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EX-32.1 - CERTIFICATION OF CEO AND CFO PURSUANT TO SECTION 906 - Inteliquent, Inc.d419556dex321.htm
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, 2012

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 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  ¨

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

As of October 31, 2012, 32,222,896 shares of the registrant’s Common Stock, $0.001 par value, were issued and outstanding.

 

 

 


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, 2012 and December 31, 2011      3   
  Condensed Consolidated Statements of Income (Loss) and Comprehensive Income (Loss)— Three and nine months ended September 30, 2012 and September 30, 2011      4   
  Condensed Consolidated Statements of Cash Flows — Nine months ended September 30, 2012 and September 30, 2011      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      20   

Item 1A.

  Risk Factors      20   

Item 2.

  Unregistered Sales of Equity Securities and Use of Proceeds      21   

Item 3.

  Defaults Upon Senior Securities      21   

Item 4.

  Mine Safety Disclosures      21   

Item 5.

  Other Information      22   

Item 6.

  Exhibits      22   

 

2


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,
2012
    December 31,
2011
 

ASSETS

    

Current assets:

    

Cash and cash equivalents

   $ 113,831      $ 90,279   

Receivables — net of allowance of $2,330 and $1,929, respectively

     49,838        46,991   

Deferred income taxes-current

     2,576        3,227   

Other current assets

     13,985        6,655   
  

 

 

   

 

 

 

Total current assets

     180,230        147,152   

Property and equipment — net

     68,338        75,045   

Intangible assets — net

     26,554        28,644   

Goodwill

     49,589        48,137   

Restricted cash

     962        962   

Other assets

     2,275        2,870   
  

 

 

   

 

 

 

Total assets

   $ 327,948      $ 302,810   
  

 

 

   

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

    

Current liabilities:

    

Accounts payable

   $ 8,255      $ 13,792   

Accrued liabilities:

    

Taxes payable

     5,078        2,567   

Circuit cost

     10,078        8,743   

Carrier settlement

     9,000        —     

Rent

     1,925        1,525   

Payroll and related items

     6,252        4,366   

Other

     3,667        2,640   
  

 

 

   

 

 

 

Total current liabilities

     44,255        33,633   

Other liabilities

     1,951        1,693   

Deferred income taxes-noncurrent

     4,981        7,806   
  

 

 

   

 

 

 

Total liabilities

     51,187        43,132   

Commitments and contingencies

     —          —     

Shareholders’ equity:

    

Preferred stock — par value of $.001; 50,000,000 authorized shares; no shares issued and outstanding at September 30, 2012 and December 31, 2011

     —          —     

Common stock — par value of $.001; 150,000,000 authorized shares; 32,223,146 shares and 31,520,121 shares issued and outstanding at September 30, 2012 and December 31, 2011, respectively

     32        32   

Less treasury stock, at cost; 3,083,446 shares at September 30, 2012 and December 31, 2011

     (50,103     (50,103 )

Additional paid-in capital

     195,108        185,014   

Accumulated other comprehensive loss

     (4,983     (4,346 )

Retained earnings

     136,707        129,081   
  

 

 

   

 

 

 

Total shareholders’ equity

     276,761        259,678   
  

 

 

   

 

 

 

Total liabilities and shareholders’ equity

   $ 327,948      $ 302,810   
  

 

 

   

 

 

 

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 (Loss) and Comprehensive Income (Loss)

(In thousands, except per share amounts)

(Unaudited)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2012     2011     2012     2011  

Revenue

   $ 68,820      $ 67,310      $ 207,788      $ 198,818   

Operating expense:

        

Network and facilities expense (excluding depreciation and amortization)

     32,377        28,724        92,936        80,797   

Operations

     13,496        10,334        36,475        29,107   

Sales and marketing

     3,989        3,383        12,001        9,851   

General and administrative

     5,960        6,352        19,364        22,771   

Depreciation and amortization

     7,703        7,520        22,798        22,040   

Carrier settlement

     9,000        —          9,000        —     

Impairment of equipment

     1,257        —          1,257        —     

(Gain) loss on disposal of equipment

     (55     159        (164     147   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expense

     73,727        56,472        193,667        164,713   
  

 

 

   

 

 

   

 

 

   

 

 

 

(Loss) income from operations

     (4,907     10,838        14,121        34,105   
  

 

 

   

 

 

   

 

 

   

 

 

 

Other (income) expense:

        

Interest expense (income)

     4        (2     (11     (32

Other (income) expense

     (20     60        (51     420   

Foreign exchange (gain) loss

     (197 )     2,068        178        (317
  

 

 

   

 

 

   

 

 

   

 

 

 

Total other (income) expense

     (213 )     2,126        116        71   
  

 

 

   

 

 

   

 

 

   

 

 

 

(Loss) income before income taxes

     (4,694 )     8,712        14,005        34,034   

(Benefit) Provision for income taxes

     (1,959 )     2,864        6,379        12,950   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) income

   $ (2,735 )   $ 5,848      $ 7,626      $ 21,084   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) income per share:

        

Basic

   $ (0.09   $ 0.19      $ 0.24      $ 0.63   
  

 

 

   

 

 

   

 

 

   

 

 

 

Diluted

   $ (0.09 )   $ 0.18      $ 0.24      $ 0.63   
  

 

 

   

 

 

   

 

 

   

 

 

 

Weighted average number of shares outstanding:

        

Basic

     31,993        31,450        31,817        33,219   
  

 

 

   

 

 

   

 

 

   

 

 

 

Diluted

     31,993        31,849        32,166        33,643   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total comprehensive (loss) income

   $ (777   $ 1,589      $ 6,989      $ 23,182   
  

 

 

   

 

 

   

 

 

   

 

 

 

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,
 
     2012     2011  

Cash Flows From Operating Activities:

    

Net income

   $ 7,626      $ 21,084   

Adjustments to reconcile net cash flows from operating activities:

    

Depreciation and amortization

     22,798        22,040   

Deferred income taxes

     (2,435     (536

Impairment of equipment

     1,257        —     

(Gain) loss on disposal of equipment

     (164     147   

Non-cash share-based compensation

     8,566        12,345   

Gain on intercompany foreign exchange transactions

     (66 )     —     

Excess tax (benefit) deficiency associated with share-based payments

     (1,176 )     220   

Changes in assets and liabilities:

    

Receivables

     (2,868 )     (5,383

Other current assets

     (5,666     (1,792

Other noncurrent assets

     587        (1,609

Accounts payable

     (1,462     (3,399

Accrued liabilities

     15,884        4,895   

Noncurrent liabilities

     281        45   
  

 

 

   

 

 

 

Net cash flows from operating activities

     43,162        48,057   
  

 

 

   

 

 

 

Cash Flows From Investing Activities:

    

Purchase of equipment

     (21,076     (19,578

Proceeds from sale of equipment

     161        16   

Purchase of other investments

     —          (500
  

 

 

   

 

 

 

Net cash flows from investing activities

     (20,915     (20,062
  

 

 

   

 

 

 

Cash Flows From Financing Activities:

    

Proceeds from the exercise of stock options

     1,315        219   

Restricted shares withheld to cover employee taxes paid

     (963     (1,026

Excess tax benefit (deficiency) associated with share-based payments

     1,176        (220

Payments made for repurchase of common stock

     —          (50,106
  

 

 

   

 

 

 

Net cash flows from financing activities

     1,528        (51,133

Effect of exchange rate changes on cash

     (223     120   

Net Increase (Decrease) In Cash And Cash Equivalents

     23,552        (23,018

Cash And Cash Equivalents — Beginning

     90,279        106,674   
  

 

 

   

 

 

 

Cash And Cash Equivalents — End

     113,831        83,656   
  

 

 

   

 

 

 

Supplemental Disclosure Of Cash Flow Information:

    

Cash paid for taxes

   $ 12,607      $ 15,387   
  

 

 

   

 

 

 

Supplemental Disclosure Of Noncash Flow Items:

    

Investing Activity — Accrued purchases of equipment

   $ 2,617      $ 2,818   
  

 

 

   

 

 

 

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. d/b/a Inteliquent (the Company) provides 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.

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, 2012 and December 31, 2011, the condensed consolidated statements of income (loss) and comprehensive income (loss) for the three and nine months ended September 30, 2012 and 2011, and the condensed consolidated statements of cash flows for the nine months ended September 30, 2012, and 2011 are unaudited. The condensed consolidated balance sheet data as of December 31, 2011 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, 2011. 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, 2011.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (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, 2012 and for the three and nine months ended September 30, 2012 and 2011 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, 2012 are not necessarily indicative of the operating results for any subsequent quarter, for the full fiscal year or any future periods.

The carrying amounts of our cash and equivalents, receivables and accounts payable approximate fair value due to their short-term nature.

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, 2012, the Company had $20.0 million of cash in banks and $93.8 million in two money market mutual funds. At December 31, 2011, the Company had $11.5 million of cash in banks and $78.8 million in two money market mutual funds.

Current Assets Held for Sale — Current assets classified as held for sale are measured at the lower of carrying amount and fair value, less cost to sell. Current assets are classified as held for sale if their carrying amounts will be recovered through a sale transaction rather than through continuing use. This condition is regarded as met only when the sale is highly probable and the asset or disposal group is available for immediate sale in its present condition subject only to terms that are usual and customary for sales of such assets. Management must be committed to the sale, which should be expected to qualify for recognition as a completed sale within one year from the date of classification as held for sale. Property and intangible assets are not depreciated once classified as held for sale.

During the quarter ended September 30, 2012, the Company ceased operations related to its hosted services business offering. The equipment has no further use in the Company’s network and is being held for sale. As a result, the Company recorded an asset impairment charge of approximately $1.3 million. As of September 30, 2012, the fair value of the assets available for sale is $1.7 million and is included in “Other current assets” on the condensed consolidated balance sheet.

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.

 

6


Table of Contents

Goodwill and Intangible Assets, Net — Goodwill is tested for impairment at least annually as of October 1 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 of goodwill impairment 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.

Factors that the Company will consider in the fourth quarter when estimating the fair value of the reporting units include (i) decrease in projected revenues and operating margins due to continued competition and related price pressure, (ii) decline in the Company’s common stock price beginning late in the third quarter of 2012 and sustained through the date of this filing, which required an increase in the discount rate used in the present value calculation in order to reconcile the Company’s market capitalization to the aggregate estimated fair value of all of the Company’s reporting units, and (iii) higher spending expected for strategic product expansion in the near-term to mid-term, with expected benefit to revenues and operating margin trailing the increased spending.

As of this filing, the Company has not completed the analysis, due to the complexities involved in determining the implied fair value of the goodwill of the reporting units. The Company expects to finalize the analysis during the fourth quarter of 2012. No assurance can be given that the Company will not be required to record an impairment loss on goodwill then or in the future.

The change in the carrying amount of goodwill and other intangible assets during the nine months ended September 30, 2012, is as follows:

 

(Dollars in thousands)

   December 31,
2011
     Currency
Translation Effect  and
Other
     September 30,
2012
 

Goodwill

   $ 48,137       $ 1,452       $ 49,589   

Intangible assets, net consist of the following:

 

     September 30, 2012  

(Dollars in thousands)

   Gross  Carrying
Amount
     Accumulated
Amortization
    Net  Intangible
Assets
 

Customer relationships

   $ 31,109       $ (4,555   $ 26,554   
     December 31, 2011  

(Dollars in thousands)

   Gross Carrying
Amount
     Accumulated
Amortization
    Net Intangible
Assets
 

Customer relationships

   $ 31,337       $ (2,693   $ 28,644   

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 $1.9 million, in the three and nine months ended September 30, 2012, respectively. 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 $2.5 million for 2012, $2.9 million for 2013, $2.8 million for 2014, $2.4 million for 2015 and $2.0 million in 2016.

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 for each customer, which is referred to as minute of use. The rates charged per minute are determined by contracts between the Company and its customers or by filed and effective tariffs.

IP Transit revenue and Ethernet services revenue are recorded each month on an accrual basis based upon bandwidth used by each customer. The rates charged are the total of a monthly fee for bandwidth (the Committed Traffic Rate) plus additional charges for the sustained peak bandwidth used monthly in excess of the Committed Traffic Rate.

Earnings per Share — In calculating earnings per common share, we allocate our earnings between common shareholders and holders of unvested share-based payment awards (i.e. non-vested shares) that contain rights to nonforfeitable dividends. This earnings allocation is referred to as the two-class method.

Under the two-class method, undistributed earnings are allocated between common stock and participating securities (non-vested shares) as if all of the net earnings for the period had been distributed. Basic earnings per common share excludes dilution and is calculated by dividing net earnings allocable to common shares by the weighted average number of common shares outstanding during the period. Diluted earnings per common share is calculated by dividing net earnings allocable to common shares by the weighted average number of common shares outstanding during the period, as adjusted for the potential dilutive effect of non-participating share-based awards such as stock options. The following table reconciles earnings per common share for the three and nine months ended September 30, 2012 and 2011.

 

7


Table of Contents
     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 

(In thousands, except per share amounts)

   2012     2011      2012      2011  

Numerator:

          

Net (loss) income applicable to common stockholders, as reported

   $ (2,735   $ 5,848       $ 7,626       $ 21,084   

Denominator:

          

Weighted average common shares outstanding

     31,993        31,450         31,817         33,219   

Effect of dilutive securities:

          

Stock options

     —          399         349         424   
  

 

 

   

 

 

    

 

 

    

 

 

 

Denominator for diluted earnings per share

     31,993        31,849         32,166         33,643   
  

 

 

   

 

 

    

 

 

    

 

 

 

Net (loss) earnings per share:

          

Basic — as reported

   $ (0.09 )   $ 0.19       $ 0.24       $ 0.63   
  

 

 

   

 

 

    

 

 

    

 

 

 

Diluted — as reported

   $ (0.09 )   $ 0.18       $ 0.24       $ 0.63   
  

 

 

   

 

 

    

 

 

    

 

 

 

For the three months ended September 30, 2012, 0.3 million incremental shares related to share-based awards were not included in the computation of diluted (loss) earnings per common share because of the net loss during the three-month period. Outstanding share-based awards of 2.7 million, 2.8 million, 2.7 million and 2.8 million were outstanding during the three months ended September 30, 2012 and September 30, 2011 and the nine months ended September 30, 2012 and September 30, 2011, respectively, but were not included in the computation of diluted earnings per share because the effect would have been antidilutive.

The undistributed earnings allocable to participating securities were $0.3 million, $0.2 million and $0.9 million for the three months ended September 30, 2011 and the nine months ended September 30, 2012 and September 30, 2011, respectively.

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 non-cash share-based expense recorded in the three months ended September 30, 2012 and 2011 was $2.5 million and $2.9 million, respectively. The amount of non-cash share-based expense recorded in the nine months ended September 30, 2012 and 2011 was $8.6 million and $12.3 million, respectively.

Foreign Currency Translation — The functional currency of each of the Company’s subsidiaries is the currency of the country in which the subsidiary operates. Assets and liabilities of foreign operations are translated using period end exchange rates, and revenues and expenses are translated using average exchange rates during the period. Translation gains and losses are reported in accumulated other comprehensive income (loss) as a component of shareholders’ equity.

Recent Accounting Pronouncements — Effective January 1, 2012, the Company adopted the Financial Accounting Standards Board Accounting Standards Update No. 2011-05, Presentation of Comprehensive Income in U.S. GAAP (ASU 2011-05) and Accounting Standards Update No. 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income (ASU 2011-12). These ASUs require 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 amendments did not change the items reported in other comprehensive income or when an item of other comprehensive income is reclassified to net income. As a result, the adoption of this guidance did not affect the Company’s financial position, results of operations or cash flows. The Company has presented the components in one continuous statement.

 

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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 matters 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 effect on its business or operating results, financial position or cash flows.

Breach of Contract Dispute

The Company is engaged in a contractual dispute with one of its largest customers, which is a telecom carrier to whom the Company terminates long distance voice traffic among other services. The carrier has asserted that the Company has been improperly terminating long distance voice traffic to it in breach of the parties’ agreement, and that this has been occurring for multiple years up until the present time. As part of its claim, the carrier has asserted that it has not been compensated for terminating this long distance traffic. The Company and the carrier have reached a preliminary verbal agreement to settle the dispute. The Company expects that the pending settlement will include a $9.0 million one-time payment to the carrier prior to December 31, 2012, and accordingly, has recorded a $9.0 million expense in the three month period ended September 30, 2012. There can be no assurance that the Company and the carrier will reach a definitive final settlement.

In addition, the settlement is also expected to include a new contractual arrangement related to the existing voice services that the Company currently provides to the carrier, and that the carrier will provide to the Company. Under these proposed arrangements, the Company would pay the carrier a significant amount to terminate long distance traffic to the carrier. As previously mentioned, the Company has not paid the carrier for such services in the past. Also, the rates that the carrier pays to the Company for voice services the Company provides would be significantly reduced. The new contractual arrangements are expected to be effective retroactively as of October 5, 2012. The Company cannot predict the final amounts the Company will pay the carrier to terminate long distance traffic to the carrier and the final rates the carrier will pay the Company for the services the Company provides, or whether the carrier will cease purchasing all or a portion of such services from the Company.

Peerless Network, Inc.

Proceeding in the United States District Court for the Northern District of Illinois

As previously disclosed, on June 12, 2008, the Company commenced a patent infringement action against Peerless Network, Inc., Peerless Network of Illinois, LLC, and John Barnicle (collectively, Peerless Network) in the United States District Court for the Northern District of Illinois to enforce the ‘708 Patent (Neutral Tandem, Inc. v Peerless Network, Inc., Peerless Network of Illinois, LLC and John Barnicle, 08 CV 3402). On July 28, 2008, Peerless Network filed a response to the Company’s complaint denying liability and asserting various affirmative defenses and counterclaims. Peerless Network generally alleged that (i) the ‘708 Patent was invalid and unenforceable under a variety of theories, (ii) assertion of the ‘708 Patent amounted to patent misuse and violation of certain monopolization laws, and (iii) 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 in substance removed the previously scheduled September 2010 trial date from the court’s calendar. However, the court also ordered that proceedings on the parties’ respective motions for summary judgment would continue, and the court set a ruling date on the parties’ summary judgment motions for September 1, 2010.

On September 2, 2010, the court issued an opinion and order granting Peerless Network’s motion for summary judgment. The court found that the ‘708 Patent is invalid in light of a prior patent, U.S. Patent No. 6,137,800. In light of the summary judgment ruling, the court denied the Company’s request to reinstate the trial date as moot.

The court’s September 2, 2010 order also denied the Company’s motion for summary judgment. The Company sought summary judgment on its claim that Peerless Network infringed the ‘708 Patent, as well as summary judgment on Peerless Network’s claim that the ‘708 Patent is unenforceable. At a hearing on September 22, 2010, the court allowed the Company to file a new motion for summary judgment on Peerless Network’s claim that the ‘708 Patent is unenforceable. The court also dismissed Counts IV-VII of Peerless Network’s counterclaims, which were claims against the Company based on allegations of monopolization, monopoly leveraging, violations of the Illinois Antitrust Act, and tortious interference with prospective business relations.

On December 9, 2010, the court issued an opinion and order granting the Company’s motion for summary judgment on Peerless Network’s claim that the ‘708 Patent was unenforceable based on alleged “inequitable conduct” and “patent misuse.” The court entered a final judgment with respect to all claims in the litigation on December 17, 2010.

 

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On December 20, 2010, the Company filed notice that it planned to appeal the court’s order granting Peerless Network’s motion for summary judgment and finding that the ‘708 Patent is invalid. On January 13, 2011, Peerless Network cross-appealed the court’s order granting the Company’s motion for summary judgment and finding that the ‘708 Patent is not unenforceable, as well as the court’s earlier ruling construing disputed terms of the patent in the Company’s favor.

On June 6, 2011, Peerless Network agreed to withdraw its cross-appeal. Briefing in the Company’s appeal was completed on July 19, 2011. Oral argument in the Company’s appeal occurred on December 8, 2011. On December 13, 2011, the federal appellate court affirmed the finding that the Company’s patent is invalid, and on January 30, 2012, the appellate court denied our petition for rehearing of the December 13, 2011 ruling. The Company had the option to ask the United States Supreme Court to review that ruling. A petition for such review was due by April 30, 2012. The Company has elected not to ask the United States Supreme Court to review that ruling. As such, the district court’s ruling that the ‘708 Patent is invalid has become final and non-appealable.

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. On May 18, 2012, the Company withdrew its appeal of the district court’s award.

Peerless Network has notified the Company that it intends to pursue a claim for attorney’s fees in the trial court. 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. Briefing in those appeals was completed in December 2011.

Now that the decision of the federal district court finding the Company’s patent invalid has become final and non-appealable, proceedings at the USPTO have ended with respect to existing claims, though the Company has asked the BPAI to remand the matter to the USPTO in order to continue proceedings with respect to new claims. The BPAI has not yet issued a ruling on that request.

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 41.7% and 45.5% for the three and nine months ended September 30, 2012, compared to 32.9% and 38.1% for the same period last year.

 

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The increase in the Company’s effective income tax rate for the three months ended September 30, 2012, as compared to the three months ended September 30, 2011 was primarily due to the Company’s net book loss for the quarter and the Company’s change in estimated valuation allowance recorded against the Company’s Illinois EDGE Credit tax carryforward. The increase in the Company’s effective income tax rate for the nine months ended September 30, 2012, as compared to the nine months ended September 30, 2011 was primarily due the company’s foreign entities’ nondeductible transaction tax and nondeductible noncash compensation. In addition, the rate increased due to changes in the Company’s estimated valuation allowance recorded against the Company’s Illinois EDGE Credit tax carryforward, which was recorded during the second quarter of 2012.

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, the Company has estimated $1.1 million as its unrecognized tax benefit. At December 31, 2011, the Company had estimated $1.0 million as its 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 4.7 million options and non-vested shares to eligible employees, officers, and independent contractors of the Company. In 2007 the Company adopted the Neutral Tandem, Inc. 2007 Equity Incentive Plan (2007 Plan) and ceased awarding equity grants under the 2003 Plan. As of September 30, 2012, the Company had granted a total of 3.0 million options and 1.1 million non-vested shares that remained outstanding under the 2007 Plan. Awards for 0.7 million shares, representing approximately 2.3% of the Company’s outstanding common stock as of September 30, 2012, 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 and independent contractors. 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 both the three and nine months ended, September 30, 2012, the Company granted less than 0.1 million options at a weighted-average exercise price of $11.75. 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, 2012 and September 30, 2011:

 

     September 30,
2012
   September 30,
2011

Expected life

   7.2 years    7.0 years

Risk-free interest rate

   1.6%    1.3% — 2.9%

Expected dividends

     

Volatility

   50.5%    50.1% — 51.9%

The weighted-average fair value of options granted, as determined by using the Black-Scholes valuation model, during the period was $11.75 and $7.95 for the nine months ended September 30, 2012 and 2011, respectively. The total grant date fair value of options that vested during the nine months ended September 30, 2012 and 2011 was approximately $5.1 million and $7.0 million, respectively. The total intrinsic value (market value of stock option less option exercise price) of stock options exercised was $4.4 million and $1.1 million during the nine months ended September 30, 2012 and 2011, respectively.

The following summarizes activity under the Company’s stock option plan for the nine months ended September 30, 2012:

 

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

Options outstanding — January 1, 2012

     3,520      $ 16.09            

Granted

     5        11.75            

Exercised

     (501     2.77            

Cancelled

     (70     17.77            
  

 

 

            

Options outstanding — September 30, 2012

     2,954      $ 18.29       $ 2,437            6.35   
  

 

 

      

 

 

       

Vested or expected to vest-September 30, 2012

     2,756      $ 18.30       $ 2,434            6.34   
  

 

 

      

 

 

       

Exercisable-September 30, 2012

     2,418      $ 18.39       $ 2,337            5.99   
  

 

 

      

 

 

       

 

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The unrecognized compensation cost associated with options outstanding at September 30, 2012 and December 31, 2011 was $4.8 million and $8.5 million, respectively. The weighted average remaining term that the compensation will be recorded is 1.8 years and 2.2 years as of September 30, 2012 and December 31, 2011, respectively.

Non-vested Shares

During the nine months ended September 30, 2012, the Company granted 0.3 million non-vested shares to members of the Company’s executive management team as well as various employees within the Company. No shares were issued during the three months ended September 30, 2012. During the three and nine months ended September 30, 2011, the Company 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.

A summary of the Company’s non-vested share activity and related information for the nine months ended September 30, 2012 is as follows:

 

     Shares
(000)
    Weighted-
Average
Grant Date
Fair Value
     Aggregate
Intrinsic
Value
($000)
 

Non-vested shares outstanding — January 1, 2012

     1,096      $ 14.47         

Granted

     300        12.15         

Vested

     (306 )     15.19         

Cancelled

     (19 )     13.06         
  

 

 

         

Non-vested shares outstanding — September 30, 2012

     1,071      $ 13.64            10,057   
  

 

 

         

Non-vested shares vested or expected to vest — September 30, 2012

     1,000      $ 13.64            9,390   
  

 

 

         

The aggregate intrinsic value represents the total pre-tax intrinsic value based on the Company’s closing stock price of $9.39 on September 30, 2012. The amount changes based upon the fair market value of the Company’s common stock.

The unrecognized compensation cost associated with non-vested shares at September 30, 2012 and December 31, 2011 was $12.5 million and $14.3 million, respectively. The weighted average remaining term that the compensation will be recorded is 2.4 years and 2.4 years as of September 30, 2012 and December 31, 2011, 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 share-based 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.

During the quarter ended September 30, 2012, Surendra Saboo, the Company’s President and Chief Operating Officer since 2006, and Rob Junkroski, the Company’s Chief Financial Officer since 2003, announced their decisions to step down from their executive positions with the Company on October 1, 2012. As a result of these decisions, during the fourth quarter of 2012, the Board approved the acceleration of the vesting of some non-vested shares and options outstanding for both individuals. As such, $2.6 million of non-cash share-based compensation expense will be recorded during the fourth quarter of 2012.

6. 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 one operating segment.

 

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7. COMPREHENSIVE INCOME (LOSS)

Comprehensive income (loss) for the three and nine months ended September 30, 2012 and 2011 consists of net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) includes certain changes in equity that are excluded from net income (loss). Specifically, foreign currency translation adjustments are included in accumulated other comprehensive income (loss) in the consolidated balance sheets.

The following table reconciles net income to comprehensive income for the three and nine months ended September 30, 2012 and September 30, 2011 (in thousands):

 

     Three Months Ended              
     September 30,
2012
    September 30,
2011
    September 30,
2012
    September 30,
2011
 

Net (loss) income

   $ (2,735 )   $ 5,848      $ 7,626      $ 21,084   

Other comprehensive income (loss)

     1,958        (4,259 )     (637     2,098   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total comprehensive (loss) income

   $ (777   $ 1,589      $ 6,989      $ 23,182   
  

 

 

   

 

 

   

 

 

   

 

 

 

8. SUBSEQUENT EVENTS

On October 5, 2012, we declared a special cash dividend of $3.00 per outstanding share of common stock, or $96.7 million in the aggregate. The special cash dividend was paid on October 30, 2012 entirely from the Company’s available cash on hand.

 

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,” “efforts,” “expects,” “estimates,” “projects,” “proposed,” “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 effects of competition, including direct connects, and downward pricing pressure resulting from such competition; our regular review of strategic alternatives; the impact of current and future regulation, including intercarrier compensation reform enacted by the Federal Communications Commission; the risks associated with our ability to successfully develop and market new services, many of which are beyond our control and all of which could delay or negatively affect our ability to offer or market new services; the risk that our business and the Tinet S.p.A. 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, including the effects of Hurricane Sandy and its aftermath on our business; the ability to attract, develop and retain executives and other qualified employees; changes in general economic or market conditions, including currency fluctuations; financing facilities and related availability and terms; changes in our capital structure, including but not limited to the reduction of our cash balance that occurred in connection with the payment of the special cash dividend transaction discussed below under “Liquidity and Capital Resources-Special cash dividend”, 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 fiscal year ended December 31, 2011 and included elsewhere in this report. Furthermore, such forward-looking statements speak only as of the date of this report. We undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.

Overview

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

Voice Services

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

 

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

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

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

We founded our company to solve these interconnection problems and better facilitate the exchange of traffic among competitive carriers and non-carriers. With the introduction of our services, we believe we became the first carrier to provide alternative tandem services capable of alleviating the ILEC tandem exhaust problem. By utilizing our managed tandem service, our customers benefit from a simplified interconnection network solution that reduces costs, increases network reliability, decreases competitive tension and adds network diversity and redundancy. We have signed agreements with major competitive carriers and non-carriers and we operated in 189 markets as of September 30, 2012.

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 or end user in the local market in which we operate. Our originating switched access service allows the originating end user or 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 S.p.A., an Italian corporation that operates a global IP backbone network. As a result of the foregoing, our service offerings now include the capability of switching and carrying local, long distance and international voice traffic.

Data Services

As part of our long-term growth strategy, we acquired Tinet S.p.A., an Italian corporation. Tinet S.p.A. 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 1,000 customers in over 80 countries. We have over 120 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. We also deploy Cisco routers at the edge of our network where we connect with certain of our customers.

Hosted Services

In 2011 we began to offer hosted services. A hosted service is an application (such as software) that we “host” on our network enabling our customer to avoid the capital expenses associated with purchasing the equipment and associated software licenses that they would need to provide the service to themselves. During the third quarter of 2012, we ceased offering hosted services and put a plan in place to sell the related equipment. As a result, the Company recorded a charge of approximately $1.3 million related to the asset impairment on the equipment. As of September 30, 2012, the fair value of the equipment available for sale was $1.7 million and is included in “Other current assets” on the condensed consolidated balance sheet.

 

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Revenue

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

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

The average fee per minute of voice traffic varies depending on market forces and type of service, such as switched access or local transit. The market rate in each market is based upon competitive conditions along with the switched access or local transit rates offered by the ILECs. Depending on the markets we enter, we may enter into contracts with our customers with either a higher or lower fee per minute than our current average.

Our service solution incorporates other components beyond switching. In addition to switching voice calls, 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 voice service solution. Our per-minute fees are intended to incorporate all of these services.

IP Transit revenue and Ethernet services revenue are recorded each month on an accrual basis based upon bandwidth used by each customer. The rates charged are the total of a monthly fee for bandwidth (the Committed Traffic Rate) plus additional charges for the sustained peak bandwidth used monthly in excess of the Committed Traffic Rate.

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

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

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

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

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

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

General and Administrative Expense. General and administrative expenses consist primarily of compensation and related costs for personnel and facilities associated with our executive, finance, human resource and legal departments and fees for professional services. Professional services principally consist of outside legal, audit, tax and transaction costs.

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

Impairment of Fixed Assets. The carrying value of long-lived assets, primarily property and equipment, is evaluated whenever events or changes in circumstances indicate that a potential impairment has occurred. A potential impairment has occurred if projected undiscounted cash flows are less than the carrying value of the assets. The estimated cash flows include management’s assumptions of cash inflows and outflows directly resulting from the use of that asset in operation. The impairment test is a two-step process. If the carrying value of the asset exceeds the expected future cash flows from the asset, impairment is indicated. The impairment loss recognized is the excess of the carrying value of the asset over its fair value. Typically, the fair value of the asset is determined by estimating future cash flows associated with the asset.

 

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

Other Income. Other income includes interest income and foreign exchange gains and losses resulting from changes in exchange rates between the functional currency and the foreign currency in which the transaction was denominated.

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

Critical Accounting Policies and Estimates

The preparation of our financial statements requires us to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses during the periods presented. Our Annual Report on Form 10-K for the fiscal year ended December 31, 2011, which we filed with the Securities and Exchange Commission on March 15, 2012, 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 2012.

Results of Operations

The following table sets forth our results of operations for the three and nine months ended September 30, 2012 and 2011:

 

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

(Dollars in thousands)

   2012     2011      2012     2011  

Revenue

   $ 68,820      $ 67,310       $ 207,788      $ 198,818   

Operating expense:

         

Network and facilities expense (excluding depreciation and amortization)

     32,377        28,724         92,936        80,797   

Operations

     13,496        10,334         36,475        29,107   

Sales and marketing

     3,989        3,383         12,001        9,851   

General and administrative

     5,960        6,352         19,364        22,771   

Depreciation and amortization

     7,703        7,520         22,798        22,040   

Carrier dispute

     9,000        —           9,000        —     

Impairment of fixed assets

     1,257        —           1,257        —     

(Gain) loss on disposal of fixed assets

     (55 )     159         (164 )     147   
  

 

 

   

 

 

    

 

 

   

 

 

 

Total operating expense

     73,727        56,472         193,667        164,713   
  

 

 

   

 

 

    

 

 

   

 

 

 

(Loss) income from operations

     (4,907 )     10,838         14,121        34,105   
  

 

 

   

 

 

    

 

 

   

 

 

 

Total other (income) expense

     (213 )     2,126         116        71   
  

 

 

   

 

 

    

 

 

   

 

 

 

(Loss) income before income taxes

     (4,694 )     8,712         14,005        34,034   

(Benefit) provision for income taxes

     (1,959 )     2,864         6,379        12,950   
  

 

 

   

 

 

    

 

 

   

 

 

 

Net (loss) income

   $ (2,735 )   $ 5,848       $ 7,626      $ 21,084   
  

 

 

   

 

 

    

 

 

   

 

 

 

Three Months Ended September 30, 2012 Compared to Three Months Ended September 30, 2011

Revenue. Revenue increased to $68.8 million in the three months ended September 30, 2012 from $67.3 million in the three months ended September 30, 2011, an increase of 2.2%. The increase in revenue of $1.5 million was due primarily to a $1.3 million increase in revenue generated from our voice business, with the remaining increase of $0.2 million related to an increase in data revenue.

The increase in voice revenue was primarily due to the increase in the average fee per voice minute and an increase in minutes of use billed. The average fee per voice minute for the three months ended September 30, 2012 of $.00158 increased from $0.00154 for the three months ended September 30, 2011. We processed 33.1 billion minutes in the three months September 30, 2012 compared to 32.9 billion minutes processed in the three months ended September 30, 2011, an increase of 0.5%.

The increase in data revenue was primarily due to the increase in traffic, measured in terabits. Traffic increased to 8.2 terabits processed in the three months ended September 30, 2012 from 5.8 terabits processed in the three months ended September 30, 2011. Offsetting the increase in terabits was a decrease in the average fee from $2.86 per megabit for the three months ended September 30, 2011 to $2.01 per megabit for the three months ended September 30, 2012.

 

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Operating Expense. Operating expenses for the three months ended September 30, 2012 of $73.7 million increased $17.2 million, or 30.6%, from $56.5 million for the three months ended September 30, 2011. The components making up operating expenses are discussed further below.

Network and Facilities Expenses. Network and facilities expenses increased to $32.4 million in the three months ended September 30, 2012, or 47.0% of revenue, from $28.7 million in the three months ended September 30, 2011, or 42.7% of revenue. The increase in network and facilities expense was due to changes in the mix of the voice services we provide and an increase in our IP Transit and Ethernet services. Due to the change in the mix of services provided, higher network and facilities expenses were incurred.

Operations Expenses. Operations expenses increased to $13.5 million in the three months ended September 30, 2012, or 19.6% of revenue, from $10.3 million in the three months ended September 30, 2011, or 15.4% of revenue. The increase of $3.2 million in our operations expenses primarily resulted from a $1.4 million increase in repairs and maintenance, $0.9 million of which was due to our hosted service offering which was ceased during third quarter of 2012, $1.2 million in amounts due to the federal universal service fund, state governments and value added taxes in various countries as we increased the provision of our data services, an increase of $0.9 million in payroll and benefits, primarily attributable to increases in headcount, and $0.5 million in non-cash compensation, contract labor and rent expenses. Expenses of $0.8 million were included in the third quarter of 2011, resulting from the settlement of a dispute with a landlord.

Sales and Marketing Expense. Sales and marketing expense increased to $4.0 million in the three months ended September 30, 2012, or 5.8% of revenue, compared to $3.4 million in the three months ended September 30, 2011, or 5.0% of revenue. The increase of $0.6 million in sales and marketing expenses for the three months ended September 30, 2012 was primarily due to an increase of $0.5 million in payroll and benefits related to increased headcount as we expand our data services.

General and Administrative Expense. General and administrative expense decreased to $6.0 million in the three months ended September 30, 2012, or 8.7% of revenue, compared with $6.4 million in the three months ended September 30, 2011, or 9.4% of revenue. The decrease of $0.4 million in our general and administrative expense was primarily due to a decrease of $0.5 million decrease in payroll, benefits and non-cash compensation.

Depreciation and Amortization Expense. Depreciation and amortization expense increased to $7.7 million in the three months ended September 30, 2012, or 11.2% of revenue, compared to $7.5 million in the three months ended September 30, 2011, or 11.2% of revenue. The increase of $0.2 million in our depreciation and amortization expense resulted from capital expenditures primarily related to the expansion of POP capacity in existing markets and the installation of POP capacity in new markets, as we expand our data services.

Carrier Dispute. We reached a preliminary verbal agreement to settle a dispute with one of our largest customers regarding the termination of traffic. We expect that the pending settlement will include a $9.0 million one-time payment to the customer prior to December 31, 2012, and accordingly, we recorded a $9.0 million expense in the three month period ended September 30, 2012. There can be no assurance that the Company and the carrier will reach a definitive final settlement.

Impairment of Fixed Assets. During the three months ended September 30, 2012, we ceased operations related to our hosted services business offering. The equipment related to this business has no further use in our network and is being held for sale. As a result, the Company recorded an asset impairment charge of approximately $1.3 million. During the same period in 2011, no impairments were recognized.

Other Expense (Income). Other income increased to $0.2 million for the three months ended September 30, 2012, compared to other expense of $2.1 million for the three months ended September 30, 2011. Other income of $0.2 million consisted primarily of a net foreign exchange gain resulting from the remeasurement of our receivable and payable balances between the functional currency and currency in which the transactions are denominated. In the three months ended September 30, 2011, we recognized $1.9 million related to foreign exchange loss recognized on the remeasurement of an intercompany loan denominated in Euros.

(Benefit) Provision for Income Taxes. In the three months ended September 30, 2012, we had a (benefit) for income taxes of $2.0 million as compared to a provision for income taxes of $2.9 million for the three months ended September 30, 2011. The effective tax rate for the three months ended September 30, 2012 and 2011 was 41.7% and 32.9%, respectively. The difference in the effective income tax rate was primarily due to the loss as a result of operations for the quarter and our change in estimated valuation allowance recorded against our Illinois EDGE Credit tax carryforward.

Nine Months Ended September 30, 2012 Compared to Nine Months Ended September 30, 2011

Revenue. Revenue increased to $207.8 million in the nine months ended September 30, 2012 from $198.8 million in the nine months ended September 30, 2011, an increase of 4.5%. The increase in revenue of $9.0 million was due primarily to a $5.1 million increase in revenue generated from our voice business, with the remaining increase of $3.9 million related to an increase in data revenue.

The increase in data revenue is primarily due to an increase of traffic to 23.3 terabits processed in the nine months ended September 30, 2012 from 15.7 terabits processed in the nine months ended September 30, 2011. Offsetting the increase in terabits was a decrease in the average fee from $3.03 per megabit for the nine months ended September 30, 2011 to $2.20 per megabit for the nine months ended September 30, 2012. The increase in voice revenue is primarily due to the increase in minutes of use to 100.1 billion minutes processed in the nine months ended September 30, 2012 from 97.2 billion minutes processed in the nine months ended September 30, 2011, an increase of 3.0%.

 

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Operating Expenses. Operating expenses for the nine months ended September 30, 2012 of $193.7 million increased $29.0 million, or 17.6% from $164.7 million for the nine months ended September 30, 2011. The components making up operating expenses are discussed further below.

Network and Facilities Expenses. Network and facilities expenses increased to $92.9 million in the nine months ended September 30, 2012, or 44.7% of revenue, from $80.8 million in the nine months ended September 30, 2011, or 40.6% of revenue. The increase in network and facilities expense was due to changes in the mix of the voice services we provide and an increase in our IP Transit and Ethernet services. Due to the change in the mix of services provided, higher network and facilities expenses were incurred.

Operations Expenses. Operations expenses increased to $36.5 million in the nine months ended September 30, 2012, or 17.6% of revenue, from $29.1 million in the nine months ended September 30, 2011, or 14.6% of revenue. The increase of $7.4 million in our operations expenses primarily resulted from an increase of $3.0 million in payroll and benefits, primarily attributable to increases in headcount, $2.5 million increase in repairs and maintenance, $1.7 million of which was due to our hosted service offering which was ceased during third quarter of 2012, $1.6 million in amounts due to the federal universal service fund, state governments and value added taxes in various countries as we increase the provision of our data services and $0.8 million in non-cash compensation, contract labor, rent expenses. Expenses of $0.8 million were included in the third quarter of 2011, resulting from the settlement of a dispute with a landlord.

Sales and Marketing Expense. Sales and marketing expense increased to $12.0 million in the nine months ended September 30, 2012, or 5.8% of revenue, compared to $9.9 million in the nine months ended September 30, 2011, or 5.0% of revenue. The increase of $2.1 million in sales and marketing expenses for the nine months ended September 30, 2012 was primarily due to an increase of $1.8 million in payroll, benefits and travel costs, as well as $0.6 million of marketing fees related to the company re-branding.

General and Administrative Expense. General and administrative expense decreased to $19.4 million in the nine months ended September 30, 2012, or 9.3% of revenue, compared with $22.8 million in the nine months ended September 30, 2011, or 11.5% of revenue. The decrease of $3.4 million in our general and administrative expense was primarily due to a decrease of $3.6 million in non-cash share-based compensation. The decrease in non-cash share-based compensation was primarily due to the accelerated vesting of options and non-vested shares related to the retirement of Rian J. Wren during the first quarter of 2011, 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 $22.8 million in the nine months ended September 30, 2012, or 11.0% of revenue, compared to $22.0 million in the nine months ended September 30, 2011, or 11.1% of revenue. The increase of $0.8 million in our depreciation and amortization expense resulted from capital expenditures primarily related to the expansion of POP capacity in existing markets and the installation of POP capacity in new markets, as we expand our data services.

Carrier Dispute. We reached a preliminary verbal agreement to settle a dispute with one of our largest customers regarding the termination of traffic. We expect that the pending settlement will include a $9.0 million one-time payment to the customer prior to December 31, 2012, and accordingly, we recorded a $9.0 million expense in the three month period ended September 30, 2012. There can be no assurance that the Company and the carrier will reach a definitive final settlement.

Impairment of Fixed Assets. During the nine months ended September 30, 2012, we ceased operations related to our hosted services business offering. The equipment related to this business has no further use in our network and is being held for sale. As a result, the Company recorded a charge of approximately $1.3 million related to the combined asset impairment and accelerated the depreciation on the equipment. During the same period in 2011, no impairments were recognized.

Other Expense (Income). Other expense of $0.1 million for the nine months ended September 30, 2012, was consistent with other expense of $0.1 million for the nine months ended September 30, 2011. Other expense of $0.1 million consists primarily of a net unrealized foreign exchange loss resulting from the remeasurement of our receivable and payable balances between the functional currency and the currency in which the transactions are denominated. In the nine months ended September 30, 2011, we recognized $0.8 million related to foreign exchange gain recognized on the remeasurement of an intercompany loan denominated in Euros during 2011. 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 a $0.5 million net unrealized foreign exchange loss resulting from the remeasurement of our receivable and payable balances between the functional currency and the currency in which the transactions are denominated.

Provision for Income Taxes. Provision for income taxes of $6.4 million for the nine months ended September 30, 2012 decreased by $6.6 million compared to $13.0 million for the nine months ended September 30, 2011. The effective tax rate for the nine months ended September 30, 2012 and 2011 was 45.5% and 38.1%, respectively. The difference in the effective income tax rate was primarily due to our foreign entities’ transaction tax which is not deductible in the foreign jurisdictions of our foreign operations. In addition, the rate increased due to changes in the Company’s estimated valuation allowance recorded against the Company’s Illinois EDGE Credit tax carryforward, which was recorded during the second quarter of 2012.

 

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Liquidity and Capital Resources

At December 31, 2011, we had $90.3 million in cash and cash equivalents, and $1.0 million in restricted cash. In comparison, at September 30, 2012, we had $113.8 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, 2012     September 30, 2011  

Net cash flows from operating activities

   $ 43,162      $ 48,057   

Net cash flows from investing activities

     (20,915     (20,062

Net cash flows from financing activities

     1,528        (51,133

Cash flows from operating activities

Net cash provided by operating activities was $43.2 million for the first nine months of 2012 compared to $48.1 million for the same period last year. 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 network maintenance costs. The decrease in operating cash flow reflects a decrease in operating earnings driven mainly by increased network and facilities expenses and an increase in prepaid expenses, partially offset by an increase in the timing of cash collections.

Cash flows from investing activities

Net cash used in investing activities was $20.9 million for the first nine months of 2012, compared to net cash used in investing activities of $20.1 million for the same period last year. Investing cash flows are primarily related to purchases of network equipment. The increase in investing cash flow used is the result of an increase in the purchase of equipment in 2012 for the expansion of our data services into new locations and the expansion and upgrades of current locations.

In the next twelve months, capital expenditures are expected to be in the range of approximately $25 to $30 million, primarily for the expansion of our data services into new locations and the expansion and upgrades of current locations.

Cash flows from financing activities

Net cash provided by financing activities was $1.5 million for the first nine months of 2012, compared to net cash used for financing activities of $51.1 million for the same period last year. The changes in cash flows from financing activities primarily relates to the 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.

We regularly review acquisitions and strategic opportunities, which may require debt or equity financing. We currently do not have any pending agreements with respect to any acquisitions or strategic opportunities which would require debt or equity financing.

Investments

As of September 30, 2012, we had $93.8 million in cash and cash equivalents invested in two money market mutual funds. As of December 31, 2011, we had $78.8 million in cash and cash equivalents invested in two money market mutual funds.

Special cash dividend

On October 5, 2012, we declared a special cash dividend of $3.00 per outstanding share of common stock, or $96.7 million in the aggregate. The special cash dividend was paid on October 30, 2012 entirely from our available cash on hand. Refer to Item 1A “Risk Factors” in Part II of this Quarterly Report on Form 10-Q for further information regarding the special cash dividend.

Issuer purchases of equity securities

We did not purchase any of our common stock during the nine months ended September 30, 2012. On August 7, 2012, we announced that our Board of Directors has authorized the repurchase of up to $50 million of our outstanding common stock as part of a stock repurchase program. The program will expire in three years. We may repurchase shares through open market, negotiated or block transactions. We do not currently plan to repurchase any stock under the stock repurchase program. We intend to conduct any stock repurchase activities in compliance with the safe harbor provisions of Rule 10b-18 of the Securities Exchange Act of 1934, as amended. The stock repurchase program will be subject to market conditions and does not obligate us to repurchase any dollar amount or number of shares of our common stock, and the program may be extended, modified, suspended or discontinued at any time.

Effect of inflation

Inflation generally affects us by increasing our cost of labor and equipment. We do not believe that inflation had any material effect on our results of operations for the three-month periods ended September 30, 2012 and 2011.

 

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Item 3. Qualitative and Quantitative Disclosure about Market Risk

Interest rate exposure

We had cash, cash equivalents and restricted cash totaling $113.8 million at September 30, 2012. 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, 2012, 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. As a result, earnings are affected by changes in the exchange rate between the Euro and the dollar. We do not believe that a 10 percent change in these currencies over a one-year period would have a material impact on our earnings.

 

Item 4. Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the 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, 2012. 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, 2012 at the reasonable assurance level.

There have been no changes during the three months ended September 30, 2012 covered by this report in our internal control over financial reporting or in other factors that could materially affect or are reasonably likely to materially affect internal control over financial reporting.

PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings

Refer to Note 3 “Legal Proceedings” in Notes to Condensed Consolidated Financial Statements of this Quarterly Report on Form 10-Q for information on legal proceedings.

 

Item 1A. Risk Factors

There have been no material changes in the risk factors outlined in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011, except for the following, which should be read in conjunction with the risk factors and information disclosed in such Annual Report.

As a result of our special cash dividend, our cash balance has decreased significantly, which may adversely affect our ability to operate and expand our business.

As discussed in this Quarterly Report on Form 10-Q under “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources — Special cash dividend”, our Board of Directors authorized the declaration and payment of a special cash dividend in the amount of $3.00 per share, or $96.7 million in the aggregate, on October 30, 2012. The special cash dividend was funded entirely from our available cash on hand.

The resulting reduction in our cash balance may reduce our flexibility to operate our business as we have in the past, including our flexibility to respond to changing business and economic conditions or to take advantage of business opportunities as they arise.

 

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Failures or interruptions of our network or other carriers’ networks could materially harm our revenues and impair our ability to conduct our operations.

We provide telecommunications services that are critical to the operations of our customers. Notably, our voice service is essential to the orderly operation of our customers’ telecommunication systems because it enables competitive carriers to ensure that telephone calls are routed to the appropriate destinations, and our IP Transit and Ethernet services are critical to the ability of our customers to transmit data, which may be critical to their operations. Our network architecture is integral to our ability to process a high volume of traffic in a timely and effective manner. We could experience failures or interruptions of our network and services, or other problems in connection with our operations, as a result of:

 

   

damage to, or failure of, our network software or hardware or our connections and outsourced service arrangements with third parties;

 

   

errors in the processing of data by our systems;

 

   

computer viruses or software defects or failures;

 

   

physical or electronic break-ins, sabotage, intentional acts of vandalism, terrorism, natural disasters and similar events, including but not limited to Hurricane Sandy and its aftermath;

 

   

increased capacity demands or changes in systems requirements of our customers;

 

   

provisioning, installing and delivering these services; and

 

   

errors by our employees or third-party service providers.

If we cannot adequately protect the ability of our network to perform consistently at a high level or otherwise fail to meet our customers’ expectations:

 

   

we may be unable to provide and bill for services;

 

   

we may experience damage to our reputation, which may adversely affect our ability to attract or retain customers for our existing services, and may also make it more difficult for us to market new services;

 

   

we may be subject to significant damages claims, under our contracts or otherwise;

 

   

our operating expenses or capital expenditures may increase as a result of corrective efforts that we must perform;

 

   

our customers may postpone or cancel subsequently scheduled work or reduce their use of our services; or

 

   

one or more of our significant contracts may be terminated early, or may not be renewed.

Any of these consequences would adversely affect our business, prospects, financial condition and operating results.

We may not have sufficient redundant systems or backup facilities to allow us to receive and process traffic in the event of a loss of, or damage to, a network switch site or other network facilities. We could lose, or suffer damage to, a site in the event of power loss, natural disasters such as fires, earthquakes, floods, hurricanes and tornadoes, telecommunications failures, such as transmission cable cuts, or other similar events that could adversely affect our customers’ ability to access our services. Further, widespread business closings or failures or interruptions in telecommunications services of other carriers as a result of power loss, natural disasters, telecommunications failures and other similar events, including but not limited to Hurricane Sandy and its aftermath, may result in a reduction of minutes of voice traffic switched or data traffic carried for which service is generally provided. Any such loss, damage or reduction in voice minutes or data traffic could interrupt our operations, materially harm our revenues and growth and require significant cash expenditures to correct the issues caused by such loss or damage.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None.

 

Item 3. Defaults Upon Senior Securities

None.

 

Item 4. Mine Safety Disclosures

Not applicable.

 

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Item 5. Other Information

None.

 

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, 2012     By:   /S/    G. EDWARD EVANS        
     

G. Edward Evans,

Chief Executive Officer

(Principal Executive Officer)

Date: November 9, 2012     By:   /S/    DAVID ZWICK        
     

Executive Vice President and Chief Financial Officer

(Principal Financial and Accounting Officer)

 

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