NeuStar represents the opportunity to invest in a firm that possesses pseudo-monopoly status; is largely insulated from economic fluctuations and seasonality; holds relatively long-term government contracts; enjoys high structural barriers to entry, which include switching costs for customers that are enormous; and is vitally important to the second-by-second stability of the telecommunications systems of North America.

 

The world of technology, and especially old technology, is usually a zero-sum game.  Simplifying and enhancing one user’s experience involves managing exponential complexity elsewhere in the value chain.  NeuStar was born out of the desire to give consumers “number portability.”  For those unfamiliar with the industry, it was not too long ago that there only existed a finite set of phone carriers.  That wall fell, and resulted in tremendous telecom competition—from cable companies to the likes of Vonage, etc., today.  A second step in giving users choice was the ability to “port” their phone numbers.  Thus, if customers have Verizon Wireless today and want to sign up for say the new iPhone at AT&T, they can take their numbers with them—the numbers are “portable.”  That portability implies that phone routing evolved from using static routing tables to dynamic ones.

 

NeuStar’s business is managing complexity in the “system.”  As telecom converges from different sources (VoIP, cable, mobile, etc.) and we `introduce an increasing number of elements in the systems (SMS, video, IM, etc.), complexity increases exponentially. It’s this ever-increasing level of complexity that creates a lasting moat around NeuStar’s critical, recurring revenue model.

 

 

Twenty years ago, Ma Bell dominated the U.S. telecommunications industry.  After the Bell break up, it was decided that all phone number assignments would then be fixedly divided amongst the various, new communications service providers (CSPs) that emerged—each with its own distinct network.  For example, all numbers that began with “212-555-XXXX” might have been Verizon’s responsibility, while those with “215-777-XXXX” might have been AT&T’s.  One of the advantages of structuring the industry as such was the increased ease of processing a call from, for instance, a “212-555-XXXX” number to a “215-777-XXXX” number.  Though they had different networks and systems in place, Verizon and AT&T knew from which CSP each call was coming from, and to which CSP each call was supposed to be forwarded.

 

Moreover, CSPs needed to know the source and destination not only for routing, but also for billing.  In addition to routing and billing, it was also necessary to verify that the source was really who s/he claimed to be (authentication), otherwise billing would flawed.  So CSPs needed routing, billing, and authentication just to provide number portability.  Furthermore, it is important to remember that the same logic applies for SMS messages, data transfers, etc.  With a legacy phone network using an addressing scheme that was designed to be static sitting on top of a network that is inherently dynamic and now fragmented, there needed to be a hub to manage or “clear” these changes.

 

That clearinghouse had to be “neutral”—unaffiliated with any telecom service provider.  NeuStar filled this critical void.

 

 

NeuStar first began operations as the Communications Industry Services (CIS) division under Lockheed Martin in 1996.  On October 9, 1997, Lockheed was officially designated the North American Numbering Plan Administrator (NANPA), “an impartial numbering administrator [that makes] telecommunications numbering available on an equitable basis.”

 

The “impartial” bit is very important—the NANPA was required by statute and regulations to administer services in a “fair, unbiased, and non-discriminatory manner,” and could not be “aligned with any particular telecommunications industry segment.”  To me what this means is that anyone that potentially has the capability to be a competitor (e.g., AT&T) would be restricted from doing so.

 

In 1998 Lockheed announced its intentions to acquire Comsat Government Services, a wholly owned Comsat subsidiary at the time, “to facilitate the strategic aims of Lockheed Martin’s newly formed Global Telecommunications subsidiary.”

 

Because of the likely conflict of interests that would arise between Lockheed’s CIS arm and its expanding Global Telecom group, Lockheed had originally planned to directly sell the division to Warburg Pincus.  However, the FCC did not approve of this move due to (again) neutrality violations—Warburg had substantial telecom holdings at the time.  Thus, ultimately Lockheed ended up deciding to divest CIS to a newly organized corporation (i.e., NeuStar) and Warburg.  A dual class voting structure allowed the deal to be consummated within Warburg.

 

 

After the acquisition was completed in November 1999, NeuStar was essentially an independent, unaffiliated entity—the ideal, centralized clearinghouse administrator for the government and CSPs.

 

Jeffrey Ganek has served as NeuStar’s Chairman and CEO ever since the 1999 acquisition.  And even before then, he was Senior VP and Managing Director of Lockheed CIS from 1999 until the divestiture.  Ganek has built and grown the organization since inception. The management team is by all measures honest, forthright and focused on delivering shareholder value.  I think their investor presentation off NeuStar’s website is an excellent resource to learn about the businesses, capital structure, and future prospects of the company:

 

 

NeuStar’s business is broken into three primary business lines.

 

1)       Addressing

 

NeuStar maintains the authoritative database of North American telephone numbering resources.  In other words, NeuStar is the agency responsible for assigning, for example, “212-333-XXXX” numbers to Sprint, “212-222-XXXX” numbers to T-Mobile, etc., and other similar allocation services.  As CSPs register new clients, they need unused phone numbers to assign to those clients.  NeuStar is the entity carriers turn to when they require such addressing services.

 

2)       Interoperability

 

This is the piece of the business that facilitates number portability, as mentioned previously.  With the advent of multiple CSPs after Bell’s dissemination, the structure of the telecommunications industry had to adapt to the new environment.  Before number portability, one could only switch service providers by changing his/her phone number.  Because this was extremely inconvenient for the general public, the government decided to mandate number portability in the 1990s.  Now, with portability, one is able today to buy a new iPhone and still retain an original Verizon Wireless number.  NeuStar’s interoperability services ensure that this is possible.  These services allow carriers to query NeuStar’s database, route calls appropriately, and handle billing and other necessary functions for one carrier to “interoperate” with another carrier.

 

3)       Network Infrastructure

 

Constant changes in the communications service industry require providers to make frequent and extensive changes in their own network infrastructure.  NeuStar manages carrier vendor changes in a centralized fashion.  In other words, instead of a CSP reporting a change to all carriers, the CSP would report the change to NeuStar, and NeuStar would then propagate the change for the entire industry.  These changes may result from technology upgrades, network modification and optimization, or reorganization of network traffic.  Imagine there was a cable cut on a CSP infrastructure and it was necessary to reroute the communications trunk.  The CSP would report the change to NeuStar, and NeuStar would deal with communicating that change to all other carriers.  There is a very good slide in the investor relations presentation that illustrates this.

 

All three of NeuStar’s businesses are intimately intertwined.  NeuStar is the authoritative “clearinghouse” that allows for a competitive telecom services environment in the United States.

 

 

NeuStar’s revenue is all fee-based, and these fees are determined by long-term and renewable government contracts.  Think of the firm as a regulated utility whose cost structure is far more favorable.  I will spare you the Porter analysis, but suffice to say that while NeuStar is dependent on its government mandates, this is one boat no one in the country would want to rock.

 

In providing clearinghouse services the FCC cares about reliability—NOT cost.  The relative cost savings to the telecom companies is inconsequential to the end users of telecom services, but the inherent risk of a service disruption on those users is not.

 

 

I think the numbers speak for themselves.

 

*Pre-tax ROIC = EBIT / Tangible Capital Employed

 

 

Regarding risk, the greatest worry to the story is NeuStar’s large dependence on contracts derived from number portability.

 

 

 

From a realistic standpoint, it is fairly intuitive to see why NeuStar has, contractually, a very stable market position. 

 

What would happen if the government decided to prematurely terminate NeuStar’s contracts?  Chaos would honestly overwhelm the North American continent.  People talk about “too big to fail” with Fannie and Lehman…  Well, NeuStar is too important to ever fail.  The success of each telephone call and SMS message relies on NeuStar; all of us depend on NeuStar every single day.  Furthermore, NeuStar has developed such a veteran expertise in this highly specialized field over the years (since the very beginning, actually) that giving another firm the job would be akin to asking a midwife to lead a surgical brain operation.  Money, time, efficiency, and societal stability would all be sacrificed.  I think the policymakers have their hands full at the moment with the banks.

 

Most people have and will never hear about NeuStar, and as an investor, I hope it stays that way because the day they do is the day NeuStar probably dropped the ball and the government decided to scrutinize the company’s monopoly status.

 

In short, I think the risk of non-renewal of these contracts is more contractual than real.

 

 

The company has grown fast and shows no signs of abating.  Between acquisitions in related spaces in which one can immediately fold in the high cost structure on to the firm’s already in place data centers, it is possible to do very accretive transactions.  As more and more countries look to provide number portability, NeuStar is the entity they turn to for those services.  While the obvious benefits of earnings growth exist, I think diversification of the revenue base is even more important.

 

The very important option to the NeuStar business is their hosted IM business.  SMS is a huge business and IM on the phone represents an equally important growth opportunity should it take off.  NeuStar has a hosted platform for offering this service to operators, and I not only think that this could meaningfully change things, but also feel that the current stock price provides this very valuable option for free.  It has the same dynamic as the firm’s core business—that is, connect users via IM on different platforms, such as Yahoo, Google, MSN, etc.  Complexity means money for NeuStar.

 

In approaching valuation we looked at a draconian low case where the company virtually comes to a standstill in terms of growth. If you assume that and a low 9X EBIT multiple in three years. It is clear that downside is virtually non-existent. Our high case is actually one where we come in line with guidance but still assume no stock-buy backs, or similarly accretive transactions. We would argue that a business with those growth levels, competitive position, and economics deserves at least 11X EBIT multiple  but under these assumptions you get a double on the stock, a 3 year IRR of 27% with multiple free-options to move well beyond that (stock-buybacks, acquisitions, IM platform growth, multiple expansion etc)

This is an exceptional business, as measured by pre-tax ROIC, that exhibits the economics of a software model but with a recurring revenue stream.  It is still growing robustly as management is able to re-deploy the firm’s excess capital in an accretive manner through global expansion, tuck-in acquisition, and material share buybacks—all under the umbrella of a highly protected market position. I would highly recommend looking at the recent presentation by the CEO at the Wedbush Morgan presentation, it really highlights the business, the future opportunity, and I think the prudent capital allocation mindset of management.

 

NeuStar is very conservatively capitalized, and earnings growth coupled with stock buybacks and multiple expansion should lead to very high IRR’s over the next three years with little realistic downside.  NeuStar is both safe and cheap.

·         Customer concentration

·         Non-renewal of contract(s)

·         System failure that increases risk on non-renewal