NEUSTAR INC 0322B
July 27, 2010 - 1:02pm EST by
danconia755
2010 2011
Price: 23.10 EPS $1.48 $1.70
Shares Out. (in M): 75 P/E 17.1x 13.6x
Market Cap (in $M): 1,730 P/FCF 14.0x 11.0x
Net Debt (in $M): -336 EBIT 172 192
TEV ($): 1,340 TEV/EBIT 7.8x 7.0x

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Description

Neustar has a highly profitable, monopolistic position as a provider of clearinghouse services to Communications Service Providers (CSPs) in the U.S. Through the use of proprietary databases Neustar enables communication devices to connect seamlessly to complete voice or data communication. Virtually all CSPs must access Neustar's databases to be able to properly route a call a service for which Neustar charges annual fees, creating unusual visibility, very limited competition, and very attractive profit margins. The Company has 65% of its revenues booked through 2015 and generates operating profits in excess of 34% and nearly $400 million in cash with no debt. In the past, Neustar's position had translated into slow steady growth, but growth may pick up significantly given Neustar's critical role in the Ultraviolet initiative from the Digital Entertainment Content Ecosystem (DECE) consortium and other initiatives centered around DNS services and cloud computing.

Any device that gets plugged into the network needs an identifier to be able to communicate with other devices. As an example, a smartphone that is able to place phone calls, send text messages, browse the Internet, and send and receive email needs an identifier for each one of those functions. Neustar's database is the receptacle for those identifiers. To be able to properly route a text message or phone call the CSP servicing the device must access a copy of Neustar's databases to find the identifier for the device or devices that are the recipients of the phone call, thereby making Neustar's databases essential for any type of communication. Besides connecting devices through disparate networks, all number portability in the U.S. and Canada is enabled by Neustar's databases. The annual fixed-fee contracts generate steady revenue as can be gleaned in the following paragraphs from Neustar's March 2010 10-Q:

The Company provides number portability administration center services (NPAC Services) which include wireline and wireless number portability, implementation of the allocation of pooled blocks of telephone numbers and network management services in the United States pursuant to seven contracts with North American Portability Management LLC (NAPM), an industry group that represents all telecommunications service providers in the United States. The aggregate fees for transactions processed under these contracts are determined by an annual fixed-fee pricing model under which the annual fixed-fee (Base Fee) was set at $340.0 million and $362.1 million in 2009 and 2010, respectively, and is subject to an annual price escalator of 6.5% in subsequent years. These contracts also provide for a fixed credit of $40.0 million in 2009, $25.0 million in 2010 and $5.0 million in 2011, which will be applied to reduce the Base Fee for the applicable year. Additional credits of up to $15.0 million annually in 2009, 2010 and 2011 may be earned if the customers under these contracts reach certain levels of aggregate telephone number inventories and adopts and implements certain IP fields and functionality. To the extent any available additional credits expire unused at the end of the year, they will be recognized in revenue at that time. The Company determines the fixed and determinable fee under these contracts on an annual basis at the beginning of each year and recognizes this fee on a straight-line basis over twelve months.

For 2009, the Company concluded that the fixed and determinable fee equaled $285.0 million, which represented the Base Fee of $340.0 million reduced by the $40.0 million fixed credit and $15.0 million of available additional credits. During 2009, the Company's carrier customers adopted and implemented the requisite IP fields and functionality, and as a result earned $7.5 million of the additional credits for each of 2009, 2010 and 2011. However, the customers did not reach the levels of aggregate telephone number inventories required to earn additional credits and as a result, the Company recognized $7.5 million of additional revenue in the fourth quarter of 2009. These contracts also enable the Company's customers to earn credits if the volume of transactions in a given year is above or below the contractually established volume range for that year. The determination of credits earned based on transaction volume is done annually at the end of the year and these credits are applied to the following year's invoices. There were no credits earned in 2009 by the Company's customers for transaction volumes above or below the contractually established volume range for 2009. For 2010, the fixed and determinable fee equals $322.1 million, which represents the Base Fee of $362.1 million, reduced by the $25.0 million fixed credit and $15.0 million of additional credits. The Company records the fixed and determinable fee as revenue earned in its Carrier Services operating segment.

 The amount of revenue derived under the Company's contracts with NAPM was approximately $74.1 million and $84.8 million for the three months ended March 31, 2009 and 2010, respectively.

The Company provides NPAC Services in Canada under its long-term contract with the Canadian LNP Consortium Inc. The Company recognizes revenue on a per-transaction fee basis as the services are performed.
The stable cash flows generated from the NPAC agreements for number portability and servicing in the U.S. and Canada have translated into a very attractive business model that throws off a lot of cash. Neustar currently has $5.69 a share in cash with no debt and generated $2.19 a share in free cash flow ($2.32 CFO) in 2009. Even in the Great Recession, revenues help up relatively well for Neustar, showcasing the inelastic demand for its services. A portion of the 2009 decline in revenues is also explained by a shift in the Neustar pricing model where the Company shifted from charging on per transaction to charging a fixed-fee model with credits assigned to CSPs that meet certain volume requirements and that adopt new IP fields that further bulk up Neustar's databases.
 
Neustar, Inc 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Earnings Model CY 06 CY 07 CY 08 CY 09 CY 10 CY 11 CY 12 CY 13 CY 14 CY 15
                     
(Three months ended)                    
                     
Gross margin 74.14% 77.88% 78.40% 76.42% 76.99% 76.50% 77.00% 76.50% 76.50% 76.50%
Revenue growth (yoy)   28.90% 13.90% -1.73% 8.97% 8.52% 4.80% 6.50% 6.50% 6.50%
Relevant Metrics                    
Statement of earnings                    
(In Thousands, except per share data) Actual Actual Actual Actual Estimate Estimate Estimate Estimate Estimate Estimate
Total Revenue 332,957 429,172 488,845 480,385 523,464 568,071 595,354 634,052 675,266 719,158
Percent of Revenue                    
Addressing 31.2% 25.6% 26.7% 27.9% n.a. n.a. n.a. n.a. n.a. n.a.
Interoperability 17.0% 14.4% 13.2% 12.2% n.a. n.a. n.a. n.a. n.a. n.a.
Infrastructure & other 51.9% 60.0% 60.1% 59.8% n.a. n.a. n.a. n.a. n.a. n.a.
Carrier Services (Reported Q1-2010 onwards) n.a. n.a. n.a.   77.7% 77.7% 77.1% 77.1% 77.1% 77.1%
Enterprise Services  (Reported Q1-2010 onwards) n.a. n.a. n.a.   22.3% 22.3% 22.9% 22.9% 22.9% 22.9%
Gross profit 246,851 334,224 383,256 367,125 403,015 434,574 458,423 485,050 516,578 550,156
GAAP gross profit 246,851 334,224 383,256 367,125 403,015 434,574 458,423 485,050 516,578 550,156
                     
Income (loss) from operations (EBIT) 122,623 149,646 69,106 167,558 172,442 192,046 203,768 222,756 246,415 279,993
GAAP operating income 122,623 149,646 69,106 167,558 172,442 192,046 203,768 222,756 246,415 279,993
Earnings (loss) before income taxes (EBT) 125,252 153,111 65,981 169,006 172,084 191,688 203,410 222,398 246,057 279,635
Income taxes    51,353    60,776    61,687    67,865 67,837 75,525 81,364 88,959 98,423 111,854
Net income before unusual charges 73,899 92,335 4,294 101,141 104,247 116,163 122,046 133,439 147,634 167,781
EPS before unusual charges (Basic) 1.02 1.21 0.06 1.36 1.40 1.55 1.62 1.77 1.95 2.20
EPS before unusual charges (Diluted) 0.94 1.16 0.06 1.34 1.38 1.53 1.60 1.74 1.92 2.17
Neustar is using its steady business to fund new ventures that leverage its networks expertise and position as a vital "cog" in the communications ecosystem. The venture we find the most interesting is managing the digital rights locker for the upcoming UltraViolet digital media technology by the Digital Entertainment Content Ecosystem (DECE). UltraViolet seeks to create an environment where buyers of media (movies, TV shows, etc.) store the content in the cloud and are able to access their content through any device. While the project and the timeline of launch by the end of 2010 seem ambitious, success seems likely since DECE members include heavy-hitters such as Adobe, Comcast, Best Buy, Intel, LG, Marvell, Microsoft, Sony Pictures, and Warner Brothers. Neustar, a DECE member, would act as a clearinghouse by maintaining a database which shows who can view what content and through what devices.
 
We do not view UltraViolet as a source of revenues in 2010 or the first half of 2011, but believe that this is the time investors can buy an option on project UltraViolet paying 2.7x EV/Sales and 7x EV/Forward EBIT. Even assuming no revenues ever materialize from UltraViolet or other new initiatives (an unlikely scenario), we view NSR as a gem due to its enviable market position, revenue visibility, profitability, and $336M in net cash (and growing $150M a year). We have a $48 price target which assumes 15x EV/ 2011 EBITDA and 4x EV/2015 EBITDA which is the end of the current NAPC contracts.

Catalyst

1. Steady adoption of smartphone devices which need identifiers to enable different functions (text-messaging, wireless phone calls, internet access, etc.)
2. Project UltraViolet driving fast-growing sales (from a small base) in the second half of 2011 as UltraViolet-licensed devices start hitting the shelves in preparation for the 2011 holiday season.
3. Compelling valuation and cash balance make it an attractive acquistion candidate.
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