iBasis Inc.

Rating Buy - 12 month price target = $17.00 (unadjusted for one-time dividend)

IBAS $10.05 — (NASDAQ) June 30, 2007

Total Revenues (Millions)/ Earnings (loss) per share;

FY (12/04) – 264 M / (1.19)
FY (12/05) – 385 M / (0.07)
FY (12/06) – 511 M / 0.04

52 - Week range: $7.36- $11.07

Shares outstanding as of 30-06-07: 33.5 million

Approximate float: 27 million

Market Capitalization: $336 million

iBasis is a leading carrier of international long distance telephone calls and provider of retail prepaid services. iBasis delivers toll-quality international call completion services over its state of the art global VoIP network to more than 100 countries. The company's customers include many of the world's largest carriers and fastest-growing consumer VoIP providers who outsource their international voice traffic to iBasis to reduce their cost of transport and service support, while providing service quality indistinguishable from that of traditional phone networks.

Key Investment Considerations:

I am rating iBasis (NASDAQ:IBAS) with a Buy and a twelve-month price target of $17.00 (post split) per share based on a total 17x TEV/2008 EBITDA . The migration of traditional networks to VOIP, the internationalization of the worlds population along with a large untapped potential in retail voice services bode well for iBasis over the next few years. Voice traffic is becoming more fragmented and regionalised, and many of the emerging carriers such as ILECs, PTTs, cable operators and ISPs lack global networks, which iBasis can capitalize on. iBasis has not yet built a sizable retail operation, however, with more effort, there exists plenty of opportunity to capture a share of this multibillion-dollar market.

In the short term, iBasis investors should look forward to a one-time dividend arising from merger between itself and KPN wholesale. The merger will allow the combined entity to extract synergies and economies as one of the largest international carriers of voice traffic.

International Long Distance: iBasis’ network covers the globe using the Internet as the primary communication gateway. Internet Branch Offices and Internet Central Offices, or IBO’s and ICO’s, respectively, make up the network. These “points of presence” (“PoPs), are the points that interconnect with the public switched telephone network (“PSTN”). The analog signal is digitised and transmitted over the Internet. This transformation effectively creates two local calls. iBasis has the ability to take calls from any source, be it mobile, landline or VOBB (Voice over Broadband), and terminate that call via transmitting it over the internet.

Granularity: A Consequence of a Growing Network:

Granularity in iBasis operations is a function of its ability to automate routing, which includes the analysis of a large number of parameters such as quality and margin, across an increasing number of routing options. A good example is a call going from the U.S. to the U.K. If that were the extent of your "granularity" of routing and rating, you'd have to price every call from anywhere within the U.S. to anywhere within the U.K. at the same rate. If you could handle slightly more granular routing and rating, let's say calls from the U.S. to not only "all U.K.", but also bypassing the central international switch and going directly to the cities of Liverpool, Manchester, and Birmingham. You'd be able to take advantage of lower termination costs on those "breakouts", leading to more competitive pricing and/or higher margin, etc. To be able to multiply that by thousands of breakouts requires very sophisticated and automated routing and rating systems that accommodate more aggressive buying and selling and much higher granularity. This requires sophisticated back office technologies that iBasis continues to develop.

Revenue and Margin:

Overall, telecommunications is a highly dynamic and elastic market; price fluctations have immediate and significant impact on traffic volume. This is true at the retail level and at the wholesale trading level. iBasis and its competitors frequently adjust pricing for a variety of reasons, such as to cover cost increases or to take advantage of cost efficiencies to capture market share, or as a throttle to achieve balance. As players in the market make these changes, others make counter-adjustments to the resulting changes in traffic flow. Those adjustments may include pursuing lower termination rates from existing or new partners, establishing off-net relationships with other carriers to opportunistically pursue short-term gains, etc. This change is constant, with hundreds of moving parts and it never ends.

Despite the automated aspect to the business, "making a call" on whether to go below our margin threshold on a specific route is up to sales, not network operations. There are strategic considerations involving the nature of the sales relationship, including whether iBasis is providing termination traffic to a specific partner in exchange for higher margin origination traffic, in which case the company would analyze the overall margin (the 360 degree view). There are times iBasis may decide to let the traffic go, knowing that there will be an opportunity to get it back under more favorable terms in the not distant future. Despite this, iBasis enforces margin thresholds on its traffic to stabilize its profit margin, and may turn away wholesale traffic that won’t produce the desired margin.

It needs to be emphasized here that what is important to iBasis is not ARPM (Average Revenue per Minute), it is AMPM (Avergae Margin per minutre). As ARPM has declined over the alst 10 years+, termination fees have decreased, keeping margins in the 5-15% region for most operators. Carriers such as iBasis who can provide large volumes of traffic can negotiate cheaper termination fees. Consequently, like any commodity business, scale is the key driver for success.

No single carrier has sufficient capacity and quality on every route to every destination in the world. To build such a network to accommodate peak traffic would be astronomically inefficient. As a result, no one carrier is the least cost provider to every country in the world. So, iBasis cooperates as it competes. It's just the accepted way the telecommunications business is conducted, and it's never been a problem.

Customers or Partners?:

iBasis’s arrangements with customers and partners (in-country providers who terminate traffic for iBasis) run the gamut from pure one-way, per-minute deals to "swaps", which are like bilaterals in which the two companies agree to exchange certain volumes of traffic at a negotiated ratio, to hybrids of both. Prerequisites include cost, coverage and quality.

Origination and Termination on Mobile Networks: Growth Area:

Termination of international calls to mobile networks was initially difficult for iBasis, as termination capacity was been difficult to get. The increase in traffic to mobile phones that iBasis continues to experience is more the result of its pursuit of that traffic and the companys ability to deliver the quality the wireless carriers require, rather than anything mobile carriers are doing. The majority of calls iBasis is terminating on mobile networks are originating from landline phones. So, most of the traffic increase is coming from its existing landline carrier customers who have put iBasis in routing for calls to those mobile networks as the company has demonstrated its capacity and quality. iBasis continues to work on adding more capacity for mobile termination through direct interconnects with mobile operators around the world, which will help the company to grow this segment of its business. iBasis also pursues opportunities to get originating traffic from the mobile operators as well. The KPN merger will result in iBasis taking a greater share of Mobile origination and termination traffic.

International Long Distance as an Offensive Weapon

Customers are interested in growing their business and making money. iBasis can help them do that, for example, by offering great pricing on calls to Mexico that enables Cricket to target the Hispanic community for its prepaid mobile phone service in the Southwest, and by offering rates that enable Skype to expand their GlobalRate program. The fact that iBasis proactively propose ideas that support their marketing initiatives, rather than simply issue rate modifications and send A-Z pricing sheets, is an approach that iBasis believes strengthen their customer relationships and its position in the marketplace.

Quality Issues

Quality VoIP at a very large scale - say 20+ million minutes per day, remains very challenging. iBasis continues to develop proprietary enhancements to its patent-pending Assured Quality Routing systems, the relevancy and importance of which are growing in step with the scale of the business and with itsincreasing retail presence. Wholesale international VoIP at iBasis’s scale involves a great deal of complexity, not only in the routing of calls, but also in managing rate changes, code changes, provisioning, billing arrangements, margin assurance, and a host of other variables. Session border controllers in the iBasis network have greatly simplified interoperability among VoIP gear from a multitude of vendors, which in turn simplifies the process of interconnecting with other providers and expanding the iBasis footprint efficiently.

The VOIP Paradigm:

Due to the lower cost structure of the internet as opposed to the PSTN, VOIP services can be provided at a much lower price to businesses and consumers than switch-based calls..The cost savings come from the reduced number of ports and carriers involved with each call. Importantly, there is no distinction among local, long distance, and international calling with VoIP. Thus, although iBasis can be considered a carrier of international traffic, it could also be considered a termination facilitator, regardless of location or traffic source.

VoIP consumes less bandwidth than traditional switched calls, resulting in lower costs. For example, silence and repetitive speech patterns, which can comprise up to 70% of normal voice interaction, consume capacity on a regular PSTN networks, but not on VOIP network. Technology resulting in silence elimination, redundancy reduction, and more efficient data throughput, ensures that VoIP utilizes only 10 to 15 percent of the bandwidth required for traditional voice communications.

iBasis needs only add capacity where it is required in the network, rather than upgrading the entire network. A new point of presence will automatically connect with the other points of presence in the network. VoIP is growing at a rapid rate and it is expected to surpass traditional PSTN traffic in 2009.

Skype: Threat or Opportunity?

Free PC to PC calling via Skype and other players could be perceived potentially as a long term threat to wholesalers of international traffic. It is however a too simplistic view of the rapidly evolving communications environment. The trend is for more networks, and providers, not less. Mobile operators in particular rely on voice traffic as a major source of revenue, and the growth of mobile networks has done little to reduce PSTN based traffic. It is against this background that PC-PC calling is most likely to remain a niche in the communications environment. Its worthy to note here that Skype is a customer of iBasis for SkypeOut, so the net effect of Skype on iBasis is most probably positive.

Computer Termination and ENUM

Number translation between the PSTN world and IP is anything but straightfoward. The industry has figured out how to enable a PC to emulate a telephone (the so-called "softphone") to enable the user to "dial" a traditional phone number with country code/area code/city code, etc., but haven't yet figured out how to enable a standard telephone to dial an IP address. Nor has the industry assigned DIDs to all the Internet-connected computers around the world, which also sounds daunting. There are a number of efforts underway to standardize the translation of numbers between the two, but the task is not easy.

Companies such as XConnect are attempting to address the need for a standardized way of handling number translations. Essentially, it involves dipping into massive databases that link phone numbers to IP addresses.

Peering a Threat?

Today, peering is like a handful of needles in a barn full of hay - there are several billions of fixed and mobile phone numbers worldwide compared to a few million VoIP users. XConnect and others continue to push peering as a solution; in the meantime interconnecting with PSTN terminators enables them to offer "off-net" termination (to PSTN and mobile networks) to their VoIP customers/members. Its worthy to note that a competitor to iBasis, the Arbinet offers a peering solution. iBasis CEO Ofer Gneezy has been quoted as “not doing free”, but is also “watching the space" closely.

Voice may be bundled, but it can never be free. The companies whose business models were built on giving it away back during what we remember as "the bubble" proved quite convincingly that "free" is not viable. However, it is essential to achieve massive scale while driving costs down.

iBasis-KPN Wholesale Merger:

iBasis and KPN announced in 2006 merger between KPN Global Carrier Services and iBasis. The merger and Royal KPN's subsequent 51% ownership of iBasis will give iBasis access to far greater mobile termination capacity in Europe (which is the largest region of mobile-terminated traffic) as well as access to mobile-originated traffic from KPN's retail mobile brands, which are leaders in The Netherlands, Germany and Belgium. The merger gas been delayed by more than 12 months by the stock options fiasco, but the scene is finally set to finalize the merger by October 2007.

Details of the merger are as follows:

-KPN will contribute its wholesale voice subsidiary plus $55.0M in cash for 40MM shares of iBasis, or 51% of the combined entity.
-iBasis will pay a cash dividend of $113MM, or about $2.94 per share, to existing shareholders of the Company. The dividend is comprised of the $55.0MM contribution from KPN, $21.0MM at KPN GCS, and a portion of iBasis’ existing $54.0MM cash balance.
- iBasis will remain as a stand alone US incorporated company with the Ofer Gneezy, Gordon van DerBrug and Dick Tennant continuing to run the company, and KPN will take 2 of 7 positions on the Board of Directors at closing.
- Combined 2005 revenues and minutes of use (“MOU”) would have been $1.1B and 15.0B versus $385M and 7.9B at iBasis by itself. Combined 2007 revenues could well be 1.3B+. (Management has provided updated 2006 guidance of $1.2B - $1.25B in revenue and $45M - $50M in EBITDA on a proforma basis. The guidance does not include expected cost savings of $10M).
- Because KPN wholesale has strong EBITDA, iBasis is giving up 51% of the stock ownership in exchange for 60% of the proforma revenue base and 68% of the proforma EBITDA. This is a good deal for iBasis.

The Options Issue:

In September 2006 an independant performed an internal investigation relating to stock options granted to the employees of the Company, the timing of such grants and their related accounting and tax treatment. This issue dragged on until very recently, when the Nasdaq Listing and Hearing Review Council that it is in compliance with all Nasdaq Marketplace Rules for continued listing on the Nasdaq Global Market and that the matter is now closed. This issue has prevented the merger to proceed. Analyst interest has also been muted in the last 12 months as the stock options issue was slowly being resolved, although it should be noted, this did not stop institutional interest in the stock.

The Retail Opportunity: Poor Execution To date:

In the last few years, Ibasis expanded into retail services through the sale of pre-paid calling cards to consumers and an online calling card portal called Pingo.com. In principle, this concept makes sense, since it is a perfect example of vertical integration, where the existing network is leveraged at little additional cost.

The opportunity for iBasis, if executed upon correctly, in the retail prepaid space is tremendous. Approximately 40% of international calls originated in the US come from prepaid calling services. In addition, the foreign-born population in the US continues to grow-it was already more than 10% of the population two years ago, according to the 2002 Census.

Prepaid Calling Cards

The calling cards are sold through relationships with distributors representing a national network of retailers. Consumers pay cash upfront for the card, the prepaid calling card business has a fast cash collection cycle than traditional wholesale services, resulting in significant deferred revenue appearing on the balance sheet. This product provides another revenue stream for the Company with minimal incremental cost. iBasis expects the service to expand and represent a large part of the revenue base in the future. Retail revenue is anticipated to bring higher margins (15-30%) than wholesale services (5-15%). Although this sounds attractive, iBasis has not yet been capable of securing stable high margins from its retail operations, primarily because of the fluctuating cycles associated with its prepaid calling cards.

Ibasis initially experienced rapid growth in its prepaid calling card business. It has however suffered some significant setbacks, which include fraudulent activity of its senior retail executive, Johnathan Kaplan, and collection issues with an east coast calling card distributor.

Private Label Calling Cards

iBasis’s relationships with many national carriers overseas gives it tremendous business opportunities to leverage the distribution network, its ability to create and manage rate tables and route the traffic over the iBasis Network. Likewise, there are significant benefits to incumbent national carriers who have been concerned about recapturing revenue from terminating inbound international calls, much of which has gone to new competitive carriers following liberalization.

Europe Opportunity

The prepaid market in Europe presents many of the same challenges and opportunities as the U.S. market. The requirements are very similar -- local access, good quality, competitive pricing, etc. It's important to establish relationships with the existing distribution channel, and the regulatory environment is comparable. The VAT (value added tax) is different. None of these differences appears to be insurmountable, and iBasis should shortly leverage its KPN relationship to launch prepaid cards in major cities of Europe.

Pingo

iBasis’s online calling card venture is called Pingo.com. An inspection of traffic rankings from Alexa.com (below) reveals the website is ranked 7th out of 35 online prepaid calling providers (Pingo.com ranked 81,588th most popular website).



An interesting trend in 2007 for these online prepaid calling providers is the decline in overall traffic rankings (below). Interpretation of this requires care, since there could be a number of unknown forces giving rise to this effect. In addition, it should be noted that website traffic does not equate to revenue.


The outlook for Pingo.com looks surprisingly healthy. As the company continues to invest in promotional activities, it has the ability to squeeze its competitors by vertically integration of its superior network.

Retail in The Future

Looking forward, with the impending merger of KPN wholesale, the retail portion of iBasis’s business will form an even smaller percentage of total revenues. Despite this, after the merger, iBasis will have more resources potentially to commit to the retail segment of its operations. After the merger, iBasis could decide to;
- Spin-off retail the retail segment into a stand-alone business
- Increase retail product offerings, for example, account-based calling plans, VOBB and mobile VOIP products. However the lack of success of companies such as Vonage suggests further enhancing this side of the business will not be easy. Despite this, iBasis will be able to rely on KPN’s expertise in retail telecommunications for assistance.

Industry Trends

The ITU estimates that there are a total of about 2.3 billion phones being used around the world. That number includes mobile phones, more than half of which probably are secondary phones, meaning that less than a quarter of the world's six-and-a-half billion people have phone service. So, there's tremendous growth opportunity for telephony, and not just in the underdeveloped countries, but also in countries that already have significant development momentum. The Internet itself is also growing, and now much of the intra-regional Internet traffic that used to travel to the US and back to the region stays in the region, which improves the quality of VoIP.

The major trend in wholesale international voice traffic suggest fewer wholesalers rather than more, and that the remaining wholesalers will grow and strengthen their positions. With the impending merger between KPN wholesale and iBasis, its clear that iBasis intends to be one of the survivors. Encumbents such as AT&T and MCI need to focus on the needs of their new parents (perhaps at the expense of the rest of their wholesale customer base), on defending their domestic marketplace from mobile carriers and emerging VoBB players (such as Vonage), and on an intensified battle in the enterprise space. This is why Verizon bought MCI and SBC bought AT&T. The LECs are weaker in the enterprise space but want to share in that business space. Technology also creates more competition in the enterprise space. Cisco is devoting huge efforts there. This forces the BT's of the world, who largely own this space, to devote more resources there.

Ten years ago the deregulation actions of the FCC (News - Alert) and the WTO in the 90s paved the way for global competition, the cost-efficiency of VoIP and the opportunity to use the Internet for transport enabled emerging providers like iBasis to roll out services and expand network footprint quickly and at a fraction of the capital investment required by circuit switching. IP has enabled iBasis to scale.

One important result of these trends is that wholesale international traffic is likely to double within the next three to five years. At the same time, many carriers are scaling back or abandoning their international wholesale business. For some this may be in favor of investment in other, higher margin aspects of their business. Others may have failed to adapt to the increasing complexity and competitiveness brought on by a more open wholesale market. In either case, iBasis is well positioned to capture a significant share of the growth in international traffic in both the wholesale and the retail ends of its business.

Domestic Long Distance ?

Domestic long distance can, in principle, deliver margins as attractive as international long distance in those countries where one has favorable termination rates. So, it varies country to country, but overall can be a significant margin opportunity. iBasis has never reported how much of its traffic is local long distance, but given the potential resistance from encumbents, who are customers, and the regulatory implications that kick in if you exceed certain thresholds (For example, in the U.S. certain fees (e.g. universal service fund) don't apply unless domestic long distance is more than 12% of your business), iBasis is likely to concentrate on international long distance for the time being.

Company History and Management Profile

Ofer Gneezy is President and Chief Executive Officer of iBasis, a leader in international long distance, VoIP, and prepaid calling cards. As co-founder, Executive Vice President and Assistant Secretary of iBasis, Gordon VanderBrug shares overall responsibility for the company’s financial performance with Ofer Gneezy and in addition, oversees the company’s marketing initiatives.

Ofer Gneezy and Gordon VanderBrug laid the foundations for iBasis in 1996, placing test voice and fax calls over the Internet, which in turn led to the launch that same year of IP voice operator, VIP Calling. In mid-1999, VIP Calling changed its name to iBasis to reflect its expanded focus on enhanced IP services, and embarked on its initial public offering.

IP has enabled iBasis to progress from a start-up to one of the largest carriers of international calls in the world in just 10 years. iBasis's annual run-rate of 20 billion minutes of international traffic — after the merger of KPN Global Carrier Services into iBasis takes effect — will be second only to Verizon (News - Alert), according to Telegeography. The transformation of global telecommunications continues to be driven by the migration to All-IP networks.

Valuation: Outlook

I am rating iBasis (NASDAQ:IBAS) with a Buy rating and a twelve-month price target of $17.00 (post split) per share based on a simple 0.7x estimated 2008 revenue of $1.3B. Post-merger, the company will have strong cash flow and will have the ability to aggressively grow its network, fund retail expansion and seek out acquisitions.

Before the transaction was announced, iBasis shares were trading at approximately 17x 2006 projected EBITDA. On a proforma basis, these metrics decline to 10.8x after the KPN merger. With more than a 2x increase in revenue and 3x increase in EBITDA, combined with significant access to new geographic markets and customer mix, iBasis should be valued closer to $17.00 post merger and post split.

The trends in telecommunications appear to favour the iBasis business model. International traffic is migrating from fixed to mobile networks; traffic is migrating from PTTs to local carriers; and it's moving from TDM to IP. In all three cases, the traffic is moving towards providers that historically have not had international networks. In addition, the growing adoption of retail voice over broadband services like that from Skype and Yahoo Broadband, as well as those from cable operators and other providers, will drive growing demand for wholesale international VoIP.

IBasis is arguably one of the success stories of the of the IP revolution, and adequately weathered the dot-com crash. The future is bright for iBasis.