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Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended March 31, 2011
OR
¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission file number: 001-33778
NEUTRAL TANDEM, INC.
(Exact name of registrant as specified in its charter)
Delaware | 31-1786871 | |
(State or other Jurisdiction of Incorporation or Organization) |
(IRS Employer Identification No.) |
550 West Adams Street
Suite 900
Chicago, IL 60661
(Address of principal executive offices, including zip code)
(312) 384-8000
(Registrants telephone number, including area code)
Indicate by checkmark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer | ¨ | Accelerated filer | x | |||
Non-accelerated filer | ¨ (Do not check if a smaller reporting company) | Smaller reporting company | ¨ |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
As of May 2, 2011, 34,441,072 shares of the registrants Common Stock, $0.001 par value, were issued and outstanding.
Table of Contents
INDEX
Page | ||||||
PART I. FINANCIAL INFORMATION | ||||||
Item 1. |
Condensed Consolidated Financial Statements | 3 | ||||
Condensed Consolidated Balance Sheets March 31, 2011 and December 31, 2010 | 3 | |||||
Condensed Consolidated Statements of Income Three months ended March 31, 2011 and March 31, 2010 | 4 | |||||
Condensed Consolidated Statements of Cash Flows Three months ended March 31, 2011 and March 31, 2010 | 5 | |||||
Notes to Condensed Consolidated Financial Statements | 6 | |||||
Item 2. |
Managements Discussion and Analysis of Financial Condition and Results of Operations | 13 | ||||
Item 3. |
Quantitative and Qualitative Disclosures about Market Risk | 19 | ||||
Item 4. |
Controls and Procedures | 19 | ||||
PART II. OTHER INFORMATION | ||||||
Item 1. |
Legal Proceedings | 20 | ||||
Item 1A. |
Risk Factors | 21 | ||||
Item 6. |
Exhibits | 24 |
Table of Contents
PART I. FINANCIAL INFORMATION
Item 1. | Condensed Consolidated Financial Statements (Unaudited) |
NEUTRAL TANDEM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share amounts)
(Unaudited)
March 31, 2011 |
December 31, 2010 |
|||||||
ASSETS |
||||||||
Current assets: |
||||||||
Cash and cash equivalents |
$ | 119,625 | $ | 106,674 | ||||
Receivables |
41,233 | 38,610 | ||||||
Deferred income taxes-current |
1,754 | 1,855 | ||||||
Other current assets |
7,748 | 7,647 | ||||||
Total current assets |
170,360 | 154,786 | ||||||
Property and equipment net |
79,498 | 77,683 | ||||||
Intangible assets net |
32,931 | 31,506 | ||||||
Goodwill |
52,229 | 49,098 | ||||||
Restricted cash |
962 | 962 | ||||||
Other assets |
1,557 | 1,492 | ||||||
Total assets |
$ | 337,537 | $ | 315,527 | ||||
LIABILITIES AND SHAREHOLDERS EQUITY |
||||||||
Current liabilities: |
||||||||
Accounts payable |
$ | 14,414 | $ | 13,748 | ||||
Accrued liabilities: |
||||||||
Taxes payable |
3,575 | 664 | ||||||
Circuit cost |
9,024 | 10,508 | ||||||
Rent |
1,273 | 1,285 | ||||||
Payroll and related items |
3,510 | 3,770 | ||||||
Other |
4,573 | 2,968 | ||||||
Total current liabilities |
36,369 | 32,943 | ||||||
Other liabilities |
957 | 914 | ||||||
Deferred income taxes-noncurrent |
10,000 | 10,387 | ||||||
Total liabilities |
47,326 | 44,244 | ||||||
Commitments and contingencies |
| | ||||||
Shareholders equity: |
||||||||
Preferred stock par value of $.001; 50,000,000 authorized shares; no shares issued and outstanding at March 31, 2011 and December 31, 2010 |
| | ||||||
Common stock par value of $.001; 150,000,000 authorized shares; 34,149,858 shares and 33,166,242 shares issued and outstanding at March 31, 2011 and December 31, 2010, respectively |
34 | 33 | ||||||
Additional paid-in capital |
177,323 | 171,343 | ||||||
Accumulated other comprehensive income (loss) |
2,646 | (2,117 | ) | |||||
Retained earnings |
110,208 | 102,024 | ||||||
Total shareholders equity |
290,211 | 271,283 | ||||||
Total liabilities and shareholders equity |
$ | 337,537 | $ | 315,527 | ||||
The accompanying notes are an integral part of these condensed consolidated financial statements.
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NEUTRAL TANDEM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share amounts)
(Unaudited)
Three Months Ended March 31, |
||||||||
2011 | 2010 | |||||||
Revenue |
$ | 66,418 | $ | 44,829 | ||||
Operating expense: |
||||||||
Network and facilities expense (excluding depreciation and amortization) |
25,819 | 14,361 | ||||||
Operations |
9,419 | 5,521 | ||||||
Sales and marketing |
3,359 | 510 | ||||||
General and administrative |
10,058 | 6,400 | ||||||
Depreciation and amortization |
7,106 | 3,948 | ||||||
Gain on disposal of fixed assets |
(6 | ) | (45 | ) | ||||
Total operating expense |
55,755 | 30,695 | ||||||
Income from operations |
10,663 | 14,134 | ||||||
Other (income) expense: |
||||||||
Interest expense |
| 4 | ||||||
Interest income |
(13 | ) | (54 | ) | ||||
Other (income) expense |
14 | (125 | ) | |||||
Foreign exchange (gain) loss |
(1,763 | ) | | |||||
Total other income |
(1,762 | ) | (175 | ) | ||||
Income before income taxes |
12,425 | 14,309 | ||||||
Provision for income taxes |
4,241 | 5,840 | ||||||
Net income |
$ | 8,184 | $ | 8,469 | ||||
Net income per share: |
||||||||
Basic |
$ | 0.24 | $ | 0.25 | ||||
Diluted |
$ | 0.24 | $ | 0.25 | ||||
Weighted average number of shares outstanding: |
||||||||
Basic |
34,251 | 33,390 | ||||||
Diluted |
34,695 | 33,852 | ||||||
The accompanying notes are an integral part of these condensed consolidated financial statements
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NEUTRAL TANDEM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
Three Months Ended March 31, |
||||||||
2011 | 2010 | |||||||
Cash Flows From Operating Activities: |
||||||||
Net income |
$ | 8,184 | $ | 8,469 | ||||
Adjustments to reconcile net cash flows from operating activities: |
||||||||
Depreciation and amortization |
7,106 | 3,948 | ||||||
Deferred income taxes |
(663 | ) | (1,262 | ) | ||||
Gain on disposal of fixed assets |
(6 | ) | (45 | ) | ||||
Non-cash share-based compensation |
6,582 | 2,391 | ||||||
Changes in fair value of ARS |
| (65 | ) | |||||
Changes in fair value of ARS rights |
| (60 | ) | |||||
Excess tax deficiency (benefit) associated with share-based payments |
98 | (54 | ) | |||||
Changes in assets and liabilities: |
||||||||
Receivables |
(1,827 | ) | 3,607 | |||||
Other current assets |
184 | (114 | ) | |||||
Other noncurrent assets |
(1,919 | ) | 1 | |||||
Accounts payable |
(1,000 | ) | 117 | |||||
Accrued liabilities |
2,258 | 2,107 | ||||||
Noncurrent liabilities |
(14 | ) | | |||||
Net cash flows from operating activities |
18,983 | 19,040 | ||||||
Cash Flows From Investing Activities: |
||||||||
Purchase of equipment |
(5,590 | ) | (2,555 | ) | ||||
Proceeds from sale of equipment |
6 | 46 | ||||||
Increase in restricted cash |
| (463 | ) | |||||
Proceeds from the redemption of ARS |
| 3,350 | ||||||
Net cash flows from investing activities |
(5,584 | ) | 378 | |||||
Cash Flows From Financing Activities: |
||||||||
Proceeds from the exercise of stock options |
94 | 15 | ||||||
Restricted shares withheld to cover employee taxes paid |
(597 | ) | | |||||
Excess tax (deficiency) benefit associated with share-based payments |
(98 | ) | 54 | |||||
Payments made for repurchase of common stock |
| (9,556 | ) | |||||
Principal payments on long-term debt |
| (235 | ) | |||||
Net cash flows from financing activities |
(601 | ) | (9,722 | ) | ||||
Effect of exchange rate changes on cash |
153 | | ||||||
Net Increase In Cash And Cash Equivalents |
12,951 | 9,696 | ||||||
Cash And Cash Equivalents Beginning |
106,674 | 161,411 | ||||||
Cash And Cash Equivalents End |
$ | 119,625 | $ | 171,107 | ||||
Supplemental Disclosure Of Cash Flow Information: |
||||||||
Cash paid for interest |
$ | | $ | 242 | ||||
Cash paid for taxes |
$ | 349 | $ | 1,595 | ||||
Supplemental Disclosure Of Noncash Flow Items: |
||||||||
Investing Activity Accrued purchases of equipment |
$ | 4,433 | $ | 1,115 | ||||
The accompanying notes are an integral part of these condensed consolidated financial statements.
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NEUTRAL TANDEM, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. DESCRIPTION OF THE BUSINESS
Organization Neutral Tandem, Inc. (the Company) provides U.S. and international voice, IP Transit, and Ethernet telecommunications services primarily on a wholesale basis. The Company offers these services using an all-IP network, which enables the Company to deliver global connectivity for a variety of media, including voice, data and video. The Companys 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. The Company also provides its solutions to customers, like content providers, who also typically do not have their own network.
Acquisition of Tinet S.p.A. On October 1, 2010 the Company completed its acquisition of Tinet S.p.A. (Tinet) for $103.1 million, comprised of $77.4 million, in cash, paid on October 1, 2010 for the outstanding shares of Tinets capital stock, repayment of $31.1 million of Tinets debt as part of the closing and $5.4 million in cash acquired. The purchase price was financed with cash from the Companys balance sheet. $7.5 million of cash consideration was placed in escrow for a period of two years following the acquisition. Additionally, the Company recorded approximately $4.0 million for acquisition-related costs, including legal, accounting and advisory services in its statement of income.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.
Interim Condensed Consolidated Financial Statements The accompanying condensed consolidated balance sheets as of March 31, 2011 and December 31, 2010, the condensed consolidated statements of income for the three months ended March 31, 2011 and 2010, and the condensed consolidated statements of cash flows for the three months ended March 31, 2011 and 2010 are unaudited. The condensed consolidated balance sheet data as of December 31, 2010 was derived from the audited consolidated financial statements which are included in the Companys Annual Report on Form 10-K for the fiscal year ended December 31, 2010. The accompanying statements should be read in conjunction with the audited consolidated financial statements and related notes contained in the Companys Annual Report on Form 10-K for the fiscal year ended December 31, 2010.
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles (GAAP) pursuant to the rules and regulations of the Securities and Exchange Commission applicable to interim periods. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations.
In the opinion of management, the unaudited interim condensed consolidated financial statements as of March 31, 2011 and for the three months ended March 31, 2011 and 2010 have been prepared on the same basis as the audited consolidated statements and reflect all adjustments, which are normal recurring adjustments, necessary for the fair presentation of its statement of financial position, results of operations and cash flows. The results of operations for the three months ended March 31, 2011 are not necessarily indicative of the operating results for any subsequent quarter, for the full fiscal year or any future periods.
Cash and Cash Equivalents The Company considers all highly liquid investments with an original maturity of 90 days or less to be cash and cash equivalents. The carrying values approximate fair value. At March 31, 2011 the Company had $22.8 million of cash in banks and $96.8 million in two money market mutual funds. At December 31, 2010, the Company had $12.9 million of cash in banks and $93.8 million in two money market mutual funds.
The carrying amounts of our cash and equivalents, receivables and accounts payable approximate fair value due to their short-term nature.
Property and Equipment Property and equipment are recorded at historical cost. These costs are depreciated over the estimated useful lives of the individual assets using the straight-line method. Any gains and losses from the disposition of property and equipment are included in operations as incurred. The estimated useful life for switch equipment and tools and test equipment is five years. The estimated useful life for computer equipment, computer software and furniture and fixtures is three years. Leasehold improvements are amortized on a straight-line basis over an estimated useful life of five years or the life of the lease, whichever is less. As discussed in further detail below, the impairment of long-lived assets is periodically evaluated when events or changes in circumstances indicate that a potential impairment has occurred.
Goodwill and Intangible Assets, Net Goodwill and intangible assets were recognized in 2010 as a result of the acquisition of Tinet.
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In accordance with the provisions of ASC Topic 350, Intangibles Goodwill and Other (ASC 350), goodwill is not amortized but is tested for impairment at least annually, or more frequently if an event occurs or circumstances change that would reduce the fair value of a reporting unit below its carrying value. The Company uses internal discounted cash flow estimates and market value comparisons to determine estimated fair value. The annual assessment occurs in the fourth quarter of each year.
The change in the carrying amount of goodwill during the three months ended March 31, 2011, is as follows:
(Dollars in thousands) |
December 31, 2010 |
Currency Translation Effect |
March 31, 2011 |
|||||||||
Goodwill |
$ | 49,098 | $ | 3,131 | $ | 52,229 |
Intangible assets, net consist of the following:
March 31, 2011 | ||||||||||||
(Dollars in thousands) |
Gross Carrying Amount |
Accumulated Amortization |
Net Intangible Assets |
|||||||||
Customer relationships |
$ | 34,116 | $ | (1,185 | ) | $ | 32,931 | |||||
December 31, 2010 | ||||||||||||
(Dollars in thousands) |
Gross Carrying Amount |
Accumulated Amortization |
Net Intangible Assets |
|||||||||
Customer relationships |
$ | 32,072 | $ | (566) | $ | 31,506 |
Intangible assets, which consist of customer relationships, have a definite life and are amortized on an accelerated basis based on the discounted cash flows recognized over their estimated useful lives (15 years). Intangible asset amortization expense was $0.6 million in the three months ended March 31, 2011. Intangible asset amortization for each of the five succeeding fiscal years is estimated at $2.1 million for 2011, $2.5 million for 2012, $2.9 million for 2013, $2.8 million for 2014, and $2.4 million for 2015.
Revenue Recognition The Company generates revenue from sales of its voice, IP Transit, and Ethernet services. The Company maintains tariffs and executed service agreements with each of its customers in which specific fees and rates are determined. Voice revenue is recorded each month on an accrual basis based upon minutes of traffic switched by the Companys network by each customer, which is referred to as minute of use. The rates charged per minute are determined by contracts between the Company and its customers or by filed and effective tariffs.
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.
Earnings Per Share Basic earnings per share is computed based on the weighted average number of shares of common stock outstanding. Diluted earnings per share is computed based on the weighted average number of shares of common stock outstanding adjusted by the number of additional shares of common stock that would have been outstanding had the potentially dilutive shares of common stock been issued. Potentially dilutive shares of common stock include stock options and non-vested shares. The following table presents a reconciliation of the numerators and denominators of basic and diluted earnings per share of common stock:
Three Months Ended March 31, |
||||||||
(In thousands, except per share amounts) |
2011 | 2010 | ||||||
Numerator: |
||||||||
Net income applicable to common shareholders |
$ | 8,184 | $ | 8,469 | ||||
Denominator: |
||||||||
Weighted average common shares outstanding |
34,251 | 33,390 | ||||||
Effect of dilutive securities: |
||||||||
Stock options |
444 | 462 | ||||||
Denominator for diluted earnings per share |
34,695 | 33,852 | ||||||
Net earnings per share: |
||||||||
Basic as reported |
$ | 0.24 | $ | 0.25 | ||||
Diluted as reported |
$ | 0.24 | $ | 0.25 | ||||
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Options to purchase 2.4 and 2.3 million shares of common stock were outstanding during the three months ended March 31, 2011 and March 31, 2010, respectively, but were not included in the computation of diluted earnings per share because the effect would have been antidilutive.
Accounting for Share-Based Payments The fair value of stock options is determined using the Black-Scholes valuation model. This model takes into account the exercise price of the stock option, the fair value of the common stock underlying the stock option as measured on the date of grant and an estimation of the volatility of the common stock underlying the stock option. Such value is recognized as expense over the service period, net of estimated forfeitures, using the straight line method. The estimation of stock awards that will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from the Companys current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. The Company considers many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience. Actual results, and future changes in estimates, may differ from the Companys current estimates.
The amount of share-based expense recorded in the three months ended March 31, 2011 and 2010, is $6.6 million and $2.4 million, respectively.
Compensation expense for non-vested shares is measured based upon the quoted closing market price for the stock on the date of grant. The compensation cost is recognized on a straight-line basis over the vesting period. See Note 6, Stock Options and Non-vested Shares
Stock Repurchase On February 16, 2010, the Company announced that its Board of Directors authorized the repurchase of up to $25.0 million of outstanding common stock as part of a stock repurchase program. In the three months ended March 31, 2010, the Company repurchased approximately 0.6 million shares for $9.6 million under the program at an average cost of $15.78 per share. The stock repurchases are accounted for under the cost method whereby the entire cost of the repurchased and retired shares, net of par value, was recorded to additional paid-in capital.
On February 21, 2011, the Company announced that our Board of Directors authorized the repurchase of up to $50.0 million of its outstanding common stock as part of a stock repurchase program. On April 18, 2011, the Company entered into a letter agreement (the Letter Agreement) with Spotlight Advisors, LLC, George Allen and Clinton Group, Inc. on behalf of themselves and their respective affiliated funds, persons and entities (collectively, the Investor Group), pursuant to which the Company agreed, subject to certain conditions, to convert its existing $50.0 million discretionary stock repurchase program into a modified Dutch auction tender offer on or prior to June 17, 2011. As of May 10, 2011, no shares have been repurchased in the discretionary stock repurchase program.
Foreign Exchange The functional currency of each of the Companys subsidiaries is the currency of the country in which the subsidiary operates. Assets and liabilities of foreign operations are translated using period end exchange rates, and revenues and expenses are translated using average exchange rates during the period. Translation gains and losses are reported in accumulated other comprehensive earnings as a component of stockholders equity.
Recent Accounting Pronouncements In December 2010, the FASB issued accounting standard update 2010-19, Disclosure of Supplementary Pro Forma Information for Business Combinations (ASU 2010-29). ASU 2010-29 clarifies the disclosure requirements for pro forma financial information related to a material business combination or a series of immaterial business combinations that are material in the aggregate. The guidance clarified that the pro forma disclosures are prepared assuming the business combination occurred at the start of the prior annual reporting period. Additionally, a narrative description of the nature and amount of material, non-recurring pro forma adjustments would be required. As this newly issued accounting standard only requires enhanced disclosure, the adoption of this standard will not impact our financial position or results of operations.
3. LEGAL PROCEEDINGS
Peerless Network, Inc.
Proceeding in the United States District Court for the Northern District of Illinois
On June 12, 2008, the Company commenced a patent infringement action against Peerless Network, Inc., Peerless Network of Illinois, LLC, and John Barnicle (collectively, Peerless Network) in the United States District Court for the Northern District of Illinois to enforce U.S. Patent No. 7,123,708 (the 708 Patent) (Neutral Tandem, Inc. v Peerless Network, Inc., Peerless Network of Illinois, LLC and John Barnicle, 08 CV 3402 ). On July 28, 2008, Peerless Network filed a response to the Companys complaint denying liability and asserting various affirmative defenses and counterclaims. Peerless Network generally alleges (i) that the 708
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Patent is invalid and unenforceable under a variety of theories, (ii) that assertion of the 708 Patent amounts to patent misuse and violation of certain monopolization laws, and (iii) that certain conduct surrounding the litigation gave rise to tortious interference and business disparagement claims and Lanham Act violations. On December 4, 2008, the court granted the Companys motion to dismiss the claims alleging business disparagement and Lanham Act violations but denied the Companys motion to dismiss the claims related to the allegations of tortious interference and alleged violation of certain monopolization laws. On January 27, 2010, the court issued an order construing each of the disputed terms in the patent in the manner the Company had proposed. On March 30, 2010, the court issued an order denying the Companys motion dated August 25, 2009 for preliminary injunctive relief which sought to enjoin Peerless Network from providing certain tandem transit services.
On April 27, 2010, the court issued an order denying without prejudice the motion of Peerless Network seeking leave to file a motion to stay the patent litigation. Peerless Network sought to stay the patent litigation pending the inter partes reexamination by the United States Patent and Trademark Office (the USPTO) of the validity of the 708 Patent, which is discussed below.
On June 1, 2010, Peerless Network filed a renewed motion asking the court to extend the trial date by nine months or stay proceedings pending the inter partes reexamination by the USPTO of the validity of the 708 Patent. The court heard the motion on June 8, 2010. After hearing the motion, the court issued an order that the Company believes in substance removed the previously scheduled September 2010 trial date from the courts calendar. However, the court also ordered that proceedings on the parties respective motions for summary judgment would continue, and the court set a ruling date on the parties summary judgment motions for September 1, 2010.
On September 2, 2010, the court issued an opinion and order granting Peerless Networks motion for summary judgment. The court found that the 708 Patent is invalid in light of a prior patent, U.S. Patent No. 6,137,800. In light of the summary judgment ruling, the court denied the Companys request to reinstate the trial date as moot.
The courts September 2, 2010 order also denied the Companys motion for summary judgment. The Company sought summary judgment on its claim that Peerless Network infringed the 708 Patent, as well as summary judgment on Peerless Networks claim that the 708 Patent is unenforceable. At a hearing on September 22, 2010, the court allowed the Company to file a new motion for summary judgment on Peerless Networks claim that the 708 Patent is unenforceable. The court also dismissed Counts IV-VII of Peerless Networks counterclaims, which were claims against the Company based on allegations of monopolization, monopoly leveraging, violations of the Illinois Antitrust Act, and tortious interference with prospective business relations. Briefing on the Companys new motion for summary judgment was completed on October 27, 2010.
On December 9, 2010, the court issued an opinion and order granting the Companys motion for summary judgment on Peerlesss claim that the 708 Patent was unenforceable based on alleged inequitable conduct and patent misuse. The court entered a final judgment with respect to all claims in the litigation on December 17, 2010.
On December 20, 2010, the Company filed notice that it plans to appeal the courts order granting Peerless Networks motion for summary judgment and finding that the 708 Patent is invalid. On January 13, 2011, Peerless Network cross-appealed the courts order granting the Companys motion for summary judgment and finding that the 708 Patent is not unenforceable, as well as the courts earlier ruling construing disputed terms of the patent in the Companys favor. The Company currently anticipates that briefing on the parties cross-appeals will be completed in approximately August 2011, though that schedule is subject to change.
Inter Partes Proceeding before the United States Patent and Trademark Office
In a separate proceeding, on January 28, 2010, Peerless Network filed a request with the USPTO requesting that the USPTO reexamine the 708 Patent. On March 26, 2010, the USPTO granted Peerless Networks inter partes reexamination request and issued an initial office action which rejected the 708 Patents 23 claims. The claims of the 708 Patent as originally issued by the USPTO remain valid and enforceable during the USPTO reexamination proceeding. Under the USPTOs rules, the Company was not allowed to respond to Peerless Networks request prior to the USPTOs initial determination.
On May 20, 2010, the USPTO granted the Companys request to extend the time by which it must file its response to the March 26, 2010 office action from May 26, 2010 to July 26, 2010.
On April 12, 2010, the Company moved separately to suspend the inter partes reexamination proceeding in its entirety, pending resolution of the litigation between the Company and Peerless Network. On June 30, 2010, the USPTO denied the Companys petition seeking to suspend the separate reexamination proceeding. Although the USPTO did not suspend the reexamination proceeding, the USPTO stated in its decision, among other things, that it is appropriate to continue both [the reexamination and litigation] proceedings to obtain the results and benefits of each, as they accrue.
On July 26, 2010, the Company responded to the USPTOs March 26, 2010 office action. On November 24, 2010, the USPTO issued an action closing prosecution, in which the USPTO maintained its rejection of the 708 Patents 23 original claims, as well as 35 additional claims added to the 708 Patent in the Companys July 26, 2010 response.
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On January 7, 2011, the Company filed a response to the USPTOs November 24, 2010 action closing prosecution. Thereafter, Peerless Network filed comments in opposition to the Companys response on February 4, 2011.
On March 11, 2011, the USPTO issued a right of appeal notice, in which the USPTO maintained its rejection of the 708 Patents 23 original claims, as well as the 35 additional claims added to the 708 Patent in the Companys July 26, 2010 response.
On April 11, 2011, the Company filed a notice of appeal of the USPTOs decision to the Board of Patent Appeals and Interferences (the BPAI). Peerless Network filed a notice of appeal of the USPTOs decision to the BPAI on April 19, 2011. The Company currently anticipates that briefing on the parties appeals before the BPAI will be completed in approximately December 2011, though that schedule is subject to change.
After reviewing the parties positions on appeal, the BPAI may affirm the USPTOs rejection of some or all of the claims, allow some or all of the claims of the 708 Patent to issue in their current form, or return the matter for further examination with respect to some or all of the claims. Thereafter, there may be further proceedings at the USPTO regarding the validity of some or all of the claims of the 708 Patent. The decision of the BPAI is ultimately appealable by either party to the United States Court of Appeals for the Federal Circuit.
Since the Company is unable to predict the outcome of Peerless Networks claim that the 708 Patent is unenforceable, the Company has not recorded a liability associated with this claim.
4. INCOME TAXES
Income taxes were computed using an effective tax rate, which is subject to ongoing review and evaluation by the Company. The Companys estimated effective income tax rate was 34.1% for the three months ended March 31, 2011, compared to 40.8% for the same period last year.
The Company evaluates its deferred income taxes quarterly to determine if a valuation allowance is required or should be adjusted. The Company assesses whether a valuation allowance should be established against our deferred tax assets based upon consideration of all available evidence, both positive and negative, using a more likely than not standard. This assessment considers, among other matters, forecasts of future profitability, the duration of statutory carryforward periods, the Companys experience with tax attributes expiring unused and tax planning alternatives. In making such judgments, significant weight is given to evidence that can be objectively verified. The Companys Illinois EDGE credit can be carried forward five years. For the year ended December 31, 2010, the Company recorded a partial valuation allowance of $0.6 million against the credit as the Company believed it was more likely than not that future taxable income would be insufficient to realize the full benefit of the credit. For the three months ended March 31, 2011, the Company believes, more likely than not, that future taxable income and the increase to the Illinois corporate income tax rate, effective as of the Companys taxable year ending December 31, 2011, will result in the realization of the full benefit of the credit. Accordingly, the Company released the full $0.6 million valuation allowance against the Illinois EDGE credit.
The decrease in the Companys effective income tax rate for the three months ended March 31, 2011, as compared to the three months ended March 31, 2010, was primarily due to the release of the valuation allowance against the Illinois EDGE credit deferred tax asset in the first quarter of 2011. Additional items that result in the variance of the Companys estimated effective income tax rate from the statutory federal income tax rate of 35% include the impact of state income taxes, Illinois EDGE credit tax benefit and foreign taxes.
The Company files U.S. Federal, various U.S. state and local, and foreign income tax returns. With few exceptions, the Company is no longer subject to U.S. Federal, state or local examinations for years before 2007. The IRS has commenced an examination of the Companys 2008 federal income tax return. As of March 31, 2011, the IRS had not proposed any material adjustments to such income tax return. Audit outcomes and the timing of audit settlements are subject to significant uncertainty. It is reasonably possible that within the next 12 months, the Company will resolve some or all of the matters presently under consideration for 2008 with the IRS. In the first quarter of 2010, the State of Illinois concluded an examination of the Companys 2006 and 2007 Illinois state income tax returns. The audit resulted in no material changes. At March 31, 2011, and December 31, 2010, the Company did not have any income tax liability due to uncertain tax positions related to U.S. federal, state or local income tax positions. At March 31, 2011, and December 31, 2010, the company had income tax liabilities in foreign jurisdictions of approximately $0.3 million and $0.2 million, respectively, due to uncertain tax positions.
5. STOCK OPTIONS AND NON-VESTED SHARES
The Company established the 2003 Stock Option and Stock Incentive Plan (2003 Plan), which provided for the issuance of up to 4,650,000 options and shares of restricted stock to eligible employees, officers, and independent contractors of the Company. In 2007 the Company adopted the Neutral Tandem, Inc. 2007 Equity Incentive Plan, which was subsequently amended and restated (2007 Plan) and ceased awarding equity grants under the 2003 Plan. As of March 31, 2011, the Company had granted a total of 794,442 options that remained outstanding under the 2003 Plan.
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At March 31, 2011, the Company had granted a total of 2,368,250 options and 860,934 non-vested shares that remained outstanding under the 2007 Plan. Awards for 1,161,543 shares, representing approximately 3.5% of the Companys outstanding common stock as of March 31, 2011, remained available for additional grants under the 2007 Plan.
The Company records stock-based compensation expense in connection with any grant of options and non-vested shares to its employees. The Company calculates the expense associated with its stock options and non-vested shares by determining the fair value of the options and non-vested shares.
Options
All options granted under the 2003 Plan and the 2007 Plan have an exercise price equal to the market value of the underlying common stock on the date of the grant. During the three months ended March 31, 2011, the Company granted 18,000 options at a weighted-average exercise price of $16.73.
The fair value of each option granted is estimated on the date of grant using the Black-Scholes option-pricing model. The following table summarizes the assumptions used for estimating the fair value of options for the three months ended March 31, 2011 and March 31, 2010:
March 31, 2011 |
March 31, 2010 | |||
Expected life |
7.0 years | 7.1 years | ||
Risk-free interest rate range |
2.54 2.87% | 3.0 3.1% | ||
Expected dividends |
| | ||
Volatility |
51.6% | 52.6% |
The weighted-average fair value of options granted, as determined by using the Black-Scholes valuation model, during the period was $9.25 and $10.06 for the three months ended March 31, 2011 and 2010, respectively. The total grant date fair value of options that vested during the three months ended March 31, 2011 and 2010 was approximately $0.9 million and $0.6 million, respectively.
The following summarizes activity under the Companys stock option plan for the three months ended March 31, 2011:
Shares (000) |
Weighted- Average Exercise Price |
Aggregate Intrinsic Value ($000) |
Weighted- Average Remaining Term (yrs) |
|||||||||||||
Options outstanding January 1, 2011 |
3,184 | $ | 16.06 | |||||||||||||
Granted |
18 | 16.73 | ||||||||||||||
Exercised |
39 | 2.65 | ||||||||||||||
Cancelled |
| | ||||||||||||||
Options outstanding March 31, 2011 |
3,163 | $ | 16.23 | $ | 9,526 | 7.1 | ||||||||||
Vested or expected to vest-March 31, 2011 |
2,989 | $ | 16.23 | $ | 9,002 | 7.1 | ||||||||||
Exercisable-March 31, 2011 |
1,843 | $ | 12.93 | $ | 9,010 | 6.5 | ||||||||||
The unrecognized compensation cost associated with options outstanding at March 31, 2011 and December 31, 2010 was $9.6 million and $13.1 million, respectively. The weighted average remaining term that the compensation will be recorded is 2.0 years and 2.2 years as of March 31, 2011 and December 31, 2010, respectively.
Non-vested Shares
During 2010, the Companys Board of Directors granted approximately 0.8 million non-vested shares to members of the Companys executive management team as well as various employees within the Company. During the three months ended March 31, 2011, the Companys Board of Directors granted less than 0.1 million non-vested shares. The non-vested shares were issued as part of the 2007 plan. The shares typically vest over a four year period. The fair value of the non-vested shares is determined using the Companys closing stock price on the grant date. Compensation cost, measured using the grant date fair value, is recognized over the requisite service period on a straight-line basis.
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A summary of the Companys non-vested share activity and related information for the three months ended March 31, 2011 is as follows:
Shares (000) |
Weighted- Average Grant Date Fair Value |
|||||||
Non-vested at January 1, 2011 |
1,073 | $ | 16.11 | |||||
Granted |
6 | 18.36 | ||||||
Vested |
(124 | ) | 15.13 | |||||
Cancelled |
(94 | ) | 15.68 | |||||
Non-vested at March 31, 2011 |
861 | $ | 15.41 | |||||
The unrecognized compensation cost associated with non-vested shares at March 31, 2011 and December 31, 2010 was $12.0 million and $16.3 million, respectively. The weighted average remaining term that the compensation will be recorded is 2.5 years and 3.2 years as of March 31, 2011 and December 31, 2010, respectively.
During the quarter ended March 31, 2011, Rian J. Wren, the Companys Chief Executive Officer since 2006, announced his decision to retire from the Company on March 31, 2011. He continues to serve on the Board of Directors following his retirement. As a result of this decision, the Board approved the acceleration of the vesting on approximately 0.2 million options and 0.1 million non-vested shares, in addition to the forfeiture of 0.1 million non-vested shares. All options and non-vested shares are fully vested as of March 31, 2011. Non-cash compensation expense of $6.6 million recorded in the first quarter 2011 included $2.0 million related to the acceleration of options and $1.6 million related to the acceleration of non-vested shares.
6. BUSINESS ACQUISITION
On October 1, 2010, the Company completed the acquisition of Tinet. The total cash paid for the acquisition was $103.1 million, comprised of $77.4 million, in cash, paid on October 1, 2010 for the outstanding shares of Tinets capital stock, repayment of $31.1 million of Tinets debt as part of the closing and $5.4 million in cash acquired. In addition to the cash, the Company recorded approximately $4.0 million for acquisition-related costs, including legal, accounting and advisory services in its statement of income under general and administrative expenses.
Tinet is a global carrier exclusively committed to the IP and Ethernet wholesale market which provides global IP transit and Ethernet connectively to carriers, service providers and content providers worldwide. With this acquisition, the Company 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. These factors contributed to the goodwill recognized.
The allocation of the purchase price is preliminary, based on initial accounting of the assets acquired and liabilities assumed at their respective estimated fair vales on the acquisition date of October 1, 2010. The final allocation of the purchase price may result in adjustments to the recognized amounts of intangible assets and deferred taxes, which could be significant. The preliminary allocation based on managements best estimate is as follows:
(Dollars in thousands) |
||||
Current assets |
$ | 15,336 | ||
Fixed assets |
28,500 | |||
Customer relationships |
32,973 | |||
Noncurrent assets |
3,102 | |||
Current liabilities |
(20,471 | ) | ||
Deferred tax liability |
(5,805 | ) | ||
Noncurrent liabilities |
(967 | ) | ||
Goodwill |
50,476 | |||
Total cash paid for acquisition |
$ | 103,144 | ||
The $33.0 million of acquired intangible assets relates to the customer relationships that will be amortized over their estimated useful life of 15 years. Goodwill is not expected to be deductible for tax purposes.
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Supplemental information on an unaudited pro from basis for the 3 months ended March 31, 2011 and March 31, 2010, as if the acquisition had taken place on January 1, 2010, respectively, is as follows:
Three Months Ended March 31, |
||||||||
(Dollars in thousands) |
2011 | 2010 | ||||||
Revenue |
$ | 66,418 | $ | 60,217 | ||||
Net income |
8,184 | 6,395 | ||||||
Diluted earnings per share |
0.24 | 0.19 |
Unaudited pro forma supplemental information is based on accounting estimates and judgments, which the Company believes are reasonable. The unaudited pro forma supplemental information also includes purchase accounting adjustments (including adjustments to depreciation on acquired property and equipment, amortization charges from acquired intangible assets, adjustments to interest income and related tax effects). The unaudited pro forma supplemental information is not necessarily indicative of the results of operations in future periods or the results that actually would have been realized had the Company and Tinet been combined at the beginning of the period presented.
7. SEGMENT AND GEOGRAPHIC INFORMATION
Segment Reporting establishes standards for reporting information about operating segments. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance.
The Companys chief operating decision maker is the Chief Executive Officer. The Chief Executive Officer reviews financial information presented on a consolidated basis. The Company operates in one industry segment, which is to provide voice, IP Transit and Ethernet interconnection services via the Companys international telecommunications network to fulfill customer agreements. Therefore, the Company has concluded that it has only one operating segment.
Item 2. | Managements 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.
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.
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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 become increasingly difficult to manage and maintain, causing delays and inhibiting competitive carrier growth, and the purchase of ILEC tandem services become an increasingly significant component of a competitive carriers 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 March 31, 2011.
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.
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 670 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.
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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 three 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.
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, 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.
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.
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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 assets carrying value, we record a gain on disposal.
Other (Income) Expense. Other (income) expense includes adjustments to the fair value of the Auction Rate Securities (ARS) and the related ARS Rights.
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.
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 three months of 2011.
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Results of Operations
The following table sets forth our results of operations for the three months ended March 31, 2011 and 2010:
Three Months Ended March 31, |
||||||||
(Dollars in thousands) |
2011 | 2010 | ||||||
Revenue |
$ | 66,418 | $ | 44,829 | ||||
Operating expense: |
||||||||
Network and facilities expense (excluding depreciation and amortization) |
25,819 | 14,361 | ||||||
Operations |
9,419 | 5,521 | ||||||
Sales and marketing |
3,359 | 510 | ||||||
General and administrative |
10,058 | 6,400 | ||||||
Depreciation and amortization |
7,106 | 3,948 | ||||||
Gain on disposal of fixed assets |
(6 | ) | (45 | ) | ||||
Total operating expense |
55,755 | 30,695 | ||||||
Income from operations |
10,663 | 14,134 | ||||||
Other (income) expense: |
||||||||
Interest expense |
| 4 | ||||||
Interest income |
(13 | ) | (54 | ) | ||||
Other (income) expense |
14 | (125 | ) | |||||
Foreign exchange (gain) loss |
(1,763 | ) | | |||||
Total other income |
(1,762 | ) | (175 | ) | ||||
Income before income taxes |
12,425 | 14,309 | ||||||
Provision for income taxes |
4,241 | 5,840 | ||||||
Net income |
$ | 8,184 | $ | 8,469 | ||||
Three Months Ended March 31, 2011 Compared to Three Months Ended March 31, 2010
Revenue. Revenue increased to $66.4 million in the three months ended March 31, 2011 from $44.8 million in the three months ended March 31, 2010, an increase of 48.2%. A portion of the increase in revenues was due to the acquisition of Tinet, which generated $16.1 million in revenues or 35.8% of the increase. The remaining increase in revenue of $5.5 million, or 12.4%, was primarily due to an increase of minutes of use to 31.7 billion minutes processed in the three months ended March 31, 2011 from 24.7 billion minutes processed in the three months ended March 31, 2010, an increase of 28.4%. 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 43 new markets since March 31, 2010. Offsetting the increase in minutes was a decrease in average fee billed per minute from $0.0018 for the three months ended March 31, 2010 to $0.0016 for the three months ended March 31, 2011.
Operating Expenses . Operating expenses for the three months ended March 31, 2011 of $55.8 million increased $25.1 million, or 81.6%, from $30.7 million for the three months ended March 31, 2010. The components making up operating expenses are discussed further below.
Network and Facilities Expenses. Network and facilities expenses increased to $25.8 million in the three months ended March 31, 2011, or 38.9% of revenue, from $14.4 million in the three months ended March 31, 2010, or 32.0% of revenue. Of this increase, $8.2 million is the network and facilities expense incurred by Tinet during the first 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 $17.6 million for the three months ended March 31, 2011, or 34.9% of revenue. As noted above, our billed voice minutes were up 28.4%, 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.
Operations Expenses. Operations expenses increased to $9.4 million in the three months ended March 31, 2011, or 14.2% of revenue, from $5.5 million in the three months ended March 31, 2010, or 12.3% of revenue. Of this increase, $2.4 million is due to operations expenses of Tinet. The remaining increase of $1.5 million in our operations expenses primarily resulted from an increase of $0.9 million in non-cash compensation and $0.4 million in payroll and benefits, due to an increase in the number of switch location personnel, as well as individuals located at our corporate office who are directly responsible for maintaining and expanding our switch network.
Sales and Marketing Expense. Sales and marketing expense increased to $3.4 million in the three months ended March 31, 2011, or 5.1% of revenue, compared to $0.5 million in the three months ended March 31, 2010, or 1.1% of revenue. Of this increase, $2.5 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 $0.4 million sales and marketing expenses for the three months ended March 31, 2011 is primarily due to an increase in non-cash compensation.
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General and Administrative Expense. General and administrative expense increased to $10.1 million in the three months ended March 31, 2011, or 15.1% of revenue, compared with $6.4 million in the three months ended March 31, 2010, or 14.3% of revenue. Of this increase, $1.0 million is due to the acquisition of Tinet. The remaining increase of $2.7 million in our general and administrative expense is primarily due to an increase of $3.1 million in non-cash compensation, offset by a decrease of $0.7 million in professional fees. The increase in non-cash compensation in primarily due to the accelerated vested of options and non-vested shares related to the retirement of Rian J. Wren, as further discussed in footnote 6 to the condensed consolidated financial statements Stock Options and Non-vested Shares
Depreciation and Amortization Expense. Depreciation and amortization expense increased to $7.1million in the three months ended March 31, 2011, or 10.7% of revenue, compared to $3.9 million in the three months ended March 31, 2010, or 8.8% of revenue. Of this increase, $2.5 million is due to Tinet. The remaining $0.7 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) Expense. Other income increased to $1.8 million for the three months ended March 31, 2011. In the three months ended March 31, 2011, we recognized $1.8 million related to foreign exchange gain recognized on the remeasurement of an intercompany loan denominated in Euros during the first quarter of 2011. In the three months ended March 31, 2010, we recognized $0.2 million related to adjustments to the fair value of our ARS and ARS Rights.
Provision for Income Taxes. Provision for income taxes of $4.2 million for the three months ended March 31, 2011 decreased by $1.6 million compared to $5.8 million for the three months ended March 31, 2010. The effective tax rate for the three months ended March 31, 2011 and 2010 was 34.1% and 40.8%, respectively. The decrease in the tax rate was primarily due to the release of a $0.6 million valuation allowance against the Illinois EDGE credit deferred tax asset in the first quarter of 2011.
Liquidity and Capital Resources
At December 31, 2010, we had $106.7 million in cash and cash equivalents, and $1.0 million in restricted cash. In comparison, at March 31, 2011, we had $119.6 million in cash and cash equivalents and $1.0 million in restricted cash. Cash and cash equivalents consist of highly liquid money market mutual funds. The restricted cash balance is pledged as collateral for certain commercial letters of credit.
Three Months Ended | ||||||||
March 31, 2011 | March 31, 2010 | |||||||
Net cash flows from operating activities |
$ | 18,983 | $ | 19,040 | ||||
Net cash flows from investing activities |
(5,584 | ) | 378 | |||||
Net cash flows from financing activities |
(601 | ) | (9,722 | ) |
Cash flows from operating activities
Net cash provided by operating activities was $19.0 million for the three months ended March 31, 2011 and March 31, 2010, respectively. Operating cash inflows are largely attributable to payments from customers which are generally received between 35 to 45 days following the end of the billing month. Operating cash outflows are largely attributable to personnel related expenditures, and facility and switch maintenance costs. Operating cash flows were consistent with prior period, mainly due to the increase in revenue during the three months ended March 31, 2011, resulting in increased cash collections during the first quarter of 2011, offset by a higher net investment in our working capital accounts, primarily due to the timing of cash collections and payments.
Cash flows from investing activities
Net cash used in investing activities was $5.6 million for the first three months of 2011, compared to net cash provided by investing activities of $0.4 million for the same period last year. Investing cash flows are primarily related to purchases of switch equipment and the purchase and sale of investments. The increase in investing cash flow used is the result of an increase in the purchase of equipment in 2011. Also, in 2010, we had cash inflows of $3.4 million from the redemption of ARS.
In the next twelve months, capital expenditures are expected to be in the range of approximately $20.0 to $24.0 million, primarily for the expansion into new locations and the expansion and upgrades of current locations.
Cash flows from financing activities
Net cash used for financing activities was $0.6 million for the first three months of 2011, compared to net cash use for financing activities of $9.7 million for the same period last year. The changes in cash flows from financing activities primarily relate to the stock repurchase during the first quarter of 2010.
We regularly review acquisitions and additional strategic opportunities, which may require additional debt or equity financing.
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Investments
We invest our excess cash in money market mutual funds which are carried at market value. As of March 31, 2011, we had $96.8 million in cash and cash equivalents invested in two money market mutual funds.
Letter Agreement dated April 18, 2011
On April 18, 2011, we entered into the Letter Agreement with the Investor Group, pursuant to which we agreed, subject to certain conditions, to convert our existing $50.0 million discretionary stock repurchase program into a modified Dutch auction tender offer on or prior to June 17, 2011.
The Letter Agreement also provides that two new independent directors will join our Board of Directors following our 2011 annual meeting of shareholders, and we will form a new Board committee responsible for considering matters regarding the Companys capital structure and capital allocation (the Capital Allocation Committee). One director will be selected by the Board from a list of nominees suggested by the Investor Group. Our Capital Allocation Committee will consider, among other matters, the allocation of capital to new investments or acquisitions, and whether any unneeded capital remains following the tender offer that may be returned to shareholders through dividends, tender offers or buybacks. As of March 31, 2011 our working capital was approximately $134.0 million. Assuming that shares of common stock are tendered and accepted in the tender offer with an aggregate purchase price of $50.0 million, our pro forma working capital as of March 31, 2011 would be approximately $84.0 million after giving effect to the tender offer. By no later than September 30, 2011, the Capital Allocation Committee will evaluate and recommend to the Board whether, among other matters, such working capital should be retained by the Company to fund future capital expenditures and anticipated growth needs, allocated to new investments or acquisitions, returned to our shareholders through future dividends, tender offers or buybacks, or some combination of the foregoing. Shareholders will not be entitled to any benefits attributable to shares of common stock that are purchased under the tender offer following the date that such shares are purchased by the Company.
This report is not an offer to buy or the solicitation of an offer to sell any shares. The full details of the Dutch auction tender offer, including complete instructions on how to tender shares, will be included in the offer to purchase, the letter of transmittal and related materials, which will become available to shareholders promptly following commencement of the offer. Shareholders should read carefully the offer to purchase, the letter of transmittal and other related materials when they are available because they will contain important information. Shareholders may obtain free copies, when available, of the offer to purchase and other related materials that will be filed by the Company with the Securities and Exchange Commission at the Commissions website at www.sec.gov. When available, shareholders also may obtain a copy of these documents, free of charge, from the Companys information agent to be appointed in connection with the offer.
Effect of Inflation
Inflation generally affects us by increasing our cost of labor and equipment. We do not believe that inflation had any material effect on our results of operations for the three month periods ended March 31, 2011 and 2010.
Item 3. | Qualitative and Quantitative Disclosure about Market Risk |
Interest rate exposure
We had cash, cash equivalents and restricted cash totaling $120.6 million at March 31, 2011. This amount was allocated primarily in two money market mutual funds. The unrestricted cash and cash equivalents are held for working capital purposes. We do not enter into investments for speculative purposes.
Based upon our overall interest rate exposure at March 31, 2011, we do not believe that a hypothetical 10 percent change in interest rates over a one year period would have a material impact on our earnings, fair values or cash flows from interest rate risk sensitive instruments discussed above.
Foreign Currency
The Company is exposed to the effect of foreign currency fluctuations in certain countries in which it operates. The functional currency of each of the Companys subsidiaries is the currency of the country in which the subsidiary operates. The exposure to foreign currency movements is limited in most countries because the operating revenues and expenses of its various subsidiaries and business units are substantially in the local currency of the country in which they operate. To the extent borrowings, sales, purchases, revenues, expenses or other transactions are not in the local currency of the subsidiary, the Company is exposed to currency risk. Accordingly, earnings are affected by changes in foreign currency exchange rates, particularly the Euro and British Pound. Collectively, these currencies represent less than 1% of the Companys operating income. The Company also has an intercompany loan denominated in Euro. As a result, earnings are affected by changes in the exchange rate between the Euro and the dollar. We do not believe that a 10 percent change in these currencies over a one-year period would have a material impact on our earnings.
Item 4. | Controls and Procedures |
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Companys reports under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SECs rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
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Evaluation
We carried out an evaluation, under the supervision, and with the participation, of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of March 31, 2011. Based on the foregoing, our Chief Executive Officer and principal financial officers concluded that our disclosure controls and procedures were effective as of March 31, 2011 at the reasonable assurance level.
There have been no changes during the three months ended March 31, 2011 covered by this report in our internal control over financial reporting or in other factors that could materially affect or are reasonably likely to materially affect internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1. | Legal Proceedings |
Peerless Network, Inc.
Proceeding in the United States District Court for the Northern District of Illinois
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 the 708 Patent (Neutral Tandem, Inc. v Peerless Network, Inc., Peerless Network of Illinois, LLC and John Barnicle, 08 CV 3402 ). On July 28, 2008, Peerless Network filed a response to our complaint denying liability and asserting various affirmative defenses and counterclaims. Peerless Network generally alleges (i) that the 708 Patent is invalid and unenforceable under a variety of theories, (ii) that assertion of the 708 Patent amounts to patent misuse and violation of certain monopolization laws, and (iii) that certain conduct surrounding the litigation gave rise to tortious interference and business disparagement claims and Lanham Act violations. On December 4, 2008, the court granted our motion to dismiss the claims alleging business disparagement and Lanham Act violations but denied our motion to dismiss the claims related to the allegations of tortious interference and alleged violation of certain monopolization laws. On January 27, 2010, the court issued an order construing each of the disputed terms in the patent in the manner we had proposed. On March 30, 2010, the court issued an order denying our motion dated August 25, 2009 for preliminary injunctive relief which sought to enjoin Peerless Network from providing certain tandem transit services.
On April 27, 2010, the court issued an order denying without prejudice the motion of Peerless Network seeking leave to file a motion to stay the patent litigation. Peerless Network sought to stay the patent litigation pending the inter partes reexamination by the USPTO of the validity of the 708 Patent, which is discussed below.
On June 1, 2010, Peerless Network filed a renewed motion asking the court to extend the trial date by nine months or stay proceedings pending the inter partes reexamination by the USPTO of the validity of the 708 Patent. The court heard the motion on June 8, 2010. After hearing the motion, the court issued an order that we believe in substance removed the previously scheduled September 2010 trial date from the courts calendar. However, the court also ordered that proceedings on the parties respective motions for summary judgment would continue, and the court set a ruling date on the parties summary judgment motions for September 1, 2010.
On September 2, 2010, the court issued an opinion and order granting Peerless Networks motion for summary judgment. The court found that the 708 Patent is invalid in light of a prior patent, U.S. Patent No. 6,137,800. In light of the summary judgment ruling, the court denied our request to reinstate the trial date as moot.
The courts September 2, 2010 order also denied our motion for summary judgment. We sought summary judgment on our claim that Peerless Network infringed the 708 Patent, as well as summary judgment on Peerless Networks claim that the 708 Patent is unenforceable. At a hearing on September 22, 2010, the court allowed us to file a new motion for summary judgment on Peerless Networks claim that the 708 Patent is unenforceable. The court also dismissed Counts IV-VII of Peerless Networks counterclaims, which were claims against us based on allegations of monopolization, monopoly leveraging, violations of the Illinois Antitrust Act, and tortious interference with prospective business relations. Briefing on our new motion for summary judgment was completed on October 27, 2010.
On December 9, 2010, the court issued an opinion and order granting our motion for summary judgment on Peerlesss claim that the 708 Patent was unenforceable based on alleged inequitable conduct and patent misuse. The court entered a final judgment with respect to all claims in the litigation on December 17, 2010.
On December 20, 2010, we filed notice that we plan to appeal the courts order granting Peerless Networks motion for summary judgment and finding that the 708 Patent is invalid. On January 13, 2011, Peerless Network cross-appealed the courts order granting our motion for summary judgment and finding that the 708 Patent is not unenforceable, as well as the courts earlier ruling construing disputed terms of the patent in our favor. We currently anticipate that briefing on the parties cross-appeals will be completed in approximately August 2011, though that schedule is subject to change.
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Inter Partes Proceeding before the United States Patent and Trademark Office
In a separate proceeding, on January 28, 2010, Peerless Network filed a request with the USPTO requesting that the USPTO reexamine the 708 Patent. On March 26, 2010, the USPTO granted Peerless Networks inter partes reexamination request and issued an initial office action which rejected the 708 Patents 23 claims. The claims of the 708 Patent as originally issued by the USPTO remain valid and enforceable during the USPTO reexamination proceeding. Under the USPTOs rules, we were not allowed to respond to Peerless Networks request prior to the USPTOs initial determination.
On May 20, 2010, the USPTO granted our request to extend the time by which we must file our response to the March 26, 2010 office action from May 26, 2010 to July 26, 2010.
On April 12, 2010, we moved separately to suspend the inter partes reexamination proceeding in its entirety, pending resolution of the litigation between us and Peerless Network. On June 30, 2010, the USPTO denied our petition seeking to suspend the separate reexamination proceeding. Although the USPTO did not suspend the reexamination proceeding, the USPTO stated in its decision, among other things, that it is appropriate to continue both [the reexamination and litigation] proceedings to obtain the results and benefits of each, as they accrue.
On July 26, 2010, we responded to the USPTOs March 26, 2010 office action. On November 24, 2010, the USPTO issued an action closing prosecution, in which the USPTO maintained its rejection of the 708 Patents 23 original claims, as well as 35 additional claims added to the 708 Patent in our July 26, 2010 response.
On January 7, 2011, we filed a response to the USPTOs November 24, 2010 action closing prosecution. Thereafter, Peerless Network filed comments in opposition to our response on February 4, 2011.
On March 11, 2011, the USPTO issued a right of appeal notice, in which the USPTO maintained its rejection of the 708 Patents 23 original claims, as well as the 35 additional claims added to the 708 Patent in our July 26, 2010 response.
On April 11, 2011, we filed a notice of appeal of the USPTOs decision to the BPAI. Peerless Network filed a notice of appeal of the USPTOs decision to the BPAI on April 19, 2011. We currently anticipate that briefing on the parties appeals before the BPAI will be completed in approximately December 2011, though that schedule is subject to change.
After reviewing the parties positions on appeal, the BPAI may affirm the USPTOs rejection of some or all of the claims, allow some or all of the claims of the 708 Patent to issue in their current form, or return the matter for further examination with respect to some or all of the claims. Thereafter, there may be further proceedings at the USPTO regarding the validity of some or all of the claims of the 708 Patent. The decision of the BPAI is ultimately appealable by either party to the United States Court of Appeals for the Federal Circuit.
Item 1A. | Risk Factors |
Set forth below is a discussion of the material changes in our risk factors as previously disclosed in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2010. We are updating the risk factor under the heading, Regulatory developments could negatively impact our business to read as follows:
Regulatory developments could negatively impact our business.
The communications services industry is extensively regulated by the federal and state governments. While the pricing of our U.S. voice service is generally not heavily regulated by the Federal Communications Commission, or FCC, or state utility agencies, these agencies have greater regulatory authority over the pricing of incumbent local exchange carriers, or ILECs, local transit and access services, which generally sets the benchmark for the prices of the competitive services that we offer. To the extent that ILEC transit or access rates are reduced or capped, it could have an adverse impact on us, as we would likely be forced to reduce our rates in order to compete with the ILEC or other competitors.
Local Tandem Transit Service
Some state regulatory authorities assert jurisdiction over the provision of local tandem transit services, particularly the ILECs provision of the service. Various states have initiated proceedings to examine the regulatory status of transit services. Some states have taken the position that transit service is an element of the transport and termination of traffic services that incumbent ILECs are required to provide at rates based on incremental costs under the Telecommunications Act, while other states have ruled that the Telecommunications Act does not apply to these services. For example:
| A declaratory action was commenced in 2008 with the DPUC pursuant to which a competitive carrier requested that the DPUC order the ILEC to reduce its transit rate to a cost-based rate similar to a rate offered by that ILEC in a different state |
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or to a rate justified in a separate cost proceeding. In 2010, the DPUC ordered the ILEC to implement a new rate based on the ILECs costs for transit. The ILEC has made this rate available to all of its customers. The ILEC appealed the DPUCs ruling to the appropriate federal court. We filed an amicus brief supporting the ILECs position. The federal court issued a decision in the ILECs appeal on May 6, 2011. The court affirmed the DPUCs decision to require the ILEC to reduce its transit rate to a cost-based rate for the competitive carrier that initiated the action at the DPUC. However, the court found that the DPUC could not require the ILEC to reduce its transit rates to other carriers without first allowing the carriers an opportunity to negotiate new rates under the terms of their contracts. The court also found that the DPUCs decision to require the ILEC to adopt an interim pricing level, without first allowing the ILEC the opportunity to negotiate, was arbitrary and capricious. The court held that, if the carriers do not reach agreement on rates, the DPUC can order the ILEC to charge cost-based rates. We already lowered the rate we charge certain of our customers, in some cases substantially, as a result of the DPUCs ruling, which has had a significant impact on the profitability of our service in Connecticut. |
| In 2005, the Michigan Public Service Commission revised the maximum allowable rate that AT&T could charge for transit service in Michigan based on AT&Ts total element long run incremental cost, or TELRIC, which was significantly below the rate previously charged by AT&T (previously SBC Communications). This decision caused us to reduce the rate we charged for our transit service and had a significant impact on the profitability of our service in Michigan. |
| In December 2008, the United States District Court for the District of Nebraska held that the Public Service Commission of Nebraska was correct in determining that the ILEC must provide transit service under the Telecommunications Act and that the Nebraska PSC did not err in ordering the ILEC to provide the service at TELRIC based rates. |
| The Telecommunications Regulatory Board of Puerto Rico (the Puerto Rico Board), recently determined that the ILEC must provide transit service at a cost-based rate, and ordered the ILEC to submit a cost study in order to support the development of a cost-based rate. In addition to submitting the cost study, on September 23, 2009, the ILEC filed a motion seeking administrative review of the Puerto Rico Boards order in the Puerto Rico appellate court. In its motion, the ILEC alleges that the Puerto Rico Boards order constitutes a regulation and as such was not approved as required by provisions of Puerto Ricos Uniform Administrative Law. |
| AT&T and Sprint are currently engaged in a series of arbitrations at state public utility commissions under the Telecommunications Act. In those proceedings, Sprint has taken the position that AT&T should be required to provide transit service at cost-based rates. AT&T and Sprint are arbitrating this issue before state commissions in Alabama, Florida, Georgia, Kentucky, Louisiana, Mississippi, North Carolina, South Carolina, Tennessee and Wisconsin. |
If, as a result of any of these current proceedings or a different proceeding, the applicable ILEC is required to reduce or limit the rate it charges for local transit service, we would likely be forced to reduce our rate, perhaps substantially, or risk losing customer traffic, any of which could have a material adverse effect on our business, financial condition and operating results.
The FCC currently does not regulate the local transit services we offer. However, in 2001, the FCC initiated a proceeding to address intercarrier compensation issues, such as rules that govern the amount that one carrier pays to another carrier for access to the others network. That proceeding remains unresolved, but on February 8, 2011, the FCC adopted a NPRM that addresses reforming the Universal Service Fund high-cost program as the program transitions to cover broadband service, as well as changes to intercarrier compensation rules. In the NPRM, the FCC states that the record indicates that local transit service is competitive, but also requests public comment as to whether the FCC should make any changes to the rules that govern local transit service. The FCC is likely to publish proposed rules for further public comment in the near future, though it is not yet known whether or when any final rules may be adopted. Any future changes to intercarrier compensation rules could have a material and adverse effect on our business. For example, the FCC could change the pricing of local transit traffic, including lowering the rate, freezing the rate or establishing uniform rates, any of which could have a material adverse effect on our business, financial condition and operating results. In addition, from time to time, carriers that we connect with have requested that we pay them to terminate traffic, and any new rules could address those rights or obligations. If the FCC determines that a terminating carrier has the right to receive payments from us for terminating traffic, it could have a material adverse effect on our business, financial condition and operating results.
Additionally, several proposals considered by the FCC in its intercarrier compensation proceeding have contained provisions that indirectly affect local transit traffic. For example, under current law, the originating carrier is typically responsible for paying the terminating carrier certain terminating charges, such as reciprocal compensation charges, for access to the terminating carriers network. As a result, we, as the intermediate transit provider, are not responsible for paying such terminating charges to a terminating carrier in connection with the transit services we offer. The FCCs proposals, however, have required that we, as the transit provider, could be responsible for paying the highest lawful terminating charge to a terminating carrier if the terminating carrier received insufficient information for the terminating carrier to bill the originating carrier for that traffic. These amounts could be significantly larger than the rate we charge for providing the transit service associated with that traffic. Although the proposals also would allow us
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to recover from the originating carrier the same amount that we paid to the terminating carrier, in such an instance we would be faced with credit risks associated with collecting such amounts from the originating carrier, as well as possible disputes with both originating and terminating carriers regarding the appropriate amount due. In this event, if we were unable to recover amounts we paid to a terminating carrier or became involved in distracting and costly disputes with the originating carrier and/or the terminating carrier over the amount due, we could experience a material adverse effect on our business. Moreover, any final order could result in changes to the demand for our services or otherwise adversely impact our business, financial condition, operating results and growth opportunities in a manner that we have not presently identified.
Access Services
We recently began providing access services using our tandem switches. Access services are provided as a part of the origination and termination of long distance calls. The FCC regulates interstate access services and the states regulate intrastate access services. The FCC, under a proposed interpretation of the Telecommunications Act, may also assert certain rights to regulate intrastate access services, and, as part of the intercarrier compensation reform discussed above, could significantly eliminate or reduce both interstate and intrastate access charges. Most recently, as part of the February 8, 2011 NPRM discussed above, the FCC proposed to significantly reduce both interstate and intrastate access charges, though it has not yet proposed specific rules to accomplish this reduction.
The FCC is likely to publish proposed rules for further public comment in the near future, though it is not yet known whether or when final rules may be adopted .
Various states are also separately conducting proceedings to determine whether to decrease existing intrastate access charges.
If the FCC or any state lowers any access charges, such change could have a material and adverse effect on our business, financial condition, operating results or growth opportunities.
The telecommunications industry recently has seen an escalating rate of disputes among telephone carriers and other service providers over the extent of the obligation to pay access charges, particularly in cases where VoIP technology is used for all or some of the call transmission. In two recent cases, federal district courts have ruled that calls that use VoIP technology at either end of the call are not subject to interstate or intrastate access tariffs, although the decisions differed in some respects and both cases are subject to further court appeals. If future rulings establish that we are not able to enforce our access tariffs with respect to some types of calls, we could experience a material and adverse effect on our revenues, financial condition, operating results or growth opportunities.
As communications technologies and the communications industry continue to evolve, the statutes governing the communications industry or the regulatory policies of the FCC, state legislatures or agencies, or local authorities may change. If this were to occur, including pursuant to any of the proceedings discussed above, the demand and pricing for our services could change in ways that we cannot easily predict and our revenues could materially decline. These risks include the ability of the federal government, including Congress or the FCC, or state legislatures or agencies, or local authorities to:
| increase regulatory oversight over the services we provide, including limiting the prices we can charge; |
| adopt or modify statutes, regulations, policies, procedures or programs that are disadvantageous to the services we provide, or that are inconsistent with our current or future plans, or that require modification of the terms of our existing contracts, including reducing the rates for our services; |
| adopt or modify statutes, regulations, policies, procedures or programs in a way that causes changes to our operations or costs or the operations of our customers, including the pricing of our services to our customers; |
| adopt or modify statutes, regulations, policies, procedures or programs in a way that causes a decrease in the amount of traffic our customers exchange with us or causes a change to our customers traffic mix, which results in our customers using, on average, lower priced services; or |
| increase or impose new or additional taxes or surcharges that are disadvantageous to the services we provide or cause a decrease in the amount of traffic our customers deliver to us. |
We cannot predict when, or upon what terms and conditions, further U.S federal, state or local regulation or deregulation might occur or the effect future regulation or deregulation may have on our business. Any of these government actions could have a material adverse effect on our business, prospects, financial condition and operating results.
In addition to the other information set forth in this report, you should carefully consider the description of the risks and uncertainties associated with our business previously disclosed in Part I, Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2010. You should carefully consider such risks and uncertainties, together with the other information contained in this report, our Annual Report on Form 10-K for the fiscal year ended December 31, 2010 and in our other public filings.
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If any of such risks and uncertainties actually occurs, our business, financial condition or operating results could differ materially from the plans, projections and other forward-looking statements included in the section titled Managements Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this report and in our other public filings. In addition, if any of these risks and uncertainties, or if any other risks and uncertainties, actually occurs, our business, financial condition or operating results could be harmed substantially, which could cause the market price of our stock to decline, perhaps significantly.
Item 6. | Exhibits |
(a) Exhibits
Exhibit 10.1 | Employment Agreement dated April 1, 2011 by and between the Company and G. Edward Evans. | |
Exhibit 10.2 | Employment Agreement dated April 13, 2011 by and between the Company and John Harrington. | |
Exhibit 10.3 | Agreement on Effect of Retirement on Unvested Equity Awards; Transition Services dated February 16, 2011 by and between the Company and Rian J. Wren (incorporated by reference to Exhibit 10.78 to the Companys Annual Report on Form 10-K filed on March 16, 2011). | |
Exhibit 10.4 | Letter Agreement dated April 18, 2011 among the Company, Spotlight Advisors, LLC, George Allen and Clinton Group, Inc. (incorporated by reference to Exhibit 10.1 to the Companys Current Report on Form 8-K filed on April 19, 2011). | |
Exhibit 31.1 | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |
Exhibit 31.2 | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |
Exhibit 32.1 | Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | |
101.INS | XBRL Instance Document. | |
101.SCH | XBRL Taxonomy Extension Schema Document. | |
101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document. | |
101.LAB | XBRL Taxonomy Extension Label Linkbase Document. | |
101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document. |
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
NEUTRAL TANDEM, INC. | ||||||
Date: May 10, 2011 | By: | /S/ G. EDWARD EVANS | ||||
G. Edward Evans, Chief Executive Officer (Principal Executive Officer) | ||||||
Date: May 10, 2011 | By: | /S/ ROBERT JUNKROSKI | ||||
Robert Junkroski, Chief Financial Officer (Principal Financial and Accounting Officer) |
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