Description

I believe that Inteliquent is a rare find, especially in this market: a cheap business with a high level of visibility on growth in revenue, EBITDA, earnings and cash flow. As a telecom company whose business is dependent on intercarrier voice traffic, it also has low sensitivity to the macroeconomic picture with no financial leverage- maybe the ideal profile in the current environment. If IQNT can execute effectively among its current customer base, I believe there is a clear path to a significantly higher stock price. The company also has three reasonably likely upside opportunities that could make it a double or better.

Inteliquent is a wholesale voice telecom carrier that provides neutral tandem interconnection services using an all-IP network. To understand their business you have to get into the plumbing of how the publicly switched telephone network actually works. When you use a phone number to call someone who uses a different telecom carrier at some point the traffic has to be connected from one company’s network to another’s, even if you are using VOIP on both ends. Traditionally, there were two ways for this to happen: (1) either the two networks would connect directly through switch pairs or (2) using what are known as “tandem switches” controlled by local ILECs that charged a (high) rate theoretically controlled by the FCC. As more competitive telecom carriers emerged, the ILEC tandem switches became overwhelmed and the competitive carriers paid the ILECs significant sums to terminate traffic. IQNT was the first carrier to offer a competitive tandem service, which allowed competitive carriers to terminate traffic at lower cost and greater reliability. The company grew by putting tandem switches into more and more local markets, offering the ability to connect to more and more phone numbers in different markets.

Rather than describing IQNT’s various products I am pasting their product descriptions below:

• Local Transit Service. Prior to the commencement of our operations in 2004, competitive carriers generally had two alternatives to send local voice traffic to other competitive carriers' networks: sending the traffic indirectly through the tandems of an Incumbent Local Exchange Carrier (“ILEC”) or directly through connected switch pairs, commonly referred to as “direct connects.” We established our company to offer an alternative to these options and better facilitate the exchange of local traffic between competitive carriers by using our tandem switches instead of the ILECs' tandems or direct connects. Since initially marketing our local transit service in several major markets, we have expanded our coverage and now provide local transit service in almost all markets in the contiguous United States, Hawaii and Puerto Rico.
• Long Distance Service. In 2006, we installed a national IP backbone network connecting our major local markets and began offering long distance services. Our long distance service allows us to carry long distance traffic that originates from our local or non-carrier customers in one market and terminates in another market. When we provide this service, we are operating as an interexchange carrier.
• Switched Access Service. In 2008, we began offering terminating switched access and originating switched access services. Switched access services are provided in connection with long distance calls. Our terminating switched access service 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 and is financially responsible for the call.
• International Voice Service. As we began interconnecting with certain non-U.S. carriers in 2010, we began terminating voice traffic that originated outside of the U.S. and terminated on the networks of carriers located in the U.S. When we provide this service, we are operating as an interexchange carrier. Our customer is the non-U.S. carrier that originates the call.
• Direct Inward Dialing Service. In 2012, we began to market Direct Inward Dialing (“DID”) service primarily to various non-carriers, including OTT providers, conference calling providers, calling card companies and interconnected Voice over Internet Protocol (“VoIP”) providers. As part of our DID offering, we assign telephone numbers to these non-carriers and then terminate voice traffic, such as conference calling or calling card traffic, that is destined to the telephone numbers that we have assigned to those non-carriers. In addition to receiving payment from our non-carrier customers for the provision of the DID service, an interexchange carrier will pay us switched access charges for terminating long distance traffic on our network, while a local exchange carrier may owe us reciprocal compensation charges for terminating local traffic on our network.
• 8XX (Toll-Free) Service. In 2014, we began offering 8XX service. We market this service to customers that seek to provide a caller with the ability to call them on a toll-free basis. Although many enterprises purchase toll-free services, we are initially marketing these services primarily to call centers or other non-enterprise users. When we provide this service, we are operating as an interexchange carrier. 

AT&T, Verizon and T-Mobile are IQNT’s largest customers. Most traffic exchanged between these giants is done through direct connects independent of IQNT or other neutral interconnection providers. However, the large carriers rely on IQNT and its competitors for connections to the numerous alternative carriers that aren’t worth directly connecting to individually as well as for redundancy and swing capacity between each other. It should be noted that the market for voice minutes is declining, but slowly. The price per minute charged for these types of services is also declining, but slowly. When you combine both of these facts the overall interconnection market opportunity is probably shrinking low single digits- although if T-Mobile and others continue outsourcing to IQNT the addressable market may actually be increasing. As the industry pioneer IQNT is the largest neutral tandem provider but also competes with Level 3, Hypercube (owned by U.S. West) and Peerless Network (founded by former IQNT executive John Barnicle).

If you pull up IQNT’s long-term stock chart, you see the stock has ranged from as high as $30 to lows of near $2 over its surprisingly volatile history as a public company. John Barnicle was a well -regarded operating executive at IQNT but left to found Peerless, which took market share and forced lower pricing in the 2009-2011 timeframe. IQNT attempted to diversify its business by buying a European data carrier by the name of TiNet which did not work out at all. The company then had a billing dispute with its largest customer AT&T in 2012 and shortly thereafter it went through management and board changes while being pressured by activist investor the Clinton Group. At the time it was feared that the AT&T dispute could be existential, which caused the stock to trade to the $2s in late 2012 in what was one of the great small cap buying opportunities of this era and marked the all-time bottom. The company turned things around in 2013. First the company sold its TiNet business for a little over $50M, more than people were expecting at the time and a significant portion of its market cap. IQNT settled with the Clinton Group, adding a new board member and instituting a special and recurring dividend. The company repaired the relationship with AT&T, who remained IQNT’s largest customer in 2015.

Inteliquent’s business and stock recovered over 2013 and 2014, but in my opinion in the mid teens the stock was fairly valued for a low-to-no growth company. However, the company announced a significant contract with T-Mobile USA in August of 2015 that changed that. T-Mobile agreed to make Inteliquent its sole provider of voice interconnection services for all calls exchanged between T-Mobile and the PSTN not done over direct connection. In conference presentations the CFO revealed that as the contract was phased in T-Mobile would likely become Inteliquent’s largest customer and the additional T-Mobile business could nearly double IQNT’s revenue. The market first sent IQNT’s stock over $20, but over the past few months between the poor market for small caps and the fact that IQNT management did a poor job communicating the costs associated with ramping up the T-Mobile contract the stock has since drifted down to $17 and change, such  that the stock can be purchased at the same price as before the T-Mobile deal was announced.

I believe the ramp-up costs poorly communicated by management in the original T-Mobile announcement have confused the market and the opportunity to buy the stock at pre-T-Mobile prices is extremely attractive. Expanding Inteliquent’s network and hiring the operations personnel to nearly double traffic supported is a daunting task, and much of the T-Mobile traffic Inteliquent is taking on is lower margin than its average minute. For this reason, in Q4 2015 Inteliquent reported a 33% increase in minutes transited across its network and 39% revenue growth, but gross margin decreased from 56.7% to 39.7%, resulting in a 9% decrease in EBITDA. However, there are numerous reasons why this gross margin will improve over time such that by the time the contract is fully ramped up EBITDA will be considerably higher than before even if overall margin is lower. The company is having to provision circuits and hire people ahead of taking on all T-Mobile’s traffic, so network utilization will be lower than previous until the contract is fully onboarded. The company is still learning how to optimize T-Mobile’s traffic mix, but has hired least-cost routing experts who will improve performance over time. Most importantly, much of the T-Mobile traffic is long distance, which requires the initiating carrier to pay termination fees to the call recipient’s carrier. However, the FCC has mandated step-downs in this type of intercarrier compensation that are phased in every June 30 for several years until they reach zero. Thus, the T-Mobile minutes should become more profitable in Q3 of 2016 and again in Q3 of 2017.

As long as IQNT executes properly, it will continue to experience a significant increase in revenue and will grow margins from a bottom in Q1 of 2016. Management guided 2016 EBITDA to $82M to $92M with next quarter’s EBITDA in the mid $18M range, implying a significant ramp in the back  half of the year. My model shows gross margin bottoming at 37% in Q1 of 2016 and reaching 44% in Q4 2017 compared to pre-T-Mobile margins in the high 50s. Similarly, I think EBITDA margins will bottom at about 22% in Q1 of 2016 and reach nearly 30% by the end of 2017 compared to EBITDA margins of 36% in 2014. Coupled with the higher revenue, I believe that simply executing on the T-Mobile contract will enable IQNT to exit 2017 at an EBITDA run rate of over $120M. If you believe that this business will get at least 6x run-rate EBITDA by the end of 2017 (and this seems conservative in light of the multiples that some crappy low growth telecom roll-ups get), coupled with $75M or so of FCF in the next two years, IQNT shares would be 50% or so higher than they are today at around $26. That seems like a pretty attractive return for a company that simply needs to execute on a contract it is in the middle of ramping up and hold on to its existing customers. Put another way, at current stock prices by the end of 2016 investors would be looking at a prospective 2017 10% FCF to equity and 13% on EV, a yield which I would not expect to last.

While simply executing on T-Mobile could lead to 50% appreciation over the next two years, I believe that IQNT has three other distinct but independent opportunities in the next couple of years that could significantly increase the value of the business:

1. Adding other contracts similar to T-Mobile: T-Mobile has concluded that it would save money by simply outsourcing its non-direct connections to the PSTN to IQNT. What is true for T-Mobile is also probably true for Sprint, as well as other non-ILEC wireless and competitive telecom carriers. Sprint is slightly smaller than T-Mobile in terms of subscribers and could presumably drive a similar level of traffic and revenue. The same calculus may also be true for a combined Charter/TimeWarner. Note that IQNT’s recently appointed CEO used to work at Sprint. Sprint may wait to see if the T-Mobile/Inteliquent relationship works out as planned and may be a tough nut to crack given the turmoil there, but if Sprint were worth an incremental $40M in EBITDA (similar to the incremental effect of T-Mobile once fully ramped), at 6x EBITDA that would be worth an additional $7.00 or so to shareholders.
2. Financial engineering: Unlike virtually every other telecom carrier, IQNT carries no debt and a substantial cash balance. Current FCF is suppressed but still positive due to T-Mobile investments, but should return to a very healthy level in 2H of 2016 and beyond. I believe this is one of the reasons for the EV/EBITDA multiple discrepancy between IQNT and other growing telecoms. In an ideal world I think IQNT would carry 1-2x net debt/EBITDA leverage, which would be substantially accretive to FCF to shareholders. Since 2013, the company has maintained that it did not want to lever up until it figured out a growth plan. The T-Mobile contract, along with the recently launched Direct Inward Dial product aimed at OTT apps making voice calls and texts, provide that growth plan. The company has plenty of room to ramp up dividends and do some kind of substantial buyback or Dutch tender.
3. M&A: Inteliquent finds itself as the largest and strongest player in the tandem interconnection space. It may use its cash balance and debt capacity to consolidate smaller and weaker players. While there has been some bad blood between Inteliquent and Peerless/John Barnicle, rumors are that Peerless took a big hit when T-Mobile decided to move all its traffic to Inteliquent. Inteliquent may be able to buy Peerless or other smaller or adjacent players from a position of strength. I believe the markets would react very favorably to an attractively priced deal for Peerless.

It is hard to quantify the last two items, but I think between executing the T-Mobile ramp over the next two years and some combination of the three value-creating opportunities it is not out of the question that IQNT could double over the next two years.

Disclosure: The fund I work for is long IQNT and may buy or sell shares at any time without notice.

Significant risks:

• IQNT could have an operational screw-up such that T-Mobile does not ramp as anticipated
• Other carrier customers could perceive the company as too closely tied to T-Mobile and move traffic to competitive tandem carriers (although we don’t see that yet, largest 2014 customer AT&T was basically flat in 2015 while second largest 2014 customer Verizon actually grew 17%)
• The FCC changes pricing on tandem interconnection (nothing I know of is on the docket)
• Voice traffic goes from shrinking slowly to shrinking rapidly, or the world moves en masse to WhatsApp or Skype

Catalyst

• Ramp in revenue, margins and FCF as the T-Mobile contract is fully implemented
• Intercarrier comp step-downs that will improve margins in Q3 2016 and 2017
• Adding a T-Mobile-type contract with Sprint or Charter
• Capital return or other optimization of the balance sheet
• Future M&A