for faster service deployment and easier customer support.

Revenue

We generate revenue from sales of our voice, IP Transit and Ethernet services. Revenue is recorded each month based upon documented minutes of traffic switched or data traffic carried for which service is provided, when collection is probable. Voice revenue is recorded each month on an accrual basis based upon minutes of traffic switched by our network by each customer, which we refer to as minutes of use. The rates charged per minute are determined by contracts between us and our customers or by filed and effective tariffs.

Minutes of use of voice traffic increase as we increase our number of customers, increase the penetration of existing markets, either with new customers or with existing customers, and increase our service offerings. The minutes of use decrease due to direct connection between existing customers, consolidation between customers, a customer using a different interconnection provider or a customer experiencing a decrease in the volume of traffic it carries.

The average fee per minute of voice traffic varies depending on market forces and type of service, such as switched access or local transit. The market rate in each market is based upon competitive conditions along with the switched access or local transit rates offered by the ILECs. Depending on the markets we enter, we may enter into contracts with our customers with either a higher or lower fee per minute than our current average. For example, although we regard the 10 additional markets we added during the first nine months of 2011 and the 42 new markets that we added in 2010 as financially attractive, the rates for local transit service we charge in the more recently opened markets are generally lower than the rates we charge in the markets we opened earlier.

Our voice service incorporates other components beyond switching. In addition to switching, we generally provision trunk circuits between our customers' switches and our network locations at our own expense and at no direct cost to our customers. We also provide quality of service monitoring, call records and traffic reporting and other services to our customers as part of our service solution. Our per-minute fees are intended to incorporate all of these services.

IP Transit revenue is recorded each month on an accrual basis based upon bandwidth used by each customer. The rates charged are the total of a monthly fee for bandwidth (the Committed Traffic Rate) plus additional charges for the sustained peak bandwidth used monthly in excess of the Committed Traffic Rate. Ethernet services are also invoiced based upon bandwidth used by each customer, or on a per-circuit basis (determined by the bandwidth ordered by the customer).

While generally not seasonal in nature, our voice revenues are affected by certain events such as holidays, the unpredictable timing of direct connects between our customers, and installation and implementation delays. These factors can cause our revenue to both increase or decrease unexpectedly.

Operating Expense. Operating expenses include network and facilities expense, operations expenses, sales and marketing expenses, general and administrative expenses, depreciation and amortization and the gain or loss on the disposal of fixed assets.

Network and Facilities Expense. Our network and facilities expenses for our voice and data services include transport capacity, or circuits, signaling network costs for voice services and facility rents and utilities, together with other costs that directly support our switch locations and POPs. We do not defer or capitalize any costs associated with the start-up of new switch locations or POPs. The start-up of an additional switch location or POP can take between three months to six months. During this time we typically incur facility rent, utilities, payroll and related benefit costs along with initial non-recurring installation costs. Revenues generally follow sometime after the sixth month.

Network transport costs typically occur on a repeating monthly basis, which we refer to as recurring transport costs, or on a one-time basis, which we refer to as non-recurring transport costs. Recurring transport costs primarily include monthly usage charges from telecommunication carriers and are related to the circuits utilized by us to connect to our customers or to carry traffic over our network backbone. As our traffic increases, we must utilize additional circuits. Non-recurring transport costs primarily include the initial installation of such circuits. Facility rents include the leases on our switch facilities, which expire through February 2025. Additionally, we pay the cost of all the utilities for all of our switch and POP locations.

Operations Expenses. Operations expenses include payroll and benefits for both our switch and POP location personnel as well as individuals located at our offices who are directly responsible for maintaining and expanding our network. Other primary components of operations expenses include switch repair and maintenance, a dispute settlement for one of our switch locations, property taxes, property insurance and supplies.

Sales and Marketing Expense. Sales and marketing expenses represent the smallest component of our operating expenses and primarily include personnel costs, sales bonuses, marketing programs and other costs related to travel and customer meetings.


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General and Administrative Expense. General and administrative expenses consist primarily of compensation and related costs for personnel and facilities associated with our executive, finance, human resource and legal departments and fees for professional services. Professional services principally consist of outside legal, audit, transaction costs and other accounting costs. The other accounting costs relate to work surrounding compliance with the Sarbanes-Oxley Act.

Depreciation and Amortization Expense. Depreciation and amortization expense is applied using the straight-line method over the estimated useful lives of the assets after they are placed in service, which are five years for switch equipment and test equipment, three years for computer equipment, computer software and furniture and fixtures. Leasehold improvements are amortized on a straight-line basis over an estimated useful life of five years or the life of the respective leases, whichever is shorter. Intangible assets, which consist of customer relationships, have a definite life and are amortized on an accelerated basis based upon the discounted cash flows recognized over their estimated useful lives of 15 years.

Gain on Disposal of Fixed Assets. We have disposed of switch equipment in connection with converting to new technology and computer equipment to replace old or damaged units. When there is a carrying value of these assets, we record the write-off of these amounts to loss on disposal. In some cases, this equipment is sold to a third party. When the proceeds from the sale of equipment identified for disposal exceeds the asset's carrying value, we record a gain on disposal.

Interest Income (Expense). Interest expense consists of interest paid each month related to our outstanding equipment loans. Interest income is earned primarily on our cash, cash equivalents and our investment in ARS.

Other (Income) Expense. Other (income) expense includes expenses incurred related to the modified "Dutch auction" tender offer to repurchase common shares during 2011 and adjustments to the fair value of the Auction Rate Securities (ARS) and the related ARS Rights during 2010.

Foreign Exchange (Gain) Loss. Foreign exchange (gain) loss consists of the gain or loss resulting from changes in exchange rates between the functional currency and the foreign currency in which the transaction was denominated.

Income Taxes. Income tax provision includes U.S. federal, state and local, and foreign income taxes and is based on pre-tax income or loss. In determining the estimated annual effective income tax rate, we analyze various factors, including projections of our annual earnings and taxing jurisdictions in which earnings will be generated, the impact of state and local income taxes and our ability to use tax credits and net operating loss carryforwards.

Patent Protection

Our ability to maintain profitability or positive cash flow depends, in part, on our ability to protect proprietary methods and technologies that we develop under the patent and other intellectual property laws of the United States, so that we can prevent others from using our inventions and proprietary information. If our patents are invalidated or otherwise limited, other companies will be better able to develop products that compete with ours, which could adversely affect our competitive business position, business prospects and financial condition.

Any resulting increased competition may cause price decreases. If we are unable to offset the effects of any price reductions by carrying higher volumes of traffic, we could experience reduced revenues and gross margins.

On June 12, 2008, we commenced a patent infringement action against Peerless Network in the United States District Court for the Northern District of Illinois to enforce our rights under the '708 Patent. On September 2, 2010, the court hearing the case granted Peerless Network's motion for summary judgment. The court found that the '708 Patent was invalid in light of a prior patent. See "Proceeding in the United States District Court for the Northern District of Illinois" above for a further description of this matter. On December 20, 2010, we filed notice that we plan to appeal the court's order granting Peerless Network's motion for summary judgment and finding that the '708 Patent is invalid. If we do not prevail in this matter, it could result in continued or increased competition, either of which could adversely affect our ability to maintain profitability or positive cash flow.


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Critical Accounting Policies and Estimates

The preparation of our financial statements requires us to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses during the periods presented. Our Annual Report on Form 10-K for the fiscal year ended December 31, 2010, which we filed with the Securities and Exchange Commission on March 16, 2011, includes a summary of the critical accounting policies we believe are the most important to aid in understanding our financial results. There have been no changes to those critical accounting policies that have had a material impact on our reported amounts of assets, liabilities, revenues or expenses during the first nine months of 2011.

Results of Operations

The following table sets forth our results of operations for the three and nine
months ended September 30, 2011 and 2010:



                                                    Three Months Ended           Nine Months Ended
                                                       September 30,               September 30,
(Dollars in thousands)                               2011          2010         2011          2010
Revenue                                           $   67,310     $ 46,454     $ 198,818     $ 136,040
Operating expense:
Network and facilities expense (excluding
depreciation and amortization)                        28,724       16,109        80,797        45,044
Operations                                            10,334        5,921        29,107        17,155
Sales and marketing                                    3,383          568         9,851         1,613
General and administrative                             6,352        6,369        22,771        19,429
Depreciation and amortization                          7,520        4,180        22,040        12,223
Loss (gain) on disposal of fixed assets                  159           (7 )         147           (74 )

Total operating expense                               56,472       33,140       164,713        95,390

Income from operations                                10,838       13,314        34,105        40,650

Other (income) expense:
Interest expense                                          -            -             -              4
Interest income                                           (2 )        (50 )         (32 )        (176 )
Other expense (income)                                    60       (1,915 )         420        (2,126 )
Foreign exchange loss (gain)                           2,068           -           (317 )          -

Total other (income) loss                              2,126       (1,965 )          71        (2,298 )

Income before income taxes                             8,712       15,279        34,034        42,948
Provision for income taxes                             2,864        5,716        12,950        16,417

Net income                                        $    5,848     $  9,563     $  21,084     $  26,531

Three Months Ended September 30, 2011 Compared to Three Months Ended September 30, 2010

Revenue. Revenue increased to $67.3 million in the three months ended September 30, 2011 from $46.5 million in the three months ended September 30, 2010, an increase of 44.9%. A portion of the increase in revenues was due to the acquisition of Tinet, which generated $16.5 million in revenues or 79.2% of the increase. The remaining increase in revenue of $4.3 million, or 20.8%, was primarily due to an increase of minutes of use to 32.9 billion minutes processed in the three months ended September 30, 2011 from 27.9 billion minutes processed in the three months ended September 30, 2010, an increase of 17.9%. The increase in the number of minutes processed by the network was a result of further penetration of current markets and customers, as well as the entry into 22 new markets since September 30, 2010. Offsetting the increase in minutes was a decrease in average fee billed per minute from $0.0017 for the three months ended September 30, 2010 to $0.0015 for the three months ended September 30, 2011.

Operating Expenses. Operating expenses for the three months ended September 30, 2011 of $56.5 million increased $23.3 million, or 70.4%, from $33.1 million for the three months ended September 30, 2010. The components making up operating expenses are discussed further below.

Network and Facilities Expenses. Network and facilities expenses increased to $28.7 million in the three months ended September 30, 2011, or 42.7% of revenue, from $16.1 million in the three months ended September 30, 2010, or 34.7% of revenue. Of this increase, $8.9 million is the network and facilities expense incurred by Tinet during the third quarter of 2011. Due to the nature of the IP Transit business, higher network and facilities expenses are expected and we anticipate this percentage will continue to increase as we reflect increased activity for our IP Transit business in proportion to our voice business.

The remaining network and facilities expenses were $19.8 million for the three months ended September 30, 2011, or 39.1% of revenue. As noted above, our billed voice minutes were up 17.9%, causing an increase to our network and facilities expense. As the expenses to process the increase in minutes has increased, while the voice rate per minute has decreased, the percentage to revenue for 2011 has increased compared to 2010.


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Operations Expenses. Operations expenses increased to $10.3 million in the three months ended September 30, 2011, or 15.4% of revenue, from $5.9 million in the three months ended September 30, 2010, or 12.7% of revenue. Of this increase, $2.2 million is due to operations expenses of Tinet. The remaining increase of $2.2 million in our operations expenses resulted primarily from an increase of $0.8 million in non-cash compensation and $0.2 million in payroll and benefits. In addition, during the three months ended September 30, 2011, we settled a dispute with a landlord for $0.8 million.

Sales and Marketing Expense. Sales and marketing expense increased to $3.4 million in the three months ended September 30, 2011, or 5.0% of revenue, compared to $0.6 million in the three months ended September 30, 2010, or 1.2% of revenue. Of this increase, $1.7 million is due to sales and marketing expenses of Tinet. Due to the nature of the IP Transit business, higher sales and marketing expenses are expected and we anticipate this percentage will continue to increase as we reflect increased activity for our IP Transit business. The remaining increase of $1.1 million sales and marketing expenses for the three months ended September 30, 2011 is primarily due to an increase in non-cash compensation and payroll and benefits.

General and Administrative Expense. General and administrative expense remained the same at $6.4 million in the three months ended September 30, 2011, or 9.4% of revenue, compared with $6.4 million in the three months ended September 30 2010, or 13.7% of revenue. The decrease in the expense compared to revenue, is the result of a decrease in professional fees of $1.2 million, partially offset by an increase of $1.1 million from the general and administrative expenses of Tinet.

Depreciation and Amortization Expense. Depreciation and amortization expense increased to $7.5 million in the three months ended September 30, 2011, or 11.2% of revenue, compared to $4.2 million in the three months ended September 30, 2010, or 9.0% of revenue. Of this increase, $2.7 million is due to Tinet, which includes $0.6 million of amortization expense related to customer intangibles. The remaining $0.6 million increase in our depreciation and amortization expense resulted from capital expenditures primarily related to the expansion of switch capacity in existing markets and the installation of switch capacity in new markets.

Other Income. Other expense was $2.1 million for the three months ended . . .

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