Description
I am recommending accumulating a long term position in Neutral Tandem (TNDM) at current trading levels. TNDM is a small cap, under covered telecom infrastructure story offering wireless, cable, VoIP and CLEC telecom providers a low cost, higher quality alternative for tandem switching local phone. While no companies are completely ‘recession resistant’, TNDM has many attributes that are allowing it to accelerate growth through this macro environment and take market share from incumbent carriers such as VZ and T.
Wireline access line losses have accelerated to 9% per quarter, as consumers choose to cut the cord and use a cable VoIP or wireless alternative as their primary phone. As this happens and as the company expands into additional geographic markets, minutes of use on TNDM’s network continue to increase, adding to the top line and leveraging the fixed cost base. The company throws off significant free cash flow, has EBITDA margins north of 40%, cash of $120 million and $4 mm of debt. The company is currently trading at $15.68 - 6x 2009 EBITDA with a 7% FCF yield. We believe in the next 6-12 months despite the economic headwinds, the stock could trade into the mid-$20s, or 50-75% upside from here.
TNDM is the only significant alternative player in the Tandem Switching market, which has substantial barriers to entry and is essentially a duopoly. In the past 3 quarters, the company has either beaten or exceeded all operational metrics and has given consistently strong guidance. Illiquidity, hedge fund redemptions as well as VC distributions has knocked the stock down to the $14-$15 level, where we believe it is trading at a highly attractive price to begin a position.
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TNDM Valuation
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Current Price
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$15.68
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Fully Diluted Shares Outstanding
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32.260
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Market Capitalization
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$ 506
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Cash (Includes $15 mm of ARS)
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122
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Total Debt
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4
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Total Enterprise Value
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$ 388
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2008
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2009
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2010
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EBITDA
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$ 49.0
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$ 64.0
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$ 85.1
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EV/EBITDA
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7.9x
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6.1x
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4.6x
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FCF/Share
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$0.56
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$1.08
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$1.71
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FCF Yield
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3.6%
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6.9%
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10.9%
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Tandem Switching Market
When a call is made from an alternative carrier - wireless, cable, VoIP or a CLEC - within a local market terminating at another carrier, the call must be routed, typically through a “tandem switch”, which has the necessary call routing and termination information. There are three alternatives to getting traffic from one carrier to another 1) Using the incumbent tandem switch –T, VZ 2) A Company could elect to use Neutral Tandem as an alternative or 3) If two carriers pass enough traffic to one another in a specific market, they could choose to directly connect fiber between both networks and avoid the tandem switch all together. However, this has a substantial upfront cost and makes sense only in certain circumstances where a large % of traffic is being routed. The tandem option has historically only been provided by the incumbent carrier in local markets, regulated by the FCC and state PUCs. Neutral Tandem over the past 5 years, has created the largest alternative tandem network to the incumbent player to take advantage of this sizeable business opportunity.
The Company
The company went public in November 2007, and operates in 92 markets currently, 99 by year end. There are significant barriers to entry in this market. TNDM had a significant first mover advantage in creating relationships with all the alternative carriers, and necessary connections to the incumbents switches. Additionally, the scale of the network that TNDM operates would take years to replicate. Other players have tried to get into this mkt including Level 3 and several other private players who are now financially constrained. Level 3 attempted to enter the Tandem switching market, and in fact blocked TNDM from interconnecting with them, and had several frivolous lawsuits outstanding which were eventually dropped.
There are multiple attractions of alternative carriers to TNDMs offering. First, the TNDM service incorporates other components beyond switching, including all the capex required to buildout the required fiber from TNDM’s network to the customer’s data trunk. Additionally, quality of service monitoring, (QoS is higher than the incumbents), call records and traffic reporting are also provided. These services are not offered by the incumbents, as they have never paid significant attention to this niche piece of the telecom market. TNDM targets an all in savings of 20-25% per minute vs the incumbent carriers, and has garnered a reputation as a neutral partner, with no competitive issues with customers. The service also offers redundancy for tandem switching - which is not highly reliable with the incumbents old TDM and circuit switched systems. TNDM utilizes 100% IP soft-switches in its network. Additionally, the scale that they can provide to a customer, with operations in 92 markets is significant and can simplify operations. TNDMs IP network, connects all of their soft-switches withiin individual markets with all carrier partners and then also connects to the other 91 markets TNDM operates. This creates additional business opportunities for the company in the future.
Current wireline trends provide for a counter-cyclical tailwind. As wireline access line loss continues to accelerate through this recession, and people “cut the cord” and choose either a cheaper VoIP alternative or to use their wireless phone as their primary phone, more and more minutes are moving on to alternative carrier networks. Last quarter, on average 9% of access lines were lost, while minutes of use continue to accelerate. This is being exacerbated by the unlimited usage offerings by both the wireless, cable and VoIP carriers. As TNDM continues its market rollouts, older markets begin to generate revenue, and the network affect of having new customers in new markets accelerates.
There are roughly 629 million phone numbers in TNDM’s addressable market, and by year end they will be able to terminate traffic to 372 million of them. This represents about 62% of the addressable market, however 37% of this is from markets just entered into in 2008. It typically takes ~1.5 to 2 years to get up to revenue run-rate in a new market, illustrating the pipeline of growth just from capex spent in 2008. The originating carrier is the customer of TNDM and pays a per minute charge (roughly .2 cents / minute) to TNDM for each minute on the network. The company in 2008 will transit roughly 60 billion minutes, up from 40 billion in 2007. TNDM needs permission to terminate on networks which are not their clients. A call terminating at the incumbent – Verizon landline or AT&T landline, will always use the incumbent tandem switch. However, a large operational catalyst earlier this year was to sign an agreement with Verizon Wireless for the ability to terminate minutes that are being routed to VZ Wireless through TNDM switches if the originating carrier is a TNDM customer (as opposed to using VZ tandems). This essentially opened up all in-territory VZ wireless customers ~25 million numbers - that they can now terminate to, that they otherwise could not. They have a similar relationship with AT&T Wireless which has been in existence for longer. The VZ arrangement began to hit the P&L in Q3/Q4 2008, earlier than expected, but will not be fully realized until 2009/2010. In addition, in Q3, they signed a customer arrangement in out of market regions for Verizon Wireless in a few markets – whereby VZ Wireless is the originating customer using TNDM switches to terminate, rather than using AT&T tandems. The relationship at this point is regionalized at this point, but optimally should cover all VZ Wireless in the next few quarters.
TNDM has virtually all of the large alternative carriers as customers - Sprint, AT&T Wireless, Comcast, CVC, Cox, TWTC, Paetec, Vonage, with over 80 name brands. As the company moves into new markets, they typically have a master service agreement with existing clients for new markets, and then work with a lean sales force to get any additional regional players in the new market. The alternative tandem local switching market is projected to be roughly $1 billion, and growing as more minutes move to alternative carriers. The breakdown of revenue by type of carrier is as follows:
Wireless – 58%
Cable – 15%
Voip – 4%
CLEC – 19%
IXC – 4%
The customer base is highly concentrated among wireless carriers posing some M&A risk. However, Alltel had been a new customer with diminimus revenue with TNDM, and could potentially offer upside with the new VZ contract. The top customers of TNDM are Sprint with 26% of revenue and T-Mobile with 14%.
The business has very attractive free cash flow characteristics. EBITDA margins have expanded from 25% to 43% last quarter. As the company enters new markets, very little additional opex is needed. They run a lean organization with less than 150 employees and only 5 salespeople. Additionally, they have seen increasing productivity in their capex buildouts. TNDM has increased their new market guidance from 27 to 30 to 35 this year, while holding steady their capex guidance as they continue to get purchasing and implementation scale.
Growth going forward will be generated from several factors. The 35 new markets the company expanded into this year should begin to scale over the next few quarters. Minutes of use on alternative networks has continued to grow at a rate greater than 50%, and should only be helped by the current economic environment. Additionally, the VZ Wireless interconnection contract signed this year will be fully rolled out to all central offices this quarter, and they will see the full impact of that in 2009 and 2010. More importantly, last quarter, they signed a few regional contracts with VZ Wireless, and are working on a larger agreement for all out of VZ territory tandems to be a customer of TNDM.
The company is also working on additional types of traffic that they can interconnect and carry over the network. The company in Q3 began testing a Termination Service business, which is similar in nature to the core business, but interconnects traffic that is inter-market, rather than local. This opportunity is estimated at 1/3 the size of the local tandem market. The client in this market is the interexchange carrier - who can benefit from the 100% IP connection offered by TNDM, rather than using outdated TDM or circuit switch technology provided by the incumbent terminating carrier. Roughly 4% of revenues were generated from the Termination Service business during Q3. Additionally, the company discussed on the Q3 call that they are talking to their current customer base about originating switched access, which can potentially be another growth driver in the future. Given the nascent stage and more competitive nature of these business lines, it will take time to see what traction TNDM sees.
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TNDM Cash Flow
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2007
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2008
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2009
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2010
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Revenue
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$ 85.6
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$ 121.0
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$ 154.0
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195.6
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% Growth
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41.4%
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27.3%
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27.0%
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Adjusted EBITDA
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$ 29.7
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$ 49.0
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$ 64.0
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85.1
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% Margin
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NM
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40.5%
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41.6%
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43.5%
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% Growth
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64.9%
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30.6%
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32.9%
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Less: Capex
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(19.5)
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(22.0)
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(18.0)
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(15.0)
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Less: Interest Expense
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(0.3)
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2.7
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4.9
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6.6
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Less: Income Taxes
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(6.2)
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(11.5)
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(16.2)
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(21.4)
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Free Cash Flow (EBITDA-Int-Tax-Capex)
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3.7
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18.2
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34.7
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55.3
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495.9%
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190.7%
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159.3%
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FCF / Share
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$0.00
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$0.56
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$1.08
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$1.71
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FCF Yield
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3.6%
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6.9%
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10.9%
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Incremental EBITDA Margin
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54.4%
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45.5%
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50.7%
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Risks to the Story
- Pricing à pricing has not historically been an issue. The incumbents have been raising prices and are not incentivized to competitively lower prices to force TNDM out of the market. However, as they move into smaller markets, the price per minute is structurally lower than the larger tier 1 cities they have historically moved into. So, as a mix shift occurs, Rev/min could fall.
- Growth in several years could taper off if new products are unsuccessful and growth in minutes on the network plateau
- Uses of cash à They have indicated they would do a minor acquisition of complementary products or technologies. Anything perceived to dilute the value of the core business could hurt the stock
- Customer concentration à If Sprint or one of TNDM’s top customers was to fail or be acquired, the company could see a headwind, depending on the circumstances and acquirer
- In the short term, extreme volatility in the stock probably will continue given the markets. The stock is relatively illiquid. In addition, the VCs still have a 14% stake, and they have been distributing shares from time to time. Also, hedge fund redemptions have hurt this stock in the past few months and may continue
- Insider selling à Has been significant insider selling which could be seen as a red flag
Catalyst
-The 35 new markets the company expanded into this year should begin to scale over the next few quarters
-Continued share shifting of MOUs from wireline to wireless and VoIP
-Full impact of VZ wireless interconnection agreement realized in 2009
-Signing of all out of market VZ Wireless as a customer
-Traction in garnering new types of traffic on the network including Termination Service and Origination Switched Access