Inteliquent: Special Dividend Creates Net-Net Illusion
IQNT is a net-net trading at 0.65x P/NCAV, as at Sept.30, 2012. It is currently valued at 0.28x P/B, a 88% discount to its five-year average P/B. However, these valuations are not a true reflection of economic reality. Following the $97 million special dividend paid to shareholders on Oct. 31, 2012, the net current asset value and book value of IQNT will be significantly reduced.
IQNT achieved a trailing twelve months ROE of 4.96% and five-year average ROE of 13.60%.
Financial And Business Risks
As at Sept. 30, 2012, IQNT is debt-free with cash of $113 million, representing 133% of its current market capitalization of $85 million. However, this cash balance of $113 million does not take into account the $97 million special dividend paid to shareholders on Oct. 31, 2012.
IQNT has faced increasing direct competition from other competitive providers of voice services in recent years, including Level 3, Hypercube, Intelepeer and, more specifically, Peerless Network. In 2008, IQNT commenced a patent infringement action against Peerless Network. Peerless Network asserted several counterclaims against IQNT generally alleging that IQNT's patent is invalid and unenforceable. On Sept. 2, 2010, the court hearing the case granted Peerless Network’s motion for summary judgment and found that IQNT's patent was invalid in light of a prior patent. On Dec. 13, 2011, the federal appellate court affirmed the finding that IQNT's patent is invalid, and on Jan. 30, 2012, the appellate court denied IQNT's petition for rehearing of the Dec. 13, 2011 ruling.
IQNT also faces indirect competition from carriers that directly connect their voice switches. When there is a significant amount of voice traffic between two switches, carriers have an economic incentive to establish direct connections to remove intermediate switching. IQNT claims that its customers are currently frequently establishing direct connections between their networks in order to avoid paying a transit fee. The risk of direct connections will increase as more carriers move to an IP-based interface, because direct connecting between two IP-based carriers is less complex, thus enabling more direct connections.
As a result of competitive pressures over the last several years, the average rates charged for voice services in certain markets in the U.S. and IP Transit services globally have decreased significantly. In addition to the regulatory risks, the primary sources of pricing pressure include competitors offering IQNT's customers services at reduced prices; customers with significant volume of traffic using their enhanced leverage in pricing negotiations with IQNT; and potential customers finding it economically advantageous to handle certain functions internally.
IQNT's top five customers, in the aggregate, represented approximately 49% of total revenues in 2011, of which its two largest customers, AT&T and Sprint Nextel, accounted for 22% and 13% respectively. Some of IQNT's customers have received proposals from other carriers to provide services that are similar to IQNT's, and in some cases, they have moved traffic to those competitors. In other cases, IQNT has been required to substantially lower the rates it charges its customers to retain their traffic.
IQNT recently reached a preliminary verbal agreement to settle a dispute with one of its largest customers regarding the termination of long distance voice traffic. It expects that the pending settlement will include a $9 million payment to the customer prior to Dec. 31, 2012.
Business Quality and Capital Allocation
IQNT operates a Tier 1 internet network; it received the Tier 1 designation from the Renesys Corporation in May 2010. As a Tier 1 provider, IQNT largely connects to every other Tier 1 internet provider without the need to purchase IP Transit services from a third party. Its IP transit network is ranked as one of the top 10 IPv4 backbones worldwide and one of the best connected IPv6 networks.
In 2010, IQNT acquired Tinet, allowing it to integrate its IP backbone network with Tinet’s global IP network. As a result, its service offerings now include the capability of switching and carrying voice and data traffic between multiple domestic and international markets and among different types of customers.
On Oct. 5, 2012, IQNT declared a special cash dividend of $3.00 per outstanding share of common stock or $96.7 million in aggregate. At $3.00 per share, the dividend represents approximately 33% of IQNT's closing stock price on Oct. 3, 2012.
The net cash valuation case is no longer valid for IQNT, following the special cash dividend.
IQNT is a excellent case study of how cheap valuations on a quantitative basis could actually be distortions as a result of a difference in timing between reported financial results and economic reality.
The author does not have a position in any of the stocks mentioned.