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This is written with serious investors in mind, though sometimes they're just drafts in progress. I'm a former reporter, private investigator and institutional equity analyst who digs deep to find niche undervalued and undiscovered securities. I manage money for individuals, institutions and family offices via my business Long Cast Advisers. This blog is part decision-diary, part investment observations and part general musings about Philadelphia sports. It should not be viewed as a solicitation for business or a recommendation to buy or sell securities.

Monday, April 22, 2013

Bearish on NSR; Buying the Oct $40 Puts

NeuStar is a technology services company focused on telecommunications and internet infrastructure. 

With 68M shares outstanding and a share price of roughly $43, it has a market cap of $2.9B. After adding in $577M in long term debt, $8M in capital leases, and netting out $347M in cash, it has an enterprise value of $3.2B. In 2012 it reported total revenues of $831M, EBITDA of $370M and EPS of $2.30. 

On a forward looking basis, using published analyst expectations, it is trading at a roughly 25% discount to its peer group: 13x NTM EPS vs the peer group of roughly 18x, and 8.5x EBITDA vs the peer group of about 11x. 

The peer group discount reflects concerns about a large contract NSR holds with the FCC that is being competitively bid for the first time since 1997. The contract is for the management of the databases that enable telephone number portability (or "porting")  in the US and Canada. Local number portability allows us to change phones and phone companies but keep our phone numbers, either landline or wireless. 

Porting is mandated by the Telecommunications Act of 1996. In 1997, NSR was awarded its initial contract to manage porting databases in three of the seven US regions (corresponding to the seven  RBOCs). Perot Systems was awarded the other four regions plus Canada, but issues with its system implementation led the FCC to give the entire management contract to NSR. It has held a monopoly on the contract ever since, despite objections from competitors. 

The current contract expires in June 2015. 

An RFP has been issued inviting bids to manage the contract. The North American Portability Management LLC (NAPM) - the industry group overseeing the RFP - is expected to make a recommendation to the FCC in August 5, 2013 with the FCC approval expected in September 20, 2013. 

Given the timing and uncertainty with the outcome, we anticipate some volatility around the stock. It is likely that NSR either maintains its existing monopoly, that the contract will be broken up into pieces some of which NSR will maintain, that the incumbent will be removed from the contract, or that the contract is delayed. Given recent moves by the FCC to increase innovation and competition, we do not expect that monopoly will be maintained. 

The size of the contract is material to NSR, which becomes apparent once we look at the segment reporting structure. There are three segments: 

1) Carrier Services. This includes "Numbering Services" (the LNP contract), telecommunications "Order Management Services" and "IP Services", which manages the interconnects between public switched networks and IP address.

2) Enterprise services. This is its "Internet infrastructure" and "Registry" services business through which it provides Domain Name System (DNS), geolocation and website performance monitoring solutions as well as registries for the .biz, .us, .co, .tel and .travel top-level domains, and the gateways for China’s .cn and Taiwan’s .tw country-code top-level domains. 

3) Information services. This segment was created by the 2011 acquisition of TARGUSinfo. It provides Caller ID, local search and targeted advertising / lead generation. TARGUS was acquired for $650M in cash. At the time of the acquisition, it had TTM revenues of $149M and 45% EBITDA margins. 

While the infrastructure aspects of the company are attractive, all this is overwhelmed by the size of the LNP contract; it contributed $418M in revenues in 2012. This reflects 50% of total revenues (after including the a full year of the TARGUSinfo acquisition) and 83% of carrier services segment revenues. 

Carrier Services segment EBIT margins have been 87% for the last two years. With more than 80% of that segment's revenues from the LNP project, it is safe to assume that LNP contract margins are at least 87%. Arithmetically, this implies that the contract contributes $365M in segment EBIT in 2012, or 62% of total segment EBIT before unallocated expenses. In short, it is a significant contributor to profitability. 

Segment EBIT excludes unallocated corporate costs. If we conservatively reduced these unallocated costs by 50% - assuming (most conservatively) that they are all variable costs that go away if the contract were removed (which of course they are not) - we would be left with $115M in EBITDA excluding the LNP contract. 

The balance sheet of course would not change without the contract though forward cash flows will diminsh. Leaving Enterprise Value as is and applying the peer group multiple of 11x to the remaining EBITDA, then deducting the net debt implies a back of the envelope value of $15 / share for the non-LNP related business and therefore $30 for the contract alone. 

The market however has likely already adjusted for its expectations. At the same 11x multiple, the contract should be worth $37. In other words, the market through its valuing mechanism has already adjusted expectations down by ~20%. 

Our bet is that the market isn't making enough of an adjustment to account for the loss of revenues if the monopoly is broken because not only will revenues go away but we expect a decrease in margins that are competed away as well. And remember this analysis accounts for the most conservative expectations of unallocated costs.   

Another approach using a DCF analysis gets us to $35 / share value. Though I understand the value of DCF as a supposed objective artbiter of value, I tend to hate using it - too many assumptions on top of forecast assumptions - but it is an industry practice. This analysis assumes a 50% reduction in revenues from the contract beginning in 2016 with a 25% erosion in contract EBIT margins competed away but 10% growth and stable margins in the other business segments. It also uses an 8% WACC. 

Ostensibly, the acquisition of TARGUSinfo was an attempt to diversify revenues sources away from this one major contract. A wise decision. While there is always room for additional wisdom, there is little room for additional diversification. The company has borrowed 90% of equity, 48% of total capitalization and 1.6x annualized EBITDA (and even more if most of that EBITDA goes away). 

All of this leads us to make a negative call on NSR by buying the out of the money Oct $40 puts for $2.70. While shorting the stock obviates the time factor risk (ie if there's a delay in the decision) the option strategy limits my capital outlay and significantly levers up the potential % return. 

LNP = Local number portability. The system that enables end users to keep their telephone numbers when switching from one communications service provider to another 

NANP = North American Numbering Plan. The system for managing Local Number Portability

North American Portability Management LLC ("NAPM") -  industry group that represents all telecommunications service providers in the United States and administers the contract. 

NPAC = Number Portability Administration Center. The name of Neustar's database.  

History: Neustar was spun off from LMT in 1999 in a forced sale to Warburg, which brought it public in 2005. 

tidbits from the 10K: 
"We were awarded the contracts to administer these services in open and competitive procurement processes in which we competed against companies including Accenture plc, Computer Sciences Corporation, Hewlett-Packard Company, International Business Machines Corporation, or IBM, Noblis, Inc., Nortel Networks Corporation, Pearson Education, Inc., Perot Systems Corporation, Telcordia Technologies, Inc., which is now a wholly-owned subsidiary of LM Ericsson Telephone Company, and VeriSign, Inc. We have renewed or extended the term of several of these contracts since they were first awarded to us. Prior to the expiration of our contracts in June 2015 to provide NPAC Services in the United States, our competitors may submit proposals to replace us as the provider of the services covered by these contracts. In addition, NAPM has initiated a selection process for the administration of NPAC services upon the expiration of our existing NPAC contracts in June 2015."

"In January 2009, we amended our seven regional contracts with NAPM to provide for an annual fixed-fee pricing model under which the annual fixed fee, or Base Fee, was set at $340.0 million, $362.1 million, $385.6 million and $410.7 million in 2009, 2010, 2011 and 2012, respectively, and is subject to an annual price escalator of 6.5% in subsequent years." 

"On February 5, 2013, the NAPM released a Request for Proposal for the selection of the next local number portability administrator under new contracts that will take effect upon expiration of the current contracts. We will compete for these contracts and to remain as the local number portability administrator."

Golf and Investing; Belated Thought from the Masters

It's the small things and the boring work - reading public filings or practicing putting - that makes all the difference