|Shares Out. (in M):||32||P/E||13.5||9.9|
|Market Cap (in $M):||589||P/FCF||21.5||10.3|
|Net Debt (in $M):||-109||EBIT||71||98|
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I believe that Inteliquent is a rare find, especially in this market: a cheap business with a high level of visibility on growth in revenue, EBITDA, earnings and cash flow. As a telecom company whose business is dependent on intercarrier voice traffic, it also has low sensitivity to the macroeconomic picture with no financial leverage- maybe the ideal profile in the current environment. If IQNT can execute effectively among its current customer base, I believe there is a clear path to a significantly higher stock price. The company also has three reasonably likely upside opportunities that could make it a double or better.
Inteliquent is a wholesale voice telecom carrier that provides neutral tandem interconnection services using an all-IP network. To understand their business you have to get into the plumbing of how the publicly switched telephone network actually works. When you use a phone number to call someone who uses a different telecom carrier at some point the traffic has to be connected from one company’s network to another’s, even if you are using VOIP on both ends. Traditionally, there were two ways for this to happen: (1) either the two networks would connect directly through switch pairs or (2) using what are known as “tandem switches” controlled by local ILECs that charged a (high) rate theoretically controlled by the FCC. As more competitive telecom carriers emerged, the ILEC tandem switches became overwhelmed and the competitive carriers paid the ILECs significant sums to terminate traffic. IQNT was the first carrier to offer a competitive tandem service, which allowed competitive carriers to terminate traffic at lower cost and greater reliability. The company grew by putting tandem switches into more and more local markets, offering the ability to connect to more and more phone numbers in different markets.
Rather than describing IQNT’s various products I am pasting their product descriptions below:
AT&T, Verizon and T-Mobile are IQNT’s largest customers. Most traffic exchanged between these giants is done through direct connects independent of IQNT or other neutral interconnection providers. However, the large carriers rely on IQNT and its competitors for connections to the numerous alternative carriers that aren’t worth directly connecting to individually as well as for redundancy and swing capacity between each other. It should be noted that the market for voice minutes is declining, but slowly. The price per minute charged for these types of services is also declining, but slowly. When you combine both of these facts the overall interconnection market opportunity is probably shrinking low single digits- although if T-Mobile and others continue outsourcing to IQNT the addressable market may actually be increasing. As the industry pioneer IQNT is the largest neutral tandem provider but also competes with Level 3, Hypercube (owned by U.S. West) and Peerless Network (founded by former IQNT executive John Barnicle).
If you pull up IQNT’s long-term stock chart, you see the stock has ranged from as high as $30 to lows of near $2 over its surprisingly volatile history as a public company. John Barnicle was a well -regarded operating executive at IQNT but left to found Peerless, which took market share and forced lower pricing in the 2009-2011 timeframe. IQNT attempted to diversify its business by buying a European data carrier by the name of TiNet which did not work out at all. The company then had a billing dispute with its largest customer AT&T in 2012 and shortly thereafter it went through management and board changes while being pressured by activist investor the Clinton Group. At the time it was feared that the AT&T dispute could be existential, which caused the stock to trade to the $2s in late 2012 in what was one of the great small cap buying opportunities of this era and marked the all-time bottom. The company turned things around in 2013. First the company sold its TiNet business for a little over $50M, more than people were expecting at the time and a significant portion of its market cap. IQNT settled with the Clinton Group, adding a new board member and instituting a special and recurring dividend. The company repaired the relationship with AT&T, who remained IQNT’s largest customer in 2015.
Inteliquent’s business and stock recovered over 2013 and 2014, but in my opinion in the mid teens the stock was fairly valued for a low-to-no growth company. However, the company announced a significant contract with T-Mobile USA in August of 2015 that changed that. T-Mobile agreed to make Inteliquent its sole provider of voice interconnection services for all calls exchanged between T-Mobile and the PSTN not done over direct connection. In conference presentations the CFO revealed that as the contract was phased in T-Mobile would likely become Inteliquent’s largest customer and the additional T-Mobile business could nearly double IQNT’s revenue. The market first sent IQNT’s stock over $20, but over the past few months between the poor market for small caps and the fact that IQNT management did a poor job communicating the costs associated with ramping up the T-Mobile contract the stock has since drifted down to $17 and change, such that the stock can be purchased at the same price as before the T-Mobile deal was announced.
I believe the ramp-up costs poorly communicated by management in the original T-Mobile announcement have confused the market and the opportunity to buy the stock at pre-T-Mobile prices is extremely attractive. Expanding Inteliquent’s network and hiring the operations personnel to nearly double traffic supported is a daunting task, and much of the T-Mobile traffic Inteliquent is taking on is lower margin than its average minute. For this reason, in Q4 2015 Inteliquent reported a 33% increase in minutes transited across its network and 39% revenue growth, but gross margin decreased from 56.7% to 39.7%, resulting in a 9% decrease in EBITDA. However, there are numerous reasons why this gross margin will improve over time such that by the time the contract is fully ramped up EBITDA will be considerably higher than before even if overall margin is lower. The company is having to provision circuits and hire people ahead of taking on all T-Mobile’s traffic, so network utilization will be lower than previous until the contract is fully onboarded. The company is still learning how to optimize T-Mobile’s traffic mix, but has hired least-cost routing experts who will improve performance over time. Most importantly, much of the T-Mobile traffic is long distance, which requires the initiating carrier to pay termination fees to the call recipient’s carrier. However, the FCC has mandated step-downs in this type of intercarrier compensation that are phased in every June 30 for several years until they reach zero. Thus, the T-Mobile minutes should become more profitable in Q3 of 2016 and again in Q3 of 2017.
As long as IQNT executes properly, it will continue to experience a significant increase in revenue and will grow margins from a bottom in Q1 of 2016. Management guided 2016 EBITDA to $82M to $92M with next quarter’s EBITDA in the mid $18M range, implying a significant ramp in the back half of the year. My model shows gross margin bottoming at 37% in Q1 of 2016 and reaching 44% in Q4 2017 compared to pre-T-Mobile margins in the high 50s. Similarly, I think EBITDA margins will bottom at about 22% in Q1 of 2016 and reach nearly 30% by the end of 2017 compared to EBITDA margins of 36% in 2014. Coupled with the higher revenue, I believe that simply executing on the T-Mobile contract will enable IQNT to exit 2017 at an EBITDA run rate of over $120M. If you believe that this business will get at least 6x run-rate EBITDA by the end of 2017 (and this seems conservative in light of the multiples that some crappy low growth telecom roll-ups get), coupled with $75M or so of FCF in the next two years, IQNT shares would be 50% or so higher than they are today at around $26. That seems like a pretty attractive return for a company that simply needs to execute on a contract it is in the middle of ramping up and hold on to its existing customers. Put another way, at current stock prices by the end of 2016 investors would be looking at a prospective 2017 10% FCF to equity and 13% on EV, a yield which I would not expect to last.
While simply executing on T-Mobile could lead to 50% appreciation over the next two years, I believe that IQNT has three other distinct but independent opportunities in the next couple of years that could significantly increase the value of the business:
It is hard to quantify the last two items, but I think between executing the T-Mobile ramp over the next two years and some combination of the three value-creating opportunities it is not out of the question that IQNT could double over the next two years.
Disclosure: The fund I work for is long IQNT and may buy or sell shares at any time without notice.
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