- NeuStar became a deep value with a catalyst story.
- Huge short interest (23% of shares out) may trigger a substantial short covering rally.
- Catalyst imminent on May 6th with an asymmetric risk/reward very skewed to the upside.
The stock price of NeuStar, Inc. (NYSE:NSR) has been under attack over the last 3 quarters by the bears due to fears of a key contract's loss. In our view, the stock market has largely priced in the failure to renew this important piece of business thus representing an attractive asymmetric risk/reward offered by a long position in the stock, should the worst case not materialize. We expect an announcement on May 6th (date of the key FCC deadline) on the status of the NPAC contract which will be the first of several potential catalysts.
NSR reported earnings last night. It was a slight miss on earnings as it had extra costs related to the contract negotiations but they confirmed the full-year consensus.
What is NSR and How Does it Make Money?
Historically, NSR's business has operated in three broad categories:
(1) Carrier Services (60% of Revenues) - operates and maintains critical databases for telephone number resources utilized by every telecommunications carrier (4,700+) in the United States. Since 1997, NSR has been the sole operator of the Number Portability Administration Center (NPAC), managing the database of all 620 million+ phone numbers in the U.S. and routing every phone call and text message within the country. NeuStar's services also allow customers to port (i.e. transfer) a phone number (within seven seconds) when switching service providers.
(2) Enterprise Services (21% of Revenues) - provides domain name systems (DNS) services to enterprise customers, assisting with the routing and managing of 15% of all internet traffic globally. The Company also operates registry services for .biz, .us, .co, .tel, and .travel domain names and common short-codes registry.
(3) Information Services (19% Revenues) - identification/verification (i.e. Caller ID) and data analytics services that allows clients to optimize revenues (and increase return on advertising dollars) by efficiently targeting and identifying customers.
The company has an impressive track record as it comes to growth, profitability and diversification. Over the last decade, NSR grew revenues, both organically and through tuck-in acquisitions, at a rate of 20+%. It has achieved EBITDA margins in the mid-40% and has diversified its business away from its NPAC contract, which now accounts for less than 50% of the revenues from nearly 80% a few years ago. The company generates ample free cash flow (c. $200-$250 p.a.) equating to free cash flow yields in the low teens. Lastly, its management has proven to be a savvy capital allocator repurchasing nearly a third of the shares over the last five years.
What do the Bears Say?
The arguments that the bears are making is that the NPAC contract is too profitable for the company and therefore upon renewal it will be severely discounted, at best, or given to someone else. Here are a couple of letters from law firm Latham & Watkins, representing an un-named client, discussing the excess profitability of the NPAC contract.
- August 21st, 2013 Letter (http://apps.fcc.gov/ecfs/document/view?id=7520939226)
- September 17th, 2013 Letter (http://apps.fcc.gov/ecfs/document/view?id=7520944319)
It is our view that the worst case is already largely priced in and any positive development represents upside.
What do the charts say?
Let's start with the technical / investor sentiment snapshot. The latest short interest represents 23% of the float with a record high, 13.6mm, shares being currently shorted. The stock is down 51% since its peak reached 8 months ago and most analysts have turned increasingly cautious on the name. Consensus estimates have already come down significantly - most notably 2016 EBITDA was reduced two months ago from $300mm to $200mm (NB: 2014E EBITDA is $456mm) and, as we will point out below, this latest forecast likely reflects quite a lot of bad news for NSR. Any bit of good news could shake the grounds in the bear camps.
Is it really all bad news?
The bearish arguments are presented loud and clear and the stock price decline reflects that. Hence an important question should be raised: Is it all bad there for NSR, could there be any good news? Let's look first at the telecom industry cost structure and the composition of the North American Numbering Council (NANC). AT&T spent $102bn on operating expenses in 2012, $55bn of which was COGS. The corresponding figures for Verizon were $93bn and $46bn, respectively. Adding to these two companies the other mega players, T-Mobile and Sprint, one can calculate that the four major carriers spent $240bn on OpEx and $130bn on COGS. Therefore, despite all the nagging about the "huge burden" NSR's "excessively profitable" contract represents for the telcos, it is a mere 15-30bps from the overall industry costs and approximately half that, if measured against sector revenues. Of course, every basis point of cost savings counts, but given the mission-critical role of the NPAC contract, it is hard to believe that shaving a few extra bps, while jeopardizing service, quality, efficiency and reliability, is the main objective of telcos' management teams. We should point here, that NANC is composed of 26 members, 13 of which are top telecom executives. These people have decided the fate of the NPAC contract for the last 17 years and will decide it again now. For them there is very little reward from a few extra bps cost savings and huge amounts of risk if the system does not work properly. This is not a contract that can be handed to an inexperienced, second-rate operator who bids aggressively.
Is NSR up to the job?
Few people, if any at all, will say that NSR is unqualified for the role. Here are a few points that indicate the quality, scope and importance of NSR's work as it relates to the NPAC contract. These points appear in most of the company's presentations for those readers who have not had a chance to see them. NSR currently manages the largest and most complex number portability service in the world for more than 4,700+ telecom service providers, providing full number management. Furthermore, it can port numbers over fixed-line, mobile, and VoIP services and it takes only seven seconds to port a number in the U.S. There are currently 60 countries that offer number portability, but in the majority of these countries it takes up to several days/weeks to port a telephone number and operators do not manage full-number portability (i.e. mobile, fixed-line, and VoIP). Number portability operators in most other countries are either government entities or a major government-sponsored telecommunications carrier. It is interesting to note that none of the 60 countries have attempted removing the incumbent portability service provider, perhaps because the risk reward of doing so is not compelling. NSR is an independent, neutral service provider and has run the contract for 17 years. During that time it has performed "flawlessly" - close to 99.999% availability - and has continuously invested to provide highest quality service. Needless to say, customers are satisfied.
Who else can do the job?
The most talked-about competitor for the NPAC contract is Telcordia, a fully-owned subsidiary of Ericsson. Telcordia currently manages India's mobile number portability, which interfaces with merely 81 telecom service providers vs. NSR's customer roaster of 4,700+. In addition, Telcordia only offers mobile number portability (not fixed-line or VoIP, as NSR does) and deals with a very different customer base (pre-paid) with lower ARPUs. Lastly, and here is the important service / quality factor, it takes up to one month to port a number in India. Of course, in India everything takes longer so perhaps it is not fully Telcordia's "fault" for such delays in the transfer, but there is no other practical evidence supporting their capabilities. Currently, porting a number in the US takes seconds, it will be unimaginable to think that US consumers will be satisfied with a month's or even a day's wait time. Furthermore, NSR is a US-based, independent, neutral service provider. Ericsson (Telcordia) is headquartered in Sweden and is a major supplier of systems and equipment to telcos. It is quite likely that there might be potential conflicts of interests arising from the Ericsson ownership, not to mention the granting of a mission-critical contract to a foreign entity. After all, in the post-Snowden world, the global telecom industry has become very sensitive when it comes to choosing non-domestic partners. Lastly, Telcordia has publicly stated that it may not be able to get ready for the contract by June 2015, which raises additional red flags. The longer the procurement process lasts, the less time Telcordia will have to prepare itself for the transition. Therefore, the other major contender, has very few, if any, qualifications that match those of NSR.
Is it just down to the price, then?
Needless to say, based on the above comparison, Telcordia's low bid is most likely what is keeping it in the race. How low could they have bid? The analysis presented in the Latham & Watkins's letter, suggest that merely taking the company's net PP&E from 2010 i.e. $50-75 mm should suffice to rebuild the know-how of the company. NSR is an application software company and very few software companies are hard asset intensive. They do have assets but those are mostly in the form of cash or intangibles. Here are a few examples - Salesforce.com (NYSE:CRM) grew mostly organically until 2010 and had a market cap at the time of $9bn, yet net PP&E of only $89mm - does Latham & Watkins believe that someone can put up $89mm and "recreate" CRM. Amdocs (NASDAQ:DOX), another telecom IT Services provider, with a market cap of $7.5bn has $275mm of net PP&E - can DOX also be replaced by a competitor who comes in with $275mm? Here is a report from the Standish group, who, by the way, were "spot on" with their healthcare.gov cost analysis, that implies that the costs of replacing the NPAC contract are up to $600mm - http://blog.standishgroup.com/BigBangBoom.pdf. Another "interesting" comment from the Latham & Watkins letter refers to the need for the NPAC contract to be priced at a very low ROIC, akin to other government contracts. However, NPAM is not a government organization and NSR's customers are also not government organizations. To the contrary, they are huge private companies, which, themselves, earn high EBITDA margins in excess of 40%. Therefore, it is unlikely that NPAM follows this Latham & Watkins suggestion either.
Is it necessary for the lawyers to get involved?
Since we are on the subject of lawyers, there are certain reports suggesting that NSR has retained a high-profile law firm, which has successfully won large cases against the US federal government. The FCC would be reluctant to engage in litigation. Most government agencies are very sensitive to the threat of lawsuits. Even though any decision might lead to litigation, regulators are likely most concerned about the threat of an NSR lawsuit on procedural grounds (e.g. revised RFP allowed for multiple rounds, yet NSR's second bid was unopened), which could throw the selection process in limbo for years. Regulators are generally risk-averse. NSR has been exploiting this fear by raising questions about the cost (i.e. $600M) and effects (porting times as long as seven days) of the transition. Such arguments are likely to carry weight with regulators, particularly within the context of a controversial procurement. Lastly, the RFP for the current round of procurement does not deal with the role of the NPAC contractor in a full Public-Switched-Telephone-Network (PSTN)-to-Internet Protocol (IP) transition which is now becoming a priority policy issue. Regulators would be wary of granting a new long-term contract while key questions on the role of the contractor in a full-IP world remain undecided at this critical time. NSR has made the point several times that their technicians are guiding the FCC in this IP transition.
After all this, is the bad news priced in?
This commentary asked the question earlier whether it is all "bad news" out there for NSR, as the bears claim, or if there is a chance for some good news. While one can agree that this is a rather binary event, it is also true that NSR is highly qualified for the job and is not sitting still. They bid high initially but as the CEO said "they are sharpening their pencil on valuation." It is not the first time that they have cut price. Historically they have offered discounts on the price-per-transactions but the volume of transactions grew so massively that their revenues increased, nevertheless. It is hard to speculate as to the actual outcome. However, it is likely that at the current stock price level, a loss of the NPAC contract is more or less priced in. Here are some back-of-the-envelope calculations:
The NPAC 2013 contract revenue is $437, as per recent guidance. Let's take Latham & Watkins' assumptions that the NPAC adj. EBITDA margin is between 60-70% i.e. 65% mid-point. Therefore, 2013 NPAC Adj. EBITDA is around $284mm. The 2013 Adj. EBITDA as per the Latham & Watkins letter is $394mm - therefore the non-NPAC 2013 Adj. EBITDA is $110mm (=$394 - $284). The company's objective is to grow the Non-NPAC business organically in the mid-teens. Last quarter they grew 15%, last year they grew 10%. Let's take the mid-point of 12% growth rate and assume no margin expansion. Therefore in 2016, the Non-NPAC EBITDA should be around $155mm. We should point here that we are assuming no cost cutting. The management has indicated that 70% of NSR's costs are variable, so cost cuts should be presumably achievable as the revenue shrinks. Let conservatively assume $25mm cost cuts i.e. we get to $180mm of 2016 EBITDA which is not far from where consensus is at present. Another $20mm of cost cuts or higher growth / margin from the business can get us to $200mm. In other words, the analyst community is already assuming a near complete loss of the NPAC contract along with some cost cutting.
What is the company worth in 2016?
Let's do some valuation analysis based on these 2016 consensus figures. The company currently has c. $400mm of net debt and 61mm shares. It generates about $250mm of FCF per year. Let's be conservative (the contract expires mid-2015) and say that it will generate $400 mm in FCF between now and the end of 2016, i.e. NSR will have $0 net debt by the end of 2016. Perhaps a relevant comp for the non-NPAC business is Verisign - it is a much larger and more mature player with EBITDA margins at 61% and 2-year projected EBITDA growth of 5% p.a. It is trading at 8.5x EV/ 2016 EBITDA. NSR Non-NPAC business is smaller and has faster growth with the possibility of margin expansion. Let's conservatively assume a 1x lower multiple i.e. 7.5x - not bad for a company growing at 10%+. Therefore 7.5x $200mm / 61 mm shares = c.$25 per share. In other words, the loss of NPAC is likely more or less priced in at the current levels. This represents presumably the worst case scenario - a more likely scenario is NSR wins with a lower margin NPAC contract or splits the contract with Telcordia. Those would likely lead to a short covering rally (simple math suggests that it would take around 21x of average trading volume to cover all existing short positions) and to a fair value in the low $40s to the low $50s, depending on the news. Hence there is a potential danger of a short position in NSR. Shorting the stock may have made sense last year or earlier this year when the risk/reward was attractive, but the market has been quite efficient pricing this situation. The attractive asymmetric risk /reward appears to be offered by a long position in the stock.