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Executive Summary

I believe Neustar (NSR - $27.62)  represents an attractive risk/reward short opportunity, as the market still seems to be overly sanguine on the renewal of NSR’s monopoly-like contract (called “NPAC”) that they have had since 1996.  Neustar is a good company known (or maybe unknown to most) for having a monopoly-like contract for local number portability in the United States.  For those of you not aware, they are the backend data provider that allows you to keep your phone number when you switch providers.  More than any time in the past, NSR has the potential for dramatic reductions in contract profitability or the loss of the entire contract, which I believe represents over 100% of profitability on a variable basis.  Additionally, the balance sheet has leverage and the Company’s other businesses do not come close to justifying the stock price at these levels in my opinion.  I believe analysts and the market are misunderstanding exactly how profitable NPAC is for Neustar, and the likelihood that there will be significant changes in terms going forward.  In summary, I believe NSR’s fair value is materially lower than today, with ~50% downside in the event of a contract loss, and at least 20% downside in the scenario with significant pricing cuts which seem increasingly likely.  Finally, the catalyst to the short is expected by May 6^th, 2014, which is when the FCC will decide on the next NPAC contract and the market should hear initial details on pricing terms and vendors.

Capitalization

 

Business Description

 

While the NPAC business represents ~49% of 2014E revenue, and an even higher percentage of EBITDA, it is worth quickly describing the other businesses.  For simplicity, I will use the old segment disclosure (more on this later).  NSR’s non-NPAC businesses consist of the following (taken almost verbatim from the 2012 10-K):

 

• Enterprise Services – These businesses provide enterprise customers with services to meet directory-related needs as well as Internet infrastructure services.  Examples of these businesses include common short codes (“text 57895 to vote for your Idol!”), IP geolocation so customers can identify the location of their consumers, and registry services and directory services that that direct, prioritize, and manage Internet traffic.  Enterprise services represented ~21% of 2012 revenue and had contribution margins of ~43%.
• Information Services – This segment provides real-time information and analytics that enables clients to identify, verify, and score their customers and prospective customers.  This business is targeted to marketers looking for more specific ways to reach customers.  Additionally, the Company is one of the largest non-carrier providers of caller-ID services.  Information services represented ~19% of 2012 revenue and had contribution margins of nearly 49%.
• Other Carrier Services – Carrier services is the segment that holds the NPAC contract.  Aside from this, there are other smaller carrier-related business that represented ~11% of 2012 revenue.  The TOTAL carrier services contribution margin was a whopping 87.3%.  This is very important:  even if we assumed that the “other” carrier services had a 100% contribution margin, it would imply that the NPAC contract was at a minimum an 84% contribution margin business.  In short, while NPAC represents nearly 50% of 2014E revenue, it represents a materially higher portion of total profit…and the math is basically in the Company’s filings.  But that hasn’t stopped analysts from missing it…

 

The non-NPAC businesses of NSR have grown at roughly 9.7% organic revenue CAGR for the past two years and are expected to grow at approximately 5.9% next year according to the Company.  Full disclosure, I do not believe this is particularly relevant to the stock at this point.  Instead, I have assumed 8% revenue growth and constant margins in my model for non-NPAC going forward.  For what it’s worth, some of the research analysts believe the non-NPAC businesses will slow down in the next 3-5 years.  But again, the real story here is NPAC.

 Source:  NSR 2012 10-K

New Segment Disclosure and 2014E Guidance

Source:  NSR Q4 2013 press release and historical SEC financials.  2014 interest expense estimated.

What is NPAC?

NPAC is the number portability administration center, which is responsible for number portability in the United States and Canada and manages over 500 million telephone numbers from over 2000 carriers.  Additionally, the NPAC system supports the continued convergence of wireline, VOIP and wireless communication.  While Neustar has run the NPAC system as the administrator since 1996, the NPAC is actually contracted out via seven independent contracts.  I think it is worth understanding the history of NPAC, because it does provide some clues into how regulators and telecommunications companies view this service, and how it might be changed going forward.

History

• As part of the Telecommunications Act of 1996, local number portability was mandated in the US to enhance telephone service competition.
• When the contract to serve as the NPAC administrator was first handed out, four regions were given to Lockheed Martin (which is now Neustar), and three regions were given to Perot Systems.  However, prior to implementation in December 1998, Perot Systems was unable to build a stable platform and Neustar has had full control of the system ever since.  Initially, the contract was given to two vendors specifically for reliability reasons in case one of the providers was unable to perform.
• Over time, there have been several enhancements to the system, allowing for VOIP porting, inter-modal porting, and other technologies.  Additionally, the contract switched from a transaction-based payment model to a fixed fee model, as transactions have grown so much with wireless numbers.
• Since 1996, NSR has successfully extended and renegotiated the contract pre-emptively four times, with the current renewal process being the fifth time.  Generally speaking, renewals have reduced the price per transaction or fixed price Neustar collects by 5-20% during each negotiation in exchange for the extension of contract terms. 

I believe this history is important, because it points out a few areas where those deciding the contract may look for change.  First, the contract was initially given to two providers.  It seems reasonable that if this was the initial intent, a split contract could still be a possibility.  Second, the decision to switch from transaction-based to fixed-fee demonstrates some cost sensitivity from those paying for the contract (average citizens, through pass-through payments from telcos).  Finally, if NSR was willingly giving 5-20% price discounts for contract extensions in the past, isn’t it reasonable to conclude that this time, which is the first competitive bid process, pricing cuts should be worse?

Technology

The NPAC has been described to me as essentially a spreadsheet with 400+mm rows and 17 columns containing the routing instructions for phone numbers in the US.  This “database” is essentially updated frequently and is constantly downloaded by carriers to ensure proper routing of phone calls.  On this point, it is important to understand that the technology behind the system is actually owned by North American Portability Management (“NAPM”), which is a group of the 10 largest telcos in the country.  Neustar simply manages the system that they own, so in theory it should be that much easier should they ever elect to switch providers as the system already exists and this should limit some of the start-up costs of switching.

Key Players/Process

It is also important to understand that this contract is not with the federal government, but is actually a private contract with NAPM that is approved by the FCC’s Wireline Competition Bureau.  This is relevant because a private enterprise can run the process however they choose to, which is something discussed a bit later.  Very briefly, the process for selecting the NPAC administrator should follow these rough steps:

• NAPM receives bids to be the next administrator
• NAPM submits their recommendation to the North American Numbering Council (NANC), who then votes on the recommendation and agrees/disagrees.  It seems as though these two parties are in communication throughout the process, such that it is unlikely that NAPM submits something that will obviously not be acceptable to NANC.  From the FCC’s website:  “The North American Numbering Council (NANC) is a Federal Advisory Committee that was created to advise the Commission on numbering issues and to make recommendations that foster efficient and impartial number administration.”  Basically, the FCC has sanctioned this smaller group with various tasks, of which the NPAC contract is one, so they can focus on larger matters.
• FCC reviews NANC recommendation and makes the final decision.  Given the NANC is a Federal Advisory Committee for the FCC, it is my expectation that the FCC will likely defer to NANC’s judgment.

Contract Profitability and Excessive Returns

I think it is safe to say that NSR doesn’t want people, especially those deciding on the contract, to figure out exactly how much they are likely making on NPAC.  Unfortunately for NSR, this information can be derived from their 2012 10K and the disclosure given on segment contribution margin.  As already discussed, I estimate that at a minimum, the NPAC contract has nearly 84% contribution margins.  Given that these figures are in their 10K, and the 84% is the minimum assumption, I’m not totally sure how this can really be debated or why analysts have missed this.  For 2014, assuming NPAC revenue (which is disclosed and known for the contract life) of $466mm, this means NPAC contribution of over $391mm on a variable basis.  NSR’s EBIT guidance for 2014 is roughly $256mm.  For 2015, the annualized revenue for NPAC is $496mm.  I believe it is clear this is very significant for NSR and I cannot stress that enough.  Obviously, there are other costs that could be cut should the contract experience a significant price hit or should NSR lose it altogether, but the point is that they NEED to cut simply to be profitable.  I have yet to hear a good explanation of why this logic is not correct, at least on a variable basis.  By contrast, the analysts appear to be taking a much more simplistic (and likely incorrect) view where revenue falls and profit adjusts by the consolidated margin.  Below are a few examples:

Under reasonable scenarios of fixed cost allocation, I believe NPAC could have as high as 60-70% EBITDA margins, versus analyst expectations above ranging from 23-38%. 

What’s Different This Time?

For the first time since the initial contract award in the late 1990s, the NPAC contract is going through a competitive procurement process, largely at the urging of Telcordia (now called Iconectiv, a division within Ericcson), who has been fighting for years to have a competitive contract award process.  As is typically the case, excess financial returns attract competition.  Telcordia is a leading number portability provider, with contracts in a number of other countries.  I’ve already highlighted the process above, and I believe we are somewhere in either the NANC submission or FCC stage at this point.  Additionally, there could be other bidders, although the only ones we can confirm at this point are Telcordia and Neustar.  The current contract expires in June 2015, and the new contract is expected to have a five year term with two one-year optional extensions.

You may be asking why the telcos or FCC would even care about this random contract and its likely excess returns.  The profitability analysis and contribution margins discussed above were actually first laid out by an investor who then sent this analysis to NAPM, via a lawyer at Latham and Watkins.  I have linked to them for reference, but these documents are available in the public domain:

• August 21st, 2013 Letter
• September 17th, 2013 Letter

Something tells me NSR probably didn’t want people to see this analysis.  Part of the reason I referenced the 2012 10-K in my analysis above is that with the most recent 2013 10-K, NSR stopped disclosing segment contribution.  Is that a coincidence?  I suspect NAPM has taken note of this as well, because as discussed below, it seems as though the contract award process is anything but the rubber stamped pathway from prior negotiations.  While telcos make a lot of profit dollars, every bit helps and there is likely greater focus on this excessive profit, especially when the consumer is essentially paying the bill.

Who Else Can Do This?

The short answer is that a lot more people can do this than the Company wants anybody to believe.  While the Company plays up the technology and there is no doubt know-how related to the system, the system is not proprietary to NSR.  Telcordia already has some infrastructure for this business, but I haven’t even considered other bidders.  Would VRSN, no stranger to monopoly contracts, or Syniverse try to bid?  I don’t know, but the profit potential could be large even at a dramatically lower price.  A few other points:

• If this contract were truly so complex and required such dramatic infrastructure, why don’t we see this in the numbers?  One can go back to NSR’s S-1 when it went public in 2005 and see a de minimis amount of PP&E.  That number has not gone up materially ex-acquisition, despite a contract revenue that continues to rise.
• Shouldn’t margins be lower if the contract was truly complex or if all these incremental transactions were so costly?  Instead, it looks like there is very little direct variable cost associated with NPAC.
• Various quotes from former NSR employees (per a Capitol Forum report on December 10^th, 2013), suggest the costs of running NPAC could be as low as $10-$20mm per year and that it is technologically feasible for a number of providers.

Timeline/Key Events in this Procurement Process

Below is a brief synopsis of the key events in this procurement process as well as some of my reaction to the events in italics.  Please note, the italicized text represent my opinion only, and people should do their own research and think for themselves.  This is really where things get interesting.  I think it is fair to say that this process has not been the same easy renewal enjoyed by NSR in prior years.

• Original bids were due in mid April of 2013 with an expected decision by September 20^th, 2013…the deadline to submit bids was extended at the last minute, presumably to allow more bids.  Final decision was expected by January 20^th, 2014.
• In August 2013, NAPM submitted a “best and final” request for bids.  This was not expected, but clearly they were looking for more competitive pricing.
• NSR, on their Q4 earnings call in late January, 2014 explained that shortly after submitting a bid during this best and final process, they submitted another unsolicited bid
  • This bid was not reviewed by NAPM and was sent back unopened
  • NSR also revealed that their CEO, Lisa Hook, had a conference call with the FCC Chairmen to discuss the unopened bid/process.  FCC Chairmen involvement in this matter seems unusual, and  NSR’s attempt to go above the committee deciding the contract seems unusual
  • NSR, in response to questions about why they would send another bid after the deadline, suggested that everyone in the process can “sharpen their pencils on value” and that another round of bidding was great for everyone.
    • Why send an unsolicited bid after the deadline that you publicly announce will be at a lower price unless you thought you had lost?

• NSR has now publicly called for another round of bidding and submitted filings suggesting that it was reasonable to think another round of bidding was coming after the “best and final offer” request.  Please read that line again…does that sound reasonable?
  • Secondly, NSR claims another round of bidding is great for everyone involved.  Really?  If I am Telcordia and it seems obvious NSR is scared…do I really want another round of bidding?
  • Finally, from the RFP: “Respondents may not request an opportunity to submit a best and final offer and no Respondent shall be considered to be entitled to have the NAPM LLC FoNPAC request that it submit a best and final offer.”
  • This is all relevant information should NSR try to legally challenge any contract decision.
• NSR has argued that it is technologically superior
  • The RFP addresses technology.
• NSR has also essentially threatened legal action now against the FCC
  • This seems like an incredibly desperate move
• NSR is now asking for new public comment on the RFP, a new bidding process, and a delayed decision
  • Telcordia, in their reply to the NSR request, highlight how NSR was actually behind the new RFP, and supported the process the whole way,
    • Why would NSR all of a sudden flip and say the RFP needs work unless they were worried?
• In the most recent show of desperation, NSR has filed third party whitepapers with the FCC, and took out a full-page advertisement in the Washington Post.
• NSR CEO recently sent another letter to NANC (available on NSR’s webpage), essentially asking for another round of bidding and offering an extension of 3 months in exchange for a $50mm discount (which equates to a 40% annual price cut).
• NANC met in a closed-door meeting on March 26^th, presumably to vote on the recommendations of NAPM.
• Thus far, there is nothing that suggests NSR is going to get another round of bidding.
• Final decision by the FCC is expected by May 6^th, 2014.

Basically nothing about this process has been normal.  The deadlines have all been pushed to allow more bids and time to decide, they requested a best and final round, and NAPM did not even open NSR’s unsolicited bid.  This seems to suggest they are thinking hard about this and there is a very real chance of meaningful price cuts, a split contract, or a change in vendor altogether.

It is important to stress that we won’t know for sure until the contract is decided.  The FCC, NANC, and NAPM can do whatever they want.  But, this mosaic doesn’t exactly inspire confidence in NSR winning the contract without severe price cuts at the very best. Big picture, NSR’s actions are looking increasingly desperate.  Certainly, this time the Company looks like they are much more scared about the prospect of keeping the contract or continuing with such a lofty margin. 

In terms of the stock, I think there are three major misconceptions which are keeping the stock at a higher than fair (in my opinion) level:

Misconception 1 – NSR won’t lose the contract and price cuts won’t be that bad if they are reduced

• I think the timeline above is enough evidence that this is not the same rubber stamped process that it has been in the past
• As already discussed, the last few times NSR has renewed the contract, pricing was adjusted down by 20% with inflationary escalators in the outer years.  Analysts seem to be anchored to this methodology, but how can the outcome this time be any better than that?
• Analysts seem to believe that NSR will take a price cut, but then have price escalators in line with historical precedent.  Nothing about this is like previous history…this is the FIRST time the contract has been competitively re-bid.
• In the actual RFP document, responders are instructed to submit a bid with no escalators.  So analysts are either not paying attention, or have decided that responders to this RFP will simply ignore the instructions?  Here is the text from the RFP:  “The pricing model will be an annual fixed fee with no annual price escalators, no transaction volume floor, no transaction volume ceiling, and no recovery of any unpaid User invoices from the rest of the industry.”

 

Game Theory?

• An interesting logical argument exists around NSR’s request for another round of bidding to provide better value.
  • If NSR had already won, wouldn’t NAPM, who runs the process and knows that they’ve awarded the contract to NSR, allow for another round of bidding to get better pricing?  Wouldn’t they be crazy not to, considering that the winner (NSR) would be telling them they can give them a better price publicly and saying they can “sharpen their pencils on value”?

   

Misconception 2 – Even if there is a price cut or they lose the contract, it won’t be that bad for them

• Analysts and investors are underestimating just how profitable the NPAC contract is for NSR. 
• Analysts frequently get the impact of pricing wrong, and I believe this is no different.  I think the analysis on how much the contract contributes is very clear, and it is very telling that NSR stopped disclosing this now that people are talking about it more.  In the case where they lose the contract entirely, I think it potentially wipes out all of NSR’s operating profit and actually results in negative GAAP earnings.
• This is likely to be the biggest debate post the contract award.  If they lose the contract or suffer a significant pricing cut and the stock doesn’t adjust properly, that may very well provide another opportunity for investors.

 

Misconception 3 – Who cares, even if they lose the contract, they have this large buyback and will buy their way out of the stock price problem

• With what cash flow?
  • Running some simple numbers, if the contract is lost completely, I estimate NSR will have to cut at least $122mm of costs by 2016 to be EBIT breakeven.  That is an enormous amount of costs versus the roughly $400mm of corporate costs that I estimate they will have by then.  While D&A would fall and stock comp would go lower, remember this is required simply to be GAAP EBIT breakeven.
  • If they lose this contract, the debt becomes a much bigger issue.  The Company’s 2013 10-K had another interesting tidbit…they drew another $175mm on their revolver, which we now know was partially to fund an acquisition.  But, this is a business with roughly $30-$35mm of annual interest expense.  The loss of the contract could temporarily lead to negative GAAP earnings and de minimis adjusted EPS (which adds back stock comp and amortization.)  I don’t think the debt service would be in jeopardy assuming they are able to dramatically lower fixed costs, but certainly, the risk profile of the debt would change substantially.

 

Valuation

When thinking about the valuation, I like to think about three major scenarios and two primary valuation methodologies.

Scenarios

• Scenario 1 - NSR experiences a 30% price cut to the contract, with no escalators (per the RFP).  Note this price reduction is actually lower than what is implied by the Company’s offer in their latest “extension” for 3 months.  $10mm of cost cuts.
• Scenario 2 – NSR experiences a price cut of 50% or loses regions (out of 7 in a split decision) in a competitive bid process such that the overall effect is little change in cost structure and a 50% reduction in price.  $20mm of cost cuts.
• Scenario 3 – NSR loses the contract entirely.  Cash cost cuts of nearly $125mm are taken during 2015 to offset the lost contract. 

Methodology

• Methodology 1 - Calculate earnings under the three scenarios and then applying a “fair” multiple of the lower run-rate.  It is hard for me to imagine that this stock will get a reasonable multiple under any of these scenarios, because going forward there will be little growth and the constant risk that the contract gets reset lower in the future.  I will use 14x a number that includes stock comp, which I think is generous for a business constantly subject to repricing.
• Methodology 2 - A DCF of the contract + 9x the EBITDA of the remaining businesses.  I’ll just use 2016 EBITDA and I won’t discount it back to be conservative.  5% discount rate and 5x terminal FCF multiple.

Output

Again, these are my estimates only.  I feel very comfortable with the variable impacts of pricing/losing the contract.  People can decide for themselves how much in cost cuts can be achieved (if necessary).  The Company was pretty successful with some cuts the last time around, but I expect this time to be much more severe.  The most significant thing is that it seems cost cuts are required to show meaningful profitability.

I will refrain from giving probabilities here, but to me it seems like Scenario 2 and Scenario 3 are far more likely at this point than Scenario 1.  Remember again that Scenario 3 assumes a significant amount of cash costs that are immediately cut from the business.  These valuation scenarios incorporate those cost cuts.  For what it is worth, most analysts I’ve spoken to think the stock goes to $16-$17 if they lose the contract.  I believe Goldman has published an $18ish fair value.  But as I already laid out above, I do not believe the analysts are calculating NPAC profitability correctly.

Conclusion

Obviously it is impossible to know if they will lose completely or where this will settle out, but it seems clear this is not the same easy process that they’ve gone through in prior years.  There are enough negative data points, from even NSR, that suggests they are very worried and that this contract could be split or even given to somebody else entirely.  It seems hard to believe that NSR will enjoy their lofty margins when this contract process is completed.  Based on today’s price, it still seems like the market is discounting too rosy of a scenario and the short has optionality on the “black swan” event that the Company loses the contract entirely.  In the scenario where the contract is renewed at 30% pricing cuts and no escalators, the stock fair value in our opinion is only about 10% higher than today.

 

Risks

 

• Contract could be awarded to NSR on favorable terms
• Delay in the process favors NSR.  Transitions take time, so the longer this drags out the more likely it will simply be given back to NSR.  A contract extension is also a lot of incremental free cash flow to NSR.

• Contract decision expected by May 6^th, 2014.