ITEM 1. BUSINESS
Our Company
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, like 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.
For the year ended December 31, 2011, we increased revenue to $268.3 million, an increase of 34.3% compared to $199.8 million for the year ended December 31, 2010. Our income from operations for the year ended December 31, 2011 was $46.6 million compared to $54.1 million for the year ended December 31, 2010. Net income for the year ended December 31, 2011 was approximately $27.1 million compared to net income of $32.6 million for the year ended December 31, 2010.
Voice Services
We provide voice interconnection services primarily to competitive carriers, including wireless, wireline, cable and broadband telephony companies. Competitive carriers use our tandem switches to interconnect and exchange local and long distance traffic between their networks without the need to establish direct switch-to-switch connections. Competitive carriers are carriers that are not Incumbent Local Exchange Carriers, or ILECs, such as AT&T, Verizon and Qwest.
Prior to the introduction of our local voice service, competitive carriers generally had two alternatives for exchanging traffic between their networks. The two alternatives were exchanging traffic through the ILEC tandems or directly connecting individual switches, commonly referred to as “direct connects.” Given the cost and complexity of establishing direct connects, competitive carriers often elected to utilize the ILEC tandem as the method of exchanging traffic. The ILECs typically required competitive carriers to interconnect to multiple ILEC tandems with each tandem serving a restricted geographic area. In addition, as the competitive telecommunications market grew, the process of establishing interconnections at multiple ILEC tandems became increasingly difficult to manage and maintain, causing delays and inhibiting competitive carrier growth, and the purchase of ILEC tandem services became an increasingly significant component of a competitive carrier’s costs.
The tandem switching services offered by ILECs consist of local transit services, which are provided in connection with local calls, and switched access services, which are provided in connection with long distance calls. Under certain interpretations of the Telecommunications Act of 1996 and implementing regulations, ILECs are required to provide local 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 switched 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, or FCC, for interstate calls and by state public utility commissions for intrastate calls. In November 2011, the FCC released an order setting forth a multi-year transition plan that will reduce, and ultimately lead to elimination of, terminating switched access charges. 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 service, our customers benefit from a simplified interconnection network solution that reduces costs, increases network reliability, decreases competitive tension and adds network diversity and redundancy.
Following the introduction of our services, we began to face competition from other non-ILEC carriers, including Level 3, Hypercube, Peerless Network, and Intelepeer. Over the past several years, competition has intensified causing us to lose traffic as well as significantly reduce certain rates we charge our customers in various markets, including with respect to our major customers. For a further discussion see “Risk Factors-Our tandem services business faces competition from the traditional ILECs and increasing competition from certain other providers such as Level 3 Communications, Peerless Network and Hypercube, and we expect to compete with new entrants to the tandem services market” in Item 1A
ITEM 1A. RISK FACTORS
Risk Factors
Investing in our common stock involves a high degree of risk, and you should carefully consider the risks and uncertainties described below in addition to the other information included or incorporated by reference in this Annual Report on Form 10-K. If any of the following risks actually occurs, our business, financial condition or results of operations would likely suffer, possibly materially. In that case, the trading price of our common stock could decline.
Risk Factors Related To Our Business
Our tandem services business faces competition from the traditional ILECs and increasing competition from certain other providers such as Level 3 Communications, Peerless Network, Hypercube and Intelepeer, and we expect to compete with new entrants to the tandem services market. In addition, our IP Transit and Ethernet service businesses face competition from many companies, including Level 3, Verizon, AT&T, Equinix, CENX, Telx, TeliaSonera and Cogent.
Our tandem (voice) services business faces competition from the traditional ILECs, other providers such as Level 3 Communications, Peerless Network, Hypercube and Intelepeer, and potentially from future entrants to the tandem services market. Please see “Item 3. Legal Proceedings” for a further description of certain litigation in which we have been engaged with Peerless Network. Competition has intensified over the past several years, especially with Peerless Network, causing us to lose some traffic as well as significantly reduce certain rates we charge our customers in various markets, including with respect to our major customers in our largest markets. We expect significant competition in the tandem services market to continue, including as a result of the adoption of IP-based switching by telecommunications carriers, which is likely to increase competition from direct connections. See “-The market for our services is competitive and increased adoption of IP switching technologies could increase the competition we face from direct connections” below.
Our IP Transit and Ethernet service businesses face competition from many companies, including Level 3, Verizon, AT&T, Equinix, CENX, Telx, TeliaSonera and Cogent.
Certain of our current and potential competitors have significantly more employees and greater financial, technical, marketing, research and development, intellectual property development and protection and other resources than us. Also, some of our current and potential competitors have greater name recognition that they can use to their advantage. Our competitors have charged rates that are below the rates we charge, at times substantially, and may continue to do so in the future. In addition, our competitors could bundle other services with their IP Transit, Ethernet or tandem services to compete with us or be able to respond more quickly to new or emerging technologies and changes in customer requirements than we can. Furthermore, changes in technology have lowered the cost of entry into our business, which could promote additional competition. Existing or increased competition as described above could result in fewer customer orders, reduced revenues, reduced gross margins and loss of market share, any of which could have a material and adverse effect on our business, prospects, financial condition and operating results.
The market for our services is competitive and increased adoption of IP switching technologies could increase the competition we face from direct connections.
When there is a significant amount of traffic between two switches, there is an economic incentive to directly connect and remove the intermediate switching that we provide using our tandem switches. As our customers grow, the amount of traffic exchanged between them grows, thus leading to the risk that they will increase the number of direct connect switch paths that exchange traffic and remove that traffic from our tandems. We believe that the frequency at which our customers are implementing these direct connections is increasing, even in the case of lower traffic volume switch pairs, and we expect this trend to continue in the
future, which will cause us to experience a reduction in our revenue. Moreover, the risk of direct connections is continually increasing as more carriers move to an IP-based interface, because direct connecting between two IP-based carriers at one or only several points is less complex than establishing multiple direct connections between carriers’ switch pairs, thus enabling more direct connections. Moreover, since these direct connections would connect networks, as opposed to switch pairs, the amount of traffic carried over such a direct connection could be significant. In addition, consolidation among telecommunications carriers can stimulate the risk of direct connections by increasing both the incentive and feasibility of establishing direct connections. For example, we have noticed that certain competitive carriers established direct connections following completion of a business combination. Increased competition from direct connections could result in fewer customer orders, reduced revenues, reduced gross margins and loss of market share, any of which could have a material and adverse effect on our business, prospects, financial condition and operating results.
Regulatory developments could negatively impact our business.
The communications services industry is extensively regulated by the federal and state governments. As described below, various state regulatory authorities have asserted regulatory authority over the pricing of incumbent local exchange carriers’ or ILECs’ local transit services, and the FCC is considering whether to adopt price regulation for local transit services at present. Moreover, the FCC has adopted a multi-year plan to reduce and, in many instances, eliminate access charges. The FCC also is considering further changes to its regulations governing access charges. To the extent that transit or access rates are further reduced or capped, it could have an adverse impact on us.
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:
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A declaratory action was commenced in 2008 with the Connecticut Department of Public Utility Control, or 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 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 ILEC’s costs for transit. The ILEC has made this rate available to all of its customers. The ILEC appealed the DPUC’s ruling to the appropriate federal court. We filed an amicus brief supporting the ILEC’s position. The federal court issued a decision in the ILEC’s appeal on May 6, 2011. The court affirmed the DPUC’s 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 DPUC’s 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. The ILEC has appealed the federal court’s decision to the United States Court of Appeals for the Second Circuit. We have filed an amicus brief supporting the ILEC’s position. We already lowered the rate we charge certain of our customers, in some cases substantially, as a result of the DPUC’s ruling, which has had a significant impact on the profitability of our service in Connecticut.
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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&T’s 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.
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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.
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The Telecommunications Regulatory Board of Puerto Rico (the Puerto Rico Board), 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 Board’s order in the Puerto Rico appellate court. In its motion, the ILEC alleges that the Puerto Rico Board’s order constitutes a regulation and as such was not approved as required by provisions of Puerto Rico’s Uniform Administrative Law.
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 other’s network. In November 2011, the FCC released an intercarrier compensation reform order. That order did not adopt price regulation for local transit service. However, the FCC is currently considering whether to adopt price regulation for local transit service as part of ongoing proceedings. Any changes to the intercarrier compensation rules related to local transit service 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 local transit 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 carrier’s 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. Previous FCC 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 previous proposals also would allow us 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 also provide 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 historically regulate intrastate access services. In its November 2011 intercarrier compensation reform order, however, the FCC approved reducing and ultimately eliminating both interstate and intrastate terminating access charges.
In the order, the FCC capped most access rates as of December 29, 2011. The FCC then requires carriers to reduce their intrastate terminating end office rates that exceed the corresponding interstate rates by 1 / 2 of the difference between the rates in July 2012, and reduce those intrastate rates to parity with the interstate rates by July 2013. Thereafter, the FCC will require carriers to reduce their termination (and for some carriers also transport) rates to bill-and-keep within six years for price cap carriers, and nine years for rate of return carriers. The FCC has issued a further notice of proposed rulemaking transition for the remaining originating and transport rate elements.
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 that we may charge our customers, 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. The FCC order described above resolved this issue on a prospective basis and holds that, prospectively, VoIP calls will be subject to interstate access charges and/or reciprocal compensation. If, however, future rulings establish that we are not able to enforce our access tariffs with respect to VoIP or other 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:
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increase regulatory oversight over the services we provide, including limiting the prices we can charge;
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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;
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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;
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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
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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. The intercarrier compensation reform order released by the FCC in November 2011 has been appealed by several parties, and we cannot predict whether any such appeals might be successful. Any of these government actions could have a material adverse effect on our business, prospects, financial condition and operating results.
Our failure to achieve or sustain market acceptance at desired pricing levels could impact our ability to maintain profitability or positive cash flow.
As a result of competition, the average rates charged for voice services in the United States and IP Transit services globally have decreased significantly over the past several years. We believe that this trend is likely to continue for the foreseeable future.
In addition to the regulatory risks that could cause price decreases, the primary sources of pricing pressure include:
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competitors offering our customers services at reduced prices, at times substantially, or bundling and pricing services in a manner that makes it difficult for us to compete. For example, a competing provider of transit services might bundle transit with other services, such as inexpensive long distance services;
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customers with a significant volume of traffic have in the past and may in the future use their enhanced leverage in pricing negotiations with us. For example, from time to time, customers have requested that we reduce the prices we charge them or they will migrate their traffic to a competitor. Such requests may result in lowered pricing or lost traffic, either of which may adversely affect our business; and
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if our prices are too high, potential customers may find it economically advantageous to handle certain functions internally, such as exchanging voice traffic, using direct connections instead of using us.
If we are unable to offset the effects of any price reductions by carrying higher volumes of traffic, we could experience reduced revenues and gross margins, either of which could have a material and adverse effect on our business, prospects, financial condition and operating results.
If we do not efficiently and effectively integrate our recent acquisition of Tinet S.p.A. and any future business acquisitions, we may not fully realize the anticipated benefits from such acquisitions.
Achieving the anticipated benefits of our recent acquisition of Tinet and any future acquisitions will depend in part upon whether we can integrate Tinet’s business with our existing business in an efficient and effective manner. The integration of Tinet and any future businesses that we may acquire involves a number of risks, including, but not limited to:
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demands on management related to the significant increase in size after the acquisition;
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the disruption of ongoing business and the diversion of management’s attention from managing daily operations to managing integration activities, which may require coordinating geographically dispersed organizations, integrating and retaining personnel with disparate business backgrounds, and combining different corporate cultures;
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failure to anticipate the costs related to accounting and tax matters resulting from operating a global business, including with respect to the costs of hiring employees and professional consultants to comply with accounting and tax matters, as well as the payment of taxes imposed by various taxing authorities and disputes related thereto;
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failure to fully achieve expected synergies and costs savings;
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unanticipated impediments in the integration of departments, systems, including accounting systems, technologies, books and records and procedures, as well as in maintaining uniform standards, controls (including internal control over financial reporting required by the Sarbanes-Oxley Act of 2002), procedures and policies;
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loss of customers or the failure of customers to order incremental services that we expect them to order;
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failure to provision services that are ordered by customers during the integration period;
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higher integration costs than anticipated; and
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difficulties in the assimilation and retention of highly qualified and experienced employees.
Successful integration of Tinet and any future acquired businesses or operations will depend on our ability to manage these operations, realize opportunities for revenue growth presented by strengthened service offerings and expanded geographic market coverage, obtain better terms from our vendors due to increased buying power, and eliminate redundant and excess costs to fully realize the expected synergies. Because of difficulties in combining geographically distant operations and systems which may not be fully compatible, we may not be able to achieve the financial benefits and growth we anticipate from the acquisitions.
In addition, acquisitions of businesses or other material operations may reduce our liquidity and capital resources and may require additional debt or equity financing, resulting in reduced financial resources, additional leverage or dilution of ownership. We may also need to record write-downs from future impairments of intangible assets, which could reduce our future reported earnings. At times, acquisition candidates may have liabilities, neutrality-related risks or adverse operating issues that we fail to discover through due diligence prior to the acquisition.
We cannot be certain that we will realize our anticipated benefits from our acquisition of Tinet or any future acquired businesses, or that we will be able to efficiently and effectively integrate the acquired operations as planned. If we fail to efficiently and effectively integrate the acquired businesses and operations or fail to realize the benefits we anticipate, we could experience material adverse effects on our business, prospects, financial condition and operating results.
International regulatory developments could negatively impact our business.
Our international communications services, especially our voice services, are subject to significant international regulation. These regulations may affect both our international business and our existing and potential competitors. Delays in receiving required regulatory approvals (including approvals relating to commencing operations, approving acquisitions or financing activities), completing interconnection agreements with other carriers, or the enactment of new and adverse regulations or regulatory requirements may have a material adverse effect on our international business. In addition, future legislative, judicial and regulatory agency actions could have a material adverse effect on our international business.
Our top five customers represent, in the aggregate, a substantial portion of our revenue.
Our top five customers, in the aggregate, represented approximately 49% of our total revenues during the year ended December 31, 2011. Our two largest customers, AT&T and Sprint Nextel, accounted for 22% and 13% respectively, of our total revenues during the year ended December 31, 2011. Certain of these customers have solicited or received proposals from other carriers to provide services that are the same as or similar to ours, and in some cases, have moved traffic to those competitors. In other cases, we have been required to substantially lower the rates we charge our customers to retain their traffic. As discussed in “-Our tandem services business faces competition from the traditional ILECs and increasing competition from certain other providers such as Level 3 Communications, Peerless Network and Hypercube, and we expect to compete with new entrants to the tandem services market  “ above, competition has intensified over the past several years, and we expect this trend to continue. In addition, our contracts with these customers have no volume or exclusivity commitments and any customer is able to discontinue the use of all or a portion of our services at any time.
We may lose all or a portion of our business with any of these customers if we fail to meet our customers’ expectations, including for performance and other reasons, or if another provider offers to provide the same or similar services at a lower cost. In addition, competitive forces resulting from the entrance of competing providers have created significant pricing pressure in certain of our largest markets with respect to all of our customers, including our top five customers. We expect this trend to continue.
Moreover, the recent economic downturn could result in a decrease in the amount of services customers purchase from us or delays or failures to pay for such services. For example, poor economic conditions could reduce both consumer and non-consumer spending on telephone services which in turn could result in a reduction in our customers’ demand for our services. Furthermore, financial pressure faced by our customers could result in mergers, acquisitions, liquidations or divestitures of all or a portion of our customers’ businesses, which in turn could result in a reduction in the use of our services.
Any of the foregoing could have a material adverse effect on our business, prospects, financial condition and operating results.
During the year ended December 31, 2011, we terminated 63% of our voice traffic in the United States to five carriers.
Although we provide multiple services, we generate a significant portion of our revenue from voice services provided in the United States. During the year ended December 31, 2011, we delivered 63% of our voice traffic in the United States to five carriers. If for any reason we are unable to terminate voice traffic to any one of these five carriers or a material amount of any terminating traffic to any other carrier(s), we would be unable to generate revenue from our customer originating the calls to such terminating carriers, which could have a material adverse effect on our business, prospects, financial condition and operating results. Moreover, if any carrier refuses to accept voice traffic or conditions receipt on terms that are not favorable to us, regardless of what we believe is their legal obligation to do so, it could have a material adverse effect on our business, prospects, financial condition and operating result. See “Carriers may refuse to directly interconnect with us and consequently, we would be unable to terminate our customers’ traffic to them” below.
Carriers may refuse to directly interconnect with us and consequently, we would be unable to terminate our customers’ traffic to them.
By operating as a voice common carrier, we benefit from certain legal rights established by federal and state statutes. We have used these rights to gain interconnection with the incumbent telephone companies. We have also used these rights to request interconnection with competitive carriers for the termination of traffic to carriers that decide for whatever reason not to utilize our service. While our experience has been that competitive carriers usually accommodate such requests, we have been involved in various state and federal regulatory proceedings against Level 3 and Verizon Wireless related to their refusal to continue to accept terminating local transit traffic. We entered into agreements resolving these disputes in 2008. If, however, any carrier in the future refuses to accept either access or local transit traffic over a direct connection or otherwise seeks to limit or condition our ability to terminate traffic on terms that are not favorable to us, it could have a material adverse effect on our business, prospects, financial condition and operating results. Moreover, even though we believe that we have the legal right to exchange traffic with carriers under reasonable terms and may seek to enforce that right in legal or regulatory proceedings, there can be no assurance that we would prevail. Our efforts therefore in any proceedings or responding to other actions could have an adverse impact on us if we do not prevail, or even if we do prevail, because of legal costs, diversion of management resources and other factors.
Our business requires the continued development of effective business support systems to implement customer orders, provide and bill for services, and pay for services we receive from our vendors.
Our business depends on our ability to continue to develop effective business support systems. We are currently expending significant resources to develop and enhance a web-based portal application in connection with providing our Ethernet services. In certain cases, the development of these business support systems is required to realize our anticipated benefits from our acquisition of Tinet. This can be a complicated undertaking that requires significant resources and expertise and support from third-party vendors. Business support systems are needed for:
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ordering services from our vendors and verifying that we are being charged the correct amount;
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quoting, accepting and inputting customer orders for services;
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provisioning, installing and delivering these services; and
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billing for these services.
Because our business plans provide for continued growth in the number of customers that we serve and the volume of services offered as well as the integration of Tinet’s, and potentially other acquired companies’, business support systems, there is a need to continue to develop our business support systems on a timely basis. The failure to continue to develop effective unified business support systems could affect our ability to implement our business plans and realize anticipated benefits from our acquisition of Tinet and therefore could have a material adverse effect on our business, prospects, financial condition and operating results.
If we are unable to manage our growth strategy, our business, prospects, financial condition and operating results could be adversely affected.
As part of our growth strategy, we recently began offering new services, such as international voice, IP Transit, Ethernet and hosted services. For a further description of our services see “-Business” above. As a result, our new service initiatives are critical components of our growth strategy.
We will face various risks associated with providing these new services, including risks relating to identifying, obtaining and integrating attractive network switch sites, suitable equipment or software, cost estimation errors or overruns, interconnection delays, material delays or shortages, our inability to obtain necessary permits on a timely basis, if at all, and other factors, including the impact of regulation, many of which are beyond our control and all of which could delay our expansion into new markets or ability to offer new services. We may not be able to enter new markets or offer new services on a timely or profitable basis, if at all. Furthermore, revenues from our growth initiatives may be lower than anticipated. In addition, entering new markets and offering new services will increase our operating expenses, including lease expenses, expenses associated with hiring, training, retaining and managing new employees, purchasing new equipment, implementing new systems and incurring additional depreciation expense. Furthermore, as our growth initiatives are implemented, we will be exposed to increased risks related to conducting operations outside of the United States, including currency exchange rate fluctuations, trade protection measures, difficulty in staffing, training and managing foreign operations, political and economic instability and diminished protection of intellectual property in some countries outside of the United States.
If we are unable to successfully manage our growth strategy, our business, prospects, financial condition and operating results could be adversely affected.
Consolidation in the industry, such as AT&T-BellSouth-Cingular, Verizon-MCI and SBC-AT&T, reduces the need for intercarrier transit services and may limit our growth opportunities.
Consolidation in the industry reduces the need for intercarrier transit services by reducing the number of carriers. As carriers merge, (i) the risks to our business of direct connections increases, see “-The market for
our services is competitive and increased adoption of IP switching technologies could increase the competition we face from direct connections” below, (ii) traffic that was carrier-to-carrier becomes intra-carrier traffic not normally addressable by us and (iii) in the case of consolidations involving an ILEC, such as AT&T or Verizon Communications Inc., or Verizon, previous transit traffic between competitive carriers and the carrier acquired by the ILEC now potentially becomes ILEC reciprocal compensation traffic and not transit traffic, and thus potentially not addressable by us. For example, as a result of the SBC-AT&T combination, beginning in the second quarter of 2006, the combined SBC and AT&T entity began reducing the amount of minutes of use processed by us. During our 2006 fiscal year, we processed approximately 55% fewer minutes from AT&T and SBC, as a combined entity, compared to our 2005 fiscal year. We have experienced growth notwithstanding this consolidation, but our ability to grow in the future could be adversely affected by greater consolidation.
Additionally, in connection with the 2006 merger of BellSouth Corp., or BellSouth, and AT&T, AT&T agreed not to seek an increase in its current local transit rates for existing transit customers for 42 months in the AT&T and BellSouth incumbent local exchange carrier service territories. While having no direct regulatory impact on us, such an agreement indirectly limits the rates we can charge for our transit service. Further consolidation in the industry could lead to similar agreements which would limit our ability to grow revenues and may materially affect our operating results.
We will face various risks associated with providing these new services, including risks relating to identifying, obtaining and integrating attractive network switch sites, suitable equipment or software, cost estimation errors or overruns, interconnection delays, material delays or shortages, our inability to obtain necessary permits on a timely basis, if at all, and other factors, including the impact of regulation, many of which are beyond our control and all of which could delay our expansion into new markets or ability to offer new services. We may not be able to enter new markets or offer new services on a timely or profitable basis, if at all. Furthermore, revenues from our growth initiatives may be lower than anticipated. In addition, entering new markets and offering new services will increase our operating expenses, including lease expenses, expenses associated with hiring, training, retaining and managing new employees, purchasing new equipment, implementing new systems and incurring additional depreciation expense. Furthermore, as our growth initiatives are implemented, we will be exposed to increased risks related to conducting operations outside of the United States, including currency exchange rate fluctuations, trade protection measures, difficulty in staffing, training and managing foreign operations, political and economic instability and diminished protection of intellectual property in some countries outside of the United States.
Our success depends, in part, on our ability to protect proprietary methods and technologies that we develop under the patent and other intellectual property laws of the United States, so that we can prevent others from using our inventions and proprietary information. However, we may not hold proprietary rights to some of our current or future methods and technologies. Because patent applications in the United States are typically not published until 18 months after filing, or in some cases not at all, and because publications of discoveries in industry-related literature lag behind actual discoveries, we cannot be certain that we were the first to make the inventions claimed in issued patents or pending patent applications, or that we were the first to file for protection of the inventions set forth in our patent applications. As a result, we may not be able to obtain adequate patent protection and competitors would be more easily able to compete with us. Moreover, we may even be required to obtain licenses under third-party patents. If licenses are not available to us on acceptable terms, or at all, we will not be able to operate our network and competitors would be more easily able to compete with us.
The process of obtaining patent protection is expensive and time consuming, and we may not be able to file and prosecute all necessary or desirable patent applications at a reasonable cost or in a timely manner. Despite our efforts to protect our proprietary rights, unauthorized parties may be able to obtain and use information that we regard as proprietary. The issuance of a patent does not guarantee that it is valid or enforceable, so even if we obtain patents, they may not be valid or enforceable against third parties. In addition, the issuance of a patent does not guarantee that we have the right to practice the patented invention. Third parties may have blocking patents that could be used to prevent us from marketing our own patented product and practicing our own patented technology.
Our pending patent applications may not result in issued patents. The patent position of technology-oriented companies, including ours, is generally uncertain and involves complex legal and factual considerations. The standards which the United States Patent and Trademark Office use to grant patents are not always applied
predictably or uniformly and can change. Accordingly, we do not know the degree of future protection for our proprietary rights or the breadth of claims allowed in any patents issued to us or to others. The allowance of broader claims may increase the incidence and cost of patent interference proceedings and/or opposition proceedings and the risk of such claims being invalidated by infringement litigation. On the other hand, the allowance of narrower claims may limit the value of our proprietary rights. Our issued patents may not contain claims sufficiently broad to protect us against third parties with similar technologies or products, or provide us with any competitive advantage. Moreover, once any patents have been issued, our patents and any patent for which we have licensed or may license rights may be challenged, narrowed, invalidated or circumvented. If our patents are invalidated or otherwise limited, other companies will be better able to develop products that compete with ours, which could adversely affect our competitive business position, business prospects and financial condition. On June 12, 2008, we commenced a patent infringement action against Peerless Network, Inc. and John Barnicle in the United States District Court for the Northern District of Illinois to enforce our rights under the ‘708 Patent (Neutral Tandem, Inc. v Peerless Network, Inc., Peerless Network of Illinois, LLC and John Barnicle, 08 CV 3402) . On September 2, 2010, the court hearing the case granted Peerless Network’s motion for summary judgment. The court found that the ’708 Patent was invalid in light of a prior patent. See “Item 3. Legal Proceedings” for a further description of this matter. On December 13, 2011, the federal appellate court affirmed the finding that our patent is invalid, and on January 30, 2012, the appellate court denied our petition for rehearing of the December 13, 2011 ruling. The Company has the option to ask the United States Supreme Court to review that ruling. A petition for such review would be due by April 30, 2012. The Supreme Court grants a very small percentage of such requests for review. We also rely on trade secrets, know-how and technology, which are not protected by patents, to maintain our competitive position. If any trade secret, know-how or other technology not protected by a patent were to be disclosed to or independently developed by a competitor, our business and financial condition could be materially and adversely affected.
If we are unable to obtain approval of any tariff, or any provision of a tariff is held to be invalid or suspended, we could be unable to enforce the relevant provisions of the tariff, including the right to collect money for delivered services.
We provide certain services, principally switched access services, pursuant to tariffs we have filed with the FCC and those states in which we operate. These tariffs essentially form the binding legal agreement under which we provide these services to certain customers, and include terms setting forth the pricing for the services, our right to collect amounts charged, and other customary terms related to the provision of the services, including provisions that limit our liability if we fail to properly provide a service. If we are unable to obtain approval of a tariff, or if a tariff is approved but it is later determined that a provision is invalid or unenforceable for any reason, such a determination could affect our ability to collect fees for any service we have provided, require us to refund payments previously received, or limit our ability to defend ourselves for services not provided in accordance with the tariff or otherwise. Any of the foregoing, or any other determination that a tariff provision is invalid or unenforceable, could materially and adversely affect our business, prospects, financial condition and operating results.
Failures or interruptions of our network and other network facilities or the loss of, or damage to, a network switch site or other network facilities could materially harm our revenues and impair our ability to conduct our operations.
We provide telecommunications services that are critical to the operations of our customers. Notably, our voice service is essential to the orderly operation of our customers’ telecommunication systems because it enables competitive carriers to ensure that telephone calls are routed to the appropriate destinations, and our IP Transit and Ethernet services are critical to the ability of our customers to transmit data, which may be critical to their operation. Our network architecture is integral to our ability to process a high volume of traffic in a timely and effective manner. We could experience failures or interruptions of our network and services, or other problems in connection with our operations, as a result of:
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damage to, or failure of, our network software or hardware or our connections and outsourced service arrangements with third parties;
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errors in the processing of data by our systems;
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computer viruses or software defects or failures;
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physical or electronic break-ins, sabotage, intentional acts of vandalism, terrorism, natural disasters and similar events;
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increased capacity demands or changes in systems requirements of our customers;
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provisioning, installing and delivering these services; and
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errors by our employees or third-party service providers.
If we cannot adequately protect the ability of our network to perform consistently at a high level or otherwise fail to meet our customers’ expectations:
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we may be unable to provide and bill for services;
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we may experience damage to our reputation, which may adversely affect our ability to attract or retain customers for our existing services, and may also make it more difficult for us to market new services;
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we may be subject to significant damages claims, under our contracts or otherwise;
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our operating expenses or capital expenditures may increase as a result of corrective efforts that we must perform;
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our customers may postpone or cancel subsequently scheduled work or reduce their use of our services; or
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one or more of our significant contracts may be terminated early, or may not be renewed.
Any of these consequences would adversely affect our business, prospects, financial condition and operating results.
We may not have sufficient redundant systems or backup facilities to allow us to receive and process traffic in the event of a loss of, or damage to, a network switch site or other network facilities. We could lose, or suffer damage to, a site in the event of power loss, natural disasters such as fires, earthquakes, floods and tornadoes, telecommunications failures, such as transmission cable cuts, or other similar events that could adversely affect our customers’ ability to access our services. Any such loss or damage could interrupt our operations, materially harm our revenues and growth and require significant cash expenditures to correct the failures caused by such loss or damage.
Our international operations and investments expose us to risks that could have a material adverse effect on our business.
We have operations and investments outside of the United States that expose us to risks inherent in international operations. These include:
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general economic, social and political conditions;
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the difficulty of enforcing agreements and collecting receivables through certain foreign legal systems;
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tax rates in some foreign countries may exceed those in the U.S.;
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possible fluctuation in foreign currency exchange rates, which could adversely affect our results of operations and the value of our international assets and investments;
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the possibility that foreign earnings may be subject to withholding requirements or the imposition of tariffs, exchange controls or other restrictions;
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difficulties and costs of compliance with foreign laws and regulations that impose restrictions on our investments and operations, with penalties for noncompliance, including loss of licenses and monetary fines;
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political or social instability and terrorism;
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difficulties in obtaining licenses or interconnection arrangements on acceptable terms, if at all; and
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changes in U.S. laws and regulations relating to foreign trade and investment.
Failure to develop and introduce new services could affect our ability to compete in the industry.
We routinely develop, test and introduce new communications services that are delivered over our communications network. These new services are intended to allow us to address new segments of the communications marketplace and to compete for additional customers. In certain instances, the introduction of new services requires the successful development of new technology. To the extent that upgrades of existing technology are required for the introduction of new services, the success of these upgrades may be dependent on reaching mutually acceptable terms with vendors and on vendors meeting their obligations in a timely manner. In addition, new service offerings may not be widely accepted by our customers. If our new service offerings are not widely accepted by our customers, we may terminate those service offerings and we may be required to impair any assets or technology used to develop or offer those services. If we are not able to successfully complete the development and introduction of new services in a timely manner, our business could be materially adversely affected.
We have a limited operating history as a company and as a network for communications services providers. If we are unable to overcome the difficulties frequently encountered by early stage companies, our business could be materially harmed.
We began our operations in February 2004. We have experienced, and expect to continue to experience, risks and difficulties frequently encountered by companies in an early stage of commercial development in new and rapidly evolving markets. This includes developing new services as we now provide services in many of the major and mid-size U.S. markets to most of the largest carriers. In order to overcome these risks and difficulties, we must, among other things:
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generate sufficient usage of our network by our customers;
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maintain and attract a sufficient number of customers to our network to achieve and sustain profitability;
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execute our business strategy successfully, including successful development and provision of new services and integration of acquired operations;
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manage our expanding operations; and
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upgrade our technology, systems and network infrastructure to accommodate increased traffic volume and to implement new features and functions.
Our failure to overcome these risks and difficulties and the risks and difficulties frequently encountered by early stage companies could adversely affect our operating results which could impair our ability to raise capital, expand our business or continue our operations.
Economic conditions could cause a material reduction in the amount of traffic we carry on our network.
We generate the majority of our revenue by charging carriers on a per minute of use or per megabit basis for the traffic we carry on our network. If weakening economic conditions result in decreased spending on telecommunications services (or a decrease in the subscriber base at our customers), the amount of traffic we carry on our network on behalf of our customers could decrease. Furthermore, financial pressure faced by our customers could result in mergers, acquisitions, liquidations or divestitures of all or a portion of our customers’ businesses, which in turn could result in a reduction in the use of our services. A reduction from these or other economic related causes could have a material and adverse effect on our business, financial condition and operating results.
We could experience material variances in our revenues due to events outside of our control.
We could experience material variances in our revenues due to events both under and outside of our control. For example, we could experience a material decline in the traffic that we process due to holidays or other seasonal variability, the timing of direct connects established between our customers, installation delays, the implementation of routing changes and traffic outages. If one or more of these events occur, especially with respect to one or more of our larger customers, it would cause a material decrease in our revenues and have a material adverse effect on our business, prospects, financial condition and operating results.
We may be unable to complete suitable acquisitions, or we may undertake acquisitions that could increase our costs or liabilities or be disruptive to our business.
In the future, we may selectively pursue acquisitions to grow our business. We do not currently have any commitments, contracts or understandings to acquire any specific businesses or other material operations. We may not be able to locate suitable acquisition candidates at prices that we consider appropriate or to finance acquisitions on terms that are satisfactory to us. See “We may be unable to obtain additional equity or debt financing to execute our business plan and, if additional financing is not available, we may need to limit, scale-back or cease our operations” below. We depended upon equity financings, as well as borrowing under a credit facility, to meet our cash requirements after we commenced operations in February 2004, neither of which may be available to us in the future on favorable terms, if at all. See “We may require substantial additional funds to execute our business plan and, if additional capital is not available, we may need to limit, scale-back or cease our operations” below. If we do identify an appropriate acquisition candidate, we may not be able to successfully negotiate the terms of an acquisition, finance the acquisition or, if the acquisition occurs, integrate the acquired business into our existing business.
Our ability to sell our services depends in part on the quality of our support and service offerings, and our failure to offer high quality support and services would have a material adverse effect on our sales and operating results.
Once our services are deployed, our customers depend on our support organization to resolve any issues. A high level of support is critical for the successful marketing and sale of our services. If we do not effectively assist carriers in deploying our services, succeed in helping carriers quickly resolve post-deployment issues and provide effective ongoing support, it will adversely affect our ability to sell our services. In addition, if we complete acquisitions, enter new geographic territories or expand our service offerings, it may become more difficult for us to provide these support services. As a result, our failure to maintain high quality support and services would have a material adverse effect on our business, prospects, financial condition and operating results.
Security breaches also adversely affect our business and our customers’ confidential information or personal data, which could result in us being subject to legal liability and our reputation could be harmed.
Our network equipment and facilities may be vulnerable to physical break-ins, computer viruses, attacks by computer hackers or similar disruptive problems. If unauthorized users gain access to our switch sites, network equipment or facilities or our databases, a security or privacy breach could result in an interruption of service or reduced quality of service, which could cause harm to our business and reputation and could result in a loss of customers. Any breach of security relating to our customers’ confidential information or personal data could result in legal liability to us and a reduction in use of our services or cancellation of our services, either of which could materially harm our business. Our personnel often receive highly confidential information from our customers that is stored in our files and on our systems. Similarly, we receive sensitive information that has historically been maintained as a matter of confidence with our customers.
We currently have procedures in place to ensure the confidentiality of our customers’ information. However, our procedures to protect against the risk of inadvertent disclosure or unintentional breaches of security might fail to adequately protect information that we are obligated to keep confidential. We may not be successful
in adopting more effective systems for maintaining confidential information, so our exposure to the risk of disclosure of the confidential information of our customers may grow as we expand our business and increase the amount of information that we possess. If we fail to adequately maintain our customers’ confidential information, some of our customers could end their business relationships with us and we could be subject to legal liability.
The failure of the third-party software and equipment we use in providing our voice services could cause interruptions or failures of our systems.
We incorporate hardware, software and equipment and license technologies developed by third parties in providing our voice, IP Transit, Ethernet and hosted services. Our third-party vendors include, among others, Cisco, Juniper and Sonus Networks for our switches, Cisco and Oracle for our database systems and software, and various network services suppliers, such as AT&T, Verizon, Qwest, and Transaction Network Services and various competitive access providers, for our transport and Signaling System 7 services. As a result, our ability to provide services depends in part on the continued performance and support of the third-party services and products on which we rely and the respective vendors’ rights to license services and products to us, including without any third-party claims for intellectual property infringement. Notably, although we have only recently begun to use Sonus to supply voice switches and, therefore, our relationship and operating history with Sonus is limited, we have extensively deployed Sonus voice switches throughout our network. If any third-party services, equipment or products are not provided to us or experience failures or have defects, or the third parties that supply the services, equipment or products fail to provide adequate support due to financial problems they face or for any other reason, this could result in or exacerbate an interruption or failure of our systems or services. Any such failure or interruption could have a material adverse effect on our business, prospects, financial condition and operating results and expose us to claims by customers.
Our business could be harmed by prolonged electrical power outages or shortages, increased costs of energy or general availability of electrical resources.
Our network switch sites are susceptible to regional costs of power, electrical power shortages, planned or unplanned power outages caused by these shortages, such as those that occurred in the northeast region of the United States in 2003 and in the southeast region of the United States in 2005, and limitations of adequate power resources. We may not be able to pass on to our customers significant increases in the cost of power and power outages could disrupt the services we provide and reduce our revenues. Power outages, which last beyond our backup and alternative power arrangements, could harm our business and expose us to claims by customers.
We generally do not have minimum revenue requirements in our contracts, which means that there is no limit to the potential adverse effect on our revenues from a decrease in the volume of traffic we handle.
We earn revenues for the vast majority of the services that we provide on a per minute of use or per megabit basis. We generally do not have minimum revenue requirements in our contracts, which means that there is no limit to the potential adverse effect on our revenues from a decrease in the volume of traffic we handle. As a result, if our customers cease, or participants reduce, their usage of our services from their current levels, our revenues and results of operations will immediately suffer because there is no contractual requirement for the purchase of our services. For example, as discussed above, certain of our customers have migrated voice services to a competitor that has been offering our customers lower pricing in certain of our largest and other markets. See “-Our tandem services business faces competition from the traditional ILECs and increasing competition from certain other providers such as Level 3 Communications, Peerless Network and Hypercube, and we expect to compete with new entrants to the tandem services market” above. If such migration continues, or our customers develop internal systems to address their traffic needs, including direct connections in the case of voice services, or if the cost of such transactions makes it impractical for a given carrier to use our services, we may experience a reduction in transaction volumes, which could have a material adverse effect on our business, prospects, financial condition and operating results.
Failure to comply with neutrality positioning could result in loss of significant business.
We have positioned ourselves as a neutral third-party provider of services (that is, we generally do not compete with any of our customers in any of their core businesses). Our failure to continue to adhere to this neutrality positioning may result in lost sales or non-renewal of contracts, any one of which could have a material adverse effect on our business, prospects, financial condition and operating results. For example, we provide national transit services and tandem access services in the United States, each of which are long distance services and which can be viewed by some of our customers as being competitive with certain of the services they provide. Likewise, some competitors have claimed that our Ethernet services are not provided on a neutral basis.
Our senior management is important to our customer relationships, and the loss of one or more of our senior managers could have a negative impact on our business.
We believe that our success depends in part on the continued contributions of our senior management. We rely on our executive officers and senior management to generate business and execute programs successfully. In addition, the relationships and reputation that members of our management team have established and maintain with our customers and our regulators contribute to our ability to maintain good customer relations and affect regulatory changes. The loss of one or more key members of senior management could impair our ability to identify and secure new contracts and otherwise to manage our business, any one of which could have a material adverse effect on our business, prospects, financial condition and operating results.
We must recruit and retain skilled employees to succeed in our business.
We believe that an integral part of our success is our ability to recruit and retain employees who have advanced skills related to the services that we provide or plan to provide and who work well with our customers in the regulated environment in which we operate. In particular, we must hire and retain employees with the technical expertise and industry knowledge necessary to maintain and continue to develop our operations and effectively manage our growing sales and marketing organization to ensure the development of new services and growth of our operations. Our future success depends on the ability of our sales and marketing organization to establish direct sales and to develop new services. The employees with the technical and other skills we require are in great demand and are likely to remain a limited resource in the foreseeable future. If we are unable to recruit and retain a sufficient number of these employees at all levels, our ability to maintain and grow our business could be negatively impacted.
We may be unable to obtain additional equity or debt financing to execute our business plan and, if additional financing is not available, we may need to limit, scale-back or cease our operations.
We depended upon equity financings, as well as borrowings under a credit facility, to meet our cash requirements after we commenced our operations in February 2004. We expect to meet our cash requirements for the next 12 months through a combination of cash flow from operations, existing cash, cash equivalents and short-term investments. If our cash requirements vary materially from those currently planned, or if we fail to generate sufficient cash flow from our business, we may require additional financing sooner than anticipated. Additional equity or debt financing may result in the incurrence of additional leverage or dilution to our stockholders.
In addition, we may seek additional funding in the future through public or private equity and debt financings. Additional funds may not be available to us on acceptable terms or at all. If we are unable to obtain funding on a timely basis, we may not be able to execute our business plan and could face the following or other risks:
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we may not be able to expand or acquire complementary businesses;
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we may not be able to continue to meet customer demand for service quality, availability and competitive pricing;
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we may be forced to reduce our operations;
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we may not be able to develop new services or otherwise respond to changing business conditions or competitive pressures; and
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we may not be able to adequately maintain or upgrade our systems and technology.
As a result, our business, operating results and financial condition could be adversely affected and we may be required to significantly curtail or cease our operations.
If we do not maintain or generate significant revenues, we may not remain profitable.
Although we achieved net income of approximately $27.1 million for the year ended December 31, 2011, we expect to incur significant future expenses, particularly with respect to the development of new services, deployment of additional infrastructure, expansion in strategic markets and additional legal, regulatory and compliance costs. To remain profitable, we must continue to increase the usage of our services by our customers and attract new customers. We must also deliver superior service to our customers, mitigate the effects of consolidation and develop and commercialize new products and services. We may not succeed in these activities and fail to generate revenues that are significant or large enough to sustain profitability on a quarterly or annual basis. A substantial portion of our revenues are derived from fees that we charge our customers based on their usage. Therefore, a decline in their usage or the prices we charge for our services could materially impact our future revenues and profits.
A substantial portion of our cash at December 31, 2011 was invested in two money market mutual funds.
As of December 31, 2011, we had $78.8 million invested in two money market mutual funds. Due to the short duration of the cash invested, we believe that we do not have any material exposure to changes in the fair value of our cash investments as a result of changes in interest rates. However, since the share price of a money market fund is typically $1, the interest rate paid on the investment or the yield, is typically the predominant measure of the return we receive. The yield may be affected by the default of any securities the fund invests in or changes in the value of investments caused by changes in interest rates; if these factors are severe, the share price of a fund could drop, which could materially and adversely affect our liquidity and ability to operate. The SEC, under the authority of the Investment Company Act of 1940, regulates money market funds to minimize these risks.
If we do not adapt to rapid technological change in the communications industry, we could lose customers or market share.
Our industry is characterized by rapid technological change and frequent new service offerings. Significant technological changes could make our technology and services obsolete, too costly or inefficient on a relative basis. We must adapt to our rapidly changing market by continually improving the features, functionality, reliability and responsiveness of our services to meet changing customer needs. We cannot ensure that we will be able to adapt to these challenges or respond successfully or in a cost-effective way. Our failure to do so could adversely affect our ability to compete and retain customers or market share. Many existing and emerging companies are providing, or propose to provide, competing services using new technologies. Furthermore, the increased adoption of IP switching technologies could increase the competition we face from direct connections. See “-The market for our services is competitive and increased adoption of IP switching technologies could increase the competition we face from direct connections” above. Our future revenues and profits will depend on our ability to provide value added service(s) to competitive carriers. If we are unable to provide these service(s), whether as a result of technology changes or otherwise, we could experience a material adverse effect on our business, prospects, financial condition and operating results.
Confidentiality agreements with employees and others may not adequately prevent disclosure of trade secrets and other proprietary information.
In order to protect our proprietary technology, processes and methods, we rely in part on confidentiality agreements with our corporate partners, employees, consultants, advisors and others. These agreements may not effectively prevent disclosure of confidential information and may not provide an adequate remedy in the event of unauthorized disclosure of confidential information. In addition, others may independently discover trade secrets and proprietary information, and in such cases we could not assert any rights against such party. Costly and time-consuming litigation could be necessary to enforce and determine the scope of our proprietary rights, and failure to obtain or maintain trade secret protection could adversely affect our competitive business position.
Others may allege that we are infringing upon their intellectual property, forcing us to expend substantial resources in resulting litigation, the outcome of which would be uncertain. Any unfavorable outcome of such litigation could have a material adverse effect on our business, financial position and operating results.
If any parties successfully claim that our creation, offer for sale, sale, import or use of technologies infringes upon their intellectual property rights, we might be forced to incur expenses to litigate the claims, pay damages, potentially including treble damages, if we are found to have willfully infringed such parties’ patents or copyrights. In addition, if we are unsuccessful in litigation, a court could issue a permanent injunction preventing us from operating our network, offering our services or using certain of our systems for the life of the patent that we have been deemed to have infringed. Litigation concerning patents and other forms of intellectual property and proprietary technologies, is becoming more widespread and can be protracted and expensive, and can distract management and other key personnel from performing their duties for us.
Any legal action against us claiming damages and seeking to enjoin commercial activities relating to the affected methods, processes, products and services could, in addition to subjecting us to potential liability for damages, require us to obtain a license in order to continue to operate our network, use the affected systems or market the affected services. Any license required under any patent may not be made available on commercially acceptable terms, if at all. In addition, some licenses may be nonexclusive, and therefore, our competitors may have access to the same technology licensed to us. If we fail to obtain a required license or are unable to design around a patent, we may be unable to effectively operate our network or market some of our technology and products, which could limit our ability to generate revenues or achieve profitability and possibly prevent us from generating revenue sufficient to sustain our operations.
From time to time we have received and we may in the future receive notices or inquiries from other companies regarding our services or the manner in which we operate our network suggesting that we may be infringing a pre-existing patent or we need to license use of their patents to avoid infringement. Such notices may, among other things, threaten litigation against us. As we have in the past, we will actively review the request and determine whether there is any validity to the request and seek to resolve the matter. Litigation over patent rights and other intellectual property rights is not uncommon with respect to network technologies, and sometimes involves patent holding companies or other adverse patent owners who have no relevant product revenues and against whom our own patents may therefore provide little or no deterrence. There can be no assurance that holders of patents will not pursue any claim against us in the future if they believe their patents are being infringed by our network or service offerings.
Risk Factors Related To Our Common Stock
Our common stock has only traded since November 2, 2007 and our stock price is likely to be volatile.
Our common stock has only traded since November 2, 2007. The market prices for securities of telecommunications companies have historically been volatile. Some of the factors that may cause the market price of our common stock to fluctuate include:
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the passage of various laws and governmental regulations governing communications-related services and internet-related services;
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a decrease in the amount of traffic we carry or the rates we charge for such traffic, whether from competition or otherwise;
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the failure to develop new services or successfully manage our growth strategy;
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the failure of or disruption to our physical infrastructure or services;
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conditions or trends in the internet, technology and communications industries;
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the addition or departure of any key employees;
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the level and quality of securities research analyst coverage of our common stock;
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changes in the estimates of our operating performance or changes in recommendations of us by any research analyst that follow our stock or any failure to meet the estimates made by research analysts;
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litigation involving ourselves, including our granted or any future patents, or our general industry or both;
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investors’ general perception of us, our services, the economy and general market conditions;
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developments or disputes concerning our patents or other proprietary rights;
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the announcement of significant acquisitions, strategic partnerships, joint ventures or capital commitments by us or our competitors; and
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other factors discussed within these “Risk Factors”.
If any of these factors cause an adverse effect on our business, operating results or financial condition, the price of our common stock could fall. In addition, public announcements by our competitors regarding, among other things, their performance, strategy, accounting practices, or legal problems could cause the price of our common stock to decline regardless of our actual operating performance.
Changes in our capital structure and level of indebtedness and the terms of such indebtedness could adversely affect our business and liquidity position.
We currently do not have any debt. However, we may issue debt in the future or increase our level of indebtedness from time to time for various reasons, including fluctuations in operating results, capital expenditures and possible acquisitions. Future consolidated indebtedness levels could materially affect our business by:
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requiring a substantial portion of our cash flow from operations to be dedicated to interest payments on such indebtedness, and thereby not available for other purposes;
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materially limiting or impairing our ability to obtain further financing;
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reducing our flexibility to respond to changing business and economic conditions or to take advantage of business opportunities that may arise; and
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further limiting our ability to pay dividends.
In addition, any credit agreement may limit our ability to enter into various transactions. If we were to default on any of our debt obligations, or if we were unable to obtain necessary liquidity, our obligation to repay such debt would become due and payable immediately and our business could be adversely affected.
Anti-takeover provisions under Delaware law and in our amended and restated certificate of incorporation and bylaws could diminish the value of our common stock and could make a merger, tender offer or proxy contest difficult or could impede an attempt to replace or remove our directors.
We are a Delaware corporation and the anti-takeover provisions of the Delaware General Corporation Law may discourage, delay or prevent a change in control by prohibiting us from engaging in a business combination
with an interested stockholder for a period of three years after the person becomes an interested stockholder, even if a change of control would be beneficial to our existing stockholders. In addition, our amended and restated certificate of incorporation and bylaws may discourage, delay or prevent a change in our management or control over us that stockholders may consider favorable or make it more difficult for stockholders to replace directors even if stockholders consider it beneficial to do so. Our amended and restated certificate of incorporation and bylaws:
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authorize the issuance of “blank check” preferred stock that could be issued by our Board of Directors to increase the number of outstanding shares to thwart a takeover attempt;
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prohibit cumulative voting in the election of directors, which would otherwise allow holders of less than a majority of the stock to elect some directors;
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require that directors only be removed from office for cause and by the affirmative vote of the holders of at least 66 2 / 3 % of the total votes eligible to be cast in the election of directors;
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require that vacancies on the Board of Directors, including newly created directorships, be filled only by a majority vote of directors then in office;
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limit who may call special meetings of stockholders;
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authorize the issuance of authorized but unissued shares of common stock and preferred stock without stockholder approval, subject to the rules and regulations of The NASDAQ Stock Market;
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prohibit stockholder action by written consent, requiring all actions to be taken at a meeting of the stockholders; and
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establish advance notice requirements for nominating candidates for election to the Board of Directors or for proposing matters.
In addition, Section 203 of the Delaware General Corporation Law may inhibit potential acquisition bids for us. Section 203 regulates corporate acquisitions and limits the ability of a holder of 15% or more of our stock from acquiring the rest of our stock. Under Delaware law a corporation may opt out of the anti-takeover provisions, but we do not intend to do so.
These provisions may prevent a stockholder from receiving the benefit from any premium over the market price of our common stock offered by a bidder in a potential takeover. Even in the absence of an attempt to effect a change in management or a takeover attempt, these provisions may adversely affect the prevailing market price of our common stock if they are viewed as discouraging takeover attempts in the future.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
Our headquarters is located at 550 W. Adams, Suite 900, Chicago, Illinois, where we lease approximately 27,000 square feet of office space. Our leased properties are described below:
We believe our existing facilities are adequate for our current needs in our existing markets and that suitable additional or alternative space will be available in the future on commercially reasonable terms as needed.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Peerless Network, Inc. Proceeding in the United States District Court for the Northern District of Illinois
As previously disclosed, on June 12, 2008, we 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 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 alleged (i) that the ‘708 Patent was invalid and unenforceable under a variety of theories, (ii) that assertion of the ‘708 Patent amounted 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 United States Patent and Trademark Office (the USPTO) of the validity of the ‘708 Patent, which is discussed under “Inter partes proceeding before the United States Patent and Trademark Office” 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 court’s 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 Network’s 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 court’s 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 Network’s 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 Network’s claim that the ‘708 Patent is unenforceable. The court also dismissed Counts IV-VII of Peerless Network’s 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.
On December 9, 2010, the court issued an opinion and order granting our motion for summary judgment on Peerless Network’s 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 planned to appeal the court’s order granting Peerless Network’s motion for summary judgment and finding that the ‘708 Patent is invalid. On January 13, 2011, Peerless Network cross-appealed the court’s order granting our motion for summary judgment and finding that the ‘708 Patent is not unenforceable, as well as the court’s earlier ruling construing disputed terms of the patent in our favor.
On June 6, 2011, Peerless Network agreed to withdraw its cross-appeal. Briefing in our appeal was completed on July 19, 2011. Oral argument in our appeal occurred on December 8, 2011. On December 13, 2011, the federal appellate court affirmed the finding that our patent is invalid, and on January 30, 2012, the appellate court denied our petition for rehearing of the December 13, 2011 ruling. The Company has the option to ask the United States Supreme Court to review that ruling. A petition for such review would be due by April 30, 2012. The Supreme Court grants a very small percentage of such requests for review.
On September 1, 2011, the district court issued an order that awarded approximately $102,000 in litigation-related costs to Peerless Network, and approximately $48,000 in litigation-related costs to us. We filed notice that we planned to appeal that part of the court’s order awarding costs to Peerless Network on September 30, 2011. Peerless Network has not cross-appealed the court’s award of costs to us.
On December 13, 2011, the federal appellate court affirmed the finding that our patent is invalid, and on January 30, 2012, the appellate court denied our petition for rehearing of the December 13, 2011 ruling. We have the option to ask the United States Supreme Court to review that ruling. A petition for such review would be due by April 30, 2012. The Supreme Court grants a very small percentage of such requests for review.
Peerless Network has notified us that it intends to pursue a claim for attorney’s fees in the trial court. The trial court has stayed proceedings with respect to this potential claim pending resolution of our appeal. We believe that a loss with respect to any such claim, if such a claim is made, is remote.
Inter partes proceeding before the United States Patent and Trademark Office
As previously disclosed, 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 Network’s inter partes reexamination request and issued an initial office action which rejected the ‘708 Patent’s 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 USPTO’s rules, we were not allowed to respond to Peerless Network’s request prior to the USPTO’s 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 USPTO’s 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 Patent’s 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 USPTO’s 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 Patent’s 23 original claims, as well as the 35 additional claims added to the ‘708 Patent in the Company’s July 26, 2010 response.
On April 11, 2011, we filed a notice of appeal of the USPTO’s decision to the Board of Patent Appeals and Interferences (the BPAI). Peerless Network filed a notice of appeal of the USPTO’s decision to the BPAI on April 19, 2011. Briefing in those appeals was completed in December 2011.
If the decision of the federal district court finding our patent invalid becomes final and nonappealable, proceedings at the USPTO will end with respect to existing claims, though we may ask the USPTO to continue proceedings with respect to new claims. If the decision of the federal district court finding our patent invalid does not become final and nonappealable, the BPAI will review the parties’ positions on appeal. In that event, after
reviewing the parties’ positions on appeal, the BPAI may affirm the USPTO’s 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.
The USPTO action will determine whether the patent is valid or invalid. The USPTO will not directly assess liability against us or Peerless Network. For a discussion of our patent infringement claim against Peerless Network, see “Proceeding in the United States District Court for the Northern District of Illinois” above.
ITEM 4.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information
Our common stock has traded on The Nasdaq Global Market under the symbol “IQNT” (prior to February 7, 2012, the symbol was “TNDM”) since November 2, 2007. Prior to that time, there was no public market for our common stock.
The following table sets forth the high and low closing sale prices per share for our common stock, for the periods indicated as regularly reported by The Nasdaq Global Market:
The following table provides information about our common stock that may be issued under all of our equity compensation plans as of December 31, 2011.
Equity Compensation Plan Information
Holders of Record
On February 29, 2012, there were approximately 57 registered holders of record of our common stock. Because many of the shares of our common stock are held by brokers and other institutions on behalf of stockholders, we are unable to determine the exact number of beneficial stockholders represented by these record holders, but we believe that there were approximately 10,865 beneficial owners of our common stock as of February 27, 2012.
Dividends
We currently do not pay regular dividends on our outstanding stock. The declaration of any future dividends and, if declared, the amount of any such dividends, will be subject to our actual future earnings, capital requirements, regulatory restrictions, debt covenants, other contractual restrictions and to the discretion of our Board of Directors. Our Board of Directors may take into account such matters as general business conditions, our financial condition and results of operations, our capital requirements, our prospects and such other factors as our Board of Directors may deem relevant. We do not anticipate paying any dividends on our common stock in the foreseeable future.
STOCK PERFORMANCE GRAPH
The following graph compares the cumulative 50-month total return provided stockholders on Inteliquent’s common stock relative to the cumulative total returns of the NASDAQ Composite Index and the NASDAQ Telecommunications Index. An investment of $100 (with reinvestment of all dividends) is assumed to have been made in our common stock and in each of the indexes on November 2, 2007, the first day of trading of our common stock, and its relative performance is tracked through December 31, 2011. The NASDAQ Telecommunications Index contains securities of NASDAQ-listed companies classified as Telecommunications and Telecommunications Equipment according to the Industry Classification Benchmark. They include providers of fixed-line and mobile telephone services, and makers and distributors of high-technology communication products. This graph is not deemed to be “filed” with the SEC or subject to the liabilities of Section 18 of the Securities Exchange Act of 1934, and the graph shall not be deemed to be incorporated by reference into any prior or subsequent filing by Inteliquent under the Securities Act of 1933 or the Exchange Act.
COMPARISON OF CUMULATIVE TOTAL RETURN
(Based upon an initial investment of $100 on November 2, 2007, the first day of trading of
our common stock, with dividends reinvested)
Issuer Purchases of Equity Securities
On February 16, 2010, we announced that our Board of Directors authorized the repurchase of up to $25.0 million of our outstanding common stock as part of a stock repurchase program. During 2010, we 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, we announced that its Board of Directors authorized the repurchase of up to $50.0 million of our outstanding common stock as part of a stock repurchase program. On April 18, 2011, we entered into a letter agreement with Spotlight Advisors, LLC, George Allen and Clinton Group, Inc. on behalf of
themselves and their respective affiliated funds, persons and entities, 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. In 2011, we repurchased approximately 3.1 million shares at a price of $16.25 per share, for a total cost of $50.1 million, exclusive of related fees and expenses. The modified “Dutch auction” tender offer expired on June 13, 2011. The common shares purchased pursuant to the tender offer represented approximately 8.9% of the common shares outstanding as of June 10, 2011. We funded the purchase of the common shares in the tender offer using cash on hand. The shares were not retired as of December 31, 2011. The stock repurchases are accounted for under the cost method whereby the entire cost of the repurchased shares was recorded to treasury stock.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
SELECTED HISTORICAL CONSOLIDATED FINANCIAL AND OTHER DATA
The selected consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes. The selected consolidated statements of operations data for the years ended December 31, 2011, 2010, and 2009 and the selected consolidated balance sheet data as of December 31, 2011 and 2010 are derived from, and are qualified by reference to, the audited consolidated financial statements included elsewhere in this annual report on Form 10-K. The selected consolidated statements of operations data for the fiscal years ended December 31, 2008 and 2007 and the selected consolidated balance sheet data as of December 31, 2009, 2008 and 2007 are derived from, and are qualified by reference to, our audited consolidated financial statements that are not included in this annual report on Form 10-K. The historical results presented below are not necessarily indicative of future results.
(1) Basic earnings per share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed giving effect to all dilutive potential common shares that were outstanding during the period. The effect of preferred shares, stock options, non-vested shares and warrants represents the only difference between the weighted average shares used for the basic earnings per share computation compared to the diluted earnings per share computation.
(2) On November 7, 2007, we completed an initial public offering of common stock in which we sold 7,247,849 shares of our common stock and selling shareholders sold 399,928 shares of our common stock, in each case at an issue price of $14.00 per share. We raised a total of $101.5 million in gross proceeds from our initial public offering, or $91.3 million in net proceeds after deducting underwriting discounts and commissions of $7.1 million and other offering costs of $3.1 million.
(3) As Tinet was acquired on October 1, 2010, there is no activity related to Tinet for the years 2009, 2008 and 2007. The activity included in 2010 relates only to the period from the October 1, 2010 acquisition date to December 31, 2010.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This annual report on Form 10-K contains “forward-looking statements” that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. Such forward-looking statements include any expectation of earnings, revenues or other financial items; any statements of the plans, strategies and objectives of management for future operations; factors that may affect our operating results; statements related to future capital expenditures; statements related to future economic conditions or performance; statements as to industry trends and other matters that do not relate strictly to historical facts or statements of assumptions underlying any of the foregoing. These statements are often identified by the use of words such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” or “may,” and similar expressions or variations. These statements are based on the beliefs and assumptions of our management based on information currently available to management. Such forward-looking statements are subject to risks, uncertainties and other factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled “Risk Factors” included in Item 1A of Part I of this annual report on Form 10-K. You should review these risk factors for a more complete understanding of the risks associated with an investment in our securities. We undertake no obligation to revise or update any forward-looking statements. The following
discussion and analysis should be read in conjunction with our “Risk Factors”, “Selected Consolidated Financial Data” and consolidated financial statements and notes thereto included elsewhere in this annual report on Form 10-K.
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 primarily to competitive carriers, including wireless, wireline, cable and broadband telephony companies. Competitive carriers use our tandem switches to interconnect and exchange local and long distance traffic between their networks without the need to establish direct switch-to-switch connections. Competitive carriers are carriers that are not Incumbent Local Exchange Carriers, or ILECs, such as AT&T, Verizon and Qwest.
Prior to the introduction of our local voice service, competitive carriers generally had two alternatives for exchanging traffic between their networks. The two alternatives were interconnecting to the ILEC tandems or directly connecting individual switches, commonly referred to as “direct connects.” Given the cost and complexity of establishing direct connects, competitive carriers often elected to utilize the ILEC tandem as the method of exchanging traffic. The ILECs typically required competitive carriers to interconnect to multiple ILEC tandems with each tandem serving a restricted geographic area. In addition, as the competitive telecommunications market grew, the process of establishing interconnections at multiple ILEC tandems became increasingly difficult to manage and maintain, causing delays and inhibiting competitive carrier growth, and the purchase of ILEC tandem services became an increasingly significant component of a competitive carrier’s costs.
The tandem switching services offered by ILECs consist of local transit services, which are provided in connection with local calls, and switched access services, which are provided in connection with long distance calls. Under certain interpretations of the Telecommunications Act of 1996 and implementing regulations, ILECs are required to provide local 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 switched 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, or FCC, 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 service, our customers benefit from a simplified interconnection network solution that reduces costs, increases network reliability, decreases competitive tension and adds network diversity and redundancy.
According to the Local Exchange Routing Guide, an industry standard guide maintained by Telcordia that is used by carriers, there are approximately 1.57 billion telephone numbers assigned to carriers in North America. Our services are principally targeted to address the estimated 874.8 million, or 56% of the total 1.57 billion, telephone numbers assigned primarily to competitive carriers; that is, all carriers that are not ILECs.
We have signed voice services agreements with major competitive carriers and non-carriers and operated in 189 markets as of December 31, 2011. During the fourth quarter of 2011, our network carried 33.3 billion minutes of traffic. As of December 31, 2011, our network was capable of connecting calls to an estimated 570 million telephone numbers assigned to carriers. Telephone numbers assigned to a carrier may not necessarily be assigned to, and in use by, an end user.
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 the capability of 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 800 customers in over 80 countries. In 2011, we carried over 1 Terebit of customer IP traffic. We have over 120 POPs where we operate our equipment in carrier neutral facilities. Our core IP Transit network uses all Juniper equipment, which reduces complexity and allows for faster service deployment and easier customer support.
Revenue
We generate revenue from sales of our voice, IP Transit and Ethernet services. Revenue is recorded each month based upon documented minutes of traffic switched or data traffic carried for which service is provided, when collection is probable. Voice revenue is recorded each month on an accrual basis based upon minutes of traffic switched by our network by each customer, which we refer to as minutes of use. The rates charged per minute are determined by contracts between us and our customers or by filed and effective tariffs.
Minutes of use of voice traffic increase as we increase our number of customers, increase the penetration of existing markets, either with new customers or with existing customers, and increase our service offerings. The minutes of use decrease due to direct connection between existing customers, consolidation between customers, a customer using a different interconnection provider or a customer experiencing a decrease in the volume of traffic it carries.
The average fee per minute of voice traffic varies depending on market forces and type of service, such as switched access or local transit. The market rate in each market is based upon competitive conditions along with the switched access or local transit rates offered by the ILECs. Depending on the markets we enter, we may enter into contracts with our customers with either a higher or lower fee per minute than our current average.
Our service solution 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 bandwidth used monthly in excess of the Committed Traffic Rate and measured with industry standard 95th percentile criteria.
Ethernet services revenue is comprised of both Ethernet Private Line (EtherCloud P2P) and Ethercloud Extension (EtherCloud E2E) revenues. Ehtercloud P2P 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 bandwidth used monthly in excess of the Committed Traffic Rate and measured with industry standard 95th percentile criteria. EtherCloud E2E revenue is recorded each month on an accrual basis based upon bandwidth used by each customer. The rates charged are usually a flat monthly fee for bandwidth (the Committed Traffic Rate) but sometimes there are additional charges for the sustained bandwidth used monthly in excess of the Committed Traffic Rate and measured with industry standard 95th percentile criteria.
While generally not seasonal in nature, our 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. See “Risk Factors-Risks Factors Related to Our Business-We could experience material variances in our revenues.”
Operating Expense
Operating expenses include network and facilities expense, operations expenses, sales and marketing expenses, general and administrative expenses, depreciation and amortization, impairment of fixed assets and the gain or loss on the disposal of fixed assets.
Network and Facilities Expense. Our network and facilities expense include transport capacity, or circuits, and signaling network costs for voice services, transport capacity for our data services, facility rents and utilities, together with other costs that directly support the POPs. We do not defer or capitalize any costs associated with the start-up of new POPs. The start-up of an additional 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 and other charges from telecommunication carriers and are related to the
circuits utilized by us to connect to our customers. 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 POPs, which expire through February 2025. Additionally, we pay the cost of all the utilities for all of our POP locations.
Operations Expenses. Operations expenses include payroll and benefits for our 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 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, tax and transaction costs.
Depreciation and Amortization Expense. Depreciation and amortization expense for fixed assets 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 network 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 on the discounted cash flows recognized over their estimated useful lives (15 years).
Impairment of Fixed Assets. The carrying value of long-lived assets, primarily property and equipment, is evaluated whenever events or changes in circumstances indicate that a potential impairment has occurred. A potential impairment has occurred if projected undiscounted cash flows are less than the carrying value of the assets. The estimated cash flows include management’s assumptions of cash inflows and outflows directly resulting from the use of that asset in operation. The impairment test is a two-step process. If the carrying value of the asset exceeds the expected future cash flows from the asset, impairment is indicated. The impairment loss recognized is the excess of the carrying value of the asset over its fair value. Typically, the fair value of the asset is determined by estimating future cash flows associated with the asset.
Gain on Disposal of Fixed Assets. We have disposed of network equipment in connection with converting to new technology and computer equipment to replace old or damaged units. When there is a carrying value of these assets, we record the write-off of these amounts to loss on disposal. In some cases, this equipment is sold to a third party. When the proceeds from the sale of equipment identified for disposal exceeds the asset’s carrying value, we record a gain on disposal.
Foreign Currency 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.
Other Expense (Income). Other expense (income) includes expenses incurred related to the modified “Dutch auction” tender offer to repurchase common shares during the second quarter of 2011 and adjustments to the fair value of the ARS, and adjustments to the fair value of the ARS Rights.
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.
See “Risk Factors” for certain matters that may bear on our future results of operations.
Patent Protection
Our ability to maintain profitability or positive cash flow depends, in part, on our ability to protect proprietary methods and technologies that we develop under the patent and other intellectual property laws of the United States, so that we can prevent others from using our inventions and proprietary information. If our patents are invalidated or otherwise limited, other companies will be better able to develop products that compete with ours, which could adversely affect our competitive business position, business prospects and financial condition.
Any resulting increased competition may cause price decreases. If we are unable to offset the effects of any price reductions by carrying higher volumes of traffic, we could experience reduced revenues and gross margins.
On June 12, 2008, we commenced a patent infringement action against Peerless Network in the United States District Court for the Northern District of Illinois to enforce our rights under the ‘708 Patent. On September 2, 2010, the court hearing the case granted Peerless Network’s motion for summary judgment. The court found that the ‘708 Patent was invalid in light of a prior patent. On December 13, 2011, a federal appellate court affirmed the ruling that the ‘708 Patent is invalid. We have the option to ask the United States Supreme Court to review that ruling. A petition for such review would be due by April 30, 2012. The Supreme Court grants a very small percentage of such requests for review. See “Item 3. Legal Proceedings” for a further description of this matter. If we do not prevail in this matter, it could result in continued or increased competition, either of which could adversely affect our ability to maintain profitability or positive cash flow.
Critical Accounting Policies and Estimates
The discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles, or GAAP, in the United States of America. The preparation of these financial statements in accordance with GAAP requires us to utilize accounting policies and make certain estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingencies as of the date of the financial statements and the reported amounts of revenue and expense during a fiscal period. The Securities and Exchange Commission (SEC) considers an accounting policy to be critical if it is important to a company’s financial condition and results of operations, and if it requires significant judgment and estimates on the part of management in its application. We have discussed the selection and development of the critical accounting policies with the audit committee of our Board of Directors, and the audit committee has reviewed our related disclosures in this annual report. Although we believe that our judgments and estimates are appropriate and correct, actual results may differ from those estimates.
We believe the following to be our critical accounting policies because they are important to the portrayal of our financial condition and results of operations and they require critical management judgments and estimates about matters that are uncertain. If actual results or events differ materially from those contemplated by us in making these estimates, our reported financial condition and results of operation for future periods could be materially affected.
Revenue Recognition
We generate revenue from sales of our voice, IP Transit and Ethernet services. We maintain tariffs and executed service agreements with each of our customers in which specific fees and rates are determined. Revenue is recorded each month based upon documented minutes of traffic switched or internet transit for which service is provided, when collection is probable. We provide voice interconnection service primarily to large, well-established competitive carriers, including wireless, wireline, cable and broadband telephony providers and internet connectivity services to other network operators.
Accounting for Income Taxes
Deferred income tax assets and liabilities are recognized for future income tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective income tax bases and for net operating loss carryforwards. Deferred income tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred income tax assets and liabilities of a change in income tax rates is recorded in earnings in the period of enactment. A valuation allowance is provided for deferred income tax assets whenever it is more likely than not that future tax benefits will not be realized. Deferred income tax assets are reviewed on a quarterly basis to determine if a valuation allowance is necessary based on current and historical performance, along with other relevant factors.
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.
We recognize the benefits of uncertain tax positions taken or expected to be taken in tax returns in the provision for income taxes only for those positions that are more likely than not to be realized. We follow a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon ultimate settlement. We consider many factors when evaluating and estimating our tax positions and tax benefits, which may require periodic adjustments and which may not accurately forecast actual outcomes. Our policy is to include interest and penalties associated with income tax obligations in income tax expense.
Stock-Based Compensation
We currently record stock-based compensation expense in connection with any grant of options or non-vested shares to our employees and independent contractors. We measure compensation cost for our stock options and non-vested shares at fair value.
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 our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. We consider many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience.
The fair value of the non-vested shares is determined using the Company’s 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.
Stock-based employee compensation is reflected in the statement of income. All options and non-vested shares granted under the Plan have an exercise price equal to the market value of the underlying common stock on the date of the grant.
Goodwill Impairment
Goodwill represents the excess of the purchase price and related costs over the value assigned to the net tangible and identifiable intangible assets of businesses acquired. Goodwill is not amortized but is tested for impairment at least annually during the fourth quarter of each year, or more frequently if an event occurs or
circumstances change that would reduce the fair value of a reporting unit below its carrying value. Our reporting units are the Americas; Europe, Middle East & Africa (EMEA) and Asia Pacific (APAC). In October 2011, the Company established the Americas, EMEA and APAC reporting units as part of an internal reorganization. Before October 2011, the Company Operated as one reporting unit. The goodwill impairment test (Step-one) is based upon the estimated fair value of our reporting units compared to the net carrying value of assets and liabilities. We determine the fair value of our reporting units by combining two valuation methods, a discounted future cash flow analysis (DCF) and market multiples of comparable publicly-traded companies. For the DCF method, we prepare annual projections of future cash flows over a period of five years (the “discrete projection period”), and apply a terminal value assumption to the final year within the discrete projection period to estimate the total value of the cash flows beyond the final year. In the market multiples method, fair value is determined by applying a multiple to EBITDA (earnings before interest, taxes, depreciation and amortization). The EBITDA multiple reflects the risk of cash flows generated by an entity. We use peer groups that are similar in size, industry, growth stage, or business model. The fair values of our reporting units are then derived using a DCF analysis similar to that described above. We utilized EBITDA multiples based on our peer companies and adjusted for growth factors for each reporting unit to estimate fair values under the market multiple approach. If the Step-one test indicates that impairment potentially exists, a second step (Step-two) is performed to measure the amount of goodwill impairment, if any. Goodwill impairment exists in Step-two when the implied fair value of goodwill is less than the carrying value of goodwill. The implied fair value of goodwill is determined based on the difference between the fair value of the reporting unit determined in Step-one and the fair value allocated to the identifiable assets, including unrecognized intangible assets, and liabilities of the reporting unit.
The goodwill impairment testing process involves the use of significant assumptions, estimates and judgments, and is subject to inherent uncertainties and subjectivity in determination of the fair value of the reporting units in Step-one, and, if necessary in Step-two, the allocation of the fair value to identifiable assets and liabilities. Estimating a reporting unit’s projected cash flows involves the use of significant assumptions, estimates and judgments with respect to numerous factors, including long-term rate of revenue growth, operating margin, including operating, sales and marketing, general and administrative expense rates, capital expenditures, allocation of shared or corporate items, among other factors. These estimates are based on internal current operating plans and long-term forecasts for each reporting unit. These projected cash flow estimates are then discounted, which necessitates the selection of an appropriate discount rate. The discount rates selected reflect market-based estimates of the risks associated with the projected cash flows of the reporting unit. The market value comparisons of fair value require the selection of appropriate peer group companies. In addition, we analyze differences between the sum of the fair value of the reporting units and our total market capitalization for reasonableness, taking into account certain factors including control premiums. In Step-two, the fair value allocation requires several analyses to determine fair value of assets and liabilities including, among others, customer relationships and property, plant and equipment.
In 2011, the Company performed a quantitative assessment of the reporting units. Based on the analyses, the Company determined it was that the fair value of each reporting unit exceeded the respective carrying value, and no adjustments to goodwill were required. A 10% decrease in the fair value estimate of each of the reporting units would not have changed the determination.
Impairment of Long-Lived and Other Assets
The carrying value of long-lived assets, including amortizable intangible assets and property and equipment, are reviewed whenever events or changes in circumstances indicate that the related carrying amounts may not be recoverable. Impairment is generally determined by comparing projected undiscounted cash flows to be generated by the asset, or appropriate grouping of assets, to its carrying value. If an impairment is identified, a loss is recorded equal to the excess of the asset’s net book value over its fair value, and the cost basis is adjusted. Determining the extent of an impairment, if any, typically requires various estimates and assumptions including using management’s judgment, cash flows directly attributable to the asset, the useful life of the asset and residual value, if any. When necessary, the Company uses internal cash flow estimates, quoted market prices and appraisals as appropriate to determine fair value. Actual results could vary from these estimates. In addition, the remaining useful life of the impaired asset is revised, if necessary.
Results of Operations
The following table sets forth our results of operations for the years ended December 31, 2011, 2010 and 2009:
NEUTRAL TANDEM, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data)
Year Ended December 31, 2011 Compared to Year Ended December 31, 2010
Revenue. Revenue of $268.3 million for the year ended December 31, 2011 increased $68.5 million, or 34.3%, from $199.8 million for the year ended December 31, 2010. A portion of the increase in revenues was due to the acquisition of Tinet, which generated $65.2 million in revenues for the full year of 2011 compared with $16.1 million during the fourth quarter of 2010. This increase accounts for $49.1 million or 71.8% of the annual increase. The remaining increase in revenue of $19.4 million, or 28.2% was primarily due to an increase in voice minutes of use billed to 130.4 billion minutes processed for the year ended December 31, 2011 from 108.5 billion minutes processed in the year ended December 31, 2010, an increase of 21.9 billion minutes, or 20.2%. The number of minutes carried over our network increased as a result of the entry into 10 new markets in 2011 and further penetration of current markets and customers.
The number of markets in which we operated increased to 189 at December 31, 2011 from 179 at December 31, 2010. The average fee per voice minute for the year ended December 31, 2011 of $0.0016 decreased from the December 31, 2010 amount of $0.0017.
Operating Expenses . Operating expenses of $221.7 million for the year ended December 31, 2011 increased $76.0 million from $145.7 million in the year ended December 31, 2010, or 82.6% and 72.9% of revenue, respectively. The components making up operating expenses are discussed further below.
Network and Facilities Expenses. Network and facilities expenses of $108.3 million for the year ended December 31, 2011, or 40.4% of revenue, increased from $69.1 million for the year ended December 31, 2010, or 34.6% of revenue. Of this increase, $24.3 million is the network and facilities expenses incurred by Tinet during the year ended December 31, 2011 compared with only three months of activity during the year ended December 31, 2010. Due to the nature of the IP Transit and Ethernet business, higher network and facilities expenses are expected and we anticipate this percentage will continue to increase as we reflect increased activity for these businesses.
The remaining increase of $14.9 million in our network and facilities expenses were primarily due to an increase in the number of switch locations we connect, increasing by 58 switch locations to 2,108 switch locations at December 31, 2011 from 2,050 switch locations at December 31, 2010. As noted above, our billed voice minutes of use were up 20.2%, 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 of $42.0 million for the year ended December 31, 2011, or 15.7% of revenue, increased $13.7 million compared to $28.3 million for the year ended December 31, 2010, or 14.2% of revenue. Of this increase, $9.4 million is due to operations expenses of Tinet during the full year of 2011 compared with only three months of activity in 2010. The remaining increase in our operations expenses primarily resulted from an increase of $0.3 million related to non-cash compensation, and an increase of $1.5 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. In addition, during the year, we settled a dispute with a landlord for $0.8 million.
Sales and Marketing Expense. Sales and marketing expense of $13.6 million for the year ended December 31, 2011, or 5.1% of revenue, increased from $5.0 million for the year ended December 31, 2010, or 2.5% of revenue. Of this increase, $5.9 million is due to sales and marketing expenses of Tinet during the full year of 2011 compared with only three months of activity in 2010. Due to the nature of the IP Transit and Ethernet business, higher sales and marketing expenses are incurred and we anticipate this percentage will continue to increase as we increase activity for our IP Transit and Ethernet business. The remaining increase in our sales and marketing expenses primarily resulted from an increase of $0.4 million related to non-cash compensation, and an increase of $1.8 million in payroll and benefits due to an increase in the number of employees in the sales force as we expand the sale of IP Transit and Ethernet in the Americas.
General and Administrative Expense. General and administrative expense increased to $28.0 million for the year ended December 31, 2011, or 10.4% of revenue, compared to $24.3 million for the year ended December 31, 2010, or 12.2% of revenue. Of this increase, $3.1 million is due to the acquisition of Tinet. The remaining increase in our general and administrative expenses of $0.6 million is primarily due to a $4.3 million increase in non-cash compensation, a $1.0 million increase in payroll and benefits, partially offset by a decrease of $3.6 million in professional fees and $1.7 million in consulting fees. The increase in non-cash compensation is primarily due to the accelerated vesting of options and non-vested shares related to the retirement of Rian J. Wren, as further discussed in footnote 11 to the consolidated financial statements - “Stock Options and Non-vested Shares”. The professional fees and consulting fees were lower in 2011 as the 2010 fees included the Tinet acquisition related costs.
Depreciation and Amortization Expense. Depreciation and amortization expense increased to $29.4 million for the year ended December 31, 2011, or 10.9% of revenue, compared to $19.1 million for the year ended December 31, 2010, or 9.5% of revenue. Of this increase, $7.5 million is due to the depreciation and amortization of Tinet assets during the year ended December 31, 2011 compared with only three months of activity in 2010. The remaining increase in our depreciation and amortization expense relates to an increase of $2.8 million in our depreciation 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 expense was $0.8 million in the year ended December 31, 2011, compared to other income of $1.0 million for the year ended December 31, 2010. Other expense in 2011 includes $0.3 million of expenses incurred related to the modified “Dutch auction” tender offer to repurchase common shares during the second quarter of 2011 and $0.4 million foreign exchange losses as part of foreign business operations. Other income in 2010 includes a gain of $1.9 million on two forward currency contracts entered into during the third quarter to reduce our currency exchange rate risk from the acquisition of Tinet on October 1, 2010. In addition, we recognized $0.9 million related to foreign exchange losses, as a result of a decrease in the Euro to dollar exchange rate during the fourth quarter of 2010.
Provision for Income Taxes . Provision for income taxes was $18.7 million for the year ended December 31, 2011, a decrease of $3.8 million compared to $22.5 million for the year ended December 31, 2010. The effective tax rate at December 31, 2011 was 40.9% compared to the effective tax rate at December 31, 2010 of 40.8%.
Year Ended December 31, 2010 Compared to Year Ended December 31, 2009
Revenue. Revenue of $199.8 million for the year ended December 31, 2010 increased $30.9 million, or 18.3%, from $168.9 million for the year ended December 31, 2009. A portion of the increase in revenues was due to the acquisition of Tinet, which generated $16.1 million in revenues or 9.5% of the annual increase. The remaining increase in revenue of $14.8 million, or 8.8%, was primarily due to an increase in voice minutes of use billed to 108.5 billion minutes processed for the year ended December 31, 2010 from 87.8 billion minutes processed in the year ended December 31, 2009, an increase of 20.7 billion minutes, or 23.5%. The number of minutes carried over our network increased as a result of the entry into 42 new markets in 2010 and further penetration of current markets and customers.
The number of markets in which we operated increased to 179 at December 31, 2010 from 137 at December 31, 2009. The average fee per voice minute for the year ended December 31, 2010 of $0.0017 decreased from the December 31, 2009 amount of $0.0019.
Operating Expenses. Operating expenses of $145.7 million for the year ended December 31, 2010 increased $40.8 million from $104.9 million in the year ended December 31, 2009, or 72.9% and 62.1% of revenue, respectively. The components making up operating expenses are discussed further below.
Network and Facilities Expenses. Network and facilities expenses of $69.1 million for the year ended December 31, 2010, or 34.6% of revenue, increased from $50.6 million for the year ended December 31, 2009, or 30.0% of revenue. Of this increase, $7.3 million is the network and facilities expenses incurred by Tinet during the fourth quarter of 2010. 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 in 2011 as we reflect increased activity for our IP Transit business.
Excluding the Tinet expenses in the fourth quarter, network and facilities expenses were $61.8 million for the year ended December 31, 2010, or 33.6% of revenue. Network and facilities expenses increased due to an increase in the number of switch locations we connect, increasing by 246 switch locations to 2,050 switch locations at December 31, 2010 from 1,804 switch locations at December 31, 2009. As noted above, our billed
voice minutes of use were up 23.5%, 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 2010 has increased compared to 2009.
Operations Expenses. Operations expenses of $28.3 million for the year ended December 31, 2010, or 14.2% of revenue, increased $8.5 million compared to $19.8 million for the year ended December 31, 2009, or 11.7% of revenue. Of this increase, $2.1 million is due to operations expenses of Tinet during the fourth quarter of 2010. Excluding the expenses of Tinet in the fourth quarter, the increase in our operations expenses primarily resulted from an increase of $3.1 million related to non-cash compensation, and an increase of $1.4 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 of $5.0 million for the year ended December 31, 2010, or 2.5% of revenue, increased from $2.0 million for the year ended December 31, 2009, or 1.2% of revenue. Of this increase, $2.0 million is due to sales and marketing expenses of Tinet during the fourth quarter of 2010. 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 in 2011 as we reflect increased activity for our IP Transit business. Excluding the expenses of Tinet in the fourth quarter, sales and marketing expenses were $3.0 million for the year ended December 31, 2010, or 1.6% of revenue. This increase is primarily due to an increase of $0.7 million in non-cash compensation.
General and Administrative Expense. General and administrative expense increased to $24.3 million for the year ended December 31, 2010, or 12.2% of revenue, compared to $18.0 million for the year ended December 31, 2009, or 10.6% of revenue. Of this increase, $5.2 million is due to the acquisition of Tinet, which contributed $1.2 million in general and administrative expenses and $4.0 million in acquisition related expenses. Excluding the acquisition of Tinet in the fourth quarter, the $1.1 million increase in our general and administrative expense is primarily due to increases in non-cash compensation and in payroll and benefits.
Depreciation and Amortization Expense. Depreciation and amortization expense increased to $19.1 million for the year ended December 31, 2010, or 9.5% of revenue, compared to $14.6 million for the year ended December 31, 2009, or 8.6% of revenue. Of this increase, $2.4 million is due to the depreciation and amortization of Tinet assets during the fourth quarter of 2010. Excluding the expenses of Tinet in the fourth quarter, the increase of $2.1 million in our depreciation 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 was $1.0 million in the year ended December 31, 2010 and December 31, 2009. Other income in 2010 includes a gain of $1.9 million on two forward currency contracts entered into during the third quarter to reduce our currency exchange rate risk from the acquisition of Tinet on October 1, 2010. In addition, we recognized $0.9 million related to foreign exchange losses, as a result of a decrease in the Euro to dollar exchange rate during the fourth quarter of 2010. Interest income decreased during the year due to a decrease in our investments in ARS in 2010 and lower interest rates earned on our investments. Interest expense associated with debt decreased during the year due to the repayment of debt outstanding throughout 2009 and 2010.
Provision for Income Taxes. Provision for income taxes was $22.5 million for the year ended December 31, 2010, a decrease of $1.0 million compared to $23.5 million for the year ended December 31, 2009. The effective tax rate at December 31, 2010 was 40.8% compared to the effective tax rate at December 31, 2009 of 36.3%. The 2010 estimated effective income tax rate is higher than the statutory rate primarily due to state income taxes, the Illinois EDGE credit tax benefit, the Illinois EDGE credit valuation allowance, the effects of foreign income tax, tax exempt municipal interest, and Tinet transaction costs.
Liquidity and Capital Resources
Our primary sources of liquidity have been cash provided by operations, the sale and issuance of equity, borrowings under our credit facility and our initial public offering completed in November 2007. Our primary ongoing sources of liquidity are our cash flows from operations. Our principal uses of cash have been capital expenditures for network equipment, working capital, debt service requirements, repurchases of common shares and our acquisition of Tinet on October 1, 2010. We anticipate that our principal uses of cash in the future will be for facility expansion and capital expenditures for network equipment and working capital.
At December 31, 2011, we had $90.3 million in cash and cash equivalents, and $1.0 million in restricted cash. In comparison, at December 31, 2010, we had $106.7 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.
Working capital at December 31, 2011 was $113.5 million compared to $121.8 million at December 31, 2010. We acquired Tinet for $103.1 million on October 1, 2010 ($108.5 million total cash paid at acquisition, less $5.4 million cash acquired from Tinet).
Our capital expenditures of $22.0 million, $18.4 million and $18.1 million in the years ended December 31, 2011, 2010 and 2009, respectively, related primarily to the installation of network equipment in existing and new locations. Capital expenditures for 2012 are expected to be between $30 million and $35 million.
We believe the cash flow from operating activities, in addition to cash and cash equivalents currently on-hand, will be sufficient to fund our operations, including our anticipated growth plans, for the foreseeable future and in any event for at least the next 12 to 18 months.
We regularly review acquisitions and strategic investments, which may require additional debt or equity financing. We currently do not have any pending agreements with respect to any acquisitions or strategic investments which would require additional debt or equity financing.
The following table sets forth components of our cash flow (in thousands) for the following periods:
Cash flows from operating activities
Net cash provided by operating activities for the year ended December 31, 2011 was $57.7 million, compared to $60.5 million for the year ended December 31, 2010. 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 network maintenance costs. The slight decrease in operating cash flow reflects lower operating earnings driven mainly by increased depreciation and non-cash compensation, offset by the timing of cash collections. The timing of payments remained the same.
Net cash provided by operating activities for the year ended December 31, 2010 was $60.5 million, compared to $56.4 million for the year ended December 31, 2009. The slight increase in operating cash flow reflects lower operating earnings driven mainly by increased non-cash compensation and a decrease in tax benefit associated with stock option exercises. Timing of cash collections and payments remained the same.
Cash flows from investing activities
Net cash used for investing activities for the year ended December 31, 2011 was $22.5 million, compared to $104.8 million for the year ended December 31, 2010. Investing cash outflows are primarily related to the acquisition of Tinet on October 1, 2010, purchases of network equipment and the timing of purchases and redemptions of short-term and long-term investments. We also use cash to support letters of credit required by certain facility landlords and other vendors. The decrease in net cash used for investing activities is primarily the result of the $103.1 million acquisition of Tinet during 2010, partially offset by a $17.1 million decrease in proceeds from the redemption of auction rate securities and a $3.6 million increase in cash flows used for the purchase of network equipment.
Net cash used for investing activities for the year ended December 31, 2010 was $104.8 million, compared to $16.4 million for the year ended December 31, 2009. The increase in net cash used for investing activities is primarily the result of the $103.1 million acquisition of Tinet, partially offset by a $15.4 million increase in proceeds from the redemption of auction rate securities.
Cash flows from financing activities
Net cash used by financing activities for the year ended December 31, 2011 was $51.6 million, compared to $10.3 million for the year ended December 31, 2010. The changes in cash flows from financing activities primarily relate to the completion of a modified “Dutch auction” tender offer during the second quarter of 2011, pursuant to which the Company repurchased approximately 3.1 million common shares at a price of $16.25 per share, for a total cost of $50.1 million, excluding related fees and expenses. The Company funded the purchase of common shares in the tender offer using cash on hand. During 2010, we repurchased approximately 0.6 million shares for $9.6 million under a stock repurchase program at an average cost of $15.78 per share.
Net cash used by financing activities for the year ended December 31, 2010 was $10.3 million, compared to net cash provided of $11.0 million for the year ended December 31, 2009. The decrease in cash provided from financing activities is the result of an increase in the repurchase of common stock related to our share repurchase program, a decrease in proceeds from the issuance of common stock associated with stock options, a decrease in the excess tax benefit associated with stock option expense and a decrease in debt payments.
The following table represents a summary of our estimated future payments under contractual cash obligations as of December 31, 2011. Changes in our business needs, cancellation provisions, changing interest rates and other factors may result in actual payments differing from these estimates. We cannot provide certainty regarding the timing and amounts of payments. There have been no significant developments with respect to our contractual cash obligations since December 31, 2011.
Letters of Credit
We use cash collateralized letters of credit issued by Bank of America, N.A. to secure certain facility leases and other obligations. At December 31, 2011 there was $1.0 million of restricted cash used as collateral for $1.0 million in letters of credit outstanding.
Operating Leases
We lease facilities and certain equipment under operating leases which expire through February 2025. Rental expense for the years ended December 2011, 2010 and 2009 was $6.0 million, $4.8 million, and $4.3 million, respectively. See Item 2 “Properties” above for a description of the location of our leased real property.
Purchase Commitment
We have a service agreement with a major telecommunications service provider, where we have committed to purchase a minimum amount of service beginning in 2011 through 2015.
Indefeasible right of use operating expense Commitment
We have a number of indefeasible rights of use (IRUs) which represent contractual agreements between the operators of a communications cable or between the operator of a communications cable and a customer that needs this capacity to provide telecom services. It is defined as the exclusive, unrestricted and indefeasible right to use the relevant capacity (including equipment, fibers or capacity) for any legal purpose. With the right to use the IRUs comes an obligation to pay a proportion of the operating cost and contractually defined amounts related to the cost of maintaining the cable, including any costs incurred repairing the cable after mishaps. These contracts extend through 2019.
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 years ended December 31, 2011, 2010 and 2009.
Off-Balance Sheet Arrangements
We do not have any off-balance sheet arrangements, investments in special purpose entities or undisclosed borrowings or debt that would be required to be disclosed pursuant to Item 303 of Regulation S-K under the Securities Exchange Act of 1934. Additionally, we do not have any synthetic leases.
Recent Accounting Pronouncements
In September 2011, the Financial Accounting Standards Board (FASB) issued accounting standards update 2011-08, Intangibles - Goodwill and Other (Topic 350), Testing Goodwill for Impairment (ASU 2011-08). ASU 2011-08 amends current guidance to allow an entity to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. Under this amendment an entity would not be required to calculate the fair value of a reporting unit unless the entity determines, based on a qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. ASU 2011-08 applies to all companies that have goodwill reported in their financial statements. The provisions of ASU 2011-08 are effective for reporting periods beginning after December 15, 2011. Early adoption is permitted, but the Company has not elected to early adopt. Since ASU 2011-08 does not change the accounting guidance for testing goodwill if the more likely than not qualitative threshold is met, the adoption of this guidance will not affect our financial position, results of operations or cash flows.
In June 2011, the FASB issued accounting standard update 2011-05, Comprehensive Income (Topic 220), Presentation of Comprehensive Income in U.S. GAAP (ASU 2011-05). ASU 2011-05 requires that comprehensive income and the related components of net income and of other comprehensive income be presented in a single continuous statement of comprehensive income or in two separate but consecutive statements. The ASU also requires reclassification adjustments from other comprehensive income to net income be presented on the face of the financial statements. ASU 2011-05 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. However, in December 2011, the FASB issued accounting standard update 2011-12 Comprehensive Income (Topic 220), Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income
in ASU 2011-05 (ASU 2011-12) to defer the requirement to present reclassification adjustments from other comprehensive income on the face of the financial statements and allow entities to continue to report reclassifications out of accumulated other comprehensive income consistent with the requirements in effect before ASU 2011-05. This guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011, and will be applied retrospectively. As this guidance only revises the presentation of comprehensive income, the adoption of this guidance will not affect our financial position, results of operations or cash flows.
In May 2011, the FASB issued accounting standard update 2011-04, Fair Value Measurement (Topic 820), Amendments to Achieve Common Fair Value Measurements and Disclosure Requirements in U.S. GAAP and IFRS (ASU 2011-04). ASU 2011-04 amends the wording used to describe many of the requirements for measuring fair value to achieve the objective of developing common fair value measurement and disclosure requirements, as well as improving consistency and understandability. Some of the requirements clarify the FASB’s intent about the application of existing fair value measurement requirements while other amendments change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. ASU 2011-04 is effective for calendar years beginning after December 15, 2011. Early adoption is prohibited. The Company has evaluated the potential impact of ASU 2011-04 on the financial position, results of operations, cash flows, and related disclosures and this guidance will not have a material impact to the Company.
Effective January 1, 2011, we adopted FASB ASU 2010-29, “Disclosure of Supplementary Pro Forma Information for Business Combinations,” which 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 clarifies 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 did not impact our financial position, results of operations or cash flows.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest rate exposure
We had cash, cash equivalents and restricted cash totaling $91.2 million and $107.6 million at December 31, 2011 and December 31, 2010, respectively. These amounts were allocated primarily in 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. At December 31, 2011, we had $78.8 million in cash and cash equivalents invested in two money market mutual funds.
Based upon our overall interest rate exposure at December 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 Company’s 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 the Company’s 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 a 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 approximately 0.3% of the Company’s operating income. 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 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Shareholders’ Equity and Other Comprehensive Income
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of
Neutral Tandem, Inc.
Chicago, Illinois
We have audited the accompanying consolidated balance sheets of Neutral Tandem, Inc. and subsidiaries (the “Company”) as of December 31, 2011 and 2010, and the related consolidated statements of income, shareholders’ equity and other comprehensive income, and cash flows for each of the three years in the period ended December 31, 2011. Our audits also included the financial statement schedule listed in the Index at Item 15. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Neutral Tandem, Inc. and subsidiaries as of December 31, 2011 and 2010, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2011, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2011, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 15, 2012 expressed an unqualified opinion on the Company’s internal control over financial reporting.
DELOITTE & TOUCHE LLP
Chicago, IL
March 15, 2012
NEUTRAL TANDEM, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share amounts)
See notes to consolidated financial statements.
NEUTRAL TANDEM, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share amounts)
See notes to consolidated financial statements.
NEUTRAL TANDEM, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY AND OTHER
COMPREHENSIVE INCOME
(Dollars in thousands)
See notes to consolidated financial statements.
NEUTRAL TANDEM, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
See notes to consolidated financial statements.
NEUTRAL TANDEM, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. DESCRIPTION OF THE BUSINESS
Organization -Neutral Tandem, Inc. d/b/a Inteliquent (Inteliquent or 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 Company’s 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 our 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 Tinet’s capital stock, repayment of $31.1 million of Tinet’s debt as part of the closing and $5.4 million in cash acquired. The purchase price was financed with cash from the Company’s balance sheet. $7.5 million of cash consideration was placed in escrow for a period of two years following the acquisition. 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.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation -The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.
Use of Estimates -The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. These accounting principles require management to make certain estimates and assumptions that can affect the reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the consolidated financial statements, as well as the reported amounts of revenues and expenses during the periods presented. The Company believes that the estimates and assumptions upon which it relies are reasonable based upon information available to it at the time that these estimates and assumptions are made. To the extent there are material differences between these estimates and actual results, the Company’s consolidated financial statements will be affected.
Cash and Cash Equivalents -The Company considers all highly liquid investments with an original maturity of 90 days or less to be cash equivalents. The carrying values approximate fair value. At December 31, 2011 the Company had $11.5 million of cash in banks and $78.8 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.
Fair Value of Financial Instruments -The Company’s financial instruments include cash and cash equivalents, receivables and accounts payable. The carrying amounts of the Company’s cash and cash 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 network 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.
Long-lived Assets -The carrying value of long-lived assets, including property and equipment and intangible assets, is evaluated whenever events or changes in circumstances indicate that a potential impairment has occurred. A potential impairment has occurred if projected undiscounted cash flows are less than the carrying value of the assets. The estimated cash flows include management’s assumptions of cash inflows and outflows directly resulting from the use of that asset in operations. The impairment test is a two-step process. If the carrying value of the asset exceeds the expected future undiscounted cash flows from the asset, impairment is indicated. The impairment loss recognized is the excess of the carrying value of the asset over its fair value.
Goodwill and Intangible Assets, Net - Goodwill represents the excess of the purchase price of an acquired business over the amounts assigned to assets and liabilities assumed in the business combination. Goodwill is not amortized. 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).
Revenue Recognition -The Company generates revenue from sales of its voice, IP Transit, and Ethernet telecommunications services. The Company maintains executed service agreements with each of its customers in which specific fees and rates are determined. Revenue is recorded each month based upon documented minutes of traffic switched or internet transit for which service is provided and when collection is probable. The Company provides voice interconnection service primarily to large, well-established competitive carriers, including wireless, wireline and cable and broadband telephony and internet connectivity and Ethernet services carriers, service providers and content providers.
Earnings Per Share -Basic earnings per share is computed based on the weighted average number of common shares and participating securities outstanding. Diluted earnings per share is computed based on the weighted average number of common shares outstanding adjusted by the number of additional shares that would have been outstanding during the period had the potentially dilutive securities been issued. The following table presents a reconciliation of the numerators and denominators of basic and diluted earnings per common share:
Outstanding share-based awards of 2.8 million, 3.4 million, and 1.8 million were outstanding during the years ended December 31, 2011, 2010 and 2009, respectively, but were not included in the computation of diluted earnings per share because the effect would have been anti-dilutive.
For the years ended December 31, 2011, 2010 and 2009, the undistributed earnings allocable to participating securities were $1.1 million, $0.6 million and $0.1 million, respectively.
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 Company’s 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 Company’s current estimates.
The amount of share-based expense recorded in the years ended December 31, 2011, 2010 and 2009 is $15.1 million, $10.1 million, and $5.7 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 11, “Stock Options and Non-vested Shares”.
Income Taxes -Deferred income tax assets and liabilities are recognized for future income tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective income tax bases and for net operating loss and tax credit carryforwards. Deferred income tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred income tax assets and liabilities of a change in income tax rates is recorded in earnings in the period of enactment. A valuation allowance is provided for deferred income tax assets whenever it is more likely than not that future tax benefits will not be realized. Deferred income tax assets are reviewed on a quarterly basis to determine if a valuation allowance is necessary based on current and historical performance, along with other relevant factors.
The income tax provision includes U.S. federal, state and foreign income taxes and is based on pre-tax income or loss.
We recognize the benefits of uncertain tax positions taken or expected to be taken in tax returns in the provision for income taxes only for those positions that are more likely than not to be realized. We follow a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount that is more than 50% likely of being realized upon ultimate settlement. We consider many factors when evaluating and estimating our tax positions and tax benefits, which may require periodic adjustments and which may not accurately forecast actual outcomes. Our policy is to include interest and penalties associated with income tax obligations in income tax expense.
Foreign Currency Translation -The functional currency of each of the Company’s 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 shareholders’ equity.
Concentrations -For the years ended 2011, 2010 and 2009, the aggregate revenues of four customers accounted for 46%, 56% and 57% of total revenues, respectively. At December 31, 2011 and 2010, the aggregate accounts receivable of four customers accounted for 38% and 33% of the Company’s total trade accounts receivable, respectively.
In 2011, the Company had two customers in excess of ten percent of sales, which were 22% and 13% of the Company’s total revenue, respectively. At December 31, 2011, the Company had one customer who accounted for 21% of the Company’s accounts receivable balance.
In 2010, the Company had two customers in excess of ten percent of sales, which were 22% and 18% of the Company’s total revenue, respectively. At December 31, 2010, the Company had one customer who accounted for 15% of the Company’s accounts receivable balance.
In 2009, the Company had three customers in excess of ten percent of sales, which were 23%, 14% and 13% of the Company’s total revenue, respectively.
At December 31, 2011, the Company had $90.3 million in cash and cash equivalents. Of this amount, approximately $78.8 million was invested in two money market mutual funds. Investment policies have been implemented that limit investments to highly liquid investments with an original maturity of 90 days or less.
Recent Accounting Pronouncements - In September 2011, the Financial Accounting Standards Board (FASB) issued accounting standards update 2011-08, Intangibles - Goodwill and Other (Topic 350), Testing Goodwill for Impairment (ASU 2011-08). ASU 2011-08 amends current guidance to allow an entity to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. Under this amendment an entity would not be required to calculate the fair value of a reporting unit unless the entity determines, based on a qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. ASU 2011-08 applies to all companies that have goodwill reported in their financial statements. The provisions of ASU 2011-08 are effective for reporting periods beginning after December 15, 2011. Early adoption is permitted, but the Company has not elected to early adopt. Since ASU 2011-08 does not change the accounting guidance for testing goodwill if the more likely than not qualitative threshold is met, the adoption of this guidance will not affect our financial position, results of operations or cash flows.
In June 2011, the FASB issued accounting standard update 2011-05, Comprehensive Income (Topic 220), Presentation of Comprehensive Income in U.S. GAAP (ASU 2011-05). ASU 2011-05 requires that comprehensive income and the related components of net income and of other comprehensive income be presented in a single continuous statement of comprehensive income or in two separate but consecutive statements. The ASU also requires reclassification adjustments from other comprehensive income to net income be presented on the face of the financial statements. ASU 2011-05 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. However, in December 2011, the FASB issued accounting standard update 2011-12 Comprehensive Income (Topic 220), Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in ASU 2011-05 (ASU 2011-12) to defer the requirement to present reclassification adjustments from other comprehensive income on the face of the financial statements and allow entities to continue to report reclassifications out of accumulated other comprehensive income consistent with the requirements in effect before ASU 2011-05. This guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011, and will be applied retrospectively. As this guidance only revises the presentation of comprehensive income, the adoption of this guidance will not affect our financial position, results of operations or cash flows.
In May 2011, the FASB issued accounting standard update 2011-04, Fair Value Measurement (Topic 820), Amendments to Achieve Common Fair Value Measurements and Disclosure Requirements in U.S. GAAP and IFRS (ASU 2011-04). ASU 2011-04 amends the wording used to describe many of the requirements for measuring fair value to achieve the objective of developing common fair value measurement and disclosure requirements, as well as improving consistency and understandability. Some of the requirements clarify the FASB’s intent about the application of existing fair value measurement requirements while other amendments change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. ASU 2011-04 is effective for calendar years beginning after December 15, 2011. Early adoption is prohibited. The Company has evaluated the potential impact of ASU 2011-04 on the financial position, results of operations, cash flows, and related disclosures and this guidance will not have a material impact to the Company.
Effective January 1, 2011, we adopted FASB ASU 2010-29, “Disclosure of Supplementary Pro Forma Information for Business Combinations,” which 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 clarifies 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 did not impact our financial position, results of operations or cash flows.
3. BUSINESS ACQUISITIONS
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 Tinet’s capital stock, repayment of $31.1 million of Tinet’s debt as part of the closing and $5.4 million in cash acquired. 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 being a primarily U.S. voice interconnection company into being 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.
During the third quarter of 2011, the Company finalized the allocation of the purchase price which resulted in immaterial adjustments to the preliminary purchase price allocation.
The final allocation of the purchase price, translated from Euros into U.S. dollars using the foreign exchange rate at the date of acquisition of October 1, 2010, is as follows:
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.
Supplemental information on an unaudited pro forma basis for the 12 months ended December 31, 2010 and 2009, as if the acquisition had taken place on January 1, 2009, is as follows:
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.
4. PROPERTY AND EQUIPMENT
Property and equipment as of December 31, 2011 and 2010 consists of the following:
5. RECEIVABLES
Receivables as of December 31, 2011 and 2010 consist of the following:
The Company primarily invoices customers for voice services occurring through the 24th of each month. The Company accrues revenue each month for voice services from the 25th through the end of the month resulting in unbilled receivables. The unbilled receivables at the end of each month are billed as part of the following month’s billing cycle. The Company primarily invoices customers for IP Transit and Ethernet services at the end of the month for that month’s services.
6. 401(k) SAVINGS PLAN
The Company sponsors a 401(k) plan covering substantially all employees. The plan is a defined contribution savings plan in which employees may contribute up to 87% of their salary, subject to certain limitations. The Company may elect to make discretionary contributions into the Plan. The Company contributed $0.5 million, $0.4 million and $0.4 million to this plan during the years ended December 31, 2011, 2010 and 2009, respectively.
7. COMMON STOCK
The Company’s total authorized capital stock consists of 150,000,000 shares of common stock, par value $0.001 per share.
Voting-Each holder of common stock has one vote in respect to each share of stock held on record for the election of directors and on all matters submitted to a vote of shareholders of the Company.
Dividends-Subject to the preferential rights of any outstanding preferred stock, the holders of shares of common stock are entitled to receive, when and if declared by the Board of Directors, out of assets of the Company which are by law available therefore, dividends payable either in cash, in property or in shares of capital stock.
Liquidation-In the event of any liquidation, dissolution or winding up of the Company, after distribution in full of the preferential amounts, if any, to be distributed to the holders of shares of any outstanding preferred stock, holders of all common stock shares, including converted preferred stock, are entitled to receive all of the remaining assets of the Company of whatever kind available for distribution to shareholders ratably in proportion to the number of shares of common stock held by them respectively.
8. COMMITMENTS AND CONTINGENCIES
Operating Leases - The Company leases its facilities and certain equipment under operating leases which expire through February 2025. Rental expense for the years ended December 2011, 2010 and 2009 was $6.0 million, $4.8 million, and $4.3 million, respectively.
The following table represents future lease payments under the operating leases:
Purchase Commitment - We have a service agreement with a major telecommunications service provider, where we have committed to purchase a minimum amount of service beginning in 2011 through 2015.
Indefeasible right of use operating expense Commitment - We have a number of indefeasible rights of use (IRUs) which represent contractual agreements between the operators of a communications cable or between the operator of a communications cable and a customer that needs this capacity to provide telecom services. It is defined as the exclusive, unrestricted and indefeasible right to use the relevant capacity (including equipment, fibers or capacity) for any legal purpose. With the right to use the IRUs comes an obligation to pay a proportion of the operating cost and contractually defined amounts related to the cost of maintaining the cable, including any costs incurred repairing the cable after mishaps. These contracts extend through 2019.
Legal Proceedings - From time to time, the Company is a party to legal proceedings arising in the normal course of its business. Aside from the matter discussed below, the Company does not believe that it is a party to any pending legal action that could reasonably be expected to have a material adverse effect on its business or operating results, financial position or cash flows.
Peerless Network, Inc.
Proceeding in the United States District Court for the Northern District of Illinois
As previously disclosed, 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 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 Company’s complaint denying liability and asserting various affirmative defenses and counterclaims. Peerless Network generally alleged (i) that the ‘708 Patent was invalid and unenforceable under a variety of theories, (ii) that assertion of the’708 Patent amounted 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 Company’s motion to dismiss the claims alleging business disparagement and Lanham Act violations but denied the Company’s 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 Company’s 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 under “Inter partes proceeding before the United States Patent and Trademark Office” 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 court’s 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 Network’s 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 Company’s request to reinstate the trial date as moot.
The court’s September 2, 2010 order also denied the Company’s 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 Network’s 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 Network’s claim that the ‘708 Patent is unenforceable. The court also dismissed Counts IV-VII of Peerless Network’s 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.
On December 9, 2010, the court issued an opinion and order granting the Company’s motion for summary judgment on Peerless Network’s 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 planned to appeal the court’s order granting Peerless Network’s motion for summary judgment and finding that the ‘708 Patent is invalid. On January 13,
2011, Peerless Network cross-appealed the court’s order granting the Company’s motion for summary judgment and finding that the ‘708 Patent is not unenforceable, as well as the court’s earlier ruling construing disputed terms of the patent in the Company’s favor.
On June 6, 2011, Peerless Network agreed to withdraw its cross-appeal. Briefing in the Company’s appeal was completed on July 19, 2011. Oral argument in the Company’s appeal occurred on December 8, 2011. On December 13, 2011, the federal appellate court affirmed the finding that our patent is invalid, and on January 30, 2012, the appellate court denied our petition for rehearing of the December 13, 2011 ruling. The Company has the option to ask the United States Supreme Court to review that ruling. A petition for such review would be due by April 30, 2012. The Supreme Court grants a very small percentage of such requests for review.
On September 1, 2011, the district court issued an order that awarded approximately $102,000 in litigation-related costs to Peerless Network, and approximately $48,000 in litigation-related costs to the Company. The Company filed notice that it planned to appeal that part of the court’s order awarding costs to Peerless Network on September 30, 2011. Peerless Network has not cross-appealed the court’s award of costs to the Company.
On December 13, 2011, the federal appellate court affirmed the finding that the Company’s patent is invalid, and on January 30, 2012, the appellate court denied the Company’s petition for rehearing of the December 13, 2011 ruling. The Company has the option to ask the United States Supreme Court to review that ruling. A petition for such review would be due by April 30, 2012. The Supreme Court grants a very small percentage of such requests for review.
Peerless Network has notified us that it intends to pursue a claim for attorney’s fees in the trial court. The trial court has stayed proceedings with respect to this potential claim pending resolution of our appeal. The Company believes that a loss with respect to any such claim, if such a claim is made, is remote.
Inter partes proceeding before the United States Patent and Trademark Office
As previously disclosed, 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 Network’s inter partes reexamination request and issued an initial office action which rejected the ‘708 Patent’s 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 USPTO’s rules, the Company was not allowed to respond to Peerless Network’s request prior to the USPTO’s initial determination.
On May 20, 2010, the USPTO granted the Company’s 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 Company’s 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 USPTO’s 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 Patent’s 23 original claims, as well as 35 additional claims added to the ‘708 Patent in the Company’s July 26, 2010 response.
On January 7, 2011, the Company filed a response to the USPTO’s November 24, 2010 action closing prosecution. Thereafter, Peerless Network filed comments in opposition to the Company’s 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 Patent’s 23 original claims, as well as the 35 additional claims added to the ‘708 Patent in the Company’s July 26, 2010 response.
On April 11, 2011, the Company filed a notice of appeal of the USPTO’s decision to the BPAI. Peerless Network filed a notice of appeal of the USPTO’s decision to the BPAI on April 19, 2011. Briefing in those appeals was completed in December 2011.
If the decision of the federal district court finding our patent invalid becomes final and nonappealable, proceedings at the USPTO will end with respect to existing claims, though we may ask the USPTO to continue proceedings with respect to new claims. If the decision of the federal district court finding our patent invalid does not become final and nonappealable, the BPAI will review the parties’ positions on appeal. In that event, after reviewing the parties’ positions on appeal, the BPAI may affirm the USPTO’s 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.
The USPTO action will determine whether the patent is valid or invalid. The USPTO will not directly assess liability against the Company or Peerless Network. For a discussion of the Company’s patent infringement claim against Peerless Network, see “Proceeding in the United States District Court for the Northern District of Illinois” above.
9. GOODWILL AND INTANGIBLES, NET
Goodwill and intangible assets were recognized in 2010 as a result of the acquisition of Tinet.
The following summarizes goodwill and intangible assets, net activity:
During the year ended December 31, 2011, we finalized the valuation of certain liabilities acquired related to our 2010 acquisition. As these adjustments did not have a material impact on our financial position or results of operations, we recorded these adjustments to goodwill during the year ended December 31, 2011.
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’s reporting units are the Americas, Europe, Middle East & Africa (EMEA) and Asia Pacific (APAC). The evaluation is based upon the estimated fair value of the Company’s reporting units compared to the net carrying value of assets and liabilities. The Company uses internal discounted cash flow estimates and market value comparisons to determine estimated fair value. If this first test indicates that impairment potentially exists, the second step is performed to measure the amount of impairment, if any. Goodwill impairment exists when the
estimated implied fair value of goodwill, a non-recurring Level 3 fair value measurement, is less than its carrying value.
In October 2011, the Company established the Americas, EMEA and APAC reporting units as part of an internal reorganization. Before October 2011, the Company operated as one reporting unit.
The annual assessment occurs in the fourth quarter of each year. In the fourth quarter of 2011, we performed a quantitative assessment of goodwill for the three reporting units. In our step one calculation, we established the fair value of the reporting units using weightings of the results of a discounted cash flow methodology and a comparative market multiples approach. We believe that using two methods to determine fair value limits the chances of an unrepresentative valuation. The results of this test indicated that the goodwill was not impaired. A 10% decrease in the fair value estimate of the each of the reporting units would not have changed this determination.
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 $2.3 million in 2011 and $0.6 million in 2010. Intangible asset amortization for each of the five succeeding fiscal years ending December 31, 2016 is estimated to be $2.5 million, $2.9 million, $2.8 million, $2.4 million and $2.0 million, respectively.
Additionally, intangible assets, net consist of the following:
10. INCOME TAXES
Prior to the Company’s acquisition of Tinet in October 2010, all earnings were domestic. Earnings before taxes, and the related provisions for taxes on earnings, for the years ended December 31 2011, 2010 and 2009, were as follows:
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company’s deferred income taxes are as follows:
The Company’s effective income tax rate was 40.9% for the year ended December 31, 2011, compared to 40.8% for the year ended December 31, 2010. The difference results significantly from the local tax impact of the Company’s foreign operations and items related to 2010 filings, specifically R&D credits and an increase in transaction costs deduction. The change in the effective tax rate from 40.8% for the year ended December 31, 2010 compared to 36.3% for the year ended December 31, 2009 was primarily due to nondeductible transaction costs associated with the acquisition of Tinet and the establishment of the Illinois EDGE credit valuation allowance.
A reconciliation of the federal statutory rate to our effective tax rate is as follows:
The Company’s foreign subsidiaries are treated for U.S. tax purposes as controlled foreign corporations. The Company does not provide for U.S. income taxes and foreign withholding taxes on the undistributed earnings of our foreign subsidiaries as it is the company’s intention that the earnings will be reinvested indefinitely.
The Company has a statutory net operating loss for its Italian entity of $1.3 million, per the Italian tax rules the NOL has no expiration and can be carried forward indefinitely.
The Company’s state income tax credit carry forward, the Illinois EDGE credit, can be carried forward five years. For the year ended December 31, 2011, the Company released a partial valuation allowance of $0.6 million as the Company believed it was more likely than not that future taxable income will be sufficient to realize the full benefit of the credit.
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 Company’s 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 Company files income tax returns in the U.S. federal jurisdiction, various states and local jurisdictions and foreign jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations by tax authorities for years before 2008. The Company’s wholly-owned Italian subsidiary files income tax returns in Italy and various foreign jurisdictions. With few exceptions the Company’s wholly-owned subsidiary is no longer subject to examinations by tax authorities for years prior to 2007 in jurisdictions where it files tax returns.
The IRS has completed an examination of the federal income tax return the Company filed for the year 2008. The IRS did not propose any adjustments to the Company’s 2008 income tax return.
The Company’s liabilities for uncertain tax positions totaled $0.6 million at December 31, 2011 and $0.2 million at December 31, 2010. A reconciliation of the beginning and ending amount of uncertain tax positions is as follows:
The Company recognizes accrued interest and penalties related to its unrecognized tax benefits as income tax expense. At December 31, 2011, the Company has included $0.3 million related to interest and penalty expense as a component of income tax expense in the consolidated statement of operations. At December 31, 2010, the Company has included $0.1 million related to interest and penalty expense as a component of income tax expense in the consolidated statement of operations. As of December 31, 2011 and 2010 the company has recorded liabilities of $0.4 million and $0.1 million, respectively, for the payment of interest and penalties. The total amount of unrecognized tax benefits, if recognized, would affect the effective tax rate.
The Company operates in multiple income tax jurisdictions both inside and outside the United States. Accordingly, we expect that the amount of tax liability for unrecognized tax benefits will change in the next twelve months due to changes in audit status, expiration of statutes of limitations and other events which could impact our determination of unrecognized tax benefits. However, an estimate of the range of potential changes cannot be determined at this time.
11. STOCK OPTIONS AND NON-VESTED SHARES
The Company established the 2003 Stock Option and Stock Incentive Plan (2003 Plan), which provided for issuance of up to 4.7 million options and non-vested shares to eligible employees, officers, and independent contractors of the Company. In 2007 the Company adopted the Neutral Tandem, Inc. 2007 Long-Term Equity Incentive Plan (2007 Plan) and ceased awarding equity grants under the 2003 plan. As of December 31, 2011, the Company had granted a total of 3.5 million options and 1.1 million non-vested shares that remained outstanding under the 2007 Plan. Awards for 0.4 million shares, representing approximately 1.2% of the Company’s outstanding common stock as of December 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 years ended December 31, 2011 and 2010, the Company granted 0.5 million and 0.1 million options at a weighted-average exercise price of $14.11 and $15.01, respectively.
The fair value of each option granted is estimated on the date of grant using the Black- Scholes option-pricing model. For the years ended December 31, 2011, 2010 and 2009, fair value of stock options was measured using the following assumptions:
The weighted-average fair value of options granted, as determined by using the Black-Scholes valuation model, during the period was $7.82, $8.42 and $14.41 for the years ended December 31, 2011, 2010 and 2009, respectively. The total grant date fair value of options that vested during years ended December 31, 2011, 2010 and 2009 was approximately $7.7 million, $8.3 million and $5.1 million, respectively. The total intrinsic value (market value of stock less option exercise price) of stock options exercised was $1.1 million, $0.7 million and $27.5 million during the years ended December 31, 2011, 2010 and 2009, respectively.
The following summarizes activity under the Company’s stock option plan:
The unrecognized compensation cost associated with options outstanding at December 31, 2011 and 2010 is $8.5 million and $13.1 million, respectively. The weighted average remaining term that the compensation will be recorded is 2.2 years and 2.2 years as of December 31, 2011 and 2010, respectively.
Non-vested Shares
During the years ended December 31, 2011 and 2010, the Company’s Board of Directors granted approximately 0.5 million and 0.8 million non-vested shares, respectively, to members of the Company’s executive management team as well as various employees within the Company. 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 Company’s 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.
A summary of the Company’s non-vested share activity and related information for the year ended December 31, 2011 and 2010 is as follows:
The aggregate intrinsic value represents the total pre-tax intrinsic value base on the Company’s closing stock price of $10.69 on December 31, 2011. The amount changes based upon the fair market value of the Company’s common stock.
The unrecognized compensation cost associated with non-vested shares at December 31, 2011 and 2010 is $14.3 million and $16.3 million, respectively. The weighted average remaining term that the compensation will be recorded is 2.4 years and 3.2 years as of December 31, 2011 and 2010, respectively.
During the first quarter of 2011, Rian J. Wren, the Company’s 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 were fully vested as of March 31, 2011. Non-cash compensation expense of $15.1 million recorded during the year ended December 31, 2011 includes $2.0 million related to the acceleration of options and $1.6 million related to the acceleration of non-vested shares.
12. 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 Company’s 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 upon the Company’s international telecommunications network to fulfill customer agreements. Therefore, the Company has concluded that it has only one operating segment.
Prior to the Company’s acquisition of Tinet, all revenues and assets were in the United States of America. The following is a summary of geographical information as of and for the year ended December 31, 2011 and 2010 (in thousands:)
Revenue from transoceanic services is geographically determined by the customers’ legal address, since IP Transit services are global services and the Company does not track the routing used to carry traffic.
The Company includes all non-current assets, except for goodwill and customer intangibles, in its long-lived assets.
13. QUARTERLY FINANCIAL DATA (UNAUDITED)
(1) The sum of the four quarters is not necessarily the same as the total for the year.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures
Our Chief Executive Officer and Chief Financial Officer, after evaluating the effectiveness of our “disclosure controls and procedures” (as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, or the “Act”), have concluded that, as of the end of the fiscal year covered by this report, our disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Act is accumulated and communicated to the issuer’s management, including its principal executive officer or officers and principal financial officer or officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure.
(b) Management Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control system was designed to provide reasonable assurance to management and our Board of Directors regarding the preparation and fair presentation of published financial statements.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.
Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2011. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission, or COSO, in Internal Control-Integrated Framework . Based on its assessment, management believes that, as of December 31, 2011, our internal control over financial reporting is effective based on those criteria.
Our independent registered public accounting firm has issued an attestation report on our internal control over financial reporting. This report appears below.
(c) Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of
Neutral Tandem Inc.
Chicago, IL
We have audited the internal control over financial reporting of Neutral Tandem Inc. (the “Company”) as of December 31, 2011, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and financial statement schedule as of and for the year ended December 31, 2011 of the Company and our report dated March 15, 2012 expressed an unqualified opinion on those financial statements and financial statement schedule.
DELOITTE & TOUCHE LLP
Chicago, IL
March 15, 2012
(d) Changes in Internal Control over Financial Reporting
No changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended December 31, 2011 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting except for controls implemented related to our goodwill impairment assessment.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information required by this item with respect to Neutral Tandem’s directors and executive officers is incorporated by reference to the information set forth in Neutral Tandem’s proxy statement for the 2011 Annual Meeting of Stockholders to be filed with the Commission within 120 days after the end of Neutral Tandem’s fiscal year ended December 31, 2011. For information pertaining to executive officers and directors of Neutral Tandem, refer to the “Management” section of Part 1, Item 1 of this annual report on Form 10-K.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information responsive to this item is incorporated herein by reference to Neutral Tandem’s definitive proxy statement with respect to our 2012 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of the fiscal year covered by this annual report on Form 10-K.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Information with respect to the security ownership of any person that we know to beneficially own more than 5% of Neutral Tandem’s common stock and by each Neutral Tandem director, each Neutral Tandem named executive officer, and all directors and executive officers as a group, can be found in Neutral Tandem’s definitive proxy statement with respect to our 2011 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of the fiscal year covered by this annual report on Form 10-K.
Information relating to securities authorized under our equity compensation plans as of December 31, 2011 is set forth in Footnote 11 to the audited financial statements included in this Annual Report on Form 10-K. Each plan reflected therein was approved by our security holders.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Information responsive to this item is incorporated herein by reference to Neutral Tandem’s definitive proxy statement with respect to our 2011 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of the fiscal year covered by this annual report on Form 10-K.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information responsive to this item is incorporated herein by reference to Neutral Tandem’s definitive proxy statement with respect to our 2011 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of the fiscal year covered by this annual report on Form 10-K.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a)(1) Consolidated Financial Statements
This Annual Report on Form 10-K contains the following financial statements which appear under Part II, Item 8 of this Form 10-K on the pages noted below:
Page
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Shareholders’ Equity and Comprehensive Income
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm on Internal Control over Financial Reporting
(a)(2) Financial Statement Schedules
Schedule II: Valuation and Qualifying Accounts
Schedules not listed above have been omitted because the information required to be set forth therein is not applicable or is shown in the consolidated financial statements or notes thereto.
(a)(3) Exhibits.
See Index to Exhibits. The Exhibits listed in the accompanying Index to Exhibits are filed or incorporated by reference as part of this annual report on Form 10-K.
Exhibit
Number
Description of Exhibit
2.1
Agreement for the Sale and Purchase of Tinet S.p.A., dated as of September 9, 2010, by and between Neutral Tandem, Inc., on the one hand, and BS Investimenti SGR S.p.A. (on behalf of the investment fund “BS Investimenti IV”), BS Private Equity S.p.A., Mauro Righetti, Paolo Susnik, Paolo Gambini, Maurizio Binello, Luciana Giordo, Francisco Rey and Sven Englehardt, on the other hand (1)
3.1
Amended and Restated Certificate of Incorporation of Neutral Tandem, Inc. (2)
3.2
Amended and Restated Bylaws of Neutral Tandem, Inc. (3)
4.1
Specimen certificate evidencing shares of common stock (2)
* Filed herewith
(1) Filed as an exhibit to the Registrant’s Form 8-K filed on September 10, 2010 and incorporated herein by reference.
(2) Filed as an exhibit to Registration Statement on Form S-1 (File No. 333-140127) and incorporated herein by reference.
(3) Filed as an exhibit to the Registrant’s Form 8-K filed on May 26, 2010 and incorporated herein by reference.
(4) Filed as an exhibit to the Registrant’s Form 10-K filed on March 5, 2008 and incorporated herein by reference.
(5) Filed as an exhibit to the Registrant’s Form 8-K filed on March 13, 2008 and incorporated herein by reference.
(6) Filed as an exhibit to the Registrant’s Form 10-K filed on March 13, 2009 and incorporated herein by reference.
(7) Filed as an exhibit to the Registrant’s Form 10-K filed on May 7, 2010 and incorporated herein by reference.
(8) Filed as an exhibit to the Registrant’s Form 10-Q filed on November 9, 2010 and incorporated herein by reference.
(9) Filed as an exhibit to the Registrant’s Form 10-K filed on March 16, 2011 and incorporated herein by reference.
(10) Filed as an exhibit to the Registrant’s Form 8-K filed on April 19, 2011 and incorporated herein by reference.
(11) Filed as an exhibit to the Registrant’s Form 10-Q filed on May 10, 2011 and incorporated herein by reference.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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 on March 15, 2012.
NEUTRAL TANDEM, INC.
By:
/S/ G. EDWARD EVANS
G. Edward Evans, Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities indicated below on March 15, 2012.
Signature
Title
/S/ G. EDWARD EVANS
G. Edward Evans
Chief Executive Officer and Director (Principal Executive Officer)
/S/ SURENDRA SABOO
Surendra Saboo
President and Chief Operating Officer
/S/ ROBERT M. JUNKROSKI
Robert M. Junkroski
Chief Financial Officer (Principal Financial and Accounting Officer)
/S/ JAMES P. HYNES
James P. Hynes
Director, Chairman
/S/ PETER J. BARRIS
Peter J. Barris
Director
/S/ ED GREENBERG
Ed Greenberg
Director
/S/ ROBERT C. HAWK
Robert C. Hawk
Director
/S/ LAWRENCE M. INGENERI
Lawrence M. Ingeneri
Director
/S/ TIMOTHY SAMPLES
Timothy Samples
Director
/S/ RIAN J. WREN
Rian J. Wren
Director