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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-Q

 

 

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2011

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission file number: 001-33778

 

 

NEUTRAL TANDEM, INC.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   31-1786871

(State or other Jurisdiction of

Incorporation or Organization)

 

(IRS Employer

Identification No.)

550 West Adams Street

Suite 900

Chicago, IL 60661

(Address of principal executive offices, including zip code)

(312) 384-8000

(Registrant’s telephone number, including area code)

 

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer   ¨    Accelerated filer   x
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)    Smaller reporting company   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

As of October 31, 2011, 31,445,348 shares of the registrant’s Common Stock, $0.001 par value, were issued and outstanding (net of 3,083,446 shares of Common Stock held in treasury at October 31, 2011).

 

 

 


Table of Contents

NEUTRAL TANDEM, INC.

INDEX

 

          Page  
PART I. FINANCIAL INFORMATION   

Item 1.

   Condensed Consolidated Financial Statements (Unaudited)      3   
   Condensed Consolidated Balance Sheets — September 30, 2011 and December 31, 2010      3   
   Condensed Consolidated Statements of Income — Three and nine months ended September 30, 2011 and September 30, 2010      4   
   Condensed Consolidated Statements of Cash Flows — Nine months ended September 30, 2011 and September 30, 2010      5   
   Notes to Condensed Consolidated Financial Statements      6   

Item 2.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations      13   

Item 3.

   Quantitative and Qualitative Disclosures about Market Risk      20   

Item 4.

   Controls and Procedures      20   
PART II. OTHER INFORMATION   

Item 1.

   Legal Proceedings      21   

Item 1A.

   Risk Factors      22   

Item 6.

   Exhibits      25   


Table of Contents

PART I. FINANCIAL INFORMATION

 

Item 1. Condensed Consolidated Financial Statements (Unaudited)

NEUTRAL TANDEM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share amounts)

(Unaudited)

 

     September 30,
2011
    December 31,
2010
 

ASSETS

    

Current assets:

    

Cash and cash equivalents

   $ 83,656      $ 106,674   

Receivables

     44,296        38,610   

Deferred income taxes-current

     2,427        1,855   

Prepaid expenses

     9,534        7,647   
  

 

 

   

 

 

 

Total current assets

     139,913        154,786   

Property and equipment — net

     76,943        77,683   

Intangible assets — net

     30,637        31,506   

Goodwill

     50,546        49,098   

Restricted cash

     962        962   

Other assets

     2,842        1,492   
  

 

 

   

 

 

 

Total assets

   $ 301,843      $ 315,527   
  

 

 

   

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

    

Current liabilities:

    

Accounts payable

   $ 10,119      $ 13,748   

Accrued liabilities:

    

Taxes payable

     792        664   

Circuit cost

     12,303        10,508   

Rent

     1,558        1,285   

Payroll and related items

     5,503        3,770   

Other

     4,189        2,968   
  

 

 

   

 

 

 

Total current liabilities

     34,464        32,943   

Other liabilities

     1,340        914   

Deferred income taxes-noncurrent

     10,362        10,387   
  

 

 

   

 

 

 

Total liabilities

     46,166        44,244   

Commitments and contingencies

     —          —     

Shareholders’ equity:

    

Preferred stock — par value of $.001; 50,000,000 authorized shares; no shares issued and outstanding at September 30, 2011 and December 31, 2010

     —          —     

Common stock — par value of $.001; 150,000,000 authorized shares; 31,447,098 shares and 33,166,242 shares issued and outstanding at September 30, 2011 and December 31, 2010

     31        33   

Less treasury stock, at cost; 3,083,446 in 2011 and no shares in 2010

     (50,106 )     —     

Additional paid-in capital

     182,664        171,343   

Accumulated other comprehensive loss

     (19 )     (2,117 )

Retained earnings

     123,107        102,024   
  

 

 

   

 

 

 

Total shareholders’ equity

     255,677        271,283   
  

 

 

   

 

 

 

Total liabilities and shareholders’ equity

   $ 301,843      $ 315,527   
  

 

 

   

 

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

3


Table of Contents

NEUTRAL TANDEM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share amounts)

(Unaudited)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
         2011             2010             2011             2010      

Revenue

   $ 67,310      $ 46,454      $ 198,818      $ 136,040   

Operating expense:

        

Network and facilities expense (excluding depreciation and amortization)

     28,724        16,109        80,797        45,044   

Operations

     10,334        5,921        29,107        17,155   

Sales and marketing

     3,383        568        9,851        1,613   

General and administrative

     6,352        6,369        22,771        19,429   

Depreciation and amortization

     7,520        4,180        22,040        12,223   

Loss (gain) on disposal of fixed assets

     159        (7 )     147        (74 )
  

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expense

     56,472        33,140        164,713        95,390   
  

 

 

   

 

 

   

 

 

   

 

 

 

Income from operations

     10,838        13,314        34,105        40,650   
  

 

 

   

 

 

   

 

 

   

 

 

 

Other (income) expense:

        

Interest expense

     —          —          —          4   

Interest income

     (2 )     (50 )     (32 )     (176 )

Other expense (income)

     60        (1,915 )     420        (2,126 )

Foreign exchange loss (gain)

     2,068        —          (317 )     —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Total other (income) expense

     2,126        (1,965 )     71        (2,298 )
  

 

 

   

 

 

   

 

 

   

 

 

 

Income before income taxes

     8,712        15,279        34,034        42,948   

Provision for income taxes

     2,864        5,716        12,950        16,417   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

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

 

 

   

 

 

   

 

 

   

 

 

 

Net income per share:

        

Basic

   $ 0.19      $ 0.29      $ 0.63      $ 0.80   
  

 

 

   

 

 

   

 

 

   

 

 

 

Diluted

   $ 0.18      $ 0.29      $ 0.63      $ 0.79   
  

 

 

   

 

 

   

 

 

   

 

 

 

Weighted average number of shares outstanding:

        

Basic

     31,450        33,068        33,219        33,164   
  

 

 

   

 

 

   

 

 

   

 

 

 

Diluted

     31,849        33,506        33,643        33,616   
  

 

 

   

 

 

   

 

 

   

 

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

4


Table of Contents

NEUTRAL TANDEM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 

     Nine Months Ended
September 30,
 
     2011     2010  

Cash Flows From Operating Activities:

    

Net income

   $ 21,084      $ 26,531   

Adjustments to reconcile net cash flows from operating activities:

    

Depreciation and amortization

     22,040        12,223   

Deferred income taxes

     (536 )     (1,436 )

Loss (gain) on disposal of fixed assets

     147        (74 )

Non-cash share-based compensation

     12,345        7,185   

Changes in fair value of ARS

     —          (923 )

Changes in fair value of ARS rights

     —          712   

Changes in fair value of currency contract

     —          (1,915 )

Excess tax deficiency associated with share-based payments

     220        301   

Changes in assets and liabilities:

    

Receivables

     (5,383 )     2,476   

Other current assets

     (1,792 )     (2,441 )

Other noncurrent assets

     (1,609 )     26   

Accounts payable

     (3,399 )     228   

Accrued liabilities

     4,895        3,610   

Noncurrent liabilities

     45        —     
  

 

 

   

 

 

 

Net cash flows from operating activities

     48,057        46,503   
  

 

 

   

 

 

 

Cash Flows From Investing Activities:

    

Purchase of equipment

     (19,578 )     (9,530 )

Proceeds from sale of equipment

     16        81   

Increase in restricted cash

     —          (467 )

Purchase of other investments

     (500 )     —     

Proceeds from the redemption of ARS

     —          17,125   
  

 

 

   

 

 

 

Net cash flows from investing activities

     (20,062 )     7,209   
  

 

 

   

 

 

 

Cash Flows From Financing Activities:

    

Proceeds from the exercise of stock options

     219        49   

Restricted shares withheld to cover employee taxes paid

     (1,026 )     (253 )

Excess tax deficiency associated with share-based payments

     (220 )     (301 )

Payments made for repurchase of common stock

     (50,106 )     (9,556 )

Principal payments on long-term debt

     —          (235 )
  

 

 

   

 

 

 

Net cash flows from financing activities

     (51,133 )     (10,296 )
  

 

 

   

 

 

 

Effect of exchange rate changes on cash

     120        —     

Net (Decrease) Increase In Cash And Cash Equivalents

     (23,018 )     43,416   

Cash And Cash Equivalents — Beginning

     106,674        161,411   
  

 

 

   

 

 

 

Cash And Cash Equivalents — End

   $ 83,656      $ 204,827   
  

 

 

   

 

 

 

Supplemental Disclosure Of Cash Flow Information:

    

Cash paid for interest

   $ —        $ 242   
  

 

 

   

 

 

 

Cash paid for taxes

   $ 15,387      $ 19,063   
  

 

 

   

 

 

 

Supplemental Disclosure Of Noncash Flow Items:

    

Investing Activity — Accrued purchases of equipment

   $ 2,818      $ 2,373   
  

 

 

   

 

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

5


Table of Contents

NEUTRAL TANDEM, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. DESCRIPTION OF THE BUSINESS

Organization — Neutral Tandem, Inc. (the Company) provides U.S. and international voice, IP Transit, and Ethernet telecommunications services primarily on a wholesale basis. The Company offers these services using an all-IP network, which enables the Company to deliver global connectivity for a variety of media, including voice, data and video. The 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 its solutions to customers, like content providers, who also typically do not have their own network.

Acquisition of Tinet S.p.A. — On October 1, 2010 the Company completed its acquisition of Tinet S.p.A. (Tinet) for $103.1 million, comprised of $77.4 million, in cash, paid on October 1, 2010 for the outstanding shares of 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. Additionally, the Company recorded approximately $4.0 million for acquisition-related costs, including legal, accounting and advisory services in its statement of income.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation — The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.

Interim Condensed Consolidated Financial Statements — The accompanying condensed consolidated balance sheets as of September 30, 2011 and December 31, 2010, the condensed consolidated statements of income for the three and nine months ended September 30, 2011 and 2010, and the condensed consolidated statements of cash flows for the nine months ended September 30, 2011 and 2010 are unaudited. The condensed consolidated balance sheet data as of December 31, 2010 was derived from the audited consolidated financial statements which are included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010. The accompanying statements should be read in conjunction with the audited consolidated financial statements and related notes contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles (GAAP) pursuant to the rules and regulations of the Securities and Exchange Commission applicable to interim periods. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations.

In the opinion of management, the unaudited interim condensed consolidated financial statements as of September 30, 2011 and for the three and nine months ended September 30, 2011 and 2010 have been prepared on the same basis as the audited consolidated statements and reflect all adjustments, which are normal recurring adjustments, necessary for the fair presentation of its statement of financial position, results of operations and cash flows. The results of operations for the three and nine months ended September 30, 2011 are not necessarily indicative of the operating results for any subsequent quarter, for the full fiscal year or any future periods.

Cash and Cash Equivalents — The Company considers all highly liquid investments with an original maturity of 90 days or less to be cash and cash equivalents. At September 30, 2011 the Company had $8.9 million of cash in banks and $74.8 million in two money market mutual funds. At December 31, 2010, the Company had $12.9 million of cash in banks and $93.8 million in two money market mutual funds.

The carrying amounts of our cash and 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 switch equipment and tools and test equipment is five years. The estimated useful life for computer equipment, computer software and furniture and fixtures is three years. Leasehold improvements are amortized on a straight-line basis over an estimated useful life of five years or the life of the lease, whichever is less. The impairment of long-lived assets is periodically evaluated when events or changes in circumstances indicate that a potential impairment has occurred.

Goodwill and Intangible Assets, Net — Goodwill and intangible assets were recognized in 2010 as a result of the acquisition of Tinet.

In accordance with the provisions of ASC Topic 350, Intangibles — Goodwill and Other (ASC 350), goodwill is not amortized but is tested for impairment at least annually, or more frequently if an event occurs or circumstances change that would reduce the fair value of a reporting unit below its carrying value. The Company’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.

 

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Table of Contents

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. Due to the timing of the Company’s internal reorganization, the level of analysis that will be performed for this year’s goodwill impairment test will be at a level lower than previously considered.

Factors that the Company will consider in the fourth quarter when estimating the fair value of the new reporting units include (i) projected revenues and operating margins and (ii) higher spending expected for strategic product expansion, in the near-term to mid-term with benefit to revenues and operating margin trailing the increased spending.

The change in the carrying amount of goodwill during the nine months ended September 30, 2011, is as follows:

 

(Dollars in thousands)

   December 31,
2010
     Currency Translation
Effect and Other
     September 30,
2011
 

Goodwill

   $ 49,098       $ 1,448       $ 50,546   

During the nine months ended September 30, 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 in the nine month period ended September 30, 2011.

Intangible assets, net consist of the following:

 

      September 30, 2011  

(Dollars in thousands)

   Gross Carrying
Amount
     Accumulated
Amortization
    Net Intangible
Assets
 

Customer relationships

   $ 32,904       $ (2,267 )   $ 30,637   
      December 31, 2010  

(Dollars in thousands)

   Gross Carrying
Amount
     Accumulated
Amortization
    Net Intangible
Assets
 

Customer relationships

   $ 32,072       $ (566 )   $ 31,506   

Intangible assets, which consist of customer relationships, have a definite life and are amortized on an accelerated basis based on the discounted cash flows recognized over their estimated useful lives (15 years). Intangible asset amortization expense was $0.6 million and $1.7 million, in the three and nine months ended September 30, 2011, respectively. Intangible asset amortization for each of the five succeeding fiscal years is estimated at $2.3 million for 2011, $2.5 million for 2012, $2.9 million for 2013, $2.8 million for 2014, and $2.4 million for 2015.

Revenue Recognition — The Company generates revenue from sales of its voice, IP Transit, and Ethernet services. The Company maintains tariffs and executed service agreements with each of its customers in which specific fees and rates are determined. Voice revenue is recorded each month on an accrual basis based upon minutes of traffic switched by the Company’s network by each customer, which is referred to as minutes of use. The rates charged per minute are determined by contracts between the Company and its customers or by filed and effective tariffs.

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

Earnings per Share — Basic earnings per share is computed based on the weighted average number of shares of common stock outstanding. Diluted earnings per share is computed based on the weighted average number of shares of common stock outstanding adjusted by the number of additional shares of common stock that would have been outstanding had the potentially dilutive shares of common stock been issued. Potentially dilutive shares of common stock include stock options and non-vested shares. The following table presents a reconciliation of the numerators and denominators of basic and diluted earnings per share of common stock:

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 

(In thousands, except per share amounts)

   2011      2010      2011      2010  

Numerator:

           

Net income applicable to common stockholders, as reported

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

Denominator:

           

Weighted average common shares outstanding

     31,450         33,068         33,219         33,164   

Effect of dilutive securities:

           

Stock options

     399         438         424         452   
  

 

 

    

 

 

    

 

 

    

 

 

 

Denominator for diluted earnings per share

     31,849         33,506         33,643         33,616   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net earnings per share:

           

Basic — as reported

   $ 0.19       $ 0.29       $ 0.63       $ 0.80   
  

 

 

    

 

 

    

 

 

    

 

 

 

Diluted — as reported

   $ 0.18       $ 0.29       $ 0.63       $ 0.79   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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Table of Contents

Options to purchase 2.8 million, 2.3 million, 2.8 million and 2.3 million shares of common stock were outstanding during the three months ended September 30, 2011 and September 30, 2010 and the nine months ended September 30, 2011 and September 30, 2010, respectively, but were not included in the computation of diluted earnings per share because the effect would have been antidilutive.

Accounting for Stock-Based Compensation — 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.

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 5, “Stock Options and Non-Vested Shares.”

The amount of share-based expense recorded in the three months ended September 30, 2011 and 2010, is $2.9 million and $2.4 million, respectively. The amount of share-based expense recorded in the nine months ended September 30, 2011 and 2010, is $12.3 million and $7.2 million, respectively.

Stock Repurchase — On February 16, 2010, the Company announced that its Board of Directors authorized the repurchase of up to $25.0 million of our outstanding common stock as part of a stock repurchase program. In the nine months ended September 30, 2010, the Company repurchased and retired approximately 0.6 million shares for $9.6 million under the program at an average cost of $15.78 per share. The stock repurchases are accounted for under the cost method whereby the entire cost of the repurchased and retired shares, net of par value, was recorded to additional paid-in capital.

On February 21, 2011, the Company announced that its Board of Directors authorized the repurchase of up to $50.0 million of its outstanding common stock as part of a stock repurchase program. On April 18, 2011, the Company entered into a letter agreement 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 the Company agreed, subject to certain conditions, to convert its existing $50.0 million discretionary stock repurchase program into a modified “Dutch auction” tender offer. In the nine months ended September 30, 2011, the Company 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. The Company funded the purchase of the common shares in the tender offer using cash on hand. The shares were not retired as of September 30, 2011. The stock repurchases are accounted for under the cost method whereby the entire cost of the repurchased shares was recorded to treasury stock.

Foreign Exchange — 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.

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. As the 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.

 

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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.

In December 2010, the FASB issued accounting standard update 2010-19, Business Combinations (Topic 805), Disclosure of Supplementary Pro Forma Information for Business Combinations (ASU 2010-29). ASU 2010-29 clarifies the disclosure requirements for pro forma financial information related to a material business combination or a series of immaterial business combinations that are material in the aggregate. The guidance clarified that the pro forma disclosures are prepared assuming the business combination occurred at the start of the prior annual reporting period. Additionally, a narrative description of the nature and amount of material, non-recurring pro forma adjustments would be required. As this newly issued accounting standard only requires enhanced disclosure, the adoption of this standard will not impact our financial position, results of operations or cash flows.

3. 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 U.S. Patent No. 7,123,708 (the ‘708 Patent) (Neutral Tandem, Inc. v Peerless Network, Inc., Peerless Network of Illinois, LLC and John Barnicle, 08 CV 3402). On July 28, 2008, Peerless Network filed a response to the 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 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 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.

 

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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 has been scheduled for December 8, 2011.

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.

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 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. The Company currently anticipates that briefing on the parties’ appeals before the BPAI will be completed in approximately the first quarter of 2012, though that schedule is subject to change.

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.

4. INCOME TAXES

Income taxes were computed using an effective tax rate, which is subject to ongoing review and evaluation by the Company. The Company’s estimated effective income tax rate was 32.9% for the three months ended September 30, 2011, compared to 37.4% for the same period last year. This difference results significantly from the local tax impact of the Company’s foreign operations and items related to 2010 tax filings, specifically R&D tax credits and an increase in transaction costs deductions.

 

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We operate in multiple income tax jurisdictions both inside and outside the United States. Accordingly, we expect that the net 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. Currently, we have estimated $0.5 million as our unrecognized tax benefit.

5. STOCK OPTIONS AND NON-VESTED SHARES

The Company established the 2003 Stock Option and Stock Incentive Plan (2003 Plan), which provided for the issuance of up to 4,650,000 share awards 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 September 30, 2011, the Company had granted a total of 3.5 million options and 1.1 million non-vested shares that remained outstanding under the 2003 and 2007 Plans. Awards for 0.5 million shares, representing approximately 1.6% of the Company’s outstanding common stock as of September 30, 2011, remained available for additional grants under the 2007 Plan.

The Company records stock-based compensation expense in connection with any grant of options and non-vested shares to its employees. The Company calculates the expense associated with its stock options and non-vested shares by determining the fair value of the options and non-vested shares.

Options

All options granted under the 2003 Plan and the 2007 Plan have an exercise price equal to the market value of the underlying common stock on the date of the grant. During the three and nine months ended, September 30, 2011, the Company granted 0.1 million and 0.4 million options at a weighted-average exercise price of $12.34 and $14.51, respectively.

The fair value of each option granted is estimated on the date of grant using the Black-Scholes option-pricing model. The following table summarizes the assumptions used for estimating the fair value of options for the nine months ended September 30, 2011 and September 30, 2010:

 

     September 30, 2011    September 30, 2010

Expected life

   7.0 years    7.1 years

Risk-free interest rate range

   1.3% – 2.9%    2.5% – 3.3%

Expected dividends

     

Volatility

   50.1% – 51.9%    52.6%

The weighted-average fair value of options granted, as determined by using the Black-Scholes valuation model, during the period was $7.95 and $9.47 for the nine months ended September 30, 2011 and 2010, respectively. The total grant date fair value of options that vested during the nine months ended September 30, 2011 and 2010 was approximately $7.0 million and $7.2 million, respectively.

The following summarizes activity under the Company’s stock option plan for the nine months ended September 30, 2011:

 

      Shares
(000)
    Weighted-
Average
Exercise
Price
     Aggregate
Intrinsic
Value
($000)
     Weighted-
Average
Remaining
Term (yrs)
 

Options outstanding — January 1, 2011

     3,184      $ 16.06         

Granted

     446        14.51         

Exercised

     (82 )     2.79         

Cancelled

     (45 )     18.18         
  

 

 

         

Options outstanding — September 30, 2011

     3,503      $ 16.14       $ 5,098         7.0   
  

 

 

      

 

 

    

Vested or expected to vest — September 30, 2011

     3,328      $ 16.13       $ 5,098         7.0   
  

 

 

      

 

 

    

Exercisable — September 30, 2011

     2,372      $ 14.87       $ 5,098         6.3   
  

 

 

      

 

 

    

The unrecognized compensation cost associated with options outstanding at September 30, 2011 and December 31, 2010 was $9.8 million and $13.1 million, respectively. The weighted average remaining term that the compensation will be recorded is 2.3 years and 2.2 years as of September 30, 2011 and December 31, 2010, respectively.

Non-vested Shares

During the three and nine months ended September 30, 2011, the Company’s Board of Directors granted approximately 0.1 million and 0.4 million non-vested shares 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.

 

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A summary of the Company’s non-vested share activity and related information for the nine months ended September 30, 2011 is as follows:

 

     Shares
(000)
    Weighted-
Average
Exercise
Price
 

Non-vested outstanding — January 1, 2011

     1,072      $ 16.11   

Granted

     393      $ 14.32   

Vested

     (248 )   $ 19.05   

Cancelled

     (105 )   $ 15.77   
  

 

 

   

Non-vested — September 30, 2011

     1,112      $ 14.85   
  

 

 

   

The unrecognized compensation cost associated with non-vested shares at September 30, 2011 and December 31, 2010 was $17.4 million and $16.3 million, respectively. The weighted average remaining term that the compensation will be recorded is 2.2 years and 3.2 years as of September 30, 2011 and December 31, 2010, respectively.

During the quarter ended March 31, 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 $6.6 million recorded in the first quarter 2011 included $2.0 million related to the acceleration of options and $1.6 million related to the acceleration of non-vested shares.

6. BUSINESS ACQUISITION

On October 1, 2010, the Company completed the acquisition of Tinet. The total cash paid for the acquisition was $103.1 million, comprised of $77.4 million, in cash, paid on October 1, 2010 for the outstanding shares of 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. In addition to the cash, the Company recorded approximately $4.0 million for acquisition-related costs, including legal, accounting and advisory services in its statement of income under general and administrative expenses.

Tinet is a global carrier exclusively committed to the IP and Ethernet wholesale market which provides global IP transit and Ethernet connectively to carriers, service providers and content providers worldwide. With this acquisition, the Company evolved from a primarily U.S. voice interconnection company into a global IP-based network services company focused on delivering global connectivity for a variety of media, including voice, data and video. These factors contributed to the goodwill recognized.

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:

 

(Dollars in thousands)

      

Current assets

   $ 15,336   

Fixed assets

     28,500   

Customer relationships

     32,973   

Noncurrent assets

     3,102   

Current liabilities

     (20,471 )

Deferred tax liability

     (5,619 )

Noncurrent liabilities

     (1,328 )

Goodwill

     50,651   
  

 

 

 

Total cash paid for acquisition

   $ 103,144   
  

 

 

 

The $33.0 million of acquired intangible assets relates to the customer relationships that will be amortized over their estimated useful life of 15 years. Goodwill is not expected to be deductible for tax purposes.

 

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Supplemental information on an unaudited pro forma basis for the three and nine months ended September 30, 2011 and September 30, 2010, as if the acquisition had taken place on January 1, 2010, respectively, is as follows:

 

      Nine Months Ended
September 30,
 

(Dollars in thousands)

   2011      2010  

Revenue

   $ 198,818       $ 179,105   

Net income

     21,084         22,934   

Diluted earnings per share

     0.63         0.68   

 

      Three Months Ended
September 30,
 

(Dollars in thousands)

   2011      2010  

Revenue

   $ 67,310       $ 59,870   

Net income

     5,848         9,388   

Diluted earnings per share

     0.18         0.28   

Unaudited pro forma supplemental information is based on accounting estimates and judgments, which the Company believes are reasonable. The unaudited pro forma supplemental information also includes purchase accounting adjustments (including adjustments to depreciation on acquired property and equipment, amortization charges from acquired intangible assets, adjustments to interest income and related tax effects). The unaudited pro forma supplemental information is not necessarily indicative of the results of operations in future periods or the results that actually would have been realized had the Company and Tinet been combined at the beginning of the period presented.

7. SEGMENT AND GEOGRAPHIC INFORMATION

Segment Reporting establishes standards for reporting information about operating segments. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance.

The 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 via the Company’s international telecommunications network to fulfill customer agreements. Therefore, the Company has concluded that it has only one operating segment.

8. COMPREHENSIVE INCOME

Comprehensive income consists of net income and other comprehensive loss. Other comprehensive loss includes certain changes in equity that are excluded from net income. Specifically, foreign currency translation adjustments are included in accumulated other comprehensive loss in the consolidated balance sheets.

The following table reconciles net income to comprehensive income for the periods ended September 30, 2011 and September 30, 2010 (in thousands):

 

     Three Months Ended      Nine Months Ended  
     September 30,
2011
    September 30,
2010
     September 30,
2011
     September 30,
2010
 

Net income

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

Other comprehensive income (loss)

     (4,259 )     —           2,098         —     
  

 

 

   

 

 

    

 

 

    

 

 

 

Total comprehensive income

   $ 1,589      $ 9,563       $ 23,182       $ 26,531   
  

 

 

   

 

 

    

 

 

    

 

 

 

 

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

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

 

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Overview

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

Voice Services

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

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

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

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

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

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

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

 

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Data and International Services

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

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

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

Revenue

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

Patent Protection

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

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

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

 

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Critical Accounting Policies and Estimates

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

Results of Operations

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

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 

(Dollars in thousands)

   2011     2010     2011     2010  

Revenue

   $ 67,310      $ 46,454      $ 198,818      $ 136,040   

Operating expense:

        

Network and facilities expense (excluding depreciation and amortization)

     28,724        16,109        80,797        45,044   

Operations

     10,334        5,921        29,107        17,155   

Sales and marketing

     3,383        568        9,851        1,613   

General and administrative

     6,352        6,369        22,771        19,429   

Depreciation and amortization

     7,520        4,180        22,040        12,223   

Loss (gain) on disposal of fixed assets

     159        (7 )     147        (74 )
  

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expense

     56,472        33,140        164,713        95,390   
  

 

 

   

 

 

   

 

 

   

 

 

 

Income from operations

     10,838        13,314        34,105        40,650   
  

 

 

   

 

 

   

 

 

   

 

 

 

Other (income) expense:

        

Interest expense

     —          —          —          4   

Interest income

     (2 )     (50 )     (32 )     (176 )

Other expense (income)

     60        (1,915 )     420        (2,126 )

Foreign exchange loss (gain)

     2,068        —          (317 )     —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Total other (income) loss

     2,126        (1,965 )     71        (2,298 )
  

 

 

   

 

 

   

 

 

   

 

 

 

Income before income taxes

     8,712        15,279        34,034        42,948   

Provision for income taxes

     2,864        5,716        12,950        16,417   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

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

 

 

   

 

 

   

 

 

   

 

 

 

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

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

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

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

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

 

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

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

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

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

Other Income. Other expense was $2.1 million for the three months ended September 30, 2011, compared to other income of $2.0 million in the three months ended September 30, 2010. In the three months ended September 30, 2011, we recognized a loss of $1.9 million related to foreign exchange gain recognized on the remeasurement of an intercompany loan denominated in Euros and an additional $0.2 million foreign exchange loss. In the three months ended September 30, 2010, we recognized 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.

Provision for Income Taxes. Provision for income taxes of $2.9 million for the three months ended September 30, 2011 decreased by $2.8 million compared to $5.7 million for the three months ended September 30, 2010. The effective tax rate for the three months ended September 30, 2011 and 2010 was 32.9% and 37.4%, respectively. This difference results significantly from the local tax impact of the Company’s foreign operations and items related to 2010 tax filings, specifically R&D tax credits and an increase in transaction costs deductions.

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

Revenue. Revenue increased to $198.8 million in the nine months ended September 30, 2011 from $136.0 million in the nine months ended September 30, 2010, an increase of 46.1%. A portion of the increase in revenues was due to the acquisition of Tinet, which generated $47.6 million in revenues or 75.8% of the increase. The remaining increase in revenue of $15.2 million, or 24.2%, was primarily due to an increase of minutes of use to 97.2 billion minutes processed in the nine months ended September 30, 2011 from 78.6 billion minutes processed in the nine months ended September 30, 2010, an increase of 23.7%. The increase in the number of minutes processed by the network was a result of further penetration of current markets and customers, as well as the entry into 22 new markets since September 30, 2010. Offsetting the increase in minutes was a decrease in average fee billed per minute from $0.0017 for the nine months ended September 30, 2010 to $0.0016 for the nine months ended September 30, 2011.

Operating Expenses. Operating expenses for the nine months ended September 30, 2011 of $164.7 million increased $69.3 million, or 72.7%, from $95.4 million for the nine months ended September 30, 2010. The components making up operating expenses are discussed further below.

Network and Facilities Expenses. Network and facilities expenses increased to $80.8 million in the nine months ended September 30, 2011, or 40.6% of revenue, from $45.0 million in the nine months ended September 30, 2010, or 33.1% of revenue. Of this increase, $25.6 million is the network and facilities expense incurred by Tinet during the nine months ended 2011. Due to the nature of the IP Transit business, higher network and facilities expenses are expected and we anticipate this percentage will continue to increase as we reflect increased activity for our IP Transit business in proportion to our voice business.

The remaining network and facilities expenses were $55.2 million for the nine months ended September 30, 2011, or 36.5% of revenue. As noted above, our billed voice minutes were up 23.7%, causing an increase to our network and facilities expense. As the expenses to process the increase in minutes has increased, while the voice rate per minute has decreased, the percentage to revenue for 2011 has increased compared to 2010.

Operations Expenses. Operations expenses increased to $29.1 million in the nine months ended September 30, 2011, or 14.6% of revenue, from $17.2 million in the nine months ended September 30, 2010, or 12.6% of revenue. Of this increase, $6.9 million is due to operations expenses of Tinet. The remaining increase of $5.0 million in our operations expenses primarily resulted from an increase of $2.5 million in non-cash compensation and $0.9 million in payroll and benefits. In addition, during the three months ended September 30, 2011, we settled a dispute with a landlord for $0.8 million.

 

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Sales and Marketing Expense. Sales and marketing expense increased to $9.9 million in the nine months ended September 30, 2011, or 5.0% of revenue, compared to $1.6 million in the nine months ended September 30, 2010, or 1.2% of revenue. Of this increase, $6.2 million is due to sales and marketing expenses of Tinet. Due to the nature of the IP Transit business, higher sales and marketing expenses are expected and we anticipate this percentage will continue to increase as we reflect increased activity for our IP Transit business. The remaining increase of $2.1 million for the nine months ended September 30, 2011 is primarily due to an increase in non-cash compensation and payroll and benefits.

General and Administrative Expense. General and administrative expense increased to $22.8 million in the nine months ended September 30, 2011, or 11.5% of revenue, compared with $19.4 million in the nine months ended September 30, 2010, or 14.3% of revenue. Of this increase, $3.3 million is due to the acquisition of Tinet. The remaining increase of $0.1 million in our general and administrative expense is primarily due to a $1.8 million increase in non-cash compensation, a $0.7 million increase in payroll and benefits and a $0.3 million increase in rent expense related to our corporate headquarters. These increases are partially offset by a decrease of $3.2 million in professional fees. The increase in non-cash compensation in 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 5 to the condensed consolidated financial statements – “Stock Options and Non-vested Shares”

Depreciation and Amortization Expense. Depreciation and amortization expense increased to $22.0 million in the nine months ended September 30, 2011, or 11.1% of revenue, compared to $12.2 million in the nine months ended September 30, 2010, or 9.0% of revenue. Of this increase, $7.8 million is due to Tinet, which includes $1.7 million of amortization expense related to customer intangibles. The remaining $2.0 million increase in our depreciation and amortization expense resulted from capital expenditures primarily related to the expansion of switch capacity in existing markets and the installation of switch capacity in new markets.

Provision for Income Taxes. Provision for income taxes of $13.0 million for the nine months ended September 30, 2011 decreased by $3.4 million compared to $16.4 million for the nine months ended September 30, 2010. The effective tax rate for the nine months ended September 30, 2011 and 2010 was 38.1% and 38.2%, respectively.

Other Income. Other expense was $0.1 million for the nine months ended September 30, 2011. In the nine months ended September 30, 2011, we recognized a gain of $0.8 million related to foreign exchange recognized on the remeasurement of an intercompany loan denominated in Euros. This gain was offset by $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 $0.5 million foreign exchange losses as part of the business operations of Tinet. Other income was $2.3 million for the nine months ended September 30, 2010. In the nine months ended September 30, 2010, we recognized 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 and we recognized a loss of $0.2 million related to adjustments to the fair value of our ARS and ARS Rights and $0.2 million of interest income on investments in money market mutual funds.

Liquidity and Capital Resources

At December 31, 2010, we had $106.7 million in cash and cash equivalents, and $1.0 million in restricted cash. In comparison, at September 30, 2011, we had $83.7 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.

 

     Nine Months Ended  
     September 30, 2011     September 30, 2010  

Net cash flows from operating activities

   $ 48,057      $ 46,503   

Net cash flows from investing activities

     (20,062 )     7,209   

Net cash flows from financing activities

     (51,133 )     (10,296 )

Cash flows from operating activities

Net cash provided by operating activities was $48.1 million and $46.5 million for the nine months ended September 30, 2011 and September 30, 2010, respectively. Operating cash inflows are largely attributable to payments from customers which are generally received between 35 to 45 days following the end of the billing month. Operating cash outflows are largely attributable to personnel related expenditures, and facility and switch maintenance costs. Operating cash flows were slightly higher than the prior period, mainly due to the increase in revenue during the nine months ended September 30, 2011, resulting in increased cash collections during the first three quarters of 2011, partially offset by a higher net investment in our working capital accounts, primarily due to the timing of cash collections and payments.

Cash flows from investing activities

Net cash used in investing activities was $20.1 million for the first nine months of 2011, compared to net cash provided by investing activities of $7.2 million for the same period last year. Investing cash flows are primarily related to purchases of switch equipment and the purchase and sale of investments. The change in investing cash flow is the result of an increase in the purchase of equipment in 2011. Also, in 2010, we had cash inflows of $17.1 million from the redemption of ARS.

In the next twelve months, capital expenditures are expected to be in the range of approximately $20.0 to $24.0 million, primarily for the expansion into new locations and the expansion and upgrades of current locations.

 

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Cash flows from financing activities

Net cash used for financing activities was $51.1 million for the first nine months of 2011, compared to net cash used for financing activities of $10.3 million for the same period last year. 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 the common shares in the tender offer using cash on hand.

During 2010, the Company repurchased approximately 0.6 million shares at an average price of $15.78 per share, for a total cost of $9.6 million, excluding related fees and expenses. The Company funded the purchase of the common shares using cash on hand.

We believe that our current capital resources will be sufficient to finance our operations, including capital expenditures, acquisitions, service development and investments in continuous improvement activities for the foreseeable future.

Investments

We invest our excess cash in money market mutual funds which are carried at market value. As of September 30, 2011, we had $74.8 million in cash and cash equivalents invested in two money market mutual funds.

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 nine month periods ended September 30, 2011 and 2010.

 

Item 3. Qualitative and Quantitative Disclosure about Market Risk

Interest rate exposure

We had cash, cash equivalents and restricted cash totaling $84.7 million at September 30, 2011. This amount was allocated primarily in two money market mutual funds. The unrestricted cash and cash equivalents are held for working capital purposes. We do not enter into investments for speculative purposes.

Based upon our overall interest rate exposure at September 30, 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 its various subsidiaries and business units are substantially in the local currency of the country in which they operate. To the extent borrowings, sales, purchases, revenues, expenses or other transactions are not in the local currency of the subsidiary, the Company is exposed to currency risk. Accordingly, earnings are affected by changes in foreign currency exchange rates, particularly the Euro and British Pound. Collectively, these currencies represent less than 10% of the Company’s operating income. The Company also has an intercompany loan denominated in Euro. As a result, earnings are affected by changes in the exchange rate between the Euro and the dollar. We do not believe that a 10% change in these currencies over a one-year period would have a material impact on our earnings.

 

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s reports under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Evaluation

We carried out an evaluation, under the supervision, and with the participation, of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of September 30, 2011. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of September 30, 2011 at the reasonable assurance level.

Changes in Internal Control over Financial Reporting

During the three months ended September 30, 2011, we established an Internal Audit function and hired an Internal Audit Director who reports directly to the Audit Committee of the Board of Directors. The Internal Audit Director will coordinate the ongoing monitoring of Sarbanes-Oxley compliance and will perform financial, operational and compliance audits based on an annual risk assessment, and make recommendations to management and the Audit Committee to strengthen internal controls. There have been no changes during the three months ended September 30, 2011 covered by this report in our internal control over financial reporting or in other factors that could materially affect or are reasonably likely to materially affect internal control over financial reporting.

 

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PART II. OTHER INFORMATION

 

Item 1. 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 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 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 has been scheduled for December 8, 2011.

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 appear 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.

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.

 

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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 BPAI. Peerless Network filed a notice of appeal of the USPTO’s decision to the BPAI on April 19, 2011. We currently anticipate that briefing on the parties’ appeals before the BPAI will be completed in approximately December 2011, though that schedule is subject to change.

After reviewing the parties’ positions on appeal, the BPAI may affirm the 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 1A. Risk Factors

Set forth below is a discussion of the material changes in our risk factors as previously disclosed in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2010. The information presented below amends, updates and should be read in conjunction with the risk factors and information disclosed in such Annual Report on Form 10-K.

Regulatory developments could negatively impact our business.

The communications services industry is extensively regulated by the federal and state governments. While the pricing of our U.S. voice service is generally not heavily regulated by the Federal Communications Commission, or FCC, or state utility agencies, these agencies have greater regulatory authority over the pricing of incumbent local exchange carriers’, or ILECs’, local transit and access services. To the extent that ILEC transit or access rates are reduced or capped, it could have an adverse impact on us, as we would likely be forced to reduce our rates in order to compete with the ILEC or other competitors.

Local Tandem Transit Service

Some state regulatory authorities assert jurisdiction over the provision of local tandem transit services, particularly the ILECs’ provision of the service. Various states have initiated proceedings to examine the regulatory status of transit services. Some states have taken the position that transit service is an element of the “transport and termination of traffic” services that incumbent ILECs are required to provide at rates based on incremental costs under the Telecommunications Act, while other states have ruled that the Telecommunications Act does not apply to these services. For example:

 

   

A declaratory action was commenced in 2008 with the 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 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.

 

   

In December 2008, the United States District Court for the District of Nebraska held that the Public Service Commission of Nebraska was correct in determining that the ILEC must provide transit service under the Telecommunications Act and that the Nebraska PSC did not err in ordering the ILEC to provide the service at TELRIC based rates.

 

   

The Telecommunications Regulatory Board of Puerto Rico (the Puerto Rico Board), 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. On February 8, 2011, the FCC adopted a notice of proposed rulemaking, or NPRM, that addresses reforming the Universal Service Fund high-cost program as the program transitions to cover broadband service, as well as changes to intercarrier compensation rules. In the NPRM, the FCC stated that the record indicates that local transit service is competitive, but also requested public comment as to whether the FCC should make any changes to the rules that govern local transit service. On October 27, 2011, the FCC approved an order addressing various intercarrier compensation issues. The FCC has only published a summary of the order at this time. The order itself is expected to be published shortly. The summary of the order published by the FCC does not indicate whether local transit service was addressed or might be addressed in a further rulemaking. 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 regulate intrastate access services. The FCC, under a proposed interpretation of the Telecommunications Act, may also assert certain rights to regulate intrastate access services. Most recently, as part of the summary of the order approved on October 27, 2011, the FCC has approved reducing and ultimately eliminating both interstate and intrastate terminating access charges.

The summary indicates that the FCC will cap most access rates as of the effective date of the order. According to the summary, the FCC will then require 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. The summary indicates that, 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 summary indicates that the FCC will issue a further notice of proposed rulemaking transition for the remaining originating and transport rate elements. The summary does not specify whether any rate reductions also will be applied to terminating tandem switching rates.

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.

 

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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 summary of the FCC order described above indicates that the FCC has resolved this issue on a prospective basis and 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:

 

   

increase regulatory oversight over the services we provide, including limiting the prices we can charge;

 

   

adopt or modify statutes, regulations, policies, procedures or programs that are disadvantageous to the services we provide, or that are inconsistent with our current or future plans, or that require modification of the terms of our existing contracts, including reducing the rates for our services;

 

   

adopt or modify statutes, regulations, policies, procedures or programs in a way that causes changes to our operations or costs or the operations of our customers, including the pricing of our services to our customers;

 

   

adopt or modify statutes, regulations, policies, procedures or programs in a way that causes a decrease in the amount of traffic our customers exchange with us or causes a change to our customers’ traffic mix, which results in our customers using, on average, lower priced services; or

 

   

increase or impose new or additional taxes or surcharges that are disadvantageous to the services we provide or cause a decrease in the amount of traffic our customers deliver to us.

We cannot predict when, or upon what terms and conditions, further U.S federal, state or local regulation or deregulation might occur or the effect future regulation or deregulation may have on our business. We also expect that the order adopted by the FCC on October 27, 2011 may be appealed, and 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.

 

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Item 6. Exhibits

(a) Exhibits

 

Exhibit 31.1    Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
Exhibit 31.2    Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
Exhibit 32.1    Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101.INS    XBRL Instance Document.
101.SCH    XBRL Taxonomy Extension Schema Document.
101.CAL    XBRL Taxonomy Extension Calculation Linkbase Document.
101.DEF    XBRL Taxonomy Extension Definition Linkbase Document.
101.LAB    XBRL Taxonomy Extension Label Linkbase Document.
101.PRE    XBRL Taxonomy Extension Presentation Linkbase Document.

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

    NEUTRAL TANDEM, INC.
Date: November 9, 2011     By:   /s/    G. EDWARD EVANS        
     

G. Edward Evans,

Chief Executive Officer

(Principal Executive Officer)

Date: November 9, 2011     By:   /s/    ROBERT JUNKROSKI        
     

Robert Junkroski,

Chief Financial Officer

(Principal Financial and Accounting Officer)

 

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