Description

Risks: First a few negatives (bad for the short case): The stock is hard (and admittedly costly) to borrow.   The NPAC transition process has been slow, which has allowed Neustar an ongoing infusion of cash.  There is a risk of ongoing legal challenges or technical hurdles that could further delay this process.  This "short" thesis entails risk and isn't for everyone, but for those who would like to dig into a shorting opportunity, please read on.

History: We began following Neustar in 2013 and shorted the stock in early 2014 (in the low-to-mid 30s), ultimately covering our position in June 2014 for a modest gain.  We have since been on the sidelines watching this play out.  Kudos to Wolverine03 and Jelly621 for the good work covering many of the key points.  Since many points have already been covered, I will attempt to contribute a few additive notes for context.  (Disclaimer: Since I'm generally not in the "shorting" business, I'll admit to having followed Neustar less closely in recent months -- but I think the points below will still ring true.)

Short Case:

A. Management has a track record of poor decision-making.  

(1) Poor results from NPAC bid. Management inexplicably took the risk of losing the extremely profitable NPAC contract -- which based on my research in 2013 should cost ~$50M-100M to operate while producing ~$500M of revenue -- by holding out for too much of a premium (some sources estimate annual operational costs for this $500M+ revenue machine at $10-20M).  When management realized they had lost the bid (and therefore the lion's share of the company's earnings), they still continued to repurchase shares at high prices (over $50/share). 

(2) Questionable M&A actions.  In recent years, management has purchased a number of businesses at unattractive prices.  Explaining that they are "lousy at spending in R&D", they have instead chosen to grow via acquisition -- paying high (revenue) multiples for businesses with limited profits.

(3) Unenviable CEO track-record.  The CEO's prior track record has included a number of other debacles -- from AOL to SunRocket -- and listening to her speak at conferences (or on earnings calls) provides little assurance that she has coherent ideas aimed at creating value.

B. Management has track record of poor shareholder disclosure

(1) Management made a number of disingenuous statements related to the NPAC contract loss.  To start with an obvious one: the CEO claimed that they "always assumed" there would be multiple rounds AFTER the "best and final offer" (huh?), and that Neustar HADN'T learned any confidential information about the bidding process when they began submitting unsolicited lower bid offers.  Throughout the process, the CEO repeatedly talked about how she didn't have "any idea" what iConectiv would be building, and that maybe it would take "three weeks" to port a number.  (Of course, the tech specs make it exactly clear what is to be built -- which is a system with real-time porting, essentially identical to Neustar's).  

(2) Managment has been disingenuous about the profitability of the NPAC.  Most notably, Neustar stopped "breaking out" the NPAC ("carrier services") profits and has lumped a variety of disparate services together (for reporting purposes) and then claiming they're unable to break out the operating profits of individual segments.  (Why report as a single segment and be so opaque about your business?  Perhaps to obscure the fact that the highly-profitable NPAC business--which you are losing--has been "subsidizing" the other segments.)   See the Latham Watkins Letter for more detail.

(3) Management spends a lot of time making nonsensical statements or meaningless disclosures.  For example, management emphasizes that they handle billions of DNS queries per day and help route millions of calls.  Neustar does have good technology, but they also aggrandize their role.  (They don't actually route my call -- they just maintain the master list that maps phone numbers to switches.)  And the large numbers that Neustar cites aren't particularly revolutionary.  (My laptop computer has a processor that can perform over 4 billion cycles per second and make database updates to millions of rows... But it's still a commodity, and I don't walk around acting like it's bleeding edge technology.)

C.  Catalysts: NPAC loss & spinoff disclosure.  The financials will eventually become clearer within 6-12 months when Neustar submits regulatory filings for their spinoff.   How profitable is the NPAC?  A lot has been written about this (see the prior writeups and the Latham Watkins letter linked above.)  However, my quick (back-of-the-envelope) estimates suggest that Neustar is unprofitable without the NPAC.   Quick math: Neustar 2015 EBIT was ~$283M.  If we add back $67M of amortization of intangibles, EBITA is $350M.  There are a number of reasons to believe that virtually all of this $350M came from the NPAC, which suggests that the other businesses are unprofitable.

(1) Based on iConectiv's bid.  Neustar NPAC revenues in 2015 were roughly ~$500M.  By comparison, iConectiv's bid was roughly $1B over 7 years (or less than $150M/year)... If iConectiv can build the whole thing AND operate it for under $150M, then shouldn't the incumbent be able to do something similar?  (This IS a database after all... The operational costs are reasonably low).  But if we assume that Neustar somehow spends $150M per year to operate the thing, they should still have $350 EBIT contribution from the NPAC.

(2) Based on Neustar's prior segment disclosures.  In 2011, Neustar disclosed NPAC revenues of $385M.  The segment had an 87% contribution margin; it's fair to assume that the NPAC margin was slightly higher than the segment average.  If we assume a 90% contribution margin for the NPAC, that implies just under $350M of contribution.  Now suppose that we burden the NPAC with half (an overestimate) of the costs of the shared company expenses (e.g. half the cost of revenue, depreciation & amortization, sales, R&D, and G&A expense).  That's probably overly punitive, since the NPAC is a relatively "automatic" database at this point.  But IF we burnden the NPAC's $350M contribution with the 50% ($103M) of shared expenses, it still produces $247M of EBIT.  If operational costs have not meaningfully since 2011, we'd expect that $247M of EBIT plus another $115M from the fee increases (since 2015 NPAC revenues were $500M, not $385M).  So we'd expect over $350M of EBIT from the NPAC, even if operational costs have risen by a few percentage points since 2011.

(3) Based on common sense.  In my interviews a year and a half ago with experts, most of them estimated that a "lean" cost of operation for the NPAC would be $10-20MM, although they could envision Neustar managing to spend $50M to $100M, if costs were really bloated.  We looked at hosting costs for their backup hosted datacenter (in NC, if memory serves), and estimated them at under $10M.  Add another 40 engineers at $300K each, and you've spent another $12M.  Spend another $10M on equipment... We're only up to $30M so far.  (Recall that the "list" Neustar keeps is not particularly long by database standards, and it's just many millions of rows for roughly a dozen fields -- data that could easily be stored on my laptop.)  It's just really hard to imagine how anyone could manage to spend $100M on hosting this database.  But if their costs are $100M, that leaves $400M of EBIT from the NPAC -- which suggests that the rest of the company is unprofitable.

So to sum it up: I think Neustar (ex-NPAC) is unprofitable as it's currently being run.  And although there's a chance that they could retain the NPAC, it looks pretty unlikely.

How will Neustar proceed?  I imagine that (related to the spinoff), Neustar will have to restructure, dramatically cut costs, and create a plan for profitability.  Perhaps a great management team could turn this ship around, but I don't have a lot of confidence in this crew.  They've made misstep after misstep.  They've arguably destroyed value by losing the NPAC bid, making high-priced acquisitions of unprofitable companies, and repurchasing their own stock when they knew it was overvalued.

I imagine that (related to the spinoff), Neustar will have to restructure, dramatically cut costs, and create a plan for profitability.  Perhaps a great managment team could turn this ship around, but I don't have a lot of confidence in this crew.  They've made misstep after misstep.  They've arguably destroyed some value by losing the NPAC bid and by making high-priced acquisitions of unprofitable companies.

I'm not sure what equity value to assign to two businesses: one that is unprofitable (Information Services) and a second (NPAC/OMS) that is losing the vast majority of its revenue and operating income... But I'd put it somewhere south of $15/share.

Catalyst

Loss of NPAC contract; Company separation