Description

Company / Ticker: NeuStar / NSR

Recommendation: Short
Timing:  Within 280 days

Current Price: $30.00
Expected Returns:

Upside Case: $0.00    (100% profit potential)
Base Case: $5.00 (83% profit potential)
Downside Case: $12.00 (63% profit potential)

Disclaimer

My comments are meant to be purely incremental to Wolverine03’s excellent April 2014 write-up (be sure to read if you haven’t already because it will provide necessary background) and any information contained in the VIC message board (given I am a first time applicant, I only have dated access so apologies if anything below is redundant for some). A comprehensive update is necessary for two reasons: (1) The situation has changed dramatically over the last year and there remains considerable, unnecessary confusion surrounding the key drivers of the stock going forward, and (2) After a significant recent squeeze the highly compelling asymmetric risk / reward profile offered at current levels is more attractive than it has ever been.

1. INTRODUCTION

• On March 26th, 2015, with a unanimous 5-0 vote the FCC officially confirmed that NSR lost its entire 18-year NPAC (Number Portability Administration Center) contract to rival Telcordia worth 90%+ of current EBITDA and 100%+ of EPS (these are not typos), which coincidentally approximates the current near-term downside to shares. Over the past year, uncertainty over how the FCC would act and the belief shared by many that NSR had a chance to hold on to the contract have kept shares largely range bound in the mid-$20s, despite deteriorating operational performance in what will be its surviving business unit. Shares recently touched a low of ~$20 in early March after the FCC publicly signaled it was going to affirm the Telcordia selection but have since been squeezed higher ~50% off March lows and are now shockingly trading ABOVE its share price this time last year when many felt NSR had a chance of retaining the contract. Ignoring all else, the squeeze presents a compelling entry point to short shares and an even more compelling opportunity for anyone who is long to take their money and run

•  There are four factors that have combined to exacerbate the recent squeeze and artificially inflate shares far above fair value. By order of importance (starting with the most important) these are:   

1. Prolonged unnecessary confusion over the magnitude of the contract’s financial contribution to NSR’s P&L  and the crippling effect its loss will have on the business and pro-forma valuation resulting from:

• Sustained efforts by NSR management  to obfuscate the financial reality of how the business looks without the NPAC contract and stall from providing this information as part of a larger effort to keep the stock inflated for as long as possible given ~90% of management comp is in stock with intermittent vesting periods throughout the year (hence the $150 million buyback conveniently announced right after the FCC vote)  

• An unsophisticated retail investor base that lacks the technical proficiency necessary to understand the numbers and stress test management’s assertions

2. The crippling effect its loss will have on the business and pro-forma valuation

3. A deep misunderstanding surrounding not only the amount of time it will take for Telcordia to successfully transition the contract, but more importantly the complete irrelevance of the time period in light of item (1) above  

• Perceptions around the transition timeline have been heavily influenced by material, misleading misstatements recently made by management in which they grossly mischaracterize and omit certain terms of their existing contract to such a degree that could potentially constitute securities fraud  

4. Sell-side coverage that has bordered on gross negligence, best exemplified by William Blair

• The Sell-side is a little more relevant here than might normally be the case given the unsophisticated retail investor base, relatively small market cap (we’re not exactly talking about a Herbalife type battleground stock here), and William Blair, who is the only firm whose analyst has a Buy, also coincidentally is the number 2 holder who owns $150 million+ of stock (10%+ of outstanding shares)  

I examine these four dynamics in detail in sections III – VI below, which collectively suggest the stock’s reversion to fair value is a question of “when”, not “if” at this point and regardless of whether the eventual move happens suddenly or more gradually, it is highly unlikely the stock will be able to remain elevated for any type of extended period of time that would diminish the tremendous short opportunity that exists today.   Ultimately, even if NSR management keeps up the current charade all the way until 2016, they  will then have to either offer guidance ex-NPAC  and / or report a full quarter of financials without the NPAC contract, at which point you  can reasonably expect a single digit stock price as going concern issues will surround the Company in advance of looming TTM covenant defaults.  But first, a brief primer on the background of the number portability contract.

2. BRIEF PRIMER ON NUMBER PORTABILITY CONTRACT NSR HAS LOST

• Put simply, number portability allows you to keep your phone number when you switch providers (i.e.  move from AT&T to Verizon). The number portability vendor (currently NSR and soon to be Telcordia) provides 3rd party software helping to facilitate the process (sample diagram below).  This technology capability has become commoditized over the years, with number portability now instituted in more than 50 countries  with multiple different vendors providing the services NSR currently offers in the U.S.  Of all these vendors, Telcordia is by far the worldwide leader currently serving as vendor in more than 40% of these countries whereas NSR only has Taiwan and Brazil besides North America (where Telcordia is also intimately involved in each number porting process).  NSR’s only real differentiator has been the unbelievable pricing they’ve been able to achieve after sneaking under the radar for years with 4 multi-year  contract extensions, with the last set to expire June 30th, 2015.  

• Telcordia moved to put an end to this in 2009 when they successfully petitioned the FCC to make the contract award a competitive RFP, kicking off an exhaustive, multi-year process that officially concluded on March 26th when the FCC unanimously voted to affirm the Telcordia selection.  During the vote, the terms of Telcordia’s bid were revealed for the first time,  finally crystallizing the absurdity of the contract economics long enjoyed by NSR.  Telcordia’s bid of ~$134 million a year is ~75% below what NSR is slated to be paid this year.  Given this bid is for only a guaranteed 5 year term, has to cover the millions of dollars Telcordia has spent over the last 6 years as a part of the process (for perspective, NSR spent $17.7 million in NPAC legal  / consultant fees in 2014 alone) and will have to spend  to implement its platform, you can thus only imagine the minimal expenses associated with the contract    

• Even though this is not a government contract (the selection of, and the money paid to the NPAC administrator is  done entirely by the telecommunications industry, who pay for the services in proportion to their usage),the  FCC is required to sign off whoever the carriers want as their NPAC vendor as a result of a random administrative duty bestowed upon them after the 1996 Telecommunications Act.

3. NON-NPAC FINANCIAL PROFILE:  TRANSITION PERIOD IRRELEVANT GIVEN MAGNITUDE OF LOST PROFITABILITY

• NSR's publicly available, reported financials reveal that the NPAC contract represented over 90%+ of NSR's adjusted EBITDA ($40 million) and over 115%+ of adjusted EPS in 2014 (i.e. NSR would actually have lost money in 2014 without the contract) There are multiple different ways you can triangulate this to double, and triple check your calculations and each one will get you to within a rounding error of the figures outlined in following the table   

• For starters, the most obvious way to verify this is to look at the segment profitability they publicly disclosed up until Q313, at which point they stopped disclosing in what appears to be an attempt to hide how profitable the contract is both from the RFP decision makers (so they wouldn’t be able to see the magnitude of the favorable terms NSR has been receiving), and investors (to hide how screwed they’d be without the contract.  

• The NPAC contract, embedded in the “Numbering Service” component, represents 80%+ of Carrier Services revenue and an even greater portion of segment profitability given we know that the second and third pieces (Order Management and IP) are lower margin.   The second largest piece of the Carrier Services is segment is Order Management Services (aka “Carrier Provisioning”) where the CFO reveled at the December Bank of America Leverage Finance conference carried margins in the 35%-40% range.  

Paul S. Lalljie: 12/3/14:  “...our carrier provisioning services also delivering margins between 35% and 40%”

This comment maps to the publicly disclosed financial profile of Evolving Systems, which was a key carrier services acquisition focused on order management made in 2011.  If you aggressively use the Evolving Systems gross margin profile (~70% per the link below) as a proxy for the contribution margin, you can back into the minimum  segment profitability of just the NPAC contract and see that it carries AT LEAST operating margins of 90%+.  

http://www.sec.gov/Archives/edgar/data/1052054/000110465911029291/a11-12064_1prem14a.htm#UnauditedProFormaCondensed_122832

• The fact that NSR stopped disclosing segment profitability in 2013 is irrelevant because we know that the economics of the NPAC contract don’t change form period to period except the contract continues to get more profitable in light of the annual 6.5% pricing increases.  As you’d expect, these pricing increases effectively flow straight to the bottom line, which means you can be fairly certain that the NPAC contract contributed around $430 million of operating profitability in 2014, or nearly 92% of NSR’s reported Adjusted EBITDA of $469 million (excluding stock option expenses and other one-time events), or ~$40 million in 2014 Non-NPAC EBITDA

• Everyone also misses the fact that NSR started disclosing Guarantor filings in their results with parent (“Neustar Inc.”, which consists of Targus and the NPAC contract) / subsidiary (which consists of all other Non-NPAC businesses besides Targus) financials after levering up to buy Targus in 2011.  These allow you to know at a BARE MINIMIMUM know the direct / variable COGS and Sales and Marketing expenses associated with the Non-NPAC businesses in 2014.  All corporate costs, particularly G&A and R&D, are treated as essentially all centralized costs and housed almost entirely within the parent.  It’s a bit cumbersome, but you can reconstruct the Non-NPAC P&L based on these filings.  If you do, you’ll get to pretty much the exact same EBITDA figures I have outlined

• Finally, the seemingly black and white reality from NSR”s public disclosures that the NPAC contract represented around $430 million of NSR’s reported $469 million of 2014 reported is further substantiated given what we saw in Telcordia’s bid.  Telcordia’s bid offered pricing of ~$134 million a year, $372 million less than what NSR is slated to earn from the contract for the full year 2015 (if they even hold it that long).   Per the terms of the RFP, the bid covers any incremental transition costs (estimated at~$90 million at the midpoint in Professor Burger’s analysis described below). Infrastructure build-out, legal fees already incurred or still to be incurred (NSR spent $18 million on this in 2014 alone and is anticipating roughly $15 million of spend in 2015), etc.  that will be borne by the new vendor.  The bid is for a contract guaranteed for 5 years, followed by two years of possible extensions.  Assuming Telcordia just wants to break even on the guaranteed portion of the contract (and you’d think they wouldn’t have spent 6 years, millions of dollars, and thousands of man hours to win a contract they were just going to breakeven on), the implied NSR 2015 EBITDA contribution is $410 million+ (~85%+ of total EBITDA).  

• We also know that Non-NPAC profitability is EXPECTED TO GET WORSE IN 2015 given their recent own recent 2015 guidance.  Not surprisingly, their presentation of guidance is a little confusing, but if you do a little work gives you enough to be able to see at a minimum that overall EBITDA margins are expected to decline ~200 bps in 2015.   Given that we know the NPAC contract is only increasing in profitability in light of the 2015 pricing increases, clearly this means the margin deterioration is coming from the Non-NPAC business.  This is principally due to:

• NSR’s two most recent acquisitions (C.O Internet SAS and Aggregate Knowledge) that are collectively losing money.  NSR has disclosed that in 2014 both acquisitions contributed ~$15 million of revenues and added ~$32 million of costs, and in Q1 admitted that these costs  are continuing to grow:

Q115 NSR Earnings Call
“These decreases were partially offset by $4.3 million of incremental operating costs from .CO Internet and higher costs related to information technology and systems.”

• Growth in Data Services; the largest piece of the Non-NPAC business (~40% of revenues) with by far the highest margin is expected to be flat in 2015

• There’s only so much operating leverage you can get out of a top-line growing in the mid-single digits

• The dire reality of these numbers helps explain why management has been so cagey  in providing any type of granularity around the Non-NPAC financial profile despite that topic being the focal point of every single investor call over the last year.   Instead, to distract investors and Sellside analysts management has thrown out a fantasy 2017 Non-NPAC revenue target of $650 million with an EBITDA margin target of 35% to 40% once this revenue base is achieved.   I've tried every possible way to get to those numbers and haven't been able to even get close, so certainly let me know if you've found a compelling case to the contrary.  

• But Ignoring all that, what's even more outrageous is that they expect people to somehow believe these 2017 targets (which the Sellside takes at face value, and then some), while completely withholding any and all detail about how the Non-NPAC business looks today despite countless, repeated questions over the last year.    Besides the fact that it would not be hard to give illustrative guidance ranges including and excluding the contract (companies do this all time to help facilitate transparency ahead of material events, such a healthcare company facing a significant reimbursement change for example), these 2017 targets must obviously be based on a detailed internal financial model that would certainly contain 2015 and 2016 projections and at least one to two years of historicals (if this is not the case, then the figures should basically be considered made up and discounted entirely).  The only logical explanation why management wouldn’t provide a more current view to investors is because they are intentionally trying to hide just how bad it looks for as long as possible.  With the majority of their compensation in stock option instruments that vest and immediately exercise at various points throughout the year, it certainly accrues to their benefit to keep the stock inflated for as long as possible.         

• Fortunately, if you dig hard enough there is enough publically available information to understand Non-NPAC profitability today.  That’s by far the most important part because by knowing your starting baseline, it’s fairly easy to see what is, and isn’t possible going forward.  Below is how I see the Non-NPAC business looking under BEST CASE GROWTH AND MARGIN assumptions.  Even in this bullish scenario, you’ll see NSR does not turn profitable until 2017!

Key underlying assumptions include:

• Revenues

• I assume NSR is able to hit NSR’s phantom 2017 Non-NPAC revenue target even though this would imply:

• A significant growth inflection to double digit growth in both 2016 and 2017 despite an organic growth profile of nearly half that in the two years prior.

• Non-NPAC revenue growth ~50% higher than the ~7.5% reported growth achieved in both 2014 and 2015 (per recent mgmt. guidance), despite 2014 and 2015 growth both having the benefit of M&A.  This is key because without the NPAC contract M&A will no longer be possible given leverage constraints.

• Expenses / Profitability

• Assumes a dramatic inflection to a ~40% contribution margin on incremental Non-NPAC revenues in by  2017 despite the structural mix shift towards higher burn, marketing based business units that has driven the negative contribution margin anticipated in 2015

• Maximum potential cost cuts achieved by 2017 (NSR achieves its publicly stated claim that $70 million of cost cuts can be achieved by 2017 one year ahead of schedule)

• NSR has a highly centralized fixed cost infrastructure with most costs shares across various operating segments.  This has allowed them to benefit from significant operating leverage over the years as continued pricing increases and a transaction-based business model have allowed them to leverage these fixed costs and maintain EBITDA margins of ~50% despite numerous unprofitable acquisitions.   

• The problem is, when the source of this operating leverage goes away (i.e. the NPAC contract) the fixed costs do not.  My conversations with the Company have almost entirely focused on going through every line item to see which have these shared costs can be cut.  While their answers didn’t surprise me, I certainly wasn’t expecting them to be so honest and forthcoming.  Below are the results:

• COGS

• Minimal

• Sales and Marketing:

• Minimal

• General and Administrative

• Zero, entirely centralized, corporate cost.

• R&D

• Zero, entirely centralized, corporate cost.

• Anecdotally, with respect to R&D, they even noted that they have already made a deliberate effort to trim all of the fat in R&D because, “they are not good at it”, hence the increased focus on M&A in recent quarters.  I bring this up because without the contract, they will no longer be financially capable of doing M&A to diversify and grow the business.
  
  

• NSR’s CFO has even (albeit unintentionally) admitted this in his public commentary.  Below is a quote from the September 2014 DB conference where notes that overall costs don’t really change under various revenue scenarios
  
  

• On their March 26th update call with analysts, they publicly affirmed this again.  When the NPAC contract goes away, there won’t be any type of massive restructuring.   

CFO Paul S. Lalljie
“Specifically, we don't have to go having terminating employees and all those types of things. We will keep our employee base that we have today. We will make sure that we can realign our resources appropriately so that everyone has a home at the end of the day that are employed with us today.”

CEO Lisa Hook

So I just want to reiterate what we're talking about is controlling the expenses, not cutting expenses

More importantly, for the first time ever they finally actually quantified the cost cut potential at $70 million (exact quote below), which my forecasts generously assume they are able to achieve.   We from their filings that that around $45 million to $50 million of these costs will be the direct (variable) COGS associated with the NPAC contract (i.e. data center costs) so in essence they believe they can squeeze out an additional $20 million of cuts over time.  

CFO Paul S. Lalljie: March 26, 2015 Update Call
“We've said publicly that we expect to exit 2016 at $650 million run rate revenue. We said that we expect EBITDA margins to be between 35% and 40%. At a midpoint, that's around 37.5%....So what you're seeing there at 35%, for example, you're looking at a $425 million operating expenditure line item. Today, that number is around $495 million. You're talking about a $70 million reduction in expenses using round numbers, probably around 14% of operating expense today.”

This quote is hilarious for a bunch of reasons:

1. He inadvertently admits that the NPAC contract represents at a minimum 85%+ of total current 2014 EBITDA.  The $495 million of current operating costs he refers to are the 2014 total INCLUDING the NPAC contract.   If they’re not planning on doing any large scale layoffs and the goal is to get down to $425 million by 2017 EXCLUDING the NPAC contract, then we know AT MOST (but likely even less) $70 million of costs are associated with the NPAC contract.  Given the $475 million of NPAC revenues received in 2014, this would equate to ~$405 million (or 86%) of NSR’s reported 2014 EBITDA of $469 million.

2. His suggestion that the business can grow to $650 million of revenues and $425 million in total operating expenses  by 2017 is calculated using the ~$495 million of 2014 operating costs as the baseline, which is irrelevant in light of the new 2015 guidance.   The correct operating expense baseline to assume is ~$550 million (with the increase in expenses predominantly due to the Non-NPAC business for reasons I’ve described) per their own 2015 guidance, meaning their actual 2017 target is for an operating expense base of ~$480 million (the $550 million of operating expenses currently anticipated for 2015 less their publicly stated $70 million of cost reductions), equating to ~$170 million and a ~26% EBITDA margin.  Even to get to these reduced targets, you would have to assume the following miracles occur:

1. There is not a single cent of incremental expense required to support a projected doubling of revenue growth from 2015 thru 2017 (no variable COGS, no wage increases, no added overhead related to employee benefits, etc.)   This is certainly an interesting assumption.  Besides the fact that management’s base salaries generally increase in the high single digits, NSR’s business is fairly labor intensive and even if you assume that you don’t give any employees raises (which would likely lead to attrition, a reduced top-line, and operating leverage deterioration)  there’s certainly other inflationary cost line-items (health insurance, etc.)

2. Massive 100% pricing increases across all lines of business despite.  Clearly, this is impossible, particularly when: the pricing environment has been challenged.  For perspective, the biggest piece of their Non-NPAC business, Data Services at ~40% of Non-NPAC revenues, suffered a ~10% pricing decline in 2014 (equated to a roughly $20 million hit to Non-NPAC EBITDA) and management has stated this is not expected to improve in 2015.  

CFO Paul S. Lalljie: Q414 Earnings Call
“So overall, from a Data Services perspective, we would expect flat to low single-digit growth.”   

4. VALUATION:  SHARES WORTH UP TO 100% BELOW CURRENT UNDER BEST CASE P&L AND VALUATION ASSUMPTIONS

• Below is a range of outcomes within which I’d expect the stock to trade once the market finally understands the financial magnitude of the lost contract. As you can see, the result will be dire even though my framework is based on BEST POSSIBLE CASE P&L AND VALUATION ASSUMPTIONS. NSR has historically always trading off of 1 year forward numbers so in theory one should think about valuation based on 2016 Non-NPAC numbers (if not 2015) but as you can see l see show 2017 as well, adjusted for any incremental cash flow per share expected to come from the NPAC contract until it is transitioned. The longest this transition is expected to possibly take is until 9/30/16, which is what I used in my below valuation framework to reflect the utmost conservatism.   

Valuation Relative to Historical Trading Levels

• At NSR’s all-time high of $50+ in late 2013, shares were trading at ~7x EBITDA and 13x to 14x P/E 1 year forward. During this period, the bull thesis on NSR was:

• There is limited risk that NSR will lose the NPAC contract and this will continue to provide the Company with a substantial source of highly visible, recurring profitability

• The Non-NPAC business has potential to see double digit revenue growth

• With the significant recurring cash flow from the NPAC contract, Company will continue to able to buy back a substantial amount of shares and look for bolt-on M&A opportunities as a key incremental growth driver  

The fantasy multiples I ascribe in my valuation framework (being short you have to assume the worst) assume that the peak valuation multiples NSR received when they still had the contract are now the lowest possible valuation they might be ascribed, or, more simply put, I’m assuming they can get MULTIPLE EXPANSION despite the following crippling changes that will have occurred since this peak valuation period.  

• The loss of the highly profitable NPAC contract representing 80%-90% of their EBITDA and 100%+ of EPS

• Non-NPAC top-line growth (and 2015 expected) that has come in half of the double digit growth assumption anticipated when NSR was a $50+ stock even despite the benefit of multiple acquisitions that were not incorporated in guidance / Street forecasts

• A roughly 80% decline in EBITDA margins and negative EPS for the first time since 2003

• Leverage ratios that will skyrocket to 140x+ Total Debt / EBITDA,  (6x higher than current levels), obviously leaving them in breach of every single one of their covenants by a wide margin

• Given these leverage constraints, an Inability to continue their longstanding buyback program

• Similarly, an inability to keep pursuing M&A.  How can you possibly believe that they can grow revenues at a double digit clip thru 2017 to hit their mythic $650 million revenue target when:

• The Company isn’t even guiding to double digit growth in 2015

• The Company  hasn’t been able to achieve better than mid-single digit top-line growth even when it had the benefit of M&A

• A stated intent to completely shut off spending that will be required to maintain even modest growth in their newer, far more capital intensive focuses (e.g. marketing)?

Valuation Relative to Publicly Traded Comparables

• Below is the most favorable comp set you could ever expect investors / Sell-side to use for NSR’s Non-NPAC business.  You’ll see from the comp table below that my assumed vValuation rRange Implies NSR is ascribed multiples equivalent, or greater than, best-in-class peers vastly superior to NSR in every conceivable comparative trading metric.  Just to name a few:

• NSR will be the only company with negative earnings

• Leverage will be nearly 97x greater than the peer average and NSR will be the only stock that’s a near-tern going concern

• NSR profitability will more than half  be half the peer average
  
  

Ignoring the range of multiples I’ve used to value NSR’s stock in the future, here is where the stock for a second, you’ll also see that even on my best case Non-NPAC projections NSR’s Non-NPAC business is trading at today’s stock price despite R is currently trading at the below ridiculous premiums despite its drastically inferior operating profile and obvious bankruptcy risk.   Granted, valuation is somewhat subjective, but I think even the bulls will agree that NSR’s Non-NPAC business doesn’t deserve anything close to these types of premiums,  unless of course there is the belief that I’ve  materially miscalculated the Non-NPAC P&L (in which case I entreat you to let me know how so this short doesn’t bankrupt me!)

• A ~315%+ premium to the broader peer group on 2016 EV / EBITDA (P/E clearly irrelevant as NSR will likely have negative EPS in 2016)

• A ~150%+ premium to the broader peer group on 2017 EV / EBITDA,

• A nearly 1700% premium to the broader peer group on 2017 P/E, the first year NSR could likely turn profitable

Granted, valuation is somewhat subjective.  That said, I think even the bulls will agree that these types of premiums are absurd (and thus NSR is worth something significantly less than $27 a share), unless of course there is the belief that I’ve  materially miscalculated the Non-NPAC P&L, in which case I entreat you to let me know how so this short doesn’t bankrupt me!

• The most attractive, highest valued segment here is Security Services, a segment that will represent less than a 1/3 NSR’s revenues.   My valuation framework ascribes NSR the same valuation as the best-in-class market leaders in the space, VeriSign and Akamai, despite the following glaring differences.  Here’s a quick comparison of how NSR would stack up against Akamai:

• Akamai carries market caps of ~$13 billion, over 20 times what NSR’s will be.  Are investors paying premiums for highly levered, illiquid small caps right now?

• Akamai is growing the top line at 15%-20%, nearly triple the growth NSR achieved in 2014 and currently guiding to in 2015

• Akamai’s EBITDA margin of ~40% to 45% is 4 to 5 times higher what NSR’s will be under the most aggressive of assumptions.

• Akamai maintains a favorable net cash position while NSR will be levered in upwards of 10x EBITDA and be in breach of every single major covenant by early 2017

• Akamai has a buyback program in place.  As mentioned, NSR will no longer be capable of this.  

• Within Data Services, it’s worth calling out the acquisition multiples NSR paid for Targus in Fall 2011 ~($650 million purchase price) because it represents the vast majority of the value in the Non-NPAC business, comprising ~30% to 40% of revenues but the majority of the what modest EBITDA will be left.    In 2011, NSR paid ~8x 1 year forward  EBITDA when

• Targus top-line was growing in the high single digits / low  double digits

• Carrying EBITDA margins of ~45%+   

• Was levered at around 2x

If Targus was worth 8x then, what is it worth now when:

• The top-line isn’t growing at all, with revenue growth actually decelerating 5%-10% in 2014 due to a pricing concession and 2015 guidance calling for revenue to remain flat from 2014 levels  

• EBITDA margins roughly 500 bps to 1000 bps lower than at acquisition, predominately resulting from the afore mentioned $20 million pricing hit that flowed straight to the bottom line.    

• Targus was levered at around 2x at the time of the acquisition.  With the contract gone, Targus will now be part of a massively levered  enterprise soon to be in breach of multiple covenants  with serious going concern issues  
  
  

Frankly, who cares when the stock is still worth single digits at 10x 2016 EBITDA, which represents a 40%+ premium to the highest valuation NSR has ever achieved in the modern era and a 25% premium to what NSR itself paid to acquire its highest valued Non-NPAC asset BEFORE its operating profile decayed substantially to what it is today. While on the topic of M&A, it’s important to realize that there’s not even really the possibility of a “last ditch” firesale where the Company tries to sell-off the various non-NPAC businesses in a succession of distressed asset sales. There is just too much shared infrastructure, prohibitive credit issues, and any prospective buyers would obviously take advantage of NSR’s desperation and gauge them on price. Even if you ignore all that and try and look at theoretical break-up values with any range of realistic sum of the parts assumptions, you’ll still arrive at a per share value well below current.

Valuation is Not Materially Impacted by a Longer than Anticipated Transition Period  

• My valuation framework conservatively assumes that NSR retains the NPAC contract until 9/30/2016 (equating to a roughly 18 month transition period) even though, for reasons I outline below, every single available data point suggests it can be done much quicker than that. More importantly, the transition period simply just doesn’t matter given the amount of profitability being lost and magnitude of the valuation disconnect implied by current trading levels. Any extension beyond the “doomsday” 9/30/16 period I’m already assuming should be thought of as a one-time after tax dividend and what that implies on a per share basis. For every 3 month transition delay / NSR contract extension beyond my assumed 9/30/2016 transition date, there is about a $1 to $1.25 per share benefit that accrues to NSR. With the stock only worth single digits even when assuming it can hold onto it for another 18 months, Telcordia headquarters would basically have to burn down at least once (and maybe twice) for there to be any type of meaningful incremental delay beyond that point of consequence to the short thesis.   

Nevertheless, because the transition period is currently a key debate I will now review in detail

5. CURRENT STOCK PRICE ALREADY REFLECTS WORST CASE TRANSITION TIMELINE; MULTIPLE DYNAMICS SUGGEST TRANSITION COULD POTENTIALLY BE COMPLETED BEFORE 9/30/16

• A logical debate surrounding the stock for months has been how long beyond the June 30 expiration will it take Telcordia to transition as any delay obviously accrues to NSR’s benefit.  Over the last year, NSR management has not surprisingly thrown out a bunch of exaggerated, unfounded claims that they think the transition could take upwards of 3 Years (~33 Months), which the Sellside obviously has parroted.  In recent weeks, these claims were officially proven to be nonsense after the following two events occurred that seem to suggest the transition will take at WORST CASE 15 months (which is what I have assumed for my valuation construct)  

• In early April, NAPM and NSR negotiated amended contract terms principally focused on all of the specifics surrounding NSR’s obligations to assist in the transition.  The amended contract also stipulates that the contract renews at current pricing terms until September 30, 2016 unless NAPM decides to terminate it earlier.  With respect to contract termination, the amendment is rife with new language that would appear to make it fairly easy for NAPM to terminate the contract before 9/30/16 if they so choose.   

http://www.sec.gov/Archives/edgar/data/1265888/000126588815000019/exhibit991april82015.htm

• In late April, NAPM issued its preliminary transition plan to the FCC.  In this plan, they included a preliminary transition timeline that ends almost exactly at 9/30/16 (the end of NSR’s contract “extension”).  In the transition plan, NAPM notes that this initial timeline will continue to  iterate and, given multiple references emphasizing the desire for speed, it appears that there is a much greater likelihood that, in the event the timeline is changed, it is compressed not expanded.  

https://www.napmllc.org/Docs/npac/ref_docs/04%2027%2015%20-%20NAPM%20LLC%20-%20Transition%20Oversight%20Plan%20-%20Clean%20PDF.pdf

“The NAPM LLC will update the timelines to reflect the results of discussions with the Manager and negotiations with iconectiv, Neustar, and third-party testing entities, as well as feedback from stakeholders and interested parties. The goal is to complete the transition as soon as possible without creating the risk of harm to the industry or the public, which requires the NAPM LLC, with the assistance of the Manager and oversight by the FCC Transition Team, to reassess and update the timeline at strategic check points.”

“There will be check points 45 days prior to the beginning of each transition event to allow for progress assessment and necessary timeline adjustments”

• Whether or not the transition actually takes until 9/30/16 is anyone’s guess at this point.  More importantly, 9/30/16 is the current market expectation reflected in shares and thus any incremental newsflow suggesting a quicker transition would certainly be a negative for the stock.  There is a wealth of publicly available information suggesting that the transition could happen sooner than people realize.  For starters, representatives of the carriers, who are writing this actual transition plan and have detailed knowledge of Telcordia’s implementation plans and capabilities, inadvertently admitted in December that a decision by year-end would be enough time for Telcordia to transition (see page 2 of the below letter from the CTIA (whose membership includes all the carriers that lead NAPM).  The carriers want to put this to bed as quickly as anyone and if they were telling the FCC it can be done within 6 months, there is a good chance it can be done even quicker.  Say you had to take your car to a mechanic notoriously unpredictable and prone to delays.  If they were to ask you when you needed it fixed by, would you give them the exact date or one much sooner to leave some cushion and makes sure they are properly motivated?
  
  

“We urged the Commission to act by year-end (2014) to allow all impacted providers' business and technical units to proceed with the necessary logistical planning for a seamless and timely transition in order to prevent an avoidable, new cost of more than $1 million per day from being passed on to the American public”

http://apps.fcc.gov/ecfs/document/view?id=60000987252

• Second, all of Telcordia’s recent number portability implementations have been completed in 4 to 5 months despite often being in situations where the number portability architecture was actually being built from scratch, there was no pressing time constraint or outsized motivation of the carriers to expedite the process, and Telcordia had no existing infrastructure in place to leverage.   The exact opposite dynamics will be in play for the NPAC transition.  Telcordia is the worldwide leader in number portability, and, as such, there is a fair amount of information available on their precedent implementations.  Below are their 5 most recent implementations (can google for the press releases confirming the information).  As you can see, every single one was successfully completed in just a few months starting from the day they were officially selected as the number portability vender.  

• Peru (4 months)

• Argentina (under 4 months)

• Chile (under 5 months)

• Mexico (4 months)

• Turkey (4 months)

• Also publicly available are past Telcordia marketing presentations where they outline sample implementation timelines that stipulate 4 to 6 months as a baseline assumption for a start to finish number portability transition period.   In these same presentations they note that the principal causes of variance from this timeframe stem from either regulatory issues that delay the official selection of the number portability vendor (with the FCC vote completed, this is clearly no longer an issue) or operator readiness (not only are the U.S. telcos probably more incentivized to get the transition done quickly than any group of carriers in the history of number portability implementations, they are also the most technologically advanced and familiar with the NPAC architecture)    

http://www.ncc.gov.ng/Archive/Workshop%20Papers/NumberingConvergencePresentations/Day1/centralized_order_processing.pdf

• Below is a second marketing deck from 2007.   

http://www.google.com/url?sa=t&rct=j&q=&esrc=s&frm=1&source=web&cd=1&ved=0CB4QFjAA&url=http%3A%2F%2Fwww.canto.org%2Fdoc%2Fgabriellago.ppt&ei=5mdOVKbLK9acygTR-YD4Ag&usg=AFQjCNHnZGvj2b-1dV3TDjORykUydPFKOg&bvm=bv.77880786,d.aWw

Later in the deck on slide 13, they note they would typically expect a 4 to 6 month implementation timeframe:  

• Perhaps more interesting is the fact that they were able to accomplish these timeframes despite having to start from scratch in most instances (i.e. countries had never implemented number portability before and Telcordia didn’t really have any type of existing presence to leverage and help speed things up).  The U.S. number portability infrastructure is fully built and functioning.  Swapping out one piece of this for another is not a herculean undertaking, particularly when switching to the biggest, most experienced vendor in the world that serves as primary vendor for ~40% of all number portability systems that have been ever been implemented.  Unlike some of these other implementations, however, Telcordia has already spent years exhaustively planning for, and investing in,  a U.S. transition

• Not only is the overall number portability architecture built, but Telcordia ALREADY HAS A SIGNFICANT, FULLY FUNCTIONING INFRASTRUCTURE within the current system and is just as, if not more engrained / interconnected to the necessary parties (including the NPAC) than NSR.  Approximately 90% of all U.S. wireless number porting transactions already go through Telcordia.  Specifically, they are the leading Service Order Activation (SOA) provider with multiple deployments of its North American Number Portability Gateway in all NPAC regions.   This means they serve as an interface element between the carriers and the NPAC, so the vast majority of the connectivity is already in place.   Below is some of the information Telcordia submitted in their RFP response outlining their capabilities
  
  
  

• NSR has actually admitted (inadvertently) that having Telcordia’s current capabilities would help facilitate a more efficient transition.  Below is a diagram NSR submitted in its RFP in an attempt to argue that transitioning to a new vendor would cost industry stakeholders more than a $1 billion - one of their many inaccurate claims about why no one except the incumbent should ever be able to operate the NPAC contact.  Not surprisingly, only $71 million of the $1 billion estimate is ascribed to explicitly known technical steps required in a number portability transition (“Set-up Costs” at the bottom), with the remaining $929 million ascribed to such gems as “reduced  brand value”, “loss of subscriber value” and “impact to strategic priorities”.   You’ll see the first key transition step they highlight is establishing SOA connectivity. TELCORDIA IS THE SOA PROVIDER!
  
  

• You’ll see that items 2 and 3 relate to the various testing that must be done before the new vendor can go live.  Commentary from wireless carrier representatives familiar with local number portability implementation I’ve consulted with agree that variability in the testing phase (i.e. how long it will take carriers to test the new computer code that will be used to provide LNP service) is typically the primary technical issue that can delay implementation timelines.   The level of sophistication of the carriers, infrastructure in place, and participating NPAC vendors along with overall operator readiness and motivation are certainly key determinants in the efficiency of the testing process that ultimately comes to pass – all of which will be working in Telcordia’s favor at a level significantly more favorable than ever experienced in any of the 44 counties that have implemented number portability since the U.S. kicked first kicked off the process nearly two decades ago.  After all:
  
  

• The NPAC architecture is built and the most technologically advanced in the world, as are the carriers using the NPAC and working with Telcordia to ensure a smooth transition

• Not only is Telcordia the most experienced  vendor when it comes to number portability implementation in the world, but they are already deeply embedded in the current system, have planned the transition for years, and started developing necessary capabilities before the FCC officially confirmed their selection in late March

• The most impartial third party analysis done on the implementation issue (length of time required for testing) was by Professor Eric Burger at Georgetown University (full report can be found in the link below).   He pegs the testing phase at 3 to 6 months:
  
  

http://apps.fcc.gov/ecfs/document/view%3Fid%3D7521824526

“…If a new NPAC operator were to write all-new code from  scratch, there is a distinct likelihood of latent errors to be found post-release.  Because of the potential for latent errors, testing of any new system will be critical.  Besides vendor testing, the carriers will need to test the interfaces and database behavior.  We would expect such testing to take a minimum of three months. Realistically, we expect such testing to take at least six months of calendar time”.

Iconectiv addressed the analysis in the below blog, where CTO Chris Drake makes multiple comments explaining why the transition could even be smoother than Professor’s Burger’s   assessment.

http://iconectiv.com/insights/index.php?blgid=transition

• Let’s also not forget that back in the late 90s when U.S .number portability was being implemented for the first time, there were initially supposed to be 2 NPAC vendors:  NSR (former subsidiary of Lockheed Martin) and Perot Systems.  The first major phase of number portability implementation was expected to be completed by December 31st, 2008 with carriers in the 100 largest MSAs.   Because of performance issues, however, NANC recommended that the contract with Perot Systems be terminated and taken over by Neustar.   The FCC did not affirm this recommendation until October 20th, 1998 with the below release.  Even so,  by December 31st,  2008 number portability was still live in the major MSAs, meaning NSR was able to transition half the contract in roughly just ~2 months despite the entire system being in infancy with technological proficiencies hardly even a fraction of what they are today.  

10/20/1998 (NSR awarded entire contract)  http://transition.fcc.gov/Bureaus/Common_Carrier/Orders/1998/fcc98275.txt

• Finally, in Exhibit D (starting on page 106) of the afore mentioned original 1998 master agreement, you can find NSR’s non-redacted responses to the original RFP (which is highly instructive given much of the subject matter in the current RFP responses from Telcordia is redacted), including their implementation plan (excerpts pasted below) where they remark that they expect it to take ~7.5 months to go live from the date the contract is signed, including ~4.5 months of testing.  If a guinea pig NPAC vendor could do this when the entire system architecture was still being built from scratch (the first number portability implementation in history no less), with technologies two decades old, you’d certainly think that Telcordia, the most experienced number portability vendor in the world already deeply embedded in the existing, fully-functioning number portability infrastructure, should be capable of completing the implementation far quicker.  

http://www.sec.gov/Archives/edgar/data/1265888/000110465905039530/a05-14668_1ex10d1.htm

“We envision that Master Contract and Service Agreement negotiations will conclude on the February 13, 1997 target date….  ….We are committed to delivering the NPAC SMS for live production system-to-system testing on May 15, 1997 and for full-scale NPAC/SMS deployment (live operations) on October 1, 1997”

• NSR management has repeatedly tried to downplay any risk of a contract termination / faster than expected transition   On a March 26th, 2015 conference call with Sellside Analysts just after the FCC vote, CFO Paul Lalljie remarked that unless a “Notice of Non-Renewal” is received in the next 5 days, NSR is effectively guaranteed to hold the contract for another year:

“Some of you may know that our contract to provide number portability services automatically renew for one year unless we receive a notice of non-renewal by April 1, 2015”

• On April 2nd, 2015, the Company released the following short 8-K in which they say the below in an obvious attempt to create the impression that they are guaranteed to hold onto the contract for at least another year:

“As of the date of this Current Report on Form 8-K, the NAPM has not provided a Non-Renewal Notice to the Company.”  

http://www.sec.gov/Archives/edgar/data/1265888/000126588815000015/form8-kapril32015.htm

• In response to the perceived “guarantee” of a contract extension, Sellside analysts issued a variety of reports lauding the developments as a significant positive for the stock.  Below are a few excerpts:

JP Morgan: “No News is Good News” – 4/6/2015

“After the close on Thursday ahead of the long weekend Neustar announced that it did not receive any notice of non-renewal from NAPM triggering the auto one year renewal feature of the contract….We still have to wait to see what the ultimate transition time frame looks like, but, in our opinion, 12-18 months post June 30, 2015 is neutral, anything longer than 18 months is a positive, and if under 12 months was a possibility (which it now appears it is not), that would have been a negative.”

“No cancellation request means another year with current pricing”

“At least twelve months to maximize profit, buy back stock, and prepare for the next phase”

Deutsche Bank: “Automatic NPAC renewal kicks in for another year” – 4/6/2015

“While this doesn’t change the outcome for NSR, the additional year provides roughly $500m in additional revenue at the existing mid-to-high-50s EBITDA margin, a little over $2 per share of free cash flow by our estimates.“

“Clearly, the extra year on existing pricing terms helps NSR’s balance sheet, particularly with the $150m repurchase program (about 10% of market cap) that the company launched on March 26. NSR also gets more time to plan and communicate its “post-NPAC” future as a provider of marketing, security and data services, where the opex profile and margin potential have been the topic of a polarizing debate in the investor community.”

• NSR’s comments to the Street are in BLATENT CONTRADICTION to they told the FCC in weeks prior on March 3rd, 2015, where NSR admits that the lack of a Notice of Non-Renewal does not in any way guarantee any type extension.  This is clearly the opposite of how they characterized the situation to the Street.     

“Our discussion focused on the provisions of the current contract between the NAPM, LLC, and Neustar related to termination and transition consistent with our ex parte letter filed February 20, 2015. The NAPM need not provide a notice of non-renewal before April 1, 2015.  On the contrary, after automatic renewal, the NAPM will have the right to provide a notice of termination at any time prior to April 1, 2016.”

http://apps.fcc.gov/ecfs/document/view?id=60001039498

• NSR continued this pattern of trying to obfuscate any risk of a contract termination with how it disclosed the contract amendment on April 7th.  In their public release, NSR released both the actual contract amendment (http://www.sec.gov/Archives/edgar/data/1265888/000126588815000019/exhibit991april82015.htm) as well as a summary 8-K in which they attempt to summarize the amendment (http://www.sec.gov/Archives/edgar/data/1265888/000126588815000019/form8-kxapril72015.htm).   For example, the very first sentence of the actual contract amendment reads:

“This Agreement shall commence as of the Effective Date of this Agreement and continue for a term ending on June 30, 2015 (the “Initial Term”), unless terminated earlier under the terms of this Agreement. This Agreement shall renew for a 15-month period ending on September 30, 2016 (the “First Renewal Period”), unless terminated earlier under the terms of this Agreement”

However, in its summary, 8-k to investors, NSR decides to simply remove these termination references so the sentence simply reads:

“The Amendment provides:

1. for a fifteen (15) month renewal of the NPAC Contracts from July 1, 2015 through September 30, 2016, fixed at 2015 price levels”

1. Not surprisingly, the stock ripped after the release and the Sellside logically interpreted management’s statements to mean that NSR is effectively guaranteed to retain the contract until at least September 30th 2016   

Wells Fargo: NSR Receives Clarity on Contracted NPAC Revenues” - 4/8/2015

“The new amendment gives NSR more visibility for revenues for 2015 and the first 3 quarters of 2016.  In addition, we expect an upside bias to estimates and the news should be a modest positive for the stock today.”

• In fact, the vast majority of the contract amendments relate to the transition services terms from Article 24 of the master agreement.   Specifically, there are 2,873 words detailing the incremental amendments and ~80% of these words relate to detail added to provisions discussing transition services.  Given that NSR has now officially lost the contract and is mandated to help with the transition process to Telcordia, this incremental detail certainly makes sense.  Transition services are only relevant in the event of a termination – so why would NAPM have done so much work to augment the transition terms if there wasn’t going to be a termination?  Another very telling addition to the April amendment NSR also fails to mention is:

“Section 24.1 of the Master Agreement is hereby deleted in its entirety and replaced with the following:

24.1 Contractor’s Obligation to Assist with Transition

Upon written notice to Contractor, which notice Customer may provide at any time, whether or not this Agreement has been terminated by Customer under either Article 23 or Article 12 hereof (a “Termination Event”), or upon election not to renew the term of this Agreement under Article 3 hereof (a “Non-Renewal”), Contractor shall assist Customer in the orderly transition of the Services specified herein from Contractor to a successor contractor or administrator for NPAC/SMS (in either case, the “Successor Contractor”), consistent with the requirements of this Article 24 - Transition to a Successor Contractor.”

• Here, the amendment is saying that NAPM can notify NSR it is being terminated at any time with a simple written letter and the contract then becomes governed by the various sections related to a new vendor transition.  In this case, NSR only gets paid on a day-by-day basis for any overage beyond the June 30th, 2015 expiration plus any transition services provided on a cost-plus basis.  In essence, the amendment appears to have potentially introduced a new, far easier way in which the contract can be terminated beyond those initially outlined in the original master agreement (Article 23 in the link below), which had suggested it would require a regulatory event to terminate the contract.  

http://www.sec.gov/Archives/edgar/data/1265888/000110465905039530/a05-14668_1ex10d1.htm

• The April 30th, 2015 issue of trade publication “Communications Daily” discussed highlights from an FCBA lunch meeting in which Todd Daubert, partner at Denton, which represents NAPM in all of its contract negotiations, said the following:

“As the Local Number Portability Administrator is transitioning, it’s important to remember that it’s only the beginning of the process and the contract is a ‘living document’”

“We're so early in the process that these timelines will be adjusted—could be adjusted to the left, they could be adjusted to the right,”

In other words, the preliminary timeline in NAPM’s Transition Oversight Plan that calls for everything to be completed by Fall 2016 is going to change, and everything we know right now appears to suggest that this timeline will be expedited, not pushed back, given:

• The telco representatives part of NAPM have publicly admitted that it can be done in under 6 months in FCC filings

• All of Telcordia’s recent number portability implementations have been completed in 4 to 5 months despite often being in situations where the number portability architecture was actually being built from scratch, there was no pressing time constraint or outsized motivation of the carriers to expedite the process, and Telcordia had no existing infrastructure in place to leverage.   The exact opposite dynamics will be in play for the NPAC transition

• In NSR’s own original master agreement signed in September 1996 they include the portion of their original RFP response related to implementation whey they can complete the implementation process in ~7.5 months.  If that was possible two decades ago when everything was being built for the first time, imagine what is possible today?

• Also related to the initial number portability rollout almost two decades ago, the original contract was supposed to be split equally between two vendors (NSR and Perot Systems).  However, because of poor performance on October 20th, 1998 the FCC authorized the termination of Perot’s contract and awarded the remaining half to NSR.   NSR in turn successfully transitioned this piece in just a little over 2 months!

• The only party that actually wants a delay (NSR) is now under contract and has nothing left at its disposal to further try and prolong the process  

• Regardless of the exact day the transition is ultimately completed, what is abundantly clear is that NSR is certainly in no position to be characterizing the current situation as one in where there is zero risk that the contract is terminated and they are effectively guaranteed to retain the contract until 9/30/16.  They are continuing to omit what appear to be very material facts about the situation   and I’ll let the lawyers in the audience opine whether this recent behavior constitutes securities fraud.  If it does and lawsuits are filed, it won’t be the first time NSR has been sued:

http://securities.stanford.edu/filings-documents/1052/NI00_01/2014715_f01c_14CV00885.pdf

6. THE SELLSIDE – UNPRECEDENTED INEPTITUDE

• Sell-side efforts so far have been laughable and I have countless, awesome examples of their negligence / incompetence.  Since being spectacularly wrong on the prospects of the contract loss for years, they have since intentionally ignored the situation for over a year as part of a larger effort to do as little work for as long as humanly possible given NSR is a relatively small cap, inconsequential name in their coverage universe with trading volumes that certainly aren’t paying anyone’s salary.  It also is obvious that they lack the basic technical skills required to understand how the P&L looks without the contract and what that implies for the pro forma valuation.  

• The only reason I bring all this up is because the Sell-side is a little more relevant here than might normally be the case.  William Blair, for instance, is the number 2 holder and owns 10% of outstanding shares.  Coincidentally, the Blair analyst also has the only “Buy” on the Street, which he has continually reiterated since initially upgrading the stock when it was at its all-time highs above $50 back in 2013.  

•  The Blair analyst’s  key “arguments” / and the glaring problems with each are:

• “We believe investors may not fully appreciate the value of the surviving non-NPAC businesses, which collectively continue to grow in the double digits and have adjusted EBITDA margins of 35%-40%, according to management.”

• For starters, this is factually incorrect.  This comment doesn’t relate to today.  It relates to management’s made-up 2017 fantasy target of $650 million of revenues at a 35%-40% margin.  The Company wouldn’t even provide guidance for the 2H of 2015 so pretty hard to put much weight in a 2017 guidance number.  In this same note Blair even says

• “In our view, 2016 will reflect a transition period where estimates are difficult to predict based on the lack of clarity into NPAC revenue”

• The reality is that organic revenue growth (which is the key metric here because the Company can no longer pursue M&A without the contract), was sub 5% in2014 and even reported, inorganic growth was just 7.3%   For 2015, NSR Non-NPAC guidance, which is also an inorganic number, is calling for just 7% to 8%  revenue growth.  Even in William Blair’s own updated model in the very same note Non-NPAC revenue growth is forecasted to be ~8% in 2015 and 2016.

• The comment on EBITDA margins is also factually incorrect.    Not only is this also a copy paste from earnings call commentary with no justification, it completely misinterprets what management is saying.   Hopefully I’ve shown why management’s “long-range target” margin target is an impossible number to hit, but even if you were to take it at face value, as Blair is trying to, the key stipulation management also says has to be true is that the margin is only achievable off of a revenue base of at least $650 million (so as to provide the scale necessary to achieve the operating leverage that will be needed), which even NSR admits won’t happen until 2017 at the earliest.  

• In Blair’s model, they jerry-rig the numbers so that a 35% EBITDA margin is magically achieved in 2016 off of a revenue base of $576 million.  They’re able to do this because of a non-subjective, MECHANICAL BUST in their model that is not only double counting  the stock comp add back to arrive at adjusted EBITDA / EPS (a stock comp figure that is more than 100% too high no less).  They are flatlining 2014 stock comp of $63 million across the projection period  (even though 2015 guidance is calling for ~$40 million in stock comp and this will be reduced even more once the contract goes away) as an arbitrary add back that is not actually flowing thru the P&L.   This becomes even more obvious when considering management’s below comment on the 3/26 conference call.

• “So what you're seeing there at 35%, for example, you're looking at a $425 million operating expenditure line item. Today, that number is around $495 million

• The $495 million operating expense number they reference is excluding stock comp, calculated as follows (the amount of stock comp allocated to each operating expense line item is publicly disclosed).   

Per the quote, management is saying they hope to bring OpEx down to $425 million by 2017.  Blair clearly uses this quote to inform the ~$440 million of assumed 2016 operating expenses currently in their model, but screwed up the fact that the management number already excludes stock comp.  So, they went ahead and added it back again  (a significantly inflated number no less) to get to the $200 million of adjusted EBITDA they are currently showing (which implies ~$375 million of OpEx - obviously a steep haircut to management’s own guidance of $425 million by 2017) instead of the ~$137 million it should be once the mislink is fixed.  This mislink is causing 2016 EBITDA to be overstated by 45% and EPS even more.   

• “The stock now trades at 19.5 times our 2016 adjusted earnings per share estimate of $1.33” (author note – once the model mislink is fixed the stock is trading at 40x+ their own 2016 adjusted EPS number)

• Completely ignoring the model error for now, this comment indicates they perceive the stock to be undervalued at 19.5x 2016E P/E, with no mention of how that compares to comps, historical precedent, etc.  For additional valuation commentary, you have to go all the way back to when Blair initially upgraded the stock in late 2013 (when the stock was trading at all-time highs of $50+)  on the following rationale:

“We are upgrading NeuStar to Outperform from Market Perform, based on our belief that the stock is undervalued relative to the company’s potential growth opportunities in the analytics space as well as what we view to be relatively muted risk regarding the company’s Number Portability Administration Center (NPAC) contract consideration.”

On valuation, Blair said:

“The stock closed trading Thursday, September 5, below 13 times our revised 2014 pro forma EPS estimate of $3.97. We believe that investor sentiment has been dampened by both an under appreciation for the company’s emerging analytics opportunity and excessive concern about the likelihood of renewal of the NPAC contract, which is targeted for January 2014 (the activity for which would begin July 1, 2015). In our opinion, the stock should have a higher multiple, perhaps 15 times or better.”

• So, when Blair upgraded they had the view that 15x is an appropriate 1 year forward P/E multiple under the following conditions

• The NPAC contract is retained entirely

• Non-NPAC revenues grow north of double digits at a compounded rate across the projection period.  Below is their summary income statement for reference

• Fast forward to today, Blair is now saying that the stock is worth something north of 20x an EPS number that is overstated by 50%+ because of a cell mislink (so effectively saying stock is worth more than 40x).  But even if you stick with their busted numbers and 20x+ assumed valuation multiple, that is still implying significant MULTIPLE EXPANSION since the upgrade when the following has happened:

• The NPAC contract has officially been lost

• Revenue growth in the Non-NPAC business has come in 30% to 40% below Blair’s expectations at the time of the upgrade despite the Company  having the benefit of 2 overpriced acquisitions , and as result Blair has slashed their own Non-NPAC forecasted revenue growth rates going forward by equivalent amounts

• Even when using their drastically overstated 2016 EPS, 2016E adjusted EPS has been slashed by 70%+ (off of

• “We continue to expect a longer transition period that could last several years, but our 2016 estimates are conservative to reflect a contract loss and transition through 2015.”

• In this, and prior notes, he does not provide a single datapoint or any justification as to why he thinks there will be a material transition delay beyond copy  and pasting an unfounded, cliché claim from management on their earnings calls.

• Ignoring that, even if he ends up being right to some degree by happenstance, it’s entirely irrelevant because any per share benefit received from a transition delay won’t come close to compensating for the per share loss of the lost contract. For perspective, let’s assume he continues to believe the stock somehow deserves significant multiple expansion to at least 20x relative to when he first upgraded the stock despite a transformational business degradation.  Fixing just the mechanical bust in his model, 20x his 2016 adjusted EPS number equates to roughly $12 a share.  The longest potential transition period I have ever heard mentioned is the ridiculous 33 month period touted by not one person except (surprise surprise) Neustar (unless you count the Sell-side parroting of this remark) .  Hypothetically, even if a freak event happened and the transition took 33 months, under Blair’s own logic below the stock would be worth $20 (25% below current)

“At current contract revenue levels, we believe the extension could be worth between $3 and $4 per share for NeuStar for every year of extension”

• I wish I could say that William Blair was an anomaly, but it doesn’t even get any better with the analyst that has the lowest price target on the street, Deutsche Bank.  On March 5th, just after the WCB circulated its written order for eventual FCC vote on the 26th, DB put out the below note  where they lowered their price target to $22 because of a correctly assumed higher probability that the NPAC contract will be lost.  In the scenario in which the contract is lost, DB says the stock is worth $17 a share.  

DB:  March 4th, 2015

We reiterate our Hold rating on the lingering uncertainty but lower our weighted-average PT to $22 from $30, now assigning a 75% probability to a bid-loss scenario”

• Just three weeks later, DB put out another note after the following two events happened:

• On March 26th, the FCC unanimously voted to affirm the Telcordia selection thus officially making his $17 price target a100% probability

• On a conference call the with investors the same day, NSR management revealed that at most $70 million of operating costs can be cut once the NPAC revenue stream goes away.

• Fittingly, the DB analyst updated their numbers to exclude the NPAC contract beginning in 2016 (see below),  and during this process the following miracles occur:  

• The stock suddenly became worth $22 despite only incrementally negative newsflow and their once 75% probability $17 price target officially becoming 100%

• Projected EBITDA and FCF margins magically doubled from what was assumed 3 weeks prior.  To justify this, they magically cut ~$160 million of operating expenses in 2016, more than double (129% to be exact) management’s own fairly explicit guidance  

   

• More recently, Wells Fargo introduced a $27 to $29 valuation range based on the below:

While his sum of the parts framework seems reasonable enough on the surface, here are the glaring mistakes with their calculations:

• Their calculations are simply omitting $200mm+ of debt, which equates to ~$4 per share

• They are assuming two entirely different sets of numbers to derive the two components their sum of the parts.  The ~$6 per share incremental FCF per share estimated to be derived from the NPAC contract from Q215 thru Q316 represents at a minimum of 75% to 80% of the total FCF NSR is expected to earn over that period and an equivalent proportion of EBITDA.   For this $6 per share number to be true, then Wells is saying that Non-NPAC EBITDA thus can’t equal anything more than roughly $90mm to $110mm of EBITDA.   However, in the second component their sum of the parts, (valuation of the Non-NPAC standalone), he is assuming Non-NPAC EBITDA equals ~$200million (you can use the detail in their model to bridge up to EBITDA from the $1.37 EPS number)!!

• Wells is also  significantly  overstating stock comp, which obviously inflates the add back to arrive at adjusted EBITDA / EPS.  NSR guidance is for ~$38mm in 2015 vs. Wells’ $57mm estimate, who then has stock comp going even higher in 2016 to $65million even though it will obviously only decrease further than $38mm when the NPAC goes away

So, even though their price target calculation simply omits $4 per share relating to NSR’s debt and overstates Non-NPAC EBITDA by 100%, they still get to a price target that is roughly 10% below current.   

• Hopefully these Sell-side case studies show just how absurd the amount of misinformation still surrounding the stock is (at least with respect to the 50% of holders that are still long).  Not to beat a dead horse, but a literal cell mislink is overstating William Blair’s EPS by over 50!  Knowing that this is the type of thought process employed by most bullish analyst on the Street and number 2 holder of the stock helps make it a little easier for me to weather these intermittent squeezes.  The question is not if NSR will be a single digit stock, but when.

APPENDIX: DOES NSR’s RECENT LAWSUIT AGAINST THE FCC MATTER?

• The short answer is no, which is why I’ve placed this section in the appendix. The FCC could give 2 sh*ts whether NSR or Telcordia is the NPAC vendor.  It’s a private contract, not even a government contract, and a small one at that.  They do care about making sure they have no legal liability, however, which is precisely why this process has dragged on for as long as it has. Every single nonsense objection from NSR over the last over the last 6 years has been exhaustively reviewed, and summarily dismissed, by the FCC and its General Counsel’s office at various points in time.  The final order is essentially a 100 page legal dissertation explaining why every single NSR’s legal argument is groundless.  If any did hold merit, the FCC would have addressed in an incremental procedural step.  Again, they could care less whether NSR or Telcordia holds the contract.

• That said, given the FCC knew NSR was likely to sue and overarching desire to make sure they are legally protected, they spent the last year collecting public comment even though they didn’t have to.   Sometimes the FCC is legally required to put an issue out for public comment, but informal adjudication procedures like NPAC vendor selection are considered optional (i.e. the FCC could have just adopted the NANC recommendation before putting it out for public comment).  The public comment process allowed the FCC to build a robust public record that shows it did not act “in an arbitrary and capricious manner”, the standard of review used by the Courts in deciding what appeals they will hear.  Below are slides from a helpful presentation by the American Bar Association that describes the procedural framework governing the FCC appeals process.

http://www.americanbar.org/content/dam/aba/events/administrative_law/2013/11/Administrative%20Law%20Fall%20Conference%202013/2_rulemaking_101.authcheckdam.pdf

• You can say a lot of things about the FCC and this process, but being “arbitrary and capricious” certainly isn’t one of them.  Since Telcordia first petitioned the FCC in 2009, the FCC requested (and received) robust public participation from all key stakeholders (NSR certainly being one) at every single step of the RFP process with multiple extensions to ensure everyone is “heard”.  

• August 6th, 2009 –  FCC released Public Notice seeking public comment on Telcordia’s petition to institute a competitive RFP for the NPAC contract to be effective at the end of the current’s contract’s expiration (6/30/2015)

https://apps.fcc.gov/edocs_public/attachmatch/DA-09-1762A1.pdf

• March 8th, 2011 –  FCC released  Public Notice seeing comment on a proposal by the NANC Chair and the NAPM regarding their respective roles in the LNPA selection process

https://apps.fcc.gov/edocs_public/attachmatch/DA-11-454A1.pdf

• August 13th, 2012  – FCC released public notice seeking comment on RFP documents that had been developed

https://apps.fcc.gov/edocs_public/attachmatch/DA-12-1333A1.pdf

• June 9th,  2014:  FCC released Public Notice seeking comment on NANC recommendation
  
  

https://apps.fcc.gov/edocs_public/attachmatch/DA-14-794A1.pdf

• November 7th,  2014:  FCC released Public Notice seeking comment on prior NSR petitions for declaratory rulings

http://transition.fcc.gov/Daily_Releases/Daily_Business/2014/db1107/DA-14-1629A1.pdf

subsequently extended by 5 days:

http://transition.fcc.gov/Daily_Releases/Daily_Business/2014/db1125/DA-14-1710A1.pdf

• Throughout this period, NSR provided numerous comments after each of the above asks and could not have been more enthusiastic and supportive of the RFP procurement documents and vendor selection process that was formulated, until of course they first got wind that they were going to lose.  A few of my favorites are:

• 3/29/2011:  NSR wrote letter to FCC arguing that “THE NPAC IS NOT FEDERALLY FUNDED AND SHOULD REMAIN A PRIVATE CONTRACT BETWEEN PRIVATE PARTIES” and thus government bodies (the FCC, federal appeals courts, etc.) should have as limited involvement as possible

http://apps.fcc.gov/ecfs/document/view?id=7021235781

• 9/13/2012:  NSR wrote 23 page letter in glowing support of the comprehensive RFP (and the practices and procedures that would govern the process going forward)   - a construct that took over 2 years to develop with the collaboration of numerous industry participants  
  
  http://apps.fcc.gov/ecfs/document/view?id=7022013437

• Even if NSR did have a quasi-legitimate argument supporting the notion that the FCC acted in an arbitrary and capricious manner, the hurdle for the courts to intervene is so incredibly high that the risk of anything coming from an NSR lawsuit would still be slim to none.   How high is this hurdle?  Well, for perspective, a comprehensive 2007 report by the GAO (link below) looked at 240 substantive FCC decisions that were appealed to the Courts.   Of those 240, 6 cases (2.5%) actually resulted in some type of incremental action from the Courts.  Perhaps even more interesting, even if NSR miraculously becomes one of the 2.5%, the legal process does not in any way delay the effectiveness of the rule or transition to Telcordia.  This certainly makes sense, as nothing would ever get done if companies on the losing side competitive procurements could just sue and hold the contract decisions up in court all the time.   This would require some type of injunction.   Good luck.  Of the 240 appeals heard by the GAO, 2 (0.8%) were granted some type of injunction.

http://www.gao.gov/products/GAO-07-1046

Catalyst

-Incremental transition timeline commentary expected in coming weeks / months

-Growing emphasis on (and awareness of) the magnitude of the NPAC contract's contriubtion to NSR's P&L

-Liquidation by large long holders in response to recent short squeeze