“There are only three ways a company can grow. First, earn more business from your current customers. Second, attract customers from your competitors. Or third, buy another company. If you can’t do the first, what makes you think you can earn more business from your competitors’ customers or from customers you buy through acquisition?”

Read the whole article here.

The idea that “lowest average cost wins” when it comes to investing is one of the most under-appreciated elements of portfolio management. And my own averaging down in Tarpon has been a very significant contributor to our returns. So I believe this is an important subject for all investors to grasp.

My theory is also that using FOLIOfn to average down is also a big advantage for portfolio managers. To understand why, you’ve got to know a little about the following four concepts:

1 – Averaging down. I define this as buying more new shares of a stock when it is trading below the average price you paid for your existing shares – while keeping the total weight of that holding constant in your portfolio. So, you’re buying new cheaper shares and selling older more expensive shares. This is synonymous with lowering the average price you paid for that stock.

2 – Tax lots. Think of a tax lot as a price tag that is wrapped around a bundle of a company’s shares that you bought at one particular time. I’ll try to explain this with an example.

Let’s say on every Tuesday of the past July, you bought 10 shares of Google. At the end of the month you owned 40 shares.

Now you want to sell 10 shares out of those 40. At most brokerage firms and mutual funds, you have no say in which ten shares you sell. That’s a bummer, because you could save a lot of money in taxes if you could select the shares you wished to sell in a way that, if your shares had gone up in value, would minimize your capital gain. And had you the option, if your shares had gone down in value, you could create a bigger tax loss (which is good, because it offsets other gains at tax time) by selling those shares that you’d paid the most for.

Again, at most brokers, you have zero control over which ten shares you sold. Fortunately, though, on FOLIOfn, you can sell shares in a tax-savvy way via tax lots.

So in the example above, you have four taxes lots – one for each bundle of Google shares you bought on Tuesdays. When it comes time to sell one of the bundles, FOLIOfn allows you to easily pick the best one to part with by comparing the price tag on each bundle to the current market price. And that can save you a ton of money when it comes to taxes.

3 – Fractional shares. FOLIOfn also allows you to buy fractions of a share. It may sound odd, but say you only have $400 to invest. At most brokers, you couldn’t even buy a single share of Google if it was trading at $535 each. At FOLIOfn, though, you could buy 0.748 shares of Google with your $400 – no problem at all.

4 – Percentage weightings. I manage the Tarpon Folio according to percentage weights. So, for instance, if I wanted to initiate a new position in Google in Tarpon, I’d tweak the core portfolio settings to, say, reflect a (6.0% weighting by dollar amount) in Google. FOLIOfn’s system then interprets that weight into the exact number of shares (and fractions of shares) to buy in each investor account to bring their accounts up to a 6.0% weighting in Google, too. So, it’s a simple concept that plays into things subtly more here in a minute.

Now, here’s an example of why it pays to average down:

On Monday I buy a single share of stock in Pork & Beans Co. for $10.00.

On Tuesday, a customer opens a can that contains neither pork nor beans, but something that can only be described as sinister. Panic ensues. Shares drop.

On Wednesday, I decide to average down, and buy another single share for $5.00.

Now I own two shares, and my average cost is $7.50 ($10 plus $5 all divided by 2). My total position size is $15.00 (the $10.00 share plus the $5.00 share).

On Thursday, I remember that I only want to have $10.00 total invested in this company’s shares, because for risk control reasons I don’t want it to be any bigger than a 10% position in my $100 total portfolio. There’s really no telling what else has been going on in that factory, it being majority-owned by Goldman Sachs and all.

So, to restate – I have $15.00 of my money invested in Pork & Beans Co., which also represents a 15% position in my total portfolio. But I want to get my ownership of that company down to a 10% position in my portfolio, and that means I’ve gotta sell $5.00 worth of shares.

If to do that I just sold the same single $5.00 share I’d bought on Wednesday, then, well, that would be dumb. Not only would I have paid money (for no reason) in commissions to buy and sell that share, but the other share I continued to own would still have a cost basis of $10.00. So after all that I’d still be eating a loss on paper and would not be any closer to clawing my way back whenever the panic subsided and the shares rose in value.

FOLIOfn, however, effectively lets me sell $5.00 worth of shares by selling half of the $10.00 share I bought on Monday – a move which maximizes my loss on that sale, which is good come tax-time. It also lowers my average cost basis, too, because afterwards I would own the 1.0 share bought at $5.00 and the remaining 0.5 shares I’d bought at $10.00. And that means I would have my ideal 10% position in Pork & Beans at an average cost basis of $6.67 ($10 total position divided by 1.5 total shares).

So, long story short, because I averaged down, my cost basis went from $10.00 to $6.67 on that 10% position in my portfolio.

A month later, a private equity firm comes along and buys out Pork & Beans for $17.00 a share. If I had not averaged down and just kept that original $10-per-share cost basis on the books, I would make $7 in profit, or a 70% return. Not too bad at all.

But because I averaged down to $6.67, though, I made $10.33 in profit, or a 155% return. Now we’re talking. Plus, Goldman was secretly short Pork & Beans stock, so that feels even better.

I greatly simplified a few things above, and completely glossed over wash sale rules, but my point is that the kind of performance differential that averaging down can create is, to me, well worth the trouble – and particularly when we don’t have to pay commissions on any trades at FOLIOfn, period. And again, those aren’t just better numbers for the sake of being able to talk about better numbers. That’s a real increase in actual profit for investors in my Spoke Fund®.

That said, please note that if you aren’t really confident in your own valuation of a company, you
probably shouldn’t attempt to average down. All of the above is meaningless if the stock price doesn’t eventually head back up. If the price instead keeps going down as you average down, you will wind up both broke and insane. The above also implies you’re willing to let your winners run, as they say. To average down and capture a price drop, only to then rebalance your position (i.e. sell some shares off) once its price climbs back up, means it might not be worth the trouble, either.

But if you can stay rational when prices drop for temporary reasons, and you’re a long-term buy and hold investor, averaging down can be very smart for your portfolio.

Update: To clarify, the 1/2 share I’m selling was a $10 share. I am taking a loss there, and I did not net that loss out against the improved gain percentage above. Call it mental accounting…I view that loss as something that can be spread over the entire portfolio come tax time. So, all things being equal, it will likely be a shield of sorts for other capital gains in the portfolio. And I am completely ignoring wash sale rules on purpose in the example above, but a good future post would probably tie it all together here.

As a reminder, none of this should be considered investment advice, or anything even close. It’s almost entirely opinion and, in parts below, is pure speculation. But those are the kinds of questions I’ve been getting lately. I’ll return to more objective, quantitative answers in the next post in this series.

And despite a crazy few weeks, I still believe Clearwire’s spectrum, under a set of pessimistic assumptions, is still worth around $6 a share. Implicit in that estimate is that the company finds the short-term funding to be able to ultimately realize that intrinsic value. And while that spectrum value is of less importance to both debt and equity investors right now then the company’s need to find funding, I believe that emphasis will likely change dramatically before the end of the year. Just my opinion, mind you.

On with the Q&A.

Q. Who is going to fund Clearwire?

A. I have no more insight into the answer to that question than any other investor out there.

The reasons I invested in Clearwire prior to knowing the answer to that question, however, were (1) I’ll get a much better price and a bigger margin of safety now then later, (2) I believe the actual probability of the raise happening is significantly higher than what the market appears to be pricing in, and (3) I have faith that somewhere in the parallel universe than can be the telco industry, someone with much bigger brains than mine did the same calculations of Clearwire’s spectrum value as I did – and because that gap between true spectrum value and its current implied pricing in the market is so large, and the TDD technology so potentially disruptive, those brains are going to get off the couch and do something with Clearwire. And, frankly, I also trust that in the negotiations that ensue, John Stanton will defend his own equity interests as strongly as I would defend my own.

So, I like my position in the capital structure as a common equity holder – though I concede Clearwire’s debt could quite be attractive here as well – because I simply don’t believe that my position as a "subordinate" equity holder is going to be relevant for long. I want to be a partner in this business – forever, hopefully – and not a lender to it, and there’s no way to do that without eating some risk. So be it.

That said, it’s also important to be realistic about the hurdles Clearwire could encounter as it seeks additional funding from a strategic partner. Specifically, investors should acknowledge that a funding partner (or partners) might not want to play second fiddle to the first-lien holders (i.e. those debt holders who essentially have first dibs on the spectrum in the event of bankruptcy). That’s a valid issue that folks like the credit analysts at Moody’s have brought up recently. I would argue, however, that the mere act of putting enough "junior capital" into Clearwire will also make the "junior" part of that phrase immaterial, as the company is on a path to self-funding its own operations in the near future. In other words, that equity stake may not be secured, but the ultimate reward for whatever group that funds Clearwire should more than make up for that risk, too, in terms of total return across its investment.

As I explained in my original article, at current prices, the market is pricing in a capital raise of well over than a billion dollars through just a very dilutive equity sale by Clearwire. I believe the actual probability of that happening is very low – less than 10%, I would say – based on a number of factors including public comments the CFO has made as well as the availability of vendor financing. I would guess the financing will be done in stages – and there will unequivocally be some dilution, but my point is that it won’t be nearly as mush as the market seems to believe.

So when shorts assert that Clearwire tried to raise money last year, and apparently couldn’t, or they tried to sell spectrum, but couldn’t, and/or otherwise appear to have no funding options last year, and then try to pass those observations off as being relevant today, I would remind them that: (a) the company only very recently formalized (and pegged the cost of) a switch to LTE Advanced, (b) the entire management team and board has recently been overhauled, and (c) the competitive dynamics throughout the industry have changed quite a bit from a year ago given the T-Mobile acquisition, another year’s worth of network congestion, a shift in emphasis at CLWR to a wholesale business model, and the emergence of Dish’s interest in the space. These things should take a little time.

Whether you’re long or short Clearwire, I’d also suggest you be sure you know the difference between the FDD and TDD flavors of LTE, specifically as they apply to both coverage- and capacity-based models. And not because it will mean you could get a 2 point bounce in the stock in the second Thursday after the full moon, but because it means the actual probability of Clearwire finding strategic funding/getting another wholesale customer/raising capital through vendor financing is considerably higher than most people who don’t understand the difference appear to believe. The technology matters here, period.

Lastly, with regards to specific partners for Clearwire – standby for rank speculation – I am personally intrigued by the potential for the company to do something with Dish. Again, I have no particular insight into either of these companies on this issue, and the odds are that my interest ultimately ends up being little more than wishful thinking, but I would encourage both longs and shorts to read this week’s Bloomberg article on Charlie Ergen’s plans at Dish and ask if there is a better fit out there than Clearwire. And while you’re at it, check out this article, in which Dish’s CEO mentions the possibility of buying or partnering with Sprint or Clearwire.

So, speculate away, I suppose. The point is that Clearwire has other options than Sprint.

Q. Who do you think is shorting Clearwire, and why?

A. This, or some derivation of it, seems to be the second most popular question I’ve gotten. I have had a decent amount of back and forth with some CLWR shorts based on my previous articles, which is valuable in terms of trying to poke further wholes in my own long thesis. Haven’t found any yet – though funding remains the big topic, obviously. That aside, I don’t particularly care who might be shorting the company, although I can certainly understand how frustrating it can be to see something that’s already ridiculously cheap get even cheaper.

Clearwire has been an excellent short if for no other reason than it’s a complicated story with ugly losses to date, a relatively limited float, and an enthusiastic but impatient retail shareholder base – and that makes its daily price subject to all manner of fear, uncertainty and/or doubt sown by the more nefarious shorts. And yeah, that happens – rules be damned, unfortunately. Those rumors show up in all kinds of places, from Yahoo message boards to crazy WiMax iPhone 5 rumors to mysterious, debunked calls to Bloomberg reporters. It’s ridiculous, but it’s also just part of the market these days.

I would characterize Clearwire shorts as follows:

1 – Those simply hedging the 2015 notes sold last fall. These would be hedge funds largely agnostic about most daily events at Clearwire simply covering their bases.

2 – Those seeing an attractive short-term trade. For instance, by selling puts on Sprint (or just going long), buying Clearwire’s 2015 senior secured debt and then shorting Clearwire’s common stock, you can create the cash that pays for the purchase of the 2015 notes, exploit the angst between the two companies, and have plenty of breathing room if there is a debt to equity conversion at Cleawrie. This trade looks good on paper, I suppose, but it (a) implies that conversion and/or major equity dilution, (b) assumes Sprint is better positioned than Clearwire, and (c) I would guess this trade is getting pretty crowded at this point. But those notes are certainly attractive right now.

3 – Those who believe the company will fail – or be massively diluted. These would be shorts who are skeptical of the company’s future based just on its historical financials and past mis-steps – and/or who believe Sprint is actually trying to bankrupt a company it owns most of. I simply disagree that this will be Clearwire’s fate, as per my previous articles. Time will tell who is right. To their credit, the shorts in this group seem to admit they don’t know the technologies here…and to me, that’s kind of the whole point – it is key to the company getting funding. More on this below.

4 – The amateur shorts. If internet message boards are any indication, this group is large.  It includes quantitative and momentum shorts as well.  Ten years ago, shorts were to be respected, but nowadays, any idiot can short anything, and many do. See this post for a whole ‘nuther rant about restoring the uptick rule and reigning in high frequency trading.

It is also important to realize that the shorts – particularly the ones that own Clearwire debt – have large financial incentives to see the company fail. It’s nothing personal, mind you, it’s just math. Should the company go bankrupt, then shorts never have to cover, and debt holders could acquire that valuable spectrum for pennies on the dollar. Fortunately, a decline in stock price alone can’t make a company go bankrupt, and Clearwire’s actual financials have never been better – though we still have a way to go, and they admittedly are taking a back seat to the company’s current funding quest. So the traders will likely have their way with shares until the current fundraising uncertainty is cleared up.

All that said, in my opinion, Clearwire is currently a dangerous short. If Clearwire raises money, signs a new wholesale customer and/or sells excess spectrum, theshort case in 2 through 4 above evaporates instantly. And we know they are currently working hard on the first two efforts there, while the third would be on the table for the right price. Same holds true to a lesser degree if Sprint clarifies on next week’s conference call that it will contract with Clearwire for WiMax beyond 2012. Lot of risk there, too.

So I can’t quite grasp the bravado on the short side here. Clearwire has one significant challenge right now – finding funding – but shorting based on the presumption that they won’t be able to do that seems awfully risky.

Q. Have you considered that Sprint is trying to force Clearwire into bankruptcy?

A. This is a common perception floating around out there – ever since the Pardus Capital letter this past May and the Sprint analyst day disaster of a few weeks ago. Fortunately – and this will disappoint the conspiracy theorists – it is also doesn’t hold any water. Never mind my own beliefs about why this is silly – here is the Chairman of Sprint’s board two weeks ago when asked about Sprint’s partnership with Clearwire:

“No question we want them to do well; it’s in our interest that they do well. Nothing good happens in a restructuring and there’s nothing good in the outcome of that.”

Sprint will also be paying Clearwire a minumum of $1 billion dollars between now and the end of next year as a wholesaler. That is not the act of one company trying to drive another into receivership. That, incidentally, is also why I am not losing sleep over the impact of new iPhone sales at Sprint on Clearwire’s wholesale subscriber trends. By the time we’ll have that billion dollars in hand, we won’t have to guess and can react accordingly then.

Q. What do you say about the fact that Clearwire’s spectrum is of poor quality?

A. In short – hogwash. Let’s step back for radio frequency (RF) engineering 101.

It’s important to understand that the advantages/disadvantages of any given band of spectrum are not absolute – Clearwire’s included.

Of the many trade-offs an RF engineering team has to make when covering an area with a wireless network, the dominant one is the balancing act between the capex budget, cell size and signal strength. It’s really just physics…higher frequency radio frequency waves can carry more traffic, but they peter out quicker and can’t penetrate structures as well.

Lower frequencies, like those owned by AT&T, Verizon, Sprint and T-Mobile travel farther and fade less over time – so they are "stronger" in the sense they’ll travel through walls. Up to now, in telecom, because all those guys were racing to cover the country with signal in order to get and keep as many subscribers as possible, those lower frequencies were an advantage, because the capex costs were lower (specifically, they had to deploy less towers at $150K each to cover the same area then someone at a higher frequency would have to). So in the historical sense, that spectrum has been judged of higher quality – for that capex reason, really.

But if the whole country is already covered with RF waves, and there is more stuff traveling over them, then coverage is irrelevant, and it’s all about making sure your dense areas can handle all the additional stuff. And higher frequencies are better suited to that.

If you’re an RF engineer designing a new network, you’re basically looking at a map, trying to figure out (among other things) where you should stick the pins, or cell phone towers. Around each pin, you draw a circle with a radius of a certain length. That radius depends (among other things) on the frequency you’re working with.

Lower frequencies travel farther, so your circles are bigger. But you’ll have a lot of empty space in the gaps between where the circles come into contact. No coverage in there. And if you overlap the circles too much to reduce that empty space, you can get interference problems – or you’re wasting money covering an area with redundant signals and gear.

But a wide range of frequency in that area is yours to use in your design. You’ve just got to play with all the variables long enough until it all comes together.

So let’s call that entire frequency range in a given area "A to F." You can best cover that whole area if you (a) minimize the gaps and the overlaps in circles and (b) alter the specific frequencies going in and out of any cell sites sitting right next to each other, to avoid interference problems. So, the first cell site will use frequency A, the next one uses B, etc, until you get to a location far enough away from the first one that you can use frequency A again without interfering with anything other A’s around. RF engineers call this "frequency re-use."

In a capacity-based model – one that means you’ve got to get really deep, tight circles – those large radius cells of the traditional lower frequency operators are in that sense less efficient because you don’t always know how closely you can snug the circles together without causing interference problems. Those signals lose strength gradually and inconsistently. So, frequency re-use can be poor.

You can have much more confidence in the spacing of smaller radius circles (like Clearwire) – and better re-use – because it’s much clearer where the signal is going to drop off. And if, say, four of those little circles cover the same general area as one big circle from above, then after enough of them, they’re going to fill in those previous gaps between big circles, too. The problem is you need more towers to do that, which jacks up your cost greatly. Only Clearwire has already built them out – thus the lack of cash flow to date.

Anyway, that’s greatly simplified. For one, the RF guys use hexagons to cover areas, not circles, but never mind. The point is that advantages in a coverage-based approach to designing a network can be disadvantages in a capacity-based model, and vice versa. Clearwire’s higher frequencies give it an advantage in the capacity-based approach – in no small way because its already put up all its towers and has better frequency re-use. It’s just inherently more efficient. For that kind of use.

A dozen years ago, the propagation problem through walls for higher frequency signals was an issue. That will not be anywhere near the same kind of problem for Clearwire under a wholesale model, though, because (1) smartphones contain chips that also can pass traffic over the WiFi that already exists inside many buildings in urban places – and didn’t a dozen years ago – and (2) as long as another carriers’ lower frequency signal can get inside the building, then the initial lift on getting that traffic from a phone to back outside the building is much more the responsibility of that carrier, and Clearwire picks up the slack, so to speak. In a wholesale model, with everyone on LTE.

So that propagation through walls issue for Clearwire is more of a problem in their retail network – but as they’ve announced, they’re no longer trying to compete there. They’re basically going to milk that retail business to fund the wholesale side. So whatever complaints you’ve seen online from retail customers are no doubt valid…but at some point, they’ll be irrelevant, too.

Also – on the differences between TDD and FDD.  The term "disruptive" is easily the most abused adjective in all of tech, but here’s why it might actually apply to Clearwire’s TDD LTE.

Actually, first you should know that the difference in efficiencies between the two technologies can be defined by a number of things – ranging from chipsets to duplexers to power consumption.

What I think is most relevant, though, is that (a) mobile data traffic is very asymmetric…meaning much more stuff is downloaded than uploaded; (b) asymmetric data is difficult/inefficient for FDD systems to handle, because they were originally built for voice, where traffic up and down is roughly the same; and (c) that asymmetry is inconsequential in a TDD system like Clearwire’s because you can so easily change the up/down ratio.

So here’s my lousy metaphor:

TDD (like Clearwire will have) is sort of like a single two-lane road with a clairvoyant yellow line painted down the middle that moves to either side to let more cars go by.

FDD (what all other 4G operators will have) is more like having two one-way roads that are running parallel to each other, with traffic going opposite ways, and a big wall separating the roads from each other.

All things being equal, you can move the same number of cars both ways, but one is going to be a helluva lot more efficient.

The size of Clearwire’s spectrum means all things are most definitely not equal, though…specifically, that spectrum represents a much bigger road with many more lanes. So more cars can use it. And combined with those crazy lines of TDD, it is a very tough combo to beat. Bigger roads, better traffic management.

All that said, if there is an undesirable part of CLWR’s spectrum, it isn’t due to the frequency or technology, but ownership. Specifically, a relatively high percentage of that CLWR spectrum is leased versus owned outright, and based on industry history, the company’s leased spectrum could be valued less than the owned spectrum by the two big dogs in the industry.

To be clear, that is irrelevant to me at these prices, and implicit in my thesis is that the pending spectrum scarcity problem will either outweigh the historical acquisition preferences of AT&T or Verizon, or – perhaps more important – the company’s willingness to opportunistically sell spectrum to anyone, including private equity firms, means the valuation should reflect the perspective of a much broader range of firms than just AT&T and Verizon.

But there is no denying that AT&T and Verizon have shown a historical preference for license ownership in their acquisitions. I just believe the pool of potential buyers and/or ways to monetize the CLWR spectrum asset is much bigger than those two firms, which is why I did my valuations the ways I did. Plus, AT&T also just paid a big premium for the QCOM bands for which nobody even makes gear yet, so they might not be as stingy here as I am presuming, either, in a theoretical buyout. Too hard to say.

Anyway, that’s a minor but legitimate knock on the spectrum – and for some folks it understandably adds even more uncertainty to things. But it’s overblown to me. Again, I think things are cheap enough down here that even if you thought it necessary to attempt to capture that owned/leased issue in a valuation sense, it would still be immaterial in a pragmatic sense for a potential buyer like DISH, or anyone else, really. So, it’s a negative, but it always has been, and the most likely outcome related to it would seem to be that AT&T or Verizon would attempt to claim a lower price on that portion of leased spectrum in the event of a buyout.

I can live with that.

Q. What do you think about the threat from LightSquared?

A. I don’t want this to sound too harsh, but I have yet to talk to anyone I would consider a reputable source in the industry that believes LightSquared will be a credible operating company. That said, it’s possible I haven’t asked around enough – and I am no doubt biased against them, both as a potential competitor to Clearwire and because they appear to be trying to exert political pressure to get what they want, which annoys me to no end.

These guys knowingly acquired slices of spectrum that were absolutely going to interfere with GPS, then bought political favors in the hopes that they could simply shrug their shoulders when it came to solving the very real GPS interference problems that they created. Things just don’t get much more corporatist.  Where are the hipsters in Zuccotti Park on this?

It’s a crapshoot on whether or not L2 gets FCC clearance, but that is hurdle one of many dozen, really, on the path to building a viable company. One of the other immediate challenges for L2 is, well, raising $3 billion – and some portion of that is likely going right out the door to Inmarsat for debt and lease payments they’ll owe.

So, as an investor, you can either write a $3 billion check to L2, see a chunk of that forked over to another company straight away, and then hope to see an undefinable eventual return on that money in about five years…or you can write a $1 billion check to Clearwire, which is guaranteed to bring in at least a billion dollars from Sprint next year, possibly see a cash on cash return within 18 months, and own a piece of the most attractive remaining independent asset in all of telecom on the eve of the Great Spectrum Crunch.

No brainer. And it seems logical to presume that both companies are probably talking to at least some of the same investors.

That said, L2 does have a point in that the GPS manufacturing industry has been sloppy to date about bleedover in their receivers…but those guys also no doubt felt entitled to bleed over given the nature of those high precision uses, and the fact that all RF anywhere near it was supposed to be low-power. I would guess that’s probably why the FCC has let it slide all these years.

Regardless, there is a lot of spin on both sides of the debate, and we still do not yet know how L2 will address any potential latency problems, as per my original article.

But assuming the FCC okayed L2 using Javan’s mysterious filters, and the GPS industry somehow agreed to eat that $400m retrofit cost, interference is unequivocally still going to be a problem in the L-band for high precision receivers. It’s just that L2 says it’s no longer going to be their problem.

And that brings me to this:

It’s hard to see the FCC endorsing the position that no one is responsible for that interference, as approval of L2 would imply.

And I would also doubt that unfunded mandates foist on everyone operating a high precision receiver in an election year will get much traction, politically.

Regardless, I thought Sprint said it best at their analyst day; the capacity that L2 represents still won’t be enough in the long-run. They believe they’re going to need new spectrum in about four years, regardless. And after all the horsetrading L2 is doing now, the usable spectrum they have will be much reduced if they do get through the FCC, at least for the foreseeable future. Specifically, they’ll have a 10Mhz by 10Mhz carrier – or what Verizon has right now for their LTE network. It’s not a small slice by any means, but my point is they’ll all still have the same problem at year five or so – needing more spectrum.

So if L2 makes it through the FCC, that might delay the time frame over which Clearwire can monetize its spectrum, but TDD over bigger swaths still gives them the easy nod in the long-run – again, assuming, as everything does these days – that they can find the funding to get there.

The other interesting angle to all this is that if L2 can’t get FCC clearance by the end of the year, then Sprint can cancel its agreement and move on to other things. So, it’s going to be interesting one way or the other.

There are also those who do not necessarily believe it is a zero sum game between L2 and CLWR, either, depending on how everything shakes out…though you can probably guess my preference for how all this might end.

So take all of that for whatever it’s worth.

Disclosure: Long CLWR. None of the above should be taken as investment advice. Ever.

First, though, know that I bought more shares in Clearwire on Friday. I viewed the drop last week as an opportunity. I also have no interest long or short in Sprint. All of that may represent biases of some sort in my thoughts below.

Second – the noise this week will probably get temporarily louder. Last week’s drop in price will continue to embolden the aggressive/opportunistic shorts, and the current investor base of Clearwire is, shall we say, a bit twitchy. That combo can be volatile. So, if the past few months are any indication, you should expect more rumors to pop up, whether about bankruptcy, delisting, debt for equity swaps, WiMax iPhone 5′s, or whatever else. My advice is to ignore them. The probability of any of them happening anytime soon is too low to take seriously.

That said, the company continues to face an important near-term challenge – the need to find additional funding. Again, Clearwire says it has enough cash to last through June of 2012, and though I am confident the company can raise capital through several different avenues, there are simply no guarantees. After Friday, it is clear Sprint will not be one of those sources of near-term capital, but as I mentioned previously, Clearwire has other (better) options, too.

If I had to summarize my thoughts about last Friday, I’d say three things:

(1) Clearwire’s spectrum is as valuable today as it was the night before Sprint’s conference call. Right now, based on asset value, Clearwire is the cheapest company I have ever seen.

(2) Welcome to the world of momentum shorts and high frequency trading. And there was no doubt a lot of selling on Friday by speculators disappointed that Sprint did not announce a Clearwire buyout or capital injection. But if you can’t distinguish between price and value, Clearwire is going to drive you insane.

(3) There really was no new news on Friday from Sprint about Clearwire for anyone who’d been paying close attention the last few months.

As Clearwire’s CEO pointed out later that day, Sprint remains completely dependent on Clearwire – through the end of 2012 at least. And nothing in my original thesis was contingent on anything other then the terms of the company’s existing relationship with Sprint, which will continue as expected.

Q. What the hell happened on Friday?

A. I’m paraphrasing there. That same question was asked a handful of different ways – including, “Do you think Hesse is angling for a better price on a take-under of Clearwire?” and, “Do you think Sprint is trying to push Clearwire into bankruptcy to buy that spectrum cheaply?”

First, a little context. From Sprint’s perspective, I think it’s safe to say they feel like they created a monster in Clearwire. Sprint gave them spectrum, helped arrange for strategic equity, and sent them wholesale traffic. In the end, Clearwire not only refused to pay Sprint to host their network like Lightsquared did, but somewhere along the way Clearwire realized they held all the cards in terms of launching a wholesale business – and that would directly compete with Sprint’s own network hosting plans.

In short, on Friday, Sprint failed or refused to answer several key questions about Clearwire for uncertain reasons that made the management team appear unprepared, arrogant or evasive. Regardless, the day further underscored that Clearwire’s largest equity owner (and currently sole wholesale customer) would not be providing any new capital, and that the relationship between the management teams was strained. Here are some other summaries from folks who were in attendance at the analyst meeting (one here and another article here).

So there was some superficial sandbagging of Clearwire by Sprint on Friday based on some combo of legitimate gripes and plain old jealousy, but I don’t think it was done because Hesse is angling for a better deal or a take-under. I think he is simply stuck for the time being, frankly, and is biding time while the other sources of uncertainty for Sprint out there become clearer…i.e. T-Mobile, L2 getting through the FCC, CLWR’s raise, etc…while hoping that a better path forward emerges for Sprint afterwards.

In the meantime, Sprint has to move ahead with LTE plans to compete with Verizon and AT&T, and the iPhone is a must for them as well. So while I’m not sure what that all means for the value of Sprint, I do know none of it impacts the value of Clearwire’s spectrum. And let’s not forget that Sprint will be paying $1 billion to Clearwire for wholesale services between now and the end of next year. This is not the act of one company trying to force another into bankruptcy.

So, to greatly simplify, there is still uncertainty about how exactly the value of Clearwire’s spectrum will get unlocked, but in my opinion, the gap between market and intrinsic value is so large and the timeline long enough that Clearwire should soon be able to find some strategic equity…and then sign other wholesale customers, line up some vendor financing and, along the way, further contrast its own fate with that of Sprint.

That won’t happen overnight, obviously, but it was going to take a little time before last Friday, anyway. And if there was an irony in all the chaos of that day, it was that Sprint appears to now have a harder road ahead of it then Clearwire.

Disclaimer: Long CLWR. The above in no way constitutes investment advice. It is for educational and informational purposes only. Nothing contained here should be construed by anyone as an invitation or solicitation to buy or sell any security. It does not contain personalized legal, tax, investment, or financial advice.

My first job in this industry was as an analyst for a small independent research shop just outside Washington, D.C. It was a technical shop that specialized in just one thing: tracking the buys and sells of corporate insiders. The legal, open-market kind, mind you. The theory the founder subscribed to – and that numerous studies confirmed – is that investors could outperform the market by buying the shares of those companies whose executives were also buying shares, ostensibly because those insiders had better insight into the company than investors.

That small little firm made a ton of money by selling expensive annual subscriptions to its research service to just a few dozen institutional investors, most notably some well-known hedge funds and a handful of even more popular mutual fund companies. The founder had developed a proprietary database that tracked every insider buy and sell of the previous 20 years or so, with deep search functionality, share price data and graphing capabilities.

That was not easy to build, considering that when the firm started, they had to pay someone to literally sit in the offices of the SEC to photocopy the physical Form 4s that came in through the mail and were dumped onto a desk every day. But by the time I’d gotten there, thanks to the mother of all insider databases, with just a few MS DOS commands (don’t ask, kids), you could quickly sort out the wheat from the chafe in terms of insider transactions.

If you’ve ever seen The Matrix, I was “Tank” at that job. I sat alone, surrounded by screens of otherwise indecipherable data that poured into via specialized feeds all day long – from 8 in the morning to 10pm, Monday through Friday, and eight to noon on Saturdays. It. Just. Kept. Coming. Long hours spent running queries were occasionally punctuated by moments of pure panic when a significant buy actually happened. Or when Laurence Fishburne called looking for a phone booth.

There are a number of research firms (and now automated services) that parse insider trading data, trying to derive insight on everything from buy/sell ratios to monthly insider volumes. They were all, to us, just bunk. That’s because, statistically speaking, we could prove that the vast majority of insider selling was meaningless. It was noise. There was little correlation between the vast majority of selling in a company’s shares and subsequent stock performance.

Here’s something that most people don’t realize about insider buying, though:

Most insider buying is also meaningless.

The truth is that most insiders are mediocre investors. While a select few are very, very good, many more are awful. And good returns were most often indistinguishable from luck. So while you might think insiders would have an informational advantage, as a group they often seemed to suffer from the same blind spots and/or delusions of grandeur as armchair investors.

Occasionally, an insider would try to game things, simply because they were aware that some schmuck like me was watching those Matrix screens. If he moved the needle enough with a big enough open market purchase, they knew some bleary-eyed analyst would instantly be sent scrambling to, say, get a report up and out to Druckenmiller’s guys before they heard about it first and called in hollering. So, to amend Peter Lynch’s oft-repeated quote about insider buying:

“Insiders might sell their shares for any number of reasons, but they buy them for only one two: they think the price will rise, or because they think they can impress the hedgies.”

Anyway, the reason our little shop did so well was because we were able to tell quicker than everyone else which insider buying was analytically significant. And here’s a hint – out of the thousands of Form 4s that are filed every month with the SEC, only one or two of them mean anything.

All of that was a long-winded way to say this:

There is a relatively small number of corporate insiders that have actually demonstrated real skill at investing in the common stock of their own companies. If you ignored all the meaningless insider buying – and just about everything else, actually – and did nothing more as an investor but buy shares in a company right after one of these guys did, then you would do very, very well.

One of those guys was John Stanton.

Stanton, the current chairman of Clearwire, was nothing short of a legend back then in that little niche of equity research. Without sounding too breathless, Stanton’s track record of insider buys at both VoiceStream and Western Wireless – companies that he personally ran – was phenomenal. To put it simply, at both companies he bought millions of dollars worth of shares at very low prices, then sold both companies for billions of dollars near their peaks.

Here’s his official Clearwire bio:

John Stanton, Executive Chairman of the Board of Directors, has held numerous leadership positions during his career in the wireless industry. He currently serves as chairman of the board of Trilogy Partnerships including Trilogy International Partners, which operates wireless systems in Haiti, Dominican Republic, Bolivia and New Zealand. Stanton served as chairman and CEO of Western Wireless Corporation from 1992 until its acquisition by ALLTEL Corporation in 2005. From 1994 to 2003, Stanton served as chairman and CEO of VoiceStream Wireless Corporation, which was sold to Deutsche Telecom and became T-Mobile USA.

I no longer have access to industrial-strength databases when it comes to Form 4 analysis, but I don’t really need it, either, to give you a glimpse of Stanton’s abilities. Here is a spreadsheet detailing all of Stanton’s insider buying back until 1998, sliced a couple of different ways.

If I were to summarize the highlights, though, it would look like this:

As CEO of Western Wireless, Stanton bought 4.4 million shares on the open market over a seven year period, at an average price of $7.71 per share. He sold the company for $40 per share. So he earned a 420% return on those shares.

As CEO of VoiceStream, Stanton bought (and acquired options) for 2.9 million shares at an average cost of $6.39. He later sold that company for about $122 per share, racking up returns of (you better sit down now) over 1,800%.

Now that VoiceStream data is a bit muddled. Prior to 1998, you cannot easily differentiate between an open market buy versus an option grant on the SEC site. Plus, VoiceStream was bought out by Deutsche Telekom in a cash/stock deal that ended up being structured several different ways, so his shares might have sold for something slightly different, depending on which option he took.

Regardless, even if these estimates of Stanton’s returns in VoiceStream were off by 1,500 percentage points, he’s still in the insider buying Hall of Fame.

To tie this all back into Clearwire, my point is this: I believe that Stanton’s recent insider buying of $5 million worth of Clearwire shares in August is significant, as it has much in common with those previous two home-runs above. Stanton apparently sees a lot of value in Clearwire at recent share prices.

Of course, the fact that a man you’ve never met has bought shares in a particular company is certainly no reason to invest in that company in and of itself. And to clarify, I started buying shares in Clearwire before Stanton’s most significant recent buying there – so his buying was confirmation, rather than a signal.

But I do think it all brings up a very valid question, which is, “What exactly does John Stanton see in Clearwire?”

I think I figured it out. My analysis of Clearwire was published this morning on the Seeking Alpha website. You can read my thoughts in full right here:

“A Value Investor’s Case for Clearwire.”

It gets a little wonky, but please check it out when you get a chance, and let me know if you have any questions.

Otherwise, here’s to pulling for some of that ole Stanton magic, eh?

Disclaimer: Long CLWR. The above in no way constitutes investment advice. It is for educational and informational purposes only. Nothing contained here or on the Seeking Alpha site should be construed by anyone as an invitation or solicitation to buy or sell any security. It does not contain personalized legal, tax, investment, or financial advice.

Closer up the shirt looks more like this. The front, anyway. On the back is printed what is perhaps the most coveted piece of timeless investing wisdom in the universe – known only to an elite, good-looking few.

My investors are awesome.

Now you may be saying to yourself, “Wait – Jackson Hole? A few weeks ago? Wasn’t that where they held that meeting with all the masters-of-the-economic-universe?”

To which I’d reply, “You know what’s even crazier? This picture was taken by a distinguished balding gentleman. One of those reserved, academic types. With copious facial hair. And whose last name begins with the letter B.”

Yup. Just blew your mind.

In any case, at least my T-shirts got out of the office this summer.

And drop me an email if you’d one day like an IIM T-shirt of your own.

Dear Investors,

Consider this just a quick update on our August performance. I’ll have a more traditional letter to you after the end of September.

In August, the Tarpon Folio declined by 4.7%, compared to a decline of 5.7% in the S&P 500 Index. In its third year, Tarpon is up 4.9% through the end of August, compared to a negative 1.6% return for the benchmark index.

The Gecko Folio declined 2.6% in August, and in its third year is down 0.8% compared to a 4.8% decline in its benchmark over the same period.

The monthly numbers for Tarpon in particular fail to convey the kind of month we really just went through, however. In mid-month, for instance, Tarpon was at one point briefly down 16.6% for the month. The strong rally we saw in Tarpon after that, however, was due to several things, not the least of which was this:

A few days prior to the nadir in the fund’s performance, I’d made Clearwire the largest position in Tarpon, with a share price for us of $1.64. By month end, due to a string of developments, Clearwire shares closed at $3.21. In other words, we clawed our way back by notching a 96% return in our largest holding over a few weeks time.

There were probably many lessons learned by investors in August, but if Clearwire is any indication, the one that seems most appropriate is once again Warren Buffett’s advice, “Be greedy when others are fearful.”

And speaking of Buffett, our performance in Gecko was also aided this month by our purchase of high-yielding preferred shares in Bank of America just days before the Oracle of Omaha struck his own deal with BofA. I believe the investing lesson in that case was,” Sometimes it’s better to be lucky than good.” But I’ll take it.

So August, in retrospect, was a gut-check kind of month. Had we been surfing, I’d have said that some days we rode the wave, and some days the wave rode us. But we’re still paddling.

We’re not out of the woods yet in terms of the economy. Today’s unemployment report was miserable but not unexpected, and the situation in Europe warrants continued close watching. The Euro countries seem to be taking slow, covert steps towards fiscal union, which though politically controversial seems pragmatically inevitable. So in the meantime, it’s probably best we not let that Clearwire thing go to our heads.

Our companies are still cheap. Valuations will one day matter again. So, as always, we will continue to fight the good fight.

More in a month. Enjoy the long weekend.

- Cale

Here are the answers to the most common questions I’ve been getting about the letter so far:

I made Clearwire a 10% position in Tarpon in the middle of the month. I would have made it bigger, but it started to get away from me.

No, I haven’t sold a share yet. There are not too many times you come across an opportunity like that. It could make for a bumpier short-term to hang on, but it will ultimately prove wise, I believe.

You can sign up to receive my letters directly here. The archive is here.

Disclaimer: This post in no way constitutes investment advice. Same for my Letters to Investors. My investors and I own shares in Clearwire. Commentary on this blog or my emails should never be relied on in making an investment decision.

Special Edition. My letter to investors from the Sunday night right after the S&P downgrade.

Special Edition Vol. II. Sent late Friday night after the end of that same week.

And here is a transcript of the investor conference call I held on the Thursday before the downgrade.

That call had actually been planned for weeks prior to the dizzying sell-off that same day, and the prices of several of our holdings had gotten beaten up pretty bad in the hours before the call (the same companies brought up in the Q&A). I’d been averaging down all day, and I think the timing of the call turned out to actually be pretty good in terms of being able to share some thoughts real-time from the front lines, so to speak. And the prices of each of those beaten up companies have since come back. So I’d like to think there was another lesson to be learned in there about not blindly following the rest of the lemmings off the cliff. The intrinsic values of our businesses have absolutely nothing to do with CDS spreads in Italy.

On the call I also talked more about our new investment in Clearwire. And based on some recent headlines, I’m not the only one to think shares were too cheap to ignore.

You can sign up to receive my letters directly here.

Disclaimer: This post in no way constitutes investment advice. Same for my Letters to Investors. My investors and I own shares in Clearwire. Commentary on this blog or my emails should never be relied on in making an investment decision.

As I mentioned in the letter, I don’t normally put too much emphasis on macro predictions, market volatility, or noise in the media in general. But it’s also easy to get depressed these days if all you hear is headline news. I think it’s important for long-term investors to realize two things in particular during times like this:

1 – Not all market downturns should be avoided. Some represent opportunity. This is one of them.

2 – Things are rarely as bad as you initially fear. Once you truly realize that you can not only handle volatility in the stock market, but do better later because of it, the market will lose its ability to make you anxious.

Also, in reference to my point in the letter about the question of who is going to buy Treasuries once QE2 stops, I thought this was an interesting take from the CEO of Blackrock, the largest asset manager in the world:

BlackRock Inc.’s (BLK) chief executive, Laurence Fink, said Friday that as the Federal Reserve exits its bond-buying program and investors seek to lower their risk, the private sector will move “huge” into U.S. Treasury debt issues.

“Investors are de-risking,” Fink told CNBC in an interview. “They are frightened of the world and all these issues we have in front of us.”

As a result, he said, “Banks are going to be forced to invest in Treasurys.

“As we’re weaned off all this purchasing from the Fed, we see a huge demand from the private sector.”

Fink also said he doesn’t see any need for another round of quantitative easing — the latest Fed buying is known as QE2 — because “we still have positive growth.” The CEO anticipates the U.S. economy to grow by about 2% for all of 2011.

Again, there will be no black hole of demand for Treasuries on July 1st. That’s just silly. Banks are sitting on hundreds of billions.

More in my letter here.

Disclaimer: This post in no way constitutes investment advice. Same for my Letters to Investors. Commentary on this blog or my emails should never be relied on in making an investment decision.

Next Monday, May 16, from 4:00 to 5:00 EST, I’m going to be joining Zack Miller of Tradestreaming.com for a webinar called:

“From the ground up: How to build a successful money management firm.”

The pitch for it is below. Join us if you can, eh? Gonna be fun.

And please reserve your webinar seat at:
https://www3.gotomeeting.com/register/545041518

Is your investment practice what you want it to be?

Many professional investors have changed their business models over the past few years. Wirehouse brokers are breaking out and going independent. Many are choosing to start or join existing RIAs. Many others are creating their own hedge funds.

Everyone is looking for the right business model, the right structure for their investment business.

Cale Smith, founder of Islamorada Investment Management, believes he’s built a better investment business mousetrap.

Called Spoke Funds®, these structures solve some of the problems associated with mutual funds (underperformance, tax inefficiency) and hedge funds (compensation schemes masquerading as an asset class).

The Spoke Fund® structure aligns incentives by ensuring the investment manager invests most of his liquid net worth in the same portfolio he’s selling to investors.

In this webinar, you’ll learn:

- Why the existing vehicles for your business (mutual/hedge funds) are broken
- How Spoke Funds® solve these problems
- Why Spoke Funds® are perfect for managers who are value investors
- How they lower start-up costs and get into business faster
- How their transparency is attracting a new class of investor

Please join Zack Miller of Tradestreaming.com and Cale Smith of Islamorada Investment Management for a frank and open chat about the future of the investment management business.

Here’s that registration link one more time. And after registering you’ll receive a confirmation email with more detailed information on joining the webinar.

Thank you!

Pentwater Capital Management, the fifth-largest holder of shares in Leap Wireless (LEAP), is going activist. As in, it’s nominating three directors to the board to give the existing directors and management a few swift kicks in the pants. My words, not theirs. Pentwater does believe Leap is “significantly undervalued” though – I’ve been saying the same thing – and they have apparently had enough.

Here’s a link to the letter Pentwater wrote to the LEAP board. A little hyperbolic to be sure – the fourth quarter was strong for LEAP – and though most activist investors are often just whiners with clout, in general, I’m all for Pentwater turning the heat up a bit over there.

The second catalyst was expected, although the timing of it was uncertain until today. According to this filing, North American Financial Holdings or NAFH, which owns 83% of Capital Bank (CBKN), has scheduled a conference call with its investors to disclose that it is seeking regulatory approval to combine the three banks it owns – Capital Bank, TIB Bank down here in the Keys and NAFH National Bank (which contains three formerly failed banks it bought on the cheap from the FDIC). NAFH will likely seek to combine its holding companies, too.

Disappointingly, the authors of several of the press reports I read this afternoon seemed to be shrugging their shoulders at what happens next. Well, I’ll tell ya what I think happens next: exactly what page 48 of last December’s CBKN proxy said would happen. Specifically:

“…the Purchaser intends to use the logos, brands, trademarks and service marks of the Company and the Bank to market the businesses of other banks and bank holding companies in which it has a majority equity interest.”

Which, when corroborated by a handful of local news stories up in North Carolina, would seem to mean there is a high probability that all the banks NAFH owns will soon be under just one masthead…that of our little ol’ CBKN. And that new and improved version of the bank will have assets of about $4.5 billion and a footprint stretching from Raleigh to Miami.

No guarantees and a lot more to it, of course, including some fuzzy accounting rules and some contingent value rights, and, yes, the consolidation could happen in any number of ways, some of which could be detrimental to us newer minority CBKN shareholders…but for a number of reasons, I doubt it. Margin of safety and all. Here’s the slide from the annual meeting a few weeks back that mentioned our investment in Capital Bank.

In any case, Tarpon is also sitting on some cash right now, so I’m back in the cave on a handful of potential new companies. Could be a bit, so shoot a flare if you need anything.

In the meantime, here’s to hoping we see a few more down days in the market. Where’s a completely irresponsible emerging market government when you really need one?

Disclaimer: My investors and I own shares of Leap Wireless and Capital Bank. This post in no way constitutes investment advice. Commentary on this blog should never be relied on in making an investment decision. So, if you go out and buy shares in either company based on the above, you are on your own, knowwhatImean?

It’s right there on page 227 of my 1990s copy of Random Walk Down Wall Street.

By the time the portfolio contains close to 20 equal-sized and well-diversified issues, the total risk (standard deviation of returns) of the portfolio is reduced by about 70 percent. Further increase in the number of holdings does not produce any significant further risk reduction.

Academic literature backs this up.

My problem is that mutual fund managers never seem to have read any of it, because when I look up the number of holdings of most mutual funds, I’m stunned.

Fidelity’s Magellan Fund – 249 different stocks. As in, a quarter-of-a-thousand.
American Funds – Investment Company of America – 154 stocks and 111 bonds.
American Funds – Growth Fund of America – 275 stocks.

And these are some of the biggest funds in the world.

Now you might ask: isn’t owning 200 stocks just diversification? Isn’t that a good thing?

Before I answer, let me clarify one point for those who have heard me rant about diversification before.

Should the opportunity ever present itself, I would theoretically consider putting my entire net worth in a single investment. As investors in my portfolios know, I believe strongly in taking meaningful positions in the stocks you own. Great opportunities are just that rare. However, if you were to next ask me how often I really expected to be presented with the kind of opportunity that deserved all my net worth, I’d say: never. Those opportunities don’t exist in the stock market.

So, back to that question about owning 200 stocks. I do believe that some diversification is a good thing. However, and this is really my point, over-diversification is not. It’s bad. Very bad, actually, since over-diversification is by definition added expense with no reduction of risk.

What those fund companies above are doing is creating “closet index funds” that basically mirror the broader stock market, while charging you actively managed fund prices. As John Bogle, the godfather of index funds, once said about mutual funds, “The scandal is not what’s illegal. It’s what’s legal.”

If you get proper diversification with 20 stocks, then why pay the extra expense of researching 200 more? That added expense doesn’t lower investors’ risk – it just decreases their returns. From the fund company’s perspective, though, it certainly decreases the odds that investors leave the fund.

Now, to be clear, this isn’t entirely the fault of mutual fund managers. The funds themselves have restrictions on how much of their portfolio they can invest in any one holding, and as these funds approach behemoth size, there are effectively more restrictions on them. That’s a good argument for investors to stay away from behemoth mutual funds, too, by the way.

But I do think some managers hide behind those fund-imposed rules, too. They are simply protecting their collective behind. It’s that old saw, “It is better to fail conventionally than to succeed unconventionally.” And that manager knows if he spreads out his client’s dollars across hundreds of holdings and one does poorly, no one will notice.

I take a different approach at my firm. And so do these other Spoke Fund® guys. I have 16 companies in my main portfolio – and that number will likely drop before the end of this year. I’d like to think my investors get what they pay for – and that’s not a manager that over-diversifies and hides his stock picks in a forest of holdings. I do my homework, pick a few great companies, and stay on top of each of them. And if my investors call with questions about the companies we own, we actually talk about them.

You think a mutual fund manager is really on top of the 233rd holding in his fund?

Quick note on that picture above:

Happy Veterans Day.

Background on Shipping

Global Ship Lease is a cutting edge biopharmaceutical company focused on the commercialization of therapeutic rapid-acting immunotherapy and refractive disease treatments.

Nah, I’m just kidding. I have no idea what that means. But it was a lot sexier than describing Global Ship Lease’s actual business. Which is, well, shipping things. By lease. Around the globe.

All the good domain names were taken, apparently.

In any case, shipping is probably the most important lousy industry you’ve never really thought about. At first glance there’s just not much to mull over when it comes to millions of identical 40-foot containers. It’s a commodity business in the sense that these days it effectively costs next to nothing for big companies to move goods overseas. There are also a ton of competitors, the industry is notoriously cyclical and capital-intensive, and most firms find themselves at the whim of large, powerful customers. In container shipping in particular, there are a ton of new ships – more than 30% of today’s existing fleet – currently being built. Overcapacity and rate wars are a recurring, permanent, and predictable part of this industry.

That said, there is no more efficient way for companies to transport their goods overseas than via containerships. By some estimates, 90% of the world’s “non-commodity goods” (think flip flops, margarita machines, tiki huts) will see the inside of a container this year. And the world’s ports handle about 1.5 million of those 40-foot containers every week.

Because of all those boxes, scale is the holy grail when it comes to shipping operators. Bigger ships haul boxes at lower cost. Specifically, lower costs per container means a firm can charge lower rates, which means they’ll attract more freight to move, which means they’ll be able to fund even more investments in even bigger ships, which will then lower their costs even more. So in good times, despite being in a tough industry, the economics of ship operators can be pretty attractive.

These have not been good times, however. And when things are bad in shipping, they’re, like, The-Adventures-of-Pluto-Nash bad. The economics of the industry explain why – and those can be boiled down to two words:

Fixed costs.

Specifically, shipping companies typically borrow large sums to buy and/or build new ships in pursuit of scale. An operator’s fleet of ships typically represents 90% of the company’s fixed assets and 70% of the total cost of running the business. Because so much of those costs consist of principal and interest payments on debt, they need to be paid no matter what.

Fixed costs also mean that in a global recession, shippers take it directly on the chin – in four ways, no less:

1 – A decrease in the amount of cargo being shipped means an operator’s fixed costs per container increase, while

2 – operators cannot maintain profitable rates, since they’re in a race to lower rates and book at least some cargo to service their debt, and

3 – both of those things mean the value of the company’s ships decreases, which

4 – means that the holders of debt that is collateralized by those ships may make aggressive demands to protect themselves from declining cash flows and dropping asset values.

All of which brings us to GSL.

Introducing Global Ship Lease

GSL is really in the business of moving cargo. It just does this by operating ships. More specifically, it buys containerships, then operates them under long-term, fixed-rate, take-or-pay contracts – meaning the company doing the shipping either uses Global’s shipping services as previously agreed, or they pay a penalty.

Those sorts of contracts are attractive because they provide a tremendous amount of predictability when it comes to cash flow, and they’re a pretty good deterrent when it comes to discouraging a customer from trying another shipper.

Plus, based on those contracts, ship operators like Global Ship Lease can really program in their own growth. It just has to be balanced with credit risk of their charterers. And therein lies a primary reason why GSL was trading at just two times cash flow this summer: all 17 of its ships serve a single customer – and that company appeared to be in dire trouble.

CMA CGM is a privately owned French company that is the third largest container transportation and shipping business in the world. It employs over 17,000 people and though it also runs containership operations similar to GSL, it’s a much more sprawling enterprise that includes luxury cruises, terminal operations at various ports, railways, logistics and passenger ferries.

Like all companies associated with transporting goods, CMA CGM suffered mightily during the recent recession, and had it defaulted on its own debt, then a wipeout of the equity at GSL seemed likely. In addition, as per those four points of doom above, GSL’s banks effectively forced the company to divert all its cash flow towards paying down debt. That meant its once-healthy dividend was suspended. And GSL’s share price plummeted.

One of the many odd things about this summer in the stock market, however, was that GSL’s share priced stayed depressed even as concerns about its big, sole customer CMA CGM began to diminish. There is no disputing that CMA had a very tough year in 2009, but business has bounced back and then some in 2010. The company should throw off well over a billion dollars in cash this year, according to recent media estimates. And had you the desire to track the prices of CMA’s unsecured debt trading in German, you’d see the bond market’s confidence in CMA CGM return as the summer went on – meaning the credit risk to GSL was dropping, too.

Perhaps just as relevant, however, is the fact that CMA CGM is actually the parent of GSL. Global Ship Lease was effectively carved out of CMA CGM several years ago, and the latter still owns a significant stake in GSL – over 45%. In addition, CMA is currently also getting paid by GSL, albeit very modestly, to provide ship management services to our company. So despite being separate companies, the ties are still very strong.

This, to me, represented diminished risk for GSL – or at least less risk than the market seemed to be presuming. If you’re going to only have one customer, after all, it’s reasonable to presume that if that same customer also owns almost half of your business, your interests are going to be aligned. And if that business also represents a potentially significant investment return for the customer, all the more reason to breath a tad easier.

Now it’s true that in this case that single customer has an incredible amount of power over the business, but GSL is lugging boxes across the pond here, not patenting cold fusion reactors. The key variables that drive revenue in this business are very transparent to all players, and macro forces tend to affect most industry players more or less simultaneously. So as long as GSL is maximizing the efficiency of its business – controlling what it can, in other words – there’s really no reason CMA needs to meddle. And it’s already got control of ship management, as I mention below.

Global’s relationship with CMA CGM also provides what is probably best referred to as a pseudo-moat. Again, the only real competitive advantage in shipping lies in economies of scale and the low cost of operations they enable – and GSL is way too small to claim any scale. So it has no moats in the traditional sense.

That said, Global does have, by nature of its unique relationship with CMA CGM and long-term contracts, two of the same advantages that are afforded to businesses with real moats – a reasonably high degree of predictability in earnings, and a systematic means by which it can significantly grow. Put another way, the odds of another ship operator stealing GSL’s business away from CMA CGM is slim to none. After all, CMA already has a huge fleet of its own containerships it could give that business to if desired. So while the long-term durability of GSL’s relationship with CMA CGM is very much open for debate, the company does appear effectively shielded from competition for the time being. And given how cheap GSL shares were this summer – and back into last year, for that matter – it was clear that even this pseudo-moat was not being fully appreciated by the market.

To be clear, while the risks of dependency on a sole customer appear to have eased considerably, GSL still has several lesser challenges ahead of it – most notably that the company needs to come up with more capital to close a funding gap for two new ships it has already ordered. Yet despite the dramatic rise in share price this month, and the existence of several other near-term challenges for the business, I continue to hold our shares.

Why is that, you might ask?

The dividend, my friends.

What Are Shares Really Worth?

Actually, that’s not the only reason we’re holding tight. GSL is also still cheap – and it’s relatively easy to demonstrate that point to yourself with some back of the envelope calculations if so inclined.

Again, GSL has those predictable cash flows due to its long-term contracts. In its SEC filings the company fully discloses the length of each charter contract, as well as the amount they are paid on a daily basis for chartering each ship. The company’s expenses are relatively easy to gauge if not handicap, too, since GSL actually outsources “ship management” to a division of CMA CGM.

These services include the day-to-day technical services like crewing, maintenance, buying supplies and towing, for instance. GSL pays an annual fixed management fee, and reimburses the management company for operating expenses up to a capped amount. Global also pays drydocking expenses and insurance premiums. Global Ship Lease does not bear the costs of fuel or anything else associated with loading, unloading or transporting containers. That’s all on the customer.

So, throw in some overhead, adjust for depreciation and a few other non-cash items, and you can determine the company’s free cash flow – and, ultimately, a range of possible values that centers around $7.00 per share.

That can be a pretty wide range, mind you, depending on how granular your assumptions become, and that sort of approach arguably ignores some things that a more formal model would not…but, well, yesterday shares closed at $4.60. So I think it’s safe to say that there is still a large gap between the company’s real value and what the market thinks it’s worth.

Also, if you value GSL on a relative basis – meaning compare certain financial metrics head-to-head with competitors of comparable size and strategy – it’s not too difficult to come up with a value of $9.00 per GSL share, either. I tend to put much more credence on valuations done using former approach, mind you, but when things appear so cheap, it never hurts to get a second opinion.

In either case, though, the point is that GSL shares, on a reasonably objective basis, still look cheap.

Wait, It Gets Better

Back to dividends.

You’ll remember GSL had to suspend its dividend to keep the bankers happy. If operations continue to improve – and providing the aggregate value of the company’s vessels increases back above a specific lender-mandated level – then not only will Global’s current borrowing costs decrease, but the company will be allowed to resume its dividend once cash flow exceeds $10 million per quarter. While that day could be as much as a year away, I suspect it will be sooner. Regardless, though, it should be worth the wait.

It’s difficult to estimate with a high degree of confidence the amount of the dividend that Global will eventually begin paying out again. The company is mum. Based on past history, though, as well as some educated guesses based on estimated cash flows, it can be instructive to run a few different scenarios. I believe it’s probably overly conservative to estimate the dividend would only be $0.30 per share per year, but we’ll start there. It’s probably more likely the dividend would be closer to $0.60 per share, and should things improve further, an eventual resumption of the $0.92 a share dividend that the company paid out before the Great Recession would seem well within the realm of possibilities.

So if you were invested in Tarpon prior to the end of July, when I bought our shares in GSL, your cost basis is about $2.35 per share. Should GSL eventually begin paying out that dividend of $0.30 a share, then, your yield would be 13% a year. At a dividend of $0.60, you’d then be earning 26%. Per year. Forever, maybe. Doing nothing more than just brushing your teeth, even. And should the dividend hit the old $0.92 payout level, that’s a potential yield of 39% a year for pre-July investors in the Tarpon Folio.

But those who feel late to the party shouldn’t exactly be fretting, either. Even if you bought shares at the close yesterday of $4.60, your annual dividend yield would be 6.5% at the $0.30 a year rate; 13% at the $0.60 a year level; and 20% at $0.92.

Again, these levels are ultimately all speculation on my part. But dividends don’t lie, and it’s that sort of simple math, I suspect, that was driving GSL’s returns in October. Those kinds of yield are obviously attractive to many investors, especially these days, and I suspect more will begin to take notice as operations at GSL continue to improve and the fears surrounding CMA CGM continue to recede.

That said, nothing in investing is guaranteed. There are certainly risks that could prevent us from realizing those sorts of returns, or that might extend the timeframe over which we might see the first dividend. And shares almost certainly won’t continue their recent dramatic ascent unabated over the next few months.

But in GSL I think we have very good odds of, over the long-term, benefiting from both significant share price appreciation and a very high yield. That’s a rare combination.

The best part is that the hard work is over. All we’ve got to do now is wait.

And a tip of the hat to Michael Demaray of Elevated Capital for the original GSL idea.

Disclaimer: My investors and I own shares of GSL. This post in no way constitutes investment advice. Commentary on this blog should never be relied on in making an investment decision.

The performance mentioned above is highly unusual and cannot be sustained. Because the Tarpon Folio contains a limited number of companies, its returns will be more volatile than a portfolio investing in a higher number of stocks. Positive returns are not guaranteed. Individual results will vary depending on market conditions and investing may cause capital loss. The performance data is “net of all fees” reflecting the deduction of advisory fees, brokerage commissions and any other client paid expenses and includes the reinvestment of capital gains. The publication of this performance data is in no way a solicitation or offer to sell securities.

As I told some folks earlier, though, benefiting from last Friday’s surge in price wasn’t due to any particular insight into the quarter on my part. Good things happen when you combine moats with cheap prices. And Google is simply the most competitively advantaged company in the world today – bar none.

From Prof. Bruce Greenwald at Columbia, via the highly recommended book The Curse of the Mogul: What’s Wrong with the World’s Leading Media Companies:

The quest to identify a single ingredient that explains Google’s remarkable results and resilience is itself misguided. Google is the rare company that seems to have strong elements of all three of the most important sources of competitive advantage identified – economies of scale, customer captivity, and cost. More remarkable is that Google displays multiple manifestations of each of these categories of advantage: Google achieves scale both by the relative size of the fixed cost and network effects, it retains customer captivity of both consumers and advertisers because of habit and switching costs, and it secures a major cost advantage through proprietary technology and learning.

Google is also, among other things, way out front in terms of turning computing power into a utility. If you invest in technology companies and have not yet read The Big Switch by Nicholas Carr, put that margarita down this instant and go buy it here right now.

Disclaimer: My investors and I own shares of Google. This post in no way constitutes investment advice. Commentary on this blog should never be relied on in making an investment decision.

I haven’t written much publicly to date about Gecko, as managing Tarpon seems to keep me awfully busy, but I hope to post more about the fund and its holdings soon.

In the meantime, here is some marketing propaganda, er, our brochure.

Disclaimer: This performance is highly unusual and cannot be sustained. Because the portfolio contains a limited number of companies, its returns will be more volatile than a portfolio investing in a higher number of stocks. Fund inception date 1/26/2009. Returns above are as of 10/15/10. Positive returns are not guaranteed. Individual results will vary depending on market conditions and investing may cause capital loss. The performance data is “net of all fees” reflecting the deduction of advisory fees, brokerage commissions and any other client paid expenses and includes the reinvestment of capital gains. The publication of this performance data is in no way a solicitation or offer to sell securities.

One of the more common questions I got over the summer was with regards to the level of cash inside the portfolio. As I’ve mentioned previously, I assume each of you holds your cash somewhere else – at the bank, for instance, or in a tin can in the backyard. And unlike many mutual fund managers, I can exit or enter most positions in our portfolio very quickly. So I don’t typically feel the need to hold lots of cash in Tarpon. And I wouldn’t have remained fully invested in Tarpon this summer if I didn’t think it would ultimately increase our returns in the long-term. Allow me to explain.

I think my philosophy on cash in the portfolio can best be explained in two words:

Garrett Wittels.

Wittels is a shortstop on the Florida International University baseball team. This spring, he tied Joe DiMaggio’s famous 1941 streak of hitting in 56 consecutive baseball games. FIU’s season ended with Wittels two hits short of the NCAA record of 58 games (set by Robin Ventura at Oklahoma State in 1987, Mr. Trebek). Fortunately, he will get to resume his record-setting attempt next season when he returns to the team as a junior.

Hitting a baseball with any kind of consistency is, to me, one of the most challenging feats in athletics. Of the many factors that explain Wittels’ success, there’s one that seems to be a particularly apt metaphor for investing these days.

As a younger hitter, it turns out Wittels had trouble hitting curve balls. So intimidated was he by the sight of a hard-thrown ball coming directly at him that he’d often scamper right out of the batter’s box before the pitch would break.

After exhausting all other means to break his son of this habit, Wittels’ father, in apparent desperation, decided to build cement walls around three sides of the batter’s box in their backyard. This left Garrett nowhere to go when the curve ball came. And then he began to hit it.

This summer I essentially dragged all of you into a batter’s box with me to wait for the best pitches the market would give us. I imagine to some of you newer investors, watching your accounts may have felt a little like being walled off in a cement batter’s box. But when things aren’t really as bad as the masses believe, holding a lot of cash in a portfolio is like scampering into the dugout. I believe we absolutely have to stand square in the box because – and there’s no other way to say this – the pitcher was out-of-his-mind drunk. Schnockered. Toasted. Blottoed. We were going to see some great pitches. And we did.

Now it certainly got a little wild in there. Balls were sailing all over the place. We got plunked now and again when the wind blew hard. That won’t matter a few years out, though. I’ll take a few on the chin if it means I can keep buying Lowe’s at $20 a share. And I’m pretty sure I can keep waiting for those perfect pitches longer than that pitcher can keep drinking.

Read the whole letter here. And sign up here to receive them via email.

I like the TNDM deal with Tinet…hard to argue that it’s not an intelligent use of cash. Fits strategically, moves EE forward by light years, which is important for network effects, and total earnings power goes up, too. Market didn’t seem to get it when first announced, but nothing new there, I suppose, and things seem to be coming around a bit since.

At a high level, on the legacy business, think there are two camps on TNDM among fundamental investors…guys who think pricing is the most important factor when customers select their service provider, and those (like me) who think the number of switches is the relevant factor. Peerless is much more a beneficiary of Verizon Wireless’ policy to have two suppliers for everything than a real threat to TNDM. At least to me.

Been asking around my old telco circles about Tinet, but they’re largely an unknown here in the U.S. I can’t see them competing with Cogent on price for transport, but they may not need to, either if Ethernet Exchange grows. EE is not real well known either, at least among my contacts, but I can’t say I was surprised to hear that, as it probably underscores how young that market it.

So, some uncertainty continues at TNDM, though arguably less than a month ago, and still not much risk. I added shares after the Tinet deal, and intend to keep holding until shares reach a target range much higher, all things being equal.

Here’s a link to more info about the deal on the TNDM IR site.

This site and the above are for educational and informational purposes only. Nothing contained here should be construed by anyone as an invitation or solicitation to buy or sell any security. This site does not contain personalized legal, tax, investment, or financial advice. Users of this site should consult with a qualified adviser to obtain advice suited to their personal circumstances. Any links provided here to other web sites are for informational purposes only.

Adam and Plan,

Here’s where I’m coming from on that last tweet about FCEC’s exchange ratio in the merger with Tower:

Net charge-offs for the six month period ended June 30, 2010 for FCEC were $2.3 million, and during the fourth quarter of 2009, net charge-offs were $16.6 million, which were obviously huge. So right now…

$16.6M plus $2.3M plus whatever charge-offs will be through August (assuming this is the month prior to the transaction closing) puts the cumulative net charge-offs at around $19M to $20M, ballpark. Add that to Delinquent Loans of $57M (Total NPAs from Q2 ‘10) and you get at least $77M as the Value for Charge-offs Post 9/30/09…and if you plug that in as per the line-item in slide 5 here, you get the adjusted exchange ratio. Based on that math, the ultimate ratio could be considerably lower than the market appeared to expect – at least up until yesterday.

I say that because with an exchange ratio of 0.291 multiplied by a recent TOBC price of $18.70, FCEC investors will only effectively get $5.44 in deal value per share. Until the big drop in FCEC yesterday, shares were priced well above this expected closing price. So perhaps someone else was doing the same math I was late Wednesday night – though now the gap seems to be narrowing as I type.

In any case, I may have missed something in the above, as I did not review every filing after the initial agreement. Did not talk to the management teams, either, though the deal at first glance seems highly probably to go through. I suspect perhaps because both stocks are so thinly traded the values have been out of whack…but as is, unless FCEC continues to drop and/or TOBC spikes, I’m passing. At least on the merger arb angle. Tower is probably worth a closer look post-merger, regardless.

Would appreciate any other insights you might have.

Thx.

Cale

Not sure what else I can say that I haven’t already said about the company. There was noise in adjusted EBITDA. Wren’s tone on the call today was, finally, positive. The company’s main competitor, Peerless, appears desperate. Any company trading at five times cash flow is worthy of your attention. This one, doubly so. I continue to be okay waiting and averaging down.

It hasn’t even been near a full year that we’ve owned Tandem shares in Tarpon. I’m looking at two Post-It notes that have been stuck to my screen for longer. Some time ago, back when men were men and before boys ran hedge funds, it used to take time to make money when investing. TNDM will probably be no exception. I believe the wait will be worth it.

Investors can view this market’s casino mentality as the curse of our age, or treat certain days as if they were made to be taken advantage of. I basically did the latter today. I bought a ton of new TNDM shares in Tarpon, and I unloaded a ton that were at a higher cost basis, too. Fortunately, I can do this pretty efficiently and at zero cost through my custodian. So though our position size is the same, Tarpon investors now own a bushel of TNDM shares priced at all-time lows.

I can only hope it happens again tomorrow.

Where’s a good sovereign debt crisis when you need one?

This site and the above are for educational and informational purposes only. Nothing contained here should be construed by anyone as an invitation or solicitation to buy or sell any security. This site does not contain personalized legal, tax, investment, or financial advice. Users of this site should consult with a qualified adviser to obtain advice suited to their personal circumstances. Any links provided here to other web sites are for informational purposes only.

The write-up below recently appeared on Value Investors Club. The author, who’d like to remain anonymous, reached out to me on some questions before he posted this. Although I believe TNDM is worth more than the author indicates, and have a few other comments I might add if time allowed, I nonetheless thought he did a solid job of analyzing the company. He gave me the okay to post the below here.

Ever since my interview on TNDM a few months back, I’ve had a pretty steady stream of emails and phone calls about the company from other portfolio managers, analysts, and individual investors. In short, while I cannot give specific investing advice here, I will say that I have been averaging down on TNDM in the Tarpon Folio over the past few months. The size of my position is a touch smaller than it was three months ago, but that’s much more a function of (a) other opportunities and (b) clearing out some higher cost-basis shares than being indicative of the company’s prospects in any way. I continue to maintain that the competitive threat from Peerless Networks is vastly overblown – it’s in a box canyon that the market doesn’t seem to recognize. I also continue to believe it is the number of switches and not per minute pricing that is the key variable when it comes to attracting new customers. At some point, the market will recognize this, and in the meantime, I continue to be okay just waiting.

The write-up follows. Please note that certain tables included in the original write-up weren’t translating well to HTML below, but you can download the entire write-up complete with those tables in PDF form here.

__________________________________

Neutral Tandem (TNDM)

Neutral Tandem (TNDM) is a company whose stock has been oversold to all-time lows on fears of
slowing growth, increasing competition, and patent issues. This has driven shares to fall from a high of
$34.56 to $11.98 as of last close (7/12/2010). However, Neutral Tandem’s healthy free cash flows and
strong financial position (over $170M in cash and no debt) make the company an attractive investment
opportunity at these prices. Although headwinds such as competition are legitimate, I believe that TNDM
shares are currently priced for a worst-case scenario in the company’s future and should offer at least a
25-35% return at current prices.

Background

Some background is necessary to understand Neutral Tandem’s core business of interconnecting voice
carriers. Calls made from one voice carrier to a different voice carrier require either a tandem switch to
rout the call or a direct connection between the carriers in the relevant markets. Due to the high costs of
establishing direct connections, most voice carriers will choose to transit their calls with tandem switches.

Before Neutral Tandem entered the market, this meant most carriers used the network of tandem
switches owned by the “Baby Bells”, called the incumbent local exchange carriers (ILECs). By law, ILECs
were required to rout all traffic, including the calls of competing carriers, with their tandem switches.
ILECs charged competing carriers by the minute for calls requiring routing by their tandems at rates
regulated by state commissions and the FCC. Not only were the ILEC tandems inefficient for operating
with competing carriers since they had been designed by for a monopolistic carrier, but ILECs were in
general unhappy about having to give up use of their overburdened tandem networks to competitors and had an incentive to not “fully cooperate” in establishing the interconnections competing carriers required.

Neutral Tandem’s Operations

Neutral Tandem was founded in 2003 to provide an alternative to the ILEC tandem switching network. Over the course of 6-7 years, it has built its own national tandem switching network that offers three main advantages over the ILECs:

1. Neutrality. Its eponymous neutrality refers to the fact that it does not compete with voice carriers like an ILEC does, thus ensuring that carriers do not need to rout calls through their biggest competitors.

2. Cost savings. Since Neutral Tandem designed their tandem switch scheme to maximize efficiency for routing calls from many different carriers it is able to undercut the ILECs’ rates by 20-25%.

3. Quality and services. Finally, Neutral Tandem has built a higher quality product than the old ILEC tandems using new IP soft-switch tandems and offering features such as quality of service reporting,
traffic reports, and redundancies in the network to ensure more reliable service.

With its first mover advantage, Neutral Tandem has managed to grow its network into the largest
alternative tandem switching network in the US. Neutral Tandem routed 87.8 billion minutes of calls in
2009 and currently serves almost all of the major carriers, with the exception of the wireline ILECs such
as AT&T and Verizon wireline (although it does serve AT&T and Verizon wireless). Its network also
handles all types of voice carriers: wireline competitive local exchange carriers (CLECs), cable
companies, VoIP, wireless, and long-distance carriers interexchange carriers (IXC). Wireless carriers and
cable companies account for 65% of revenue, IXC carriers account for 20%, and the rest is from CLECs
and VoIP.

Like the ILECs, Neutral Tandem charges carriers on a per minute basis for calls that go through their
tandem switches. Revenue recognition is straightforward and is recorded each month based on the
number of minutes trafficked for each specific tandem switching service Neutral Tandem offers. The
tandem switching business is highly scalable and as Neutral Tandem’s network expands, operations
become more efficient, capex decreases as a percentage of sales, and margins increase. This had led to
rapid growth in the sales, profits, and margins in the past 3 years (see tables in original PDF here).

Future Growth

Neutral Tandem’s core business of voice tandem switching is benefiting from the secular trends of
consumers increasingly moving towards wireless, cable, and broadband carriers. As fewer consumers
use wireline ILEC services, more calls will be routed through Neutral Tandem’s network. Beyond these
secular trends, there are several services that are potential drivers of growth for Neutral Tandem (and
potential catalysts for the stock).

60-70% of Neutral Tandem’s revenues currently come from providing tandem routing services for local
calls. While Neutral Tandem is still expanding into new markets to grow its local call services, it is now
entering mainly smaller less profitable markets. Interconnections within larger existing markets also
provide room for Neutral Tandem’s local tandem services to grow. However, the drivers of Neutral
Tandem’s future growth in its core voice business are in two different areas: terminating switched access and originating services.

1. Terminating switched access. In the terminating switched access business, Neutral tandem uses its network to terminate long-distance calls for long-distance carriers, or interexchange carriers (IXC). This is currently 20% of Neutral Tandem’s revenue and management has stated that it may double within a year. Neutral Tandem is also seeking to grow its business by providing terminating services for international long-distance carriers. Neutral Tandem has recently solved the technology aspects of this international service, and is currently working to resolve the contractual aspects with international carriers.

2. Originating switched access. Originating switched access services essentially serve 800 number calls. 800 number calls need to be translated by a tandem to determine which carrier to send it to. Recently, TNDM has begun to offer originating services. However, management has said growth in this area is
currently stalled since Neutral Tandem cannot match the marketing fees often paid to carriers. Future
growth of originating services will depend on whether a number of current lawsuits filed by others will lead to the FCC restricting the marketing fee practice.

Neutral Tandem has also begun a service outside its core business of voice tandem switching in late
2009. It is a joint venture with TelX to launch an Ethernet exchange network. I won’t spend too much time describing this venture since it is a very new venture in a very young industry that will likely interest growth investors more than value investors. The basic concept of this service is to provide efficient interconnection services for companies using the Ethernet system. The Ethernet interconnection industry has been projected to be worth twice as much as the voice tandem business, but this remains to be seen.

Neutral Tandem is behind the main competitors in this new space, CENX and Equinix, by roughly 8
months. That being said, Neutral Tandem has two large advantages in the Ethernet interconnection
industry: 1) its existing network that it can leverage, and 2) existing business relationships with many of the potential Ethernet exchange customers. As a value investor, I would not necessarily invest in TNDM on the potential prospects of the Ethernet exchange network, but growth investors may, which I will discuss in the catalysts section.

Current Concerns

Three main concerns have been contributing to the recent sell-off of TNDM :

1. Competition. Over the past year, Neutral Tandem has seen increasing competitive pressure from firms such as Level 3 and Peerless Networks that has led to a large sell-off. While management has said
that they have retained all major customers, they have admitted that there has been increased price
pressure. This is reflected by the decreasing average rate per minute from 0.19c/minute in 2009 to
0.18c/minute in Q1 of 2010. (While this decrease is occurring partly because of competition, part of the
decrease can also be attributed to Neutral Tandem entering new smaller markets that generally yield
lower rates.) Management was quoted as saying that they had “seen some of the toughest pricing that I
pretty much expect to see”. Regardless of whether this is the case, management appears to be taking the competition seriously and stated that it is competing aggressively to retain customers and gain new ones with long-term contracts and leveraging its ability to provide comprehensive solutions to customers (e.g. broader geographic coverage, more capacity to handle call traffic).

Even with increasing competition, Neutral Tandem has several competitive advantages. First, no
competitor has a tandem network approaching Neutral Tandem’s network’s size. This means that
competitors can only offer a partial solution to carriers at best and makes it unlikely that Neutral Tandem will lose business with carriers that have a national presence (No major customers have been to competitors thus far). Second, Neutral Tandem has built a network with very few quality issues while it is reported that some competitors have had issues with their tandem switching quality. Therefore, large scale defections of Neutral Tandem’s customers are unlikely, and the main legitimate concern is margin compression in local markets.

However, as I’ll discuss in my valuation, even if the easy days of growth are over and margins decline, Neutral Tandem is priced so that in most scenarios is remains a compelling buy. Furthermore, as I discussed previously, the international long-distance, originating access services, and Ethernet exchange are both potential growth areas for Neutral Tandem that could counteract competition in the tandem market.

2. Patent Litigation. In June 2008, Neutral Tandem sued Peerless Networks for patent infringement of its tandem network design, but Peerless Network responded by questioning the validity of Neutral Tandem’s patent and calling for the USTPO to re-examine the patent. Initial action by the USTPO in
March 2010 has been to reject Neutral Tandem’s patent claims, although the USTPO’s final decision on
the re-examination and the Court’s final ruling will not likely be until this fall. This patent dispute and the unfavorable developments have contributed to the sell-off of TNDM in 2010. However, I believe that concerns regarding the patent are overblown.

First, remember that Peerless Networks and likely other competitors have already been infringing on
Neutral Tandem’s patent for over a year to date. An unfavorable ruling for Neutral Tandem would
therefore not materially alter the competitive environment. Second, the company’s balance sheet is
immune to an unfavorable ruling since the company does not appear to assign its patent any value on its books. (Or if they do, it is negligible and filed under “Other assets” which is valued at $511,000.) So while Neutral Tandem may lose its patent battle, it will not fundamentally change its competitive environment. Any favorable ruling on the patent case, while unlikely based on recent developments, will be a catalyst for TNDM and a deterrent against Neutral Tandem’s competition though.

3. Fear of Obsolescence. Similar to the issue of competition, I believe that growth investors have also steadily fallen out of favor with TNDM because of the fear of eventual obsolescence due to VoIP. VoIP
relies on IP-switching technology that greatly reduces the cost and complexity of creating direct
connections between carriers, thereby bypassing the need for tandem switches. However, even
assuming a constant high growth rate of 31.1% CAGR in residential VoIP lines, based on past growth in
VoIP lines, it will still be approximately 7-8 years before VoIP overtakes the number of current US
residential wirelines. This also assumes that there will be no slowdown in VoIP growth due to necessary
infrastructure investments or regulatory hurdles.

Even if adoption occurs at this high rate, it is important to remember that establishing direct connections between VoIP carriers will still take time and that tandem switching will still be necessary for connecting VoIP with wireless carriers and the remaining wireline carriers. Therefore, while the terminal value of Neutral Tandem’s core business of tandem switching should be discounted for the risks of VoIP adoption, an all-VoIP network that makes tandem switching obsolete is still years away.

Valuation

Based on 2009 results and today’s prices, TNDM is attractively valued with a 9.8% FCF yield, FCF/EV of
18.5%, and a low 2.6 EV/EBITDA multiple. (See tables here again.)

Note: EV and all following calculations use an adjusted cash measure that includes auction rate securities (ARS). Neutral Tandem currently has $171M in cash and cash equivalents and holds par value $12.9M of ARS. Beginning on 6/30/2010, it will have the right to sell these ARS back to UBS at par value. Therefore, I use an adjusted cash figure of $184M.

I consider two useful scenarios in valuing Neutral Tandem: 1.) “worst-case” scenario and 2.) a “normal”
scenario. Both scenarios use the low ends of management guidance given for FY2010. In the worst-case
scenario, I assume that revenue steadily declines and that EBITDA margins decline 17% by 2014
(compared to 2010) due to competition and pricing pressure. To approximate the risk of faster-than
expected VoIP adoption and competitive pressures I substantially discount the terminal value based on
2014 FCFs (as per the tables here).

After adding back cash to the DCFs, I estimate that this “worst-case” scenario implies a fair value for
TNDM at approximately $10.90-$11.20 per share. This implies a decent margin of safety with a 6%-9%
downside risk at current trading levels of $11.98.

In the more likely “normal scenario”, I model very modest growth occurring at declining rates until 2014 but that EBITDA margins will decline by 14% in 2014 (compared to 2010) from pricing pressure. Terminal value is increased from the worst-case scenario to approximate a more modest level of expected risk (again, as per the tables here):

After adding back cash to the DCFs, I conservatively estimate that under normal circumstances TNDM’s fair value should be at least $15-$16.20, representing a 25%-35% upside from the current price of $11.98.

Note that the 2010 guidance figures used in both valuations assume there is no sales contribution from
the Ethernet exchange project. These guidance figures do assume a $4M operations cost and $4M in
capex related to the Ethernet exchange project. Therefore, if the Ethernet exchange development is
stopped after 2010 (due to poor results or low revenue) actual EBITDA and FCFs will be higher than I
estimated. If the Ethernet exchange project is continued, one would hope that it provided enough FCF to
offset its costs though. Given the competent management of Neutral Tandem thus far, I feel the risk of a
serious capital budgeting mistake with respect to the Ethernet exchange is low though.

In summary, TNDM shares are oversold mainly due to fears of competition, lawsuits, and future growth.
These are all legitimate concerns, but TNDM shares are trading at worst-case scenario prices. Estimates
of the fair value of Neutral Tandem’s business suggest that TNDM shares are conservatively worth at
least $15-$16.20, representing a 25-35% upside from current prices.

Catalysts

1. Value/Activist investor attention. In a May 13, 2010 13D filing ValueAct Small Cap Partners
disclosed that they had purchased 6.2% of Neutral Tandem at an average price of $15.15. ValueAct has
a reputation for being long-term value-oriented investors with an activist bent. Barron’s reports that
ValueAct sits on roughly half of their holdings’ boards. While I do not know their exact plans for their
TNDM position, a potential board seat or further acquisitions of Neutral Tandem’s stock could be a
catalyst for the stock.

2. Growth in core business: Management has outlined how their terminating business and originating
businesses could see increased growth this year. Management has already set expectations low by
predicting results at the lower range of its guidance. If the core business can grow better than expected,
catalysts could include beating guidance expectations and analyst upgrades.

3. Positive Ethernet exchange news. There may be surprise revenues from the Ethernet exchange
being developed. Management has not factored in any potential Ethernet exchange revenue, but has
noted it is possible to see Ethernet revenue this year. Neutral Tandem has also been stressing the
exchange’s growth opportunities to growth investors recently, devoting an entire presentation and
conference call this May to the Ethernet exchange. If growth investors begin to buy TNDM based on
potentially favorable developments in this Ethernet venture, I believe that value investors could exit their
positions at share prices at or above the fair value of TNDM’s core tandem switching business.

4. Share buyback. With a mountain of cash, if TNDM decides not to aggressively pursue the Ethernet
exchange venture for whatever reason, another share buyback could occur. In the latest 10Q, the
company reported that $15.4M of shares was still available for repurchase as of 3/31/2010. Given the
high FCF and large cash position of Neutral Tandem, it is certainly possible that more buybacks could be
announced.

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