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Friday, February 26, 2010

Establish Neutral Tandem Inc. Covered Calls

A new covered calls position was established today in the Covered Calls Advisor Portfolio (CCAP) with the purchase of Neutral Tandem Inc. (TNDM) covered calls as follows:

Established Neutral Tandem Inc. (TNDM) Covered Calls for Apr2010:
02/26/2010 Bought 200 TNDM @ $15.86
02/26/2010 Sold 2 TNDM Apr2010 $17.50 Calls @ $.40

Normally, the Covered Calls Advisor sells the near-month expiration. But with Neutral Tandem currently priced at $15.86, the first out-of-the-money strike price is at $17.50 and its near-month (Mar2010) expiration was bid at only $.15. Since this advisor is very bullish on Neutral Tandem and thus prefers to sell out-of-the-money calls, a decision was made to extend to the Apr2010 expiration and obtain a more satisfactory $.40 call option premium.

Neutral Tandem Inc. was founded in 2003 and is the dominant provider of tandem switching services to competitive carriers in the telecom sector (including wireless, wireline, cable telephone and broadband service providers). Its network enables competitive carriers to interconnect and exchange local and long distance voice traffic between their networks without establishing direct switch-to-switch connections. Neutral Tandem serves as an independent (hence its corporate name of "Neutral") intermediary between its own tandem switches and its customers' switches. Its network automatically switches Internet Protocol (IP)-originated or conventional Time Division Multiplexing (TDM) traffic to terminating carriers, using either protocol. Prior to the introduction of Neutral Tandem’s service, the primary method for competitive carriers to exchange traffic was through the use of the Incumbent Local Exchange Carriers’ (ILECs) tandem switches. Neutral Tandem’s approach enables competitive carriers to benefit from an independently-provided network interconnection solution since its network reduces costs, increases network reliability, decreases competitive tension, and adds network diversity and redundancy.

Neutral Tandem is used by nearly every national and regional wireless carrier, cable and Competitive Local Exchange Carrier(CLEC) in the 137 markets in the U.S. (up from 100 at the end of 2008) that they serve. Their network currently carries over seven billion minutes of traffic per month and they plan to add 36 additional markets in 2010. As one analyst insightfully summarizes: "There simply aren’t too many companies in the world with strong earnings power, high returns on invested capital, no debt, solid management, improving margins and a simple business that is hard for competitors to replicate." While Neutral Tandem's stock is already value-priced, the growth potential of its existing network makes the stock seem underpriced on this basis alone. But an even more dramatic growth driver exists in Neutral Tandem's current development of a new Ethernet eXchange service for data transmission. In this regard, I am impressed with TNDM's CEO, and it is very encouraging to listen to him say that "Neutral Tandem's goal is to address the void in the Ethernet market by providing Ethernet service providers with a more efficient and simplified method of interconnecting on a one-to-many basis. Our new Ethernet eXchange platform will help these service providers accelerate revenue in the rapidly growing Ethernet market." In short, Neutral Tandem will be attempting to duplicate what they've done in the voice market in the potentially much larger (and likely higher-margined) Ethernet data market.

The Covered Calls Advisor readily admits that the technical aspects of these technologies are outside my circle of competence. But I've read enough about the technology to convince myself that Neutral Tandem has a significant competitive advantage in their Ethernet quest compared with any potential competitors based simply on the wide U.S. footprint of their switching network sites. This infrastructure would be costly for potential competitors to duplicate and thus is supportive of the notion that Neutral Tandem can continue to be the low-cost network provider in their niches. To this advisor, Neutral Tandem seems like a good investment value based solely on the continued growth of their existing tandem interconnection services as: (1) their footprint expands even further in the U.S.; (2) mobile phone useage minutes continues to grow; and (3) the potential for growth into international markets is realized. Furthermore, if they are successful in their plans to obtain a critical mass of core customers to utilize their new Ethernet eXchange service network (which will begin its operation later this year), the stock appreciation potential is enormous.

The Covered Calls Advisor's Buy Alerts spreadsheet is shown below. The total points of 17.92 is below the desired "Buy" threshold of 20.0. However, the key value and profitability metrics are strong, and the company's growth potential (as described above), seems compelling.

Note: For expanded view, left click on the spreadsheet above.

Two possible overall performance results (including commissions) for the TNDM transactions would be as follows:
Stock Purchase Cost: $3,160.95
= ($15.76*200+$8.95 commission)

Net Profit:
(a) Options Income: +$69.55
= (200*$.40 - $10.45 commissions)
(b) Dividend Income: +$0.00
(c) Capital Appreciation (If stock price unchanged at $15.76):
-$8.95 = ($15.76-$15.76)*200 - $8.95 commissions
(c) Capital Appreciation (If exercised at $17.50): +$339.05
= ($17.50-$15.76)*200 - $8.95 commissions

Total Net Profit(If stock price unchanged at $15.76): +$60.60
= (+$69.55 +$0.00 -$8.95)
Total Net Profit(If stock price exercised at $17.50): +$408.60
= (+$69.55 +$0.00 +$339.05)

Absolute Return if Unchanged at $15.76: +2.0%
= +$60.60/$3,160.95
Annualized Return If Unchanged (ARIU): +14.5%
= (+$60.60/$3,160.95)*(365/49 days)

Absolute Return if Exercised at $17.50: +12.9%
= +$408.60/$3,160.95
Annualized Return If Exercised (ARIE): +96.3%
= (+$408.60/$3,160.95)*(365/49 days)

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